October 2006

Double Vision Data

On Wednesday, October 25th, the Federal Open Market Committee (FOMC) decided to leave its targeted federal funds rate unchanged at 5 ¼%, as expected. In its press release, the FOMC sighted “Economic growth has slowed over the course of the year, partly reflecting a cooling of the housing market. Going forward, the economy seems likely to expand at a moderate pace.” With household debt near all-time highs, the health of the housing market and the consumer’s view therein will likely play a disproportionate role in consumer spending as we head into the holiday season and into 2007. The jury is still out with regard to sustainable economic growth or the probability of recession.

One of the big questions overhanging the market is at what pace will economic growth continue? In the U.S., the answer largely depends on the financial health of the consumer since consumption represents approximately two-thirds of Gross Domestic Product (GDP), or the value of all goods and services produced within a country for a specific period of time. The methodology for arriving at our GDP figure is [consumption + investment + government spending + net exports] and is issued by the U.S. Department of Commerce’s Bureau of Economic Analysis each quarter. On October 27th, the Commerce Department reported that third quarter GDP increased at a seasonally-adjusted 1.6% annual rate, down from a rate of 2.6% in the second quarter and a 5.6% rate in the first quarter. The latest reading marks the third consecutive drop in quarterly GDP and the lowest growth rate in three years. One bright spot in the latest report is a 3.1% increase in consumer spending, following a 2.6% rise in the second quarter. It is widely understood that economic growth is slowing on the back of the interest-sensitive consumers and a softening of the housing market. The risks going forward are that lowered business confidence slows capital investment in coming quarters and, subsequently, this will lead to job insecurity and a drop in future consumer spending. Third quarter corporate profits, to date, have been a plus for the stock market with stocks in the S&P 500 showing a year-over-year gain of more than 15% on average. Approximately, a third of the companies have yet to announce.

Adding to a positive view on the economy, at least from the consumer side, have been a pullback in energy and commodity prices and a milder softening of the housing market to date, than many analysts have predicted. We believe a more pronounced downturn in the residential housing market will be forthcoming. Some in the financial field, fearing an overly tight monetary policy bringing about a recession have called for the Fed to lower interest rates in the coming months. However, with our major trading partners leaning toward tightening monetary policy at the current time, the Fed finds itself in the all too familiar Catch-22 position – on one hand the need to maintain lower rates for continued economic growth and, on the other, to support the U.S. dollar in foreign exchange markets with more attractive interest rates. The U.S. remains reliant on the inflow of foreign capital in order to finance current expenditures and our comfortable way-of-life. With talk bubbling from time to time from different Central Banks around the world of further diversifying their reserves out of dollars and into other assets, i.e. gold, euro, etc., support of the U.S. dollar by the Federal Reserve (or at least the appearance of dollar support) becomes all that much more necessary going forward. The Fed stood pat on interest rates at its October 25th announcement allowing the economy to further digest the previous seventeen interest rate increases.

On October 17th, the U.S. Department of Labor reported the September preliminary figures for its Producer Price Index (PPI), or wholesale prices. Seasonally-adjusted producer prices of all finished goods fell 1.3% during September, following 0.1% increases in both of the previous two months, largely impacted by a record decline in energy prices. Excluding food and energy prices, core wholesale prices unexpectedly rose 0.6%, three times what the street was anticipating, on a surprise surge in motor vehicle prices during the month.

The Labor Department also reported the widely-watched Consumer Price Index (CPI) figure for September. The headline number decreased more than had been expected at 0.5% from the previous month, while the core rate of inflation increased, as expected, by 0.2% during September. As with producer prices, consumer prices were largely influenced by the sharp drop in energy prices, down 7.2% in September. On a year-over-year basis, consumer prices have risen 2.1% from September 2005. Core consumer prices are up 2.9% from year earlier levels, and notably above the Fed’s “comfort level” of approximately 1.5% to 2.0%.

In a separate report from the Federal Reserve, Industrial Production from the nation’s factories, mines and utilities fell 0.6% in September, marking the biggest decline in a year. In particular, manufacturing output fell 0.3%, mining output increased 0.7% and utility output dropped 4.4% in the period. Adding to the lessening of inflationary pressures argument was capacity utilization, which fell to 81.9% in September from 82.5% in the prior month.