WEEK OF DECEMBER 17, 2007—IS ECONOMY TOO HOT?

The holidays are bringing more Christmas cheer to the economy. Holiday shoppers are out in droves, in spite of the high gas prices. And so economists are revising fourth quarter growth estimates upward.

Year end figures show a U.S. economy that is red hot, rather than in danger of grinding to a halt. Not only are consumers spending as if there is no tomorrow, but industrial production is straining at full capacity and it is pushing up the inflation rate.

Retail sales, which account for half of all consumer purchases, surged 1.2 percent in November and are up 6.3 percent in 12 months. These are numbers reminiscent of boom times, and should raise 4^th quarter GDP growth to more than 2 percent from the 1 percent consensus forecast.

Industrial production is also growing, in part because of surging exports. Production is up 2.1 percent in one year, and operating at 0.5 percent above its 1972-2006 average capacity level, according to the Federal Reserve. ‘Real’, or after-inflation Gross Domestic Product has grown 2.8 percent in 12 months, which is close to its maximum growth potential.

This means supply bottlenecks, and bottlenecks mean higher prices. As a consequence, November wholesale (PPI) and retail (CPI) prices rose sharply, mostly due to scarcer gas and oil supplies. Producer prices are up 7.2 percent, and consumer prices have risen 4.3 percent in 12 months.

And, although home sales continue downward, the Federal Reserve reports that household wealth—the value of household assets minus liabilities—rose $625 billion in the third quarter. It is below the average $1 trillion increase of recent quarters, but still huge.

And disposable incomes and spending, a key indicator of economic health, continued upward in November. Real disposable incomes (after taxes and inflation are deducted) are actually exceeding 2006 levels.

This may explain why consumers still feel wealthy enough to continue spending, even though housing starts fell 3.7 percent in November. And though the Conference Board’s Index of Leading Economic Indicators (LEI) is down 1.2 percent in 6 months, its components are evenly balanced between strengths and weaknesses.

In addition, Martin Feldman, president of the National Bureau of Economic Research—the agency that determines the beginning and end of business cycles—recently said that the 4 indicators used to determine business cycles--employment, wholesale and retail sales, real personal income, and industrial production— indicate no oncoming recession. So, it looks like economic growth may continue to exceed everyone’s expectations!

Copyright © 2007

WEEK OF DECEMBER 17, 2007—IS FEDERAL RESERVE RIGHT?

The Federal Reserve Open Market Committee lowered its interest rates one-quarter percent, causing a stock market selloff. Why didn’t the Fed’s action cheer the markets? Because it believes there is no recession looming on the horizon, while Wall Street sees the danger of a recession next year. Therefore the rate drop disappointed investors and resulted in a flight to the safety of Treasury bonds. This means longer-term fixed rates could continue their recent descent.

The FOMC statement said, “Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks. Today's action, combined with the policy actions taken earlier, should help promote moderate growth over time.”

Part of the problem is the confusing signals put out by the markets. For instance,

the Mortgage Bankers Association put out a highly deceptive headline, “US Mortgage Foreclosures at Record High.” There were 1.69 percent of homeowners somewhere in the foreclosure process in Q3, while 5.59 percent of all mortgages were more than 30 days late on their mortgage payments.

Although this is clearly a sign that many borrowers are in trouble, 1 percent is the historical average for foreclosures of conventional loans, and 4.25 percent the average for those at least 30 days in default of their payment. So foreclosure rate are up by one-third, or 50 percent.

But 43 percent of all new foreclosures are in subprime adjustable-rate programs, and they comprise just 6.8 percent of all outstanding mortgages. So if we take out the recent spate of subprime originations, the majority of which occurred over the past 2 years, then we are back to historical averages for so-called prime mortgages!

The debate is whether the ongoing credit crunch--precipitated by the subprime debacle—will brake the overall economy. Economists are predicting just 1 percent GDP growth for the fourth quarter, a very drastic slowdown from Q3’s 4.9 percent growth. This is because they believe consumer spending will also grind to a halt.

But in fact spending was rising 5.2 percent in Q3, and consumers in October borrowed $6.4 billion more on their credit cards, a 2.5 percent jump, according to the Federal Reserve. Top this off with same-store retail sales rising 4 percent in November, and we see much better growth closing out this year.

We also had a good employment report in November, with 94,000 more payroll jobs created and the jobless rate holding at 4.7 percent. The household survey that actually determines the jobless rate showed a huge 696,000 job increase, including the self-employed. The unemployed and out of the labor force totals also shrank, indicating increased activity, rather than an impending slowdown.

The credit crunch seems to be largely self-induced by Wall Streeters that has the potential to affect their bottom line for several quarters, but not the overall economy.

Copyright © 2007

WEEK OF DECEMBER 3, 2007—NO 2008 RECESSION

Two revisions last week decreased the chances of a recession in 2008. Both indicators showed a huge increase in economic growth through the third quarter. Firstly, the revision of Q3 GDP growth, the amount of all goods and services produced domestically, was raised to 4.9 from 3.9 percent, the fastest growth in 4 years.

Second was the revision of third quarter labor productivity from 4.9 to 6.3 percent, also the strongest gains in 4 years. Both signal that not only is the economy continuing to grow, but labor costs which make up two-thirds of production costs are actually declining—down 2 percent in Q3 after declining 1.1 percent in Q2, according to the Labor Dept.

So the efficiency of our economy is actually increasing at a time of trouble in the real estate and financial sectors, higher energy costs, and greater geopolitical risks. If this economy can perform in the worst of times, what will it do when conditions improve?

Top this off with 94,000 payroll jobs added in November’s employment report and we see almost no possibility of a recession next year. In fact, calculating a recession is left to the National Bureau of Economic Research, who always announces it after the fact. It is considered to be 2 quarters of negative GDP growth, negative jobs growth, as well as shrinking retail sales and personal incomes. Current economic growth would therefore have to do more than slow down. It would have to literally reverse course and that is not very likely in the near term, given a business-friendly administration and Federal Reserve willing to print enough money to support their banks’ credit problems.

The huge upward revision in GDP growth was because exports and inventories were actually higher than initially estimated. Exports surged because the rest of the world is now growing faster than the U.S. The International Monetary Fund estimates 2007 worldwide economic growth at 5.1 percent and 2008 growth at 4.8 percent. These countries can therefore afford to buy more U.S. goods.

Higher business investment is spurring the increased productivity. Investment is rising 9.4 percent in Q3 after an 11 percent rise in Q2. Productivity is measured in output per hour of work. Output of all goods and services surged 5.7 percent while hours worked dropped 0.6 percent, hence the fantastic 6.3 percent productivity rate in Q3.

This is while consumer spending actually increased from Q2, as did disposable incomes. In fact, November retail chain-store sales—a crucial indicator of consumer behavior—exceeded expectations by rising a robust 4 percent, according to Thomson Financial. Department stores led with a 9.2 percent surge.

That leaves us with the housing question. October existing and new-home sales were basically unchanged, while new-home sales rose slightly. The problem is with so-called “sticky” prices that homeowners are notoriously reluctant to drop when sales slow, which in turn cause inventories to pile up. But with this kind of economic growth, does anyone doubt that sales will pick up in 2008? I don’t.

Copyright © 2007

WEEK OF NOVEMBER 26, 2007—BERNANKE’S PROMISE

Fed Chairman Ben Bernanke recently made a promise that the Fed will be “flexible” in doing what needs to be done to bolster the financial markets. This is after he and other Fed Governors had hinted at the October FOMC meeting that they were done with lowering interest rates this year. But news of further hemorrhaging of the credit markets and plunging stock prices have alarmed the Fed enough to reverse their stance.

“These developments have resulted in a further tightening in financial conditions, which has the potential to impose additional restraint on activity in housing markets and in other credit-sensitive sectors.” said Bernanke, in a speech to his home state North Carolinians.

“Needless to say, the Federal Reserve is following the evolution of financial conditions carefully, with particular attention to the question of how strains in financial markets might affect the broader economy.”

Yet overall economic activity hasn’t slowed to date. In fact, it has picked up with third quarter GDP growth revised upward from 3.9 percent to 4.9 percent after 3.8 percent growth in Q2, and consumer spending increasing at a 5.2 percent clip. New home construction and sales also rose slightly in the latest October surveys.

What has tipped the Fed’s thinking is perhaps its most recent Beige Book report, an anecdotal survey of activity in the 12 Federal Reserve Bank Districts. It basically announced that the slowdown has arrived, noting that 7 of the 12 districts reported a slower pace of growth, with the remainder describing conditions as moderate or mixed.

What probably alarmed Fed officials most was evidence that the financial market turmoil is impacting the credit markets. Business loans were down and standards for consumer loans were up. The report found soft retail sales and pessimism about the holiday season from retailers, who were also concerned that goods were beginning to pile up on store shelves.

But real estate had some good news in October, as it showed a leveling out of activity.

HOUSING STARTS—A 3 percent rise in new-home construction was mostly due to a surging demand for apartment units, as rental rates rise. But many of these renters will eventually go back to buying homes when housing prices have stabilized.

NEW-HOME SALES—New home sales rose 1.7 percent, probably because builders are offering plenty of incentives, including lower prices. The Midwest region increased a whopping 14.2 percent, 6.8 percent in the South. Sales dropped 15.7 percent in the West, however.

EXISTING-SALES—Sales fell just 1.2 percent in October, while the median price declined 5.1 percent, the largest year-over-year price drop ever recorded, according to the NAR.

NAR chief economist Lawrence Yun said, “I don’t anticipate any further major sales declines,” unless there is further overall economic deterioration. Yun expects 5.67 million in existing home sales in 2007, the fifth best year ever for real estate sales. There is already a pent up demand from so-called Generation X and Y buyers, said Yun. Generation Y buyers born in 1980-1996 are the children of the baby boomers who fueled the last housing boom, and will have as much buying power as their parents when they come of age.

We are now all waiting for the Fed’s December 11 FOMC meeting. The financial markets are anticipating at least a quarter to one-half percent rate drop at that time.

Copyright © 2007

NOVEMBER MORTGAGE APPLICATIONS SURGE

The mortgage market is regaining its health. The Mortgage Bankers Association (MBA) reported that its Applications Survey for the week ending November 30, 2007 surged 22.5 percent on a seasonally adjusted basis from one week earlier. On an unadjusted basis, the Index increased 51.5 percent compared with the previous week-which was a shortened week due to the Thanksgiving holiday-and was up 24.2 percent compared with the same week one year earlier.

The Refinance Index increased 31.9 percent from the previous week and the seasonally adjusted Purchase Index increased 15.2 percent from the earlier week. On an unadjusted basis, the Purchase Index increased 37.3 percent from the previous week. The seasonally adjusted Conventional Index increased 21.9 percent from the previous week, and the seasonally adjusted Government Index increased 27.8 percent in a week.

Some of the increase was because of the shortened Thanksgiving week, but also because interest rates are plunging. Even short-term rates that control ARM indexes have fallen approximately 20 basis points in the past month, perhaps in anticipation of another Federal Reserve rate cut on December 11, the Fed’s last FOMC meeting this year.

The more stable four week moving average for the seasonally adjusted Market Index is up 4.5 percent, up 3.1 percent for the Purchase Index, while this average is up 6.7 percent for the Refinance Index.

The refinance share of mortgage activity had the biggest jump, increasing to 56.0 percent of total applications from 51.4 percent the previous week. The adjustable-rate mortgage (ARM) share of activity decreased to 11.6 from 14.6 percent of total applications from the previous week, reflecting the rush to refinance ARMs to fixed rate mortgages, as rates have fallen.

The average contract interest rate nationally for 30-year fixed-rate mortgages decreased to 5.82 percent from 6.09 percent, with points unchanged at 1.07 (including the origination fee) for 80 percent loan-to-value (LTV) ratio loans, according to the MBA survey. But it has fallen as low as 5.50 percent in some regions, such as California.

The average contract interest rate for 15-year fixed-rate mortgages decreased to 5.38 percent from 5.69 percent, with points decreasing to 1.12 from 1.13 (including the origination fee) for 80 percent LTV loans.

The average contract interest rate for one-year ARMs increased to 6.28 percent from 6.24 percent, with points increasing to 0.99 from 0.96 (including the origination fee) for 80 percent LTV loans.

Does this signal the beginning of the end of the credit crunch that is bedeviling real estate? It will, if this gives a boost to home sales, which have leveled out of late after falling 25 to 30 percent this year.

Copyright © 2007

WEEK OF NOVEMBER 19, 2007—FOURTH QUARTER

All eyes are now on the fourth quarter. This is make or break time for both consumers and the Federal Reserve, whose Dec. 11 meeting is the last of the year. Consumer spending has been holding up, even if much of it is spent on gas, heating oil, and groceries. So economists are watching holiday retail sales closely to gauge whether consumers (and the economy) will stay healthy.

Consumers’ health depends in part on whether the credit crunch continues for mortgages. Lenders are again offering a full range of jumbo loan programs with stated income, the segment most affected by the crunch, though jumbo rates are still high. This could signal some easing of the mortgage crunch.

But it really is up to Congress to raise the conforming lending limits on Freddie Mac, Fannie Mae, and FHA. Even Treasury Secretary Hank Paulson is urging action, since the so-called GSE’s (Government Sponsored Enterprises) were set up to be lenders of last resort when banks cut back on their lending.

He has called the Senate's failure to pass legislation overhauling mortgage giants Fannie Mae and Freddie Mac "very frustrating," saying that the two government-sponsored entities need to be playing a bigger role in the housing market.

"If we ever need them it's during times like today, and they're most valuable when there is distress in the mortgage market," he said. "I'd like to see them playing an even bigger role."

The Fed has just come out with the first of its quarterly reports designed to make its decisions more transparent. Inflation is expected to remain contained. Headline inflation, as measured by the PCE index, is expected to slow to 1.8-2.1 percent in 2008, down from around 2.95 percent this year. Core inflation will remain steady in a range of 1.7-1.9 percent. It is expected to plunge below 2 percent by 2010, another reason for the Fed to cut interest rates further in Dec.

Inflation is subsiding in part because Fed officials cut their growth forecast in 2008 to a range of 1.8 percent to 2.5 percent next year, down from the previous forecast of 2.5 percent to 2.7 percent released last July. This is why consumer spending is so important, since it makes up some two-thirds of economic growth.

New-home construction and sales are firming, as Oct. new-home sales actually rose 3 percent on higher apartment construction. And the NAR’s Oct. pending home sales index was unchanged for the first time in a year.

The Conference Board’s Index of Leading Indicators (LEI) that attempts to predict future economic activity has been somewhat of a mystery this year. The LEI has been essentially flat in 2007, continuing the yearlong pattern of alternating monthly increases and decreases, and it has gradually returned to its August 2006 level.

“Meanwhile, real GDP grew at a 3.9 percent annual rate in the third quarter, moderately stronger than the 2.2 percent average annual rate in the first half of the year,” said the release. “The behavior of the composite indexes so far continues to suggest that risks for economic weakness persist, but economic growth should continue in the near term, albeit at a slower pace.”

Consumer sentiment indexes, another closely-watched indicator, are less reliable. But they also measure consumer attitudes towards inflation, and it is the consumers’ perception of inflation that determines how tightly they control spending.

The U. of Michigan Consumer Sentiment index was 76.1 in November, down from 80.9 in October, and "significantly" below the 92.1 during the same period in the prior year, according to the Reuters/University of Michigan Surveys of Consumers.

"Rising prices for fuel and food had a devastating impact on household budgets, and falling home prices have diminished consumers' sense of financial security," said Richard Curtin, director of the survey.

The Conference Board’s confidence survey also declined for the third consecutive month, “and continues to hover at 2-year lows”, said its press release. But a more recent spending survey was more upbeat. "Consumers are in a festive mood heading into the Thanksgiving holiday," says Lynn Franco, Director of The Conference Board Consumer Research Center. "And, it appears they are willing to spend more than last year, though retailers can still expect a fair share of bargain hunters will be lining up for the traditional kickoff this Friday."

Copyright © 2007

WEEK OF NOVEMBER 12, 2007—TOO MUCH IRRATIONAL PESSIMISM

Remember irrational exuberance, the creator of asset bubbles? Well, we may now have irrational pessimism, the creator of panic selling in the credit markets. We know this because many of the assets being written off, or sold at a discount by banks and hedge funds, are AAA-rated. It is the highest credit rating possible—the rating of Treasury bonds as well.

This belies the underlying strength of the economy. Consumers are still buying—with retail sales up 5.2 percent annually in the latest October survey. So the credit crunch is not yet affecting overall consumer spending, just what they are buying. Inflation is up slightly, but not what one would expect with soaring oil prices.

A famous 2001 research paper on “Herd Behavior in Financial Markets” stated that “Intuitively, an individual can be said to herd if she would have made an investment without knowing other investors’ decisions, but does not make that investment when she finds that others have decided not to do so. Alternatively, she herds when knowledge that others are investing changes her decision from not investing to making the investment.”

Much of it is generated by media pundits, who love to dramatize the adversity without doing the hard work of actually analyzing the numbers. And it sells ads. Human nature is controlled in large part by emotions, and during crises the motivating emotion can be fear. It magnifies all events. The glass is then half empty instead of being half full, in a word.

One example is predictions that banks may suffer upwards of $250 billion in writedowns before the dust has settled. Yet the top 5 banks’ revenues—banks such as Citicorp, JP Morgan/Chase, Wachovia, and Bank of America that are writing off those losses—have had record-breaking revenues this year. Business Week reports that their revenues could be up 7 percent from last year’s high of $127 billion.

The S&L crisis cost banks and taxpayers some $160 billion in the early 1990s, and helped to cause the 1991 recession. But this was when total Gross Domestic Product was 44 percent of what it is today. Banks were also not in the greatest shape then, with much lower capital and loan loss reserve requirements. Add to this the worldwide glut of savings that has poured into our stock and credit markets, and we see that this credit crunch may mostly be motivated by fear, rather than fundamentals.

And so in the words of a famous radio commentator, we should be looking at “the rest of the story”. What is it? Labor productivity jumped a huge 4.9 percent in Q3, mainly because the business investment that brings new technologies is up almost 8 percent. This will boost incomes while counteracting the high energy prices.

PPI/CPI—Overall wholesale inflation (PPI) rose just 0.1 percent in October, and retail prices (CPI) rose 0.3 percent. But PPI/CPI prices are up 3.5 percent and 6.1 percent, respectively, in 12 months. Still, with oil prices over $90 per barrel and gas above $3 per gallon, this is remarkable.

PENDING HOME SALES—This is signed contracts only, and attempts to predict existing-home sales that will close. The Pending Home Sales Index (PSHI), a forward-looking indicator based on contracts signed in September, rose 0.2 percent to a reading of 85.7 from an index of 85.5 in August, according to the National Association of Realtors. This was the first rise in one year, even though it was 20.4 percent lower than the September 2006 level of 107.6. “Even with relatively low fourth quarter sales, 2007 will be the fifth highest year on record for existing-home sales. The median existing-home price in 2007 will have fallen by less than 2 percent from an all-time high set in 2006,” said the NAR’s chief economist Lawrence Yun.

We know that the concept of irrational exuberance was first trumpeted by Fed Chairman Alan Greenspan in 1996. It wasn’t until 2000 that the stock market bubble burst. Now we are hearing dire predictions that are more due to the herd behavior of media pundits than economic fundamentals. Most of it is based on unfounded fears. This is no substitute for a better understanding of the complex factors that determine economic growth.

Copyright © 2007