Raymond N Latiano : Northwestern Mutual - Economic Commentary - July 2007 : Article: Economic Commentary

Economic Commentary - July 2007

By Clare W. Zempel, CFA
Economic and Investment Strategies Consultant

Overview
The headlines remain focused on worst-case economic and market scenarios. Since 2003, we have been warned often about the threats inherent in the more than two-fold increase in oil prices since 2003, the more than five-fold increase in short-term interest rates since mid-2004, the steep slide in home construction since 2005, a potential financial crisis related to sub-prime loan losses, and more. To be sure, weakness in home construction has slowed the economic expansion since 2005, but no recession has occurred, and there is some evidence that the slowdown has ended.

The stock market has almost doubled since 2003 despite the pessimistic headlines because the fundamentals have been and remain favorable. The fundamental cause behind past recessions and most bear markets has been restrictive Federal Reserve policies. Real interest rate levels provide the best clues about the extent to which the Fed’s policies are restrictive or not.

The Fed’s policies were restrictive in the past when the real or inflation-adjusted federal funds interest rate rose above 450 basis points. Until and unless the real fed funds rate rose above that level, no recession or serious financial crisis occurred and Real GDP (Gross Domestic Product) expanded faster than its historical trend.

The causes behind bear markets in common stocks have been restrictive Federal Reserve policies and/or extreme market overvaluation relative to interest rates. Until and unless the real fed funds rose above 450 basis points and/or the stock market became overvalued in the extreme, corrections occurred but no bear market erupted.

The real federal funds interest rate is now around 325 basis points – well below the 450 basis points that preceded recessions and bear markets in the past. And the stock market remains undervalued relative to interest rates – not overvalued in the extreme like it was around past market peaks.

Since real interest rates and the stock market’s relative valuation are nowhere near their respective “tipping point” levels, the economic expansion should reaccelerate and the stock market should rise on balance in the months and quarters ahead. These favorable trends should remain intact until and unless the Federal Reserve raises interest rates sharply. And there is no particular reason to expect the Fed to do that for quite some time to come.

Investors should take care not to let the headlines distract them from these favorable fundamental forces – or from their well-founded asset allocation plans.

Economic and Market Update

Recession Risk

Recession risk is important to investors because most major stock market declines have occurred in conjunction with economic downturns. Most investors know this to be true and would reduce their exposure to common stocks if a recession seemed imminent. (Figure 1.)

But how does one know when a recession lies ahead? The headlines warned us about the economic threats inherent in the more than two-fold increase in oil prices since 2003, the more than five-fold increase in short-term interest rates since mid-2004, and the steep slide in home construction since 2005. To be sure, the economic expansion has decelerated since 2005. But no recession has occurred so far. And there is some evidence that even the moderate slowdown has ended.

The one factor that has never failed to produce a recession – or a bear market in common stocks – is a high “real” or inflation-adjusted short-term interest rate level. A real interest rate is determined by subtracting inflation from the “nominal” interest rate level that is quoted in the marketplace.

To illustrate, the Federal Reserve has held the federal funds rate at 5.25% since June 2006. Based on the Federal Reserve’s favorite benchmark (the Personal Consumption Expenditure Deflator Excluding Food and Energy Prices), the “core” inflation rate is now 2.00%. Hence, the real federal funds rate is 3.25% – the 5.25% nominal fed funds rate minus the 2.00% inflation rate – or 325 basis points. (Figure 2.)

The critical lesson from how the real fed funds rate has behaved over time is this: recessions have not occurred in the past until after the real federal funds rate had risen above 450 basis points. It follows that a real fed funds rate above 450 basis points has been the “tipping point” – the level where the Federal Reserve’s policies became sufficiently “restrictive” to halt economic expansions – the level where recession risk became material.

If this historical benchmark still holds, then recession risk remains low now – and the Federal Reserve’s policies remain stimulative to further economic expansion – because the current 325 basis point real fed funds rate remains well below the historical recession-inducing level.

But does this historical real-rate benchmark still hold? Ever since the Federal Reserve started raising the federal funds rate from its 1% low in mid-2004, pessimists have warned that increased debt burdens combined with high energy prices would make the economy more vulnerable to rising interest rates than was true in the past.

But the rise in the federal funds rate to 5.25% has not stopped the economic expansion and job creation so far. And the sustained rise in the Commodities/Claims Ratio indicates that the increased real fed funds rate has not even caused the economic expansion to lose much speed outside the housing sector.

The top number in the Commodities/Claims Ratio is the CRB (Commodities Research Bureau) Spot Raw Industrial Commodities Price Index. This index measures prices for metals and raw industrial materials other than oil and food-related commodities. This number has soared since 2002 and reached another record level in June. Such an upward trend in industrial commodities prices almost always coincides with increased production demands and sustained economic expansion. (Figure 3.)

The bottom number in the Commodities/Claims Ratio is Initial Unemployment Insurance Claims – a number that counts those who have just lost their jobs and filed for unemployment insurance for the first time. Unemployment claims rose somewhat last winter but then fell to a 15-month low in May. Month-to month fluctuations aside, jobless claims have remained in a downward trend since 2002. Such a downward trend in unemployment claims almost always coincides with improvements in job creation and in economic conditions overall. (Figure 4.)

The Commodities/Claims Ratio has been an especially sensitive economic indicator because its two components have been quite quick to reflect shifts in the demand for the basic inputs to industrial production – raw materials and labor. Whenever a recession (1960-61, 1969-70, 1973-75, 1980, 1981-82, 1990-91, 2001) – or even just a pronounced economic slowdown (1966-67, 1984-86, and 1995-96) – loomed in the past, this indicator was always among the first to decline and warn that an economic downturn was on the horizon.

The fact that the Commodities/Claims Ratio has not fallen to date is powerful evidence that interest rates have not reached levels that have made a recession – or even just a severe slowdown – inevitable. (Figure 5.)

Another lesser-known but nonetheless useful indicator that has not turned bearish on economic prospects is the “diffusion index” for all 50 states in the union. The latest (May) reading for this index shows that, compared to three months earlier, economic conditions have improved in 49 states. In contrast, six months before the last two national recessions started, 10 states had recorded 3-month declines.

Moreover, compared to 12 months earlier, economic conditions in April also improved in all 50 states. Positive economic momentum remains too broad-based to be consistent with a deep national slowdown or a recession. (Figure 6.)

Despite concerns that the undeniable weakness in housing will deepen and spread, neither the Commodities/Claims Ratio nor the U.S. State Economic Diffusion Index indicates that a recession or even just a severe economic slowdown has been set in motion. This casts considerable doubt on the view that the Federal Reserve’s past interest rate increases have been overdone.

Growth Prospects
Real interest rates have been and remain low and stimulative to economic expansion, even with the rise in oil prices to record levels. In the past, when interest rates were rising and the real federal funds rate was about where it is now, Real GDP rose at an above-trend 3.6% annualized rate over the next 4-5 quarters. Were all else equal, then, current consensus expectations that Real GDP will rise 2.2% in 2007 and 2.8% over the next four quarters would seem to be too pessimistic. (Figure 7.)

But all else is certainly not equal. Something should probably be subtracted from Real GDP’s future expansion rate for the fact that oil prices soared above $75 per barrel last summer and have remained high – around $67 per barrel on average in June. But, if something should be subtracted from Real GDP for high oil prices, then something should probably be added for the fact that real long- term interest rates are much lower than usual. (Figure 8.)

The nominal yield on the 10-year T-Note averaged about 5.11% in June. Subtracting the 2.00% “core” inflation rate, the real 10-year T-Note yield was 311 basis points. This was some 40-50 basis points lower than it was in the past when the real fed funds was around its current 325 basis point level.

Below-normal long-term interest rates, in combination with somewhat lower oil prices, should help support residential construction and stimulate business investment, and make it seem quite possible that Real GDP will rise at least as fast and probably faster than the consensus expects. At a minimum, lower-than-normal long-term interest rates and somewhat lower oil prices should mean that recession or even just a severe economic slowdown remains quite improbable.

But can Real GDP rise at all if housing continues to decline? There is no question that the housing market has weakened to a considerable extent. Housing starts fell from 2.3 million units (seasonally adjusted and annualized) in January 2006 to 1.5 million in May 2007. Other housing benchmarks – new and existing home sales – have weakened less but have not yet stabilized. (Figure 9.)

From December 2003 to June 2005, home prices rose almost 24% while the median family’s income rose less than 5%. In rather quick reaction to this price-induced decline in demand, the 12-month change in the median home price plummeted from +16.9% in October 2005 to -2.4% in May 2007.

This abrupt reversal in home-price inflation has combined with lower interest rates and rising incomes to reverse the decline in the number of families that can afford the median priced home. Stable-to-lower home prices should combine with rising employment to help stabilize housing sales and construction in coming months and quarters. (Figure 10.)

Housing is important but there have been times in the past when weakness in that sector did not preclude a solid expansion in Real GDP overall. One such period was 1989-1995 – an extended period that encompassed declines in home prices in New England and Pacific states, and all-but-flat home prices in Middle Atlantic states.

The 1989-95 period did include a mild recession in 1990-91. Federal Reserve tightening had raised the real fed funds rate above 500 basis points in 1989 to set the stage for a severe economic slowdown. That slowdown became a recession when Saddam Hussein invaded Kuwait in August 1990. But before and after that recession, expansion in business investment and elsewhere more than offset weakness in housing to keep Real GDP’s advances strong. (Figure 11.)

Real GDP should expand around 3% over the next 4-6 quarters because real interest rates remain low and oil prices have retreated some. Sustained job creation should continue to support consumer spending. Sustained job creation should also combine with flat-to-lower home prices to stabilize residential real estate markets.

Economic leadership will continue to shift toward business investment and to exports. Corporate profits and cash flow should support increased business investment in plant and equipment. The dollar’s decline has kept our export products competitive and the world’s economic prospects remain quite positive. Demand for our exports should remain strong because world economic prospects remain quite favorable.

Just three of the 180 countries covered by the International Monetary Fund are expected to be in recession in 2007. Those three countries are Chad, Iceland and Zimbabwe. And just one country – Zimbabwe – is expected to be in recession in 2008. This would be the smallest number and the lowest percentage in recession on record since 1980. Moreover, average real economic growth for the 180 covered countries, which reached a record-high 5.6% in 2006, is expected to average a robust 5.3% in 2007-2008. (Figure 12.)

There is a chance that the correction in residential real estate or past increases in oil prices and interest rates could combine to hold Real GDP’s expansion below 2.5% in 2007. There is a precedent for this in the so-called “mini-recession” which occurred in 1966-67. But there seems to be an equal or better chance that low long-term interest rates here and robust economic expansion abroad could combine to lift Real GDP’s advance above 3%.

Much more important than Real GDP’s precise pace, recession remains quite improbable. And low recession risk is positive for the stock market.

Asset Allocation Implications and Considerations

Fixed Income Investments
June saw a major shift in expectations about economic prospects and the Federal Reserve’s policies. Based on the futures market, the view had been that the fed funds rate would be cut 50 basis points within the next 12 months in reaction to economic weakness. Then, when the Purchasing Manager Indexes and other reports showed unexpectedly sharp rebounds, the view shifted to the idea that the fed funds rate would be held at 5.25% for the foreseeable future.

The view has since shifted back toward the idea that there is a chance that the fed funds rate could be cut in 6-12 months. Even so, longer-term interest rates are still about 50 basis points above their April levels. (Figure 13.)

The 10-year T-note’s yield was near 5.1% late in June. A statistical model built with data from 1987-2006 indicates that the 10-year T-note’s yield “should” be 4.7-6.4% in 2007. If that statistical model remains relevant, the 10-year T-note’s yield is unlikely to decline much and could well rise.

The 10-year T-note yield has tended toward the lower end of the model’s predicted range since mid-2005. The “savings glut” that accumulated in Asia since the 1997-98 “Asian PacRim crisis” helps to explain that. So does the notion that worldwide economic conditions have become “safer” – less volatile in real terms and less inflation-prone on balance – and made bonds more attractive to investors.

The T-note yield has also remained low because central banks around the world have been creating excess liquid assets that have been used to purchase bonds. With most other central banks now following the Federal Reserve’s shift toward less accommodative policies, this particular support for bond prices should weaken. (Figure 14.)

Absent a much deeper economic slowdown than now seems probable in 2007-8, the federal funds rate seems unlikely to be cut from its current 5.25% level and the 10-year T-note yield could well rise above 5.25%. The risk that longer-term interest rates could rise implies that investors should continue to keep their fixed income (bond) portfolio maturities somewhat shorter than normal. The chance that risk spreads could widen from their recent historic lows implies that investors should continue to favor high-quality bonds.

Common Stock Investments

Skepticism toward common stocks continues to be reflected in the estimate that the stock market is undervalued 3-11% relative to interest rates. Interest rates would have to soar – the BAA corporate bond yield would have to rise from around 6.7% to 8.5% – or corporate profits would have to drop 20% – in order to eliminate the undervaluation at current market levels. (Figure 15.)

Interest rates could well increase but should not soar. Profits could rise slower than in the past but the level will not collapse unless an economic recession occurs – and recession remains quite improbable.

It is important to note that bull markets in common stocks do not end just because “undervaluation” has been eliminated. The usual pattern is that the stock market rises until it becomes overvalued in the extreme – usually by more than 40%.

The current real federal funds interest rate level is 325 basis points – well below the 425 basis point level that induced both recessions and bear markets in the past. This plus its estimated undervaluation should limit the market’s downside risk to occasional “corrections” and support its further advance on balance in future months and quarters. (Figure 16.)

The stock market’s persistent undervaluation relative to interest rates reflects concern about economic and investment risks. This is understandable based on the shocks behind the market’s extended decline in 2000-3 and the uncertain economic-political climate that has prevailed since 2001. But the pessimism beneath the market’s estimated undervaluation has not been without precedents in depth (1974-75) and duration (1976-79, 1988-90, 1993-96). It proved profitable to invest in stocks in those periods – much more so than it was when extreme optimism and overvaluation prevailed (1987 and 1999).

The stock market’s undervaluation also seems to reflect skepticism about economic prospects. The press has focused on worst-case economic scenarios since 2003. But real interest rates are nowhere near the 450 basis point level that induced both recessions and bear markets in the past. And the Commodities/Claims Ratio and 50-State Diffusion Index are still on the rise. Based on these fundamental indicators, the odds continue to favor the view that most future economic surprises will be toward the upside.

It should also be noted that 2007 is the third year in the four-year presidential election cycle. This is relevant because the stock market has recorded well-above trend advances in almost all such “third years” since 1951. The sole exception in the 14 “third years” in question occurred in 1987, when the stock market soared to an extremely overvalued level in August and then “crashed” in October. As noted earlier, the stock market seems undervalued now.

Asset Allocation Implications
Based on the fundamentals, economic prospects remain better than the consensus expects. If so, then current expectations that the Federal Reserve will not raise interest rates could be disappointed. Some caution on bonds remains warranted because long-term yields and quality spreads could well rise further in those circumstances (better-than-expected economic expansion and no rate cut).

The low real federal funds rate and the stock market’s undervaluation relative to interest rates makes the stock market seem vulnerable to no worse than an occasional short-term correction. This seems all the more plausible because “third years” in the election cycle have been favorable and because investors’ mood is far below “irrationally exuberant” levels.

Investors with well-considered asset allocation plans should check on the need to rebalance their portfolios but should otherwise adhere to their plans. Those without such plans should develop and implement some as soon as possible.

All should focus on the fundamental forces and not the headlines. The most important and reliable fundamental forces that have warned about recessions and bear markets in the past are just not present. The most important and reliable fundamental forces remain favorable.

Clare W. Zempel, CFA

Economic and Investment Strategies Consultant

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