Economic Commentary - October 2007

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

Overview

The markets were volatile this summer when stock market indexes recorded their sharpest declines since 2003. The major cause behind the sell-off was the concern that the residential real estate recession and its related debt problems would worsen and spread to other sectors. That concern fulfilled itself when investors shifted funds from riskier securities into U.S. Treasuries. The Federal Reserve’s initial response to the resultant “credit crunch” for some mortgage lenders and mortgage investors was reassurance in word and deed that it would provide whatever funds were needed for the markets to function. The stock market rebounded after the Fed’s mid-August actions and also after its mid-September decision to cut the federal funds rate 50 basis points to 4.75%.

Anxieties remain elevated but it seems doubtful that a more serious credit crunch or financial crisis is in process or imminent. The fundamental cause behind most crunches and crises – and the recessions and bear markets that followed them – has been restrictive Federal Reserve policies. The Fed’s policies were restrictive 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 serious financial crisis or recession occurred, and Real GDP (Gross Domestic Product) rose at or above its trend.

Likewise, 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, or until and unless the stock market became overvalued in the extreme relative to interest rates, corrections occurred but no bear market erupted.

The real federal funds interest rate was around 335 basis points before the Fed’s recent half-point cut and is now about 285 basis points – even further below the 450 basis points reached before past recessions and bear markets. And the stock market remains undervalued -- not overvalued in the extreme like it was before past bull-market peaks. With real interest rates and stock market valuation nowhere near their respective “tipping point” levels, severe credit crunch, financial crisis, recession and bear market seem possible but improbable. Commodities prices’ failure to fall, unemployment claims’ failure to rise, and the stock market’s rebound support this view.

Home construction will weaken further but other economic sectors should remain robust. Credit has become costlier for some but this marks a return to more normal terms rather than a crunch. The economic expansion should continue and could even reaccelerate somewhat. The stock market should suffer no worse than another correction even if the Fed does not cut interest rates further. The fundamental trends should remain favorable – and much more so than has been feared -- until and unless the Federal Reserve raises interest rates sharply. And there is no reason whatsoever to expect the Fed to do that anytime soon.
It is not the case that there are no problems or threats but the downside risks seem to be overstated in the media and well discounted in market prices. Rebalance portfolios if needed but otherwise remain true to well-founded asset allocation plans.

Economic and Market Update: Some Questions and Answers

Why does an economic recession seem improbable? Recessions do not come from nowhere. The recurring cause behind past major economic downturns has been “restrictive monetary policy.”

How do we know when monetary policy is restrictive? Real or inflation-adjusted interest rate levels measure the extent to which the Federal Reserve’s policies are restrictive or not.

What is a “real” or “inflation-adjusted” interest rate? Think about the federal funds interest rate. This is the interest rate that applies to funds that banks with excess reserves sell to other banks that need them to support loans and investments. This is also the interest rate that the Federal Reserve raises and lowers to affect its policies. The Fed lowered the fed funds rate 50 basis points to 4.75% in mid-September. This 4.75% level where federal funds now trade is called the “nominal” interest rate level. (Figure 1)

The real fed funds rate is the difference between the nominal rate and inflation. The inflation rate used here is based on the Personal Consumption Expenditure Deflator (PCED) – a price index that is similar to but broader and more sensitive to shifts in spending habits than the Consumer Price Index (CPI). The “core” inflation rate – the 12-month change in the PCED excluding food and energy – is now about 1.9%. Hence, the real fed funds rate is about 2.85% or 285 basis points -- the 4.75% nominal fed funds rate minus the 1.9% inflation rate. (Figure 2)

So what? What is so important about the real fed funds interest rate’s current level? The reason that it is important to know that the real fed funds rate is around 285 basis points is that there has never been a recession until sometime after the real fed funds rate rose above 450 basis points. The 450 basis points level has been the “tipping point” where the Fed’s policies restricted or reduced borrowing and spending, resulting in a broad and sustained economic decline. Recession risk has been and remains low because the real fed funds rate has been nowhere near 450 basis points since before the 2001 recession. (Figure 3)

Could the severe weakness in residential construction and the recent decline in non-farm jobs mean that the “tipping point” has fallen? First, until now, the weakness in residential construction has been much more a reaction to the extreme run-up in home prices than to a rise in interest rates or restrictive credit conditions. Second, if the job market is in steep decline and recession is imminent, initial or first-time unemployment insurance claims should be on the rise. Jobless claims, which have jumped 15% or more before all past recessions, have remained rather flat in 2007. The fact that jobless claims have not risen casts considerable doubt on the weak jobs report. Since the jobless claims count is far more reliable than the non-farm jobs estimate, the fact that jobless claims have not risen implies that recession fears have been overdone. (Figure 4)

Likewise, if recent real interest rate levels had reached restrictive levels, commodities prices should have fallen. The CRB Raw Industrials Commodities Price Index – a spot index that excludes food and energy prices – has tended to fall whenever recessions approached and took hold in the past, but it has not done so now. Commodities prices slipped somewhat in August but have since returned to peak levels. Commodities prices’ failure to plummet is inconsistent with the idea that a recession has started or is about to do so. (Figure 5)

Do these numbers still matter? Could the crisis in the financial markets this summer cause a recession even without the usual statistical preliminaries? Some perspectives on shocks and crises seem useful here. Shocks and crises have not been uncommon in financial market history. Major episodes since 1970 include:

1970 Penn Central Railroad Bankruptcy
1974 Franklin National Bank Failure
1980 First Pennsylvania Bank Failure
1981 Mexican Crisis and Penn Square Failure
1984 Continental Illinois Bank Problems
1987 Wall Street’s “Black Monday”
1990 General Banking Crisis
1994 Mexican Crisis and Orange County Bankruptcy
1997 Asian/PacRim Crisis
1998 Russian Debt Default and Long- Term Capital Management Crisis
1999 Brazilian Devaluation
2002 Corporate Financial Scandals
2007 Mortgage Defaults and Funding Problems

About half the shocks and crises listed above occurred after a recession had started or just after a recession had ended. The Penn Central Railroad bankruptcy in 1970, the Franklin National Bank failure in 1974, the First Pennsylvania Bank failure in 1980, the Penn Square failure in 1981 and the banking crisis in 1990 – all these resulted from economic downturns that in turn resulted from restrictive Federal Reserve policies. (Figure 6)

Most other shocks and crises resulted from loans or investments that were made based on interest rate expectations that proved to be incorrect. This applied to the Continental Illinois Bank’s problems in 1984, Orange County’s bankruptcy in 1994, the Long-Term Capital Management crisis in 1998, and the current mortgage default and funding problems. Wall Street’s “Black Monday” occurred after the stock market reached an extremely overvalued level – and it neither came from nor resulted in an economic recession. The crises that arose overseas – Mexico (twice), Asian/PacRim, Russia and Brazil -- had rather limited economic and market effects here.
(Figure 7)

On balance, the historical evidence does not support the idea that financial shocks and crises cause recessions and bear markets. Rather, such shocks and crises either resulted from a recession, or did not in themselves have sufficient power to cause deep and sustained economic or stock market declines. This has been all the more true when the Federal Reserve responded to a problem like it did to the current one -- with interest rate reductions and otherwise easier credit policies.

Can the economy grow if housing declines further? Real GDP (Gross Domestic Product) is the most comprehensive inflation-adjusted economic output measure available. Real GDP rose just 1.9% over the four quarters that ended in June 2007. That pace is slow or weak relative to Real GDP’s 3.3% average four-quarter growth rate since 1960.

The slowdown in Real GDP’s growth rate since mid-2006 is due to declines in residential investment (home construction) and inventory investment. Those two sectors subtracted 1.4% from Real GDP’s advance. The other sectors in Real GDP – consumption, government spending, business investment in plant and equipment, and net exports – added 3.3%. Hence, if residential and inventory were to just stop declining, Real GDP’s advance would probably rise toward 3.3%. (Figure 8)

When the real federal funds rate was about where it is now in the past, Real GDP rose at an above-trend 3.6% annualized rate over the next 4-5 quarters. Were all else equal, then, the current consensus forecast that Real GDP will rise just 2.1% in 2007 and 2.6% in 2008 would seem to be too pessimistic.
 
All else is certainly not equal. Something should be subtracted from Real GDP’s future expansion rate for further declines in housing. Something should also be subtracted for the fact that oil prices soared above $80 per barrel in recent weeks. 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 remain much lower than usual.

The nominal yield on the 10-year T-Note has averaged about 4.5% so far in September. Subtracting the 1.9% “core” inflation rate, the real 10-year T-Note yield was just 260 basis points. This is more than 110 basis points below the trend since 1987, and much lower than it was in the past when the real fed funds was around its current 285 basis point level. (Figure 9)

Real GDP should expand 2.5-3% over the next 5-6 quarters because real interest rates remain low. Sustained job creation should continue to support consumer spending. Sustained job creation should also combine with flat-to-lower home prices to help stabilize residential real estate markets. Economic leadership will shift further toward exports and business investment. Corporate profits and cash flow should support increased business investment in plant and equipment. The dollar’s decline has made our export products more and more competitive, and the economic prospects outside the U.S. remain quite positive.

There is a chance that the correction in residential real estate or increases in oil prices could combine to hold Real GDP’s expansion to 2% in 2007-2008. But there is also a chance that low real interest rates here and robust economic expansion abroad could 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 corporate profits and the stock market.

Will the Fed cut rates further? The Federal Reserve eased its policies in August and September specifically to counter “credit crunch” conditions in the markets for mortgage-related securities. The Fed’s measures – adding liquidity to the financial system, lending under easier terms and lowering the fed funds rate – have alleviated fears and enabled the markets to function. The remaining uncertainties about how to price mortgage-related risks will require more time and more information to be resolved. Information will be much more important in this process than further interest rate reductions.
This is not the first time that the Federal Reserve cut interest rates in reaction to a financial shock. It did so in 1987 (Wall Street’s “Black Monday” crash) and 1998 (Long-Term Capital Management crisis). But the Fed has tended not to make deep and sustained reductions in the federal funds rate until and unless initial or first-time unemployment insurance claims have risen sharply and threaten to continue to do so. (Figure 10)

As discussed above, unemployment claims have remained stable so far in 2007. This, in combination with the rebound in the stock market, and with concerns about the dollar’s weakness and the potential for an increase in inflation, implies that the Fed will not rush to lower interest rates further. The fact that real interest rates are well below the “tipping point” level that would threaten a recession and a bear market implies that further rate reductions should not be needed.

What is the outlook for the bond market? The 10-year T-note’s yield was near 4.6% late in September. A model built with data from 1987-2006 indicates that the 10-year T-note’s yield “should” be 4.7-6.4% in 2007-2008. If that model is relevant, the 10-year T-note’s yield is unlikely to decline and could rise as mortgage- and recession-related fears diminish.

The chance that longer-term interest rates could rise implies that investors should keep their fixed income (bond) portfolio maturities somewhat shorter than normal. The likelihood that risk spreads could widen further implies that investors should continue to favor higher-quality bonds.

What is the outlook for the stock market? Skepticism about common stocks continues to be reflected in the estimation that the stock market is undervalued 5-10% relative to interest rates. Interest rates would have to soar -- the BAA corporate bond yield would have to rise from around 6.7% to more than 8.75% -- or corporate profits would have to drop more than 20% -- in order to eliminate the undervaluation at current market price levels.

Interest rates could rise but should not soar. Profits could increase more slowly than in the recent past but the level will not collapse unless an economic recession occurs -- and recession seems improbable. And 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%. (Figure 11)

The current targeted real federal funds interest rate level is 285 basis points -- well below the 450 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 a “correction” and support its further advance on balance in future months and quarters. (Figure 12)

What is the “bottom line” for investors? What does all this mean for asset allocation? Based on fundamental relationships that have been dependable over the decades, economic stock market prospects remain better than the consensus fears. If so, then expectations that the Federal Reserve will slash interest rates further will be disappointed. This warrants some caution on bonds, because long-term yields and quality spreads could both well rise in those circumstances. The low real federal funds rate and the stock market’s undervaluation relative to interest rates seem to make the stock market vulnerable to no worse than occasional corrections. This relative optimism seems all the more warranted now because investor “bullishness” is nowhere near “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. Remain focused on fundamental forces and not near-hysterical headlines. The most important and reliable fundamental forces that have warned about recessions and bear markets in the past are not present. The most important and reliable fundamental forces remain positive.