Economic Commentary - February 2008   Clare Zempel Economic and Investment Strategies Consultant   Overview   Fears that problems related to housing finance and oil prices near $90 per barrel could lead to recession have continued to undercut the stock market. The consensus foresees economic weakness at best and has raised the odds that a recession will occur soon to near 50:50.   It is true that steep declines in housing activity have preceded recessions in the past. The usual pattern has been that a sharp rise in interest rates hurt housing first and the weakness then spread to other sectors. The current housing downturn differs because it is much more a reaction to unsustainable home-price increases than to higher interest rates or tighter credit conditions.   It is also true that steep increases in oil prices contributed to causing the last five recessions. The current oil-price rise’s impact has had less impact than feared because the percentage of their incomes that consumers spend on energy has risen but remained below the 1959-2007 average.   Housing-related financial problems and high oil prices pose risks but the major cause behind recessions and bear markets has been restrictive Federal Reserve policies. Those policies have been restrictive whenever 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 occurred and Real GDP (Gross Domestic Product) tended to rise as fast or faster than its historical trend.   The causes behind bear markets in common stocks have been restrictive Federal Reserve policies or extreme market overvaluation relative to interest rates. Unless the real fed funds rose above 450 basis points, or unless the stock market became overvalued in the extreme relative to interest rates, corrections happened but no bear market ensued.   The real federal funds interest rate has been nowhere near 450 basis points since before the 2001 recession. The real fed funds rate peaked around 334 basis points last June and has now plummeted to around 73 basis points. 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 are improbable. Commodities prices’ failure to collapse and unemployment claims’ failure to soar continue to support this view.   Home construction could weaken further but other economic sectors should remain robust. Credit has become costlier and harder to obtain for some borrowers but this marks more a return to normal terms than a crunch. And there is no question that the Federal Reserve and its counterparts will take further steps if need to ease credit conditions.   Rebalance portfolios as needed to correct portfolio imbalances but adhere to well-considered asset allocation plans. Stock market prices have already “corrected” and the real fed funds rate has already fallen below levels that ended recessions in the past. Problems and threats exist but the risks have been discounted in the marketplace. Extreme reallocation based on the assumption that a recession is certain could be far from riskless for long-term investors.   Economic and Market Update: A Continuing Discussion   Housing continues to decline and oil prices remain near record levels. Similar developments preceded past recessions. What is different now? Housing starts fell before recessions in the past and a rise in oil prices did precede the last five economic downturns. But housing starts have sometimes fallen and oil prices have sometimes risen without a recession. The deciding difference – the fundamental cause behind past major economic downturns – has been “restrictive monetary policy.” And monetary policy has not been restrictive since 2000.   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. The federal funds interest rate is the most important rate to watch. This rate applies to funds that banks with excess reserves sell to other banks that need them to support their loans and investments. This is also the interest rate that the Federal Reserve raises and lowers to implement its policies.   The Fed has now lowered the fed funds rate from 5.25% to 3.00%. The 3.00% level where federal funds now trade is called the “nominal” interest rate level in the marketplace. (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 2.24%. Hence, the real fed funds rate is about 0.76% or 76 basis points – the 3.00% nominal fed funds rate minus the 2.24% inflation rate.   One reason it is important to know that the real fed funds rate is around 76 basis points is that there has never been a recession until sometime after the real fed funds rate rose above 450 basis points. That 450 basis point level has been the “tipping point” where the Fed’s policies restricted or reduced borrowing and spending, resulting in a broad and sustained economic slowdown or decline. Recession risk has been and remains low now because the real fed funds rate has been nowhere near 450 basis points since before the 2001 recession. The real fed funds peaked around 334 basis points – well below the historical tipping point – last summer. Its current level – 76 basis points – is in line with or below levels seen when most past recessions ended. (Figure 2.)   Can we be sure that what worked in the past is relevant now? Could the severe weakness in residential construction and/or the sharp rise in oil prices pull the economy down into recession despite low real rates? There are several reasons to think that low real interest rates continue to support economic expansion. First, the weakness in residential construction has been much more a reaction to the extreme run-up in home prices in 2001-2005 than to a rise in interest rates or otherwise restrictive credit conditions that would threaten a broader economic decline.   Second, despite the sharp rise in oil prices since 2001, household expenditures on energy as a percentage of income and as a percentage of total spending are about where they were before the first oil “shock” in 1973-75. This plus low real interest rates help explain why the economy has remained solid outside housing.   Third, if recession were imminent, then initial or first-time unemployment insurance claims should have soared. Jobless claims, which have jumped 15% or more before all past recessions, have risen somewhat in recent months but much less so than occurred before past economic downturns. Jobless claims are important because the numbers are released weekly and seldom revised much. The fact that jobless claims have not soared is hard evidence that recession fears have been overdone. (Figure 3.)   Fourth, if recent real interest rate levels have been restrictive, then commodities prices should have plummeted. The CRB Raw Industrials Commodities Price Index – a spot index that excludes food and energy prices – has tended to plummet whenever recessions approached and unfolded in the past. Commodities prices have slipped but not much in recent weeks. Commodities prices’ failure to collapse is also consistent with the idea that a recession has not started or is about to do so.   But can the economy expand if the housing sector weakens further? Real GDP (Gross Domestic Product) – the total value of goods and services produced and sold – is the most comprehensive inflation-adjusted economic output measure available. Real GDP rose 2.5% over the four quarters that ended in December 2007. That is a dramatic improvement from the 1.6% increase over the four quarters that ended in March, but it is weaker than Real GDP’s 3.3% average four-quarter pace in 1960-2007.   The slowdown in Real GDP’s growth rate since mid-2006 was due to declines in residential investment (home construction) and inventory investment. Those two sectors subtracted 1.4% from Real GDP’s advance in the four quarters that ended last March, and 1.2% from the advance in the four quarters that ended in December. The other sectors in Real GDP – consumption, government spending, business investment in plant and equipment, and net exports – added 3.6%. Hence, if residential and inventory were to just stop declining, Real GDP’s overall advance could rise above the 3.3% historical trend. (Figure 4.)   In the past, when the real federal funds rate was about where it is now, Real GDP rose at an above-trend pace over the next 4-6 quarters. Were all else equal, then, the current consensus forecast that Real GDP will rise just 1.6% in 2008 would seem to be too pessimistic.   But 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 have been above $90 per barrel in recent months. But, if something should be subtracted from Real GDP for housing problems and high oil prices, then something should probably be added for the fact that real long-term interest rates are much lower than in the past and real short-term rates are declining.   The nominal yield on the 10-year T-Note was near 3.6% in early February. Subtracting the 2.2% “core” inflation rate, the real 10-year T-Note yield was just 140 basis points. This is about 230 basis points below its trend since 1987.   Real GDP should expand 2-3% over the next 5-6 quarters because real interest rates remain low. Even modest sustained job creation should continue to support consumer spending. Sustained job creation should also combine with flat-to-lower home prices and low long-term rates to help residential real estate markets stabilize over the next several quarters. 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 economic prospects outside the U.S. remain positive. Business investment and exports should continue to lead the expansion.   There is a chance that the correction in residential real estate and increases in oil prices could combine to hold Real GDP’s expansion below 2% in 2008. But there is also a chance that low real interest rates here and robust economic expansion abroad could combine with a decline in oil prices – and now some fiscal stimulus – to lift Real GDP’s advance above 3%.   Much more important than Real GDP’s precise pace, recession remains improbable. And low recession risk should be positive for corporate profits and stock market prices.   Will the Federal Reserve lower rates further? The Federal Reserve has eased its policies specifically to counter “credit crunch” conditions in the markets for mortgage-related securities. The Fed’s actions – adding liquidity to the financial system, lending under easier terms and reducing the fed funds rate from 5.25% to 3.00% – have eased 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 in full. Information will be much more important to this process than further interest rate reductions.   The fact that real interest rates have fallen so far below the “tipping point” levels that caused recessions and bear markets in the past implies that further rate reductions may not be needed.   What is the outlook for the bond market? The 10-year T-note’s yield was near 3.6% early in February. Analysis based on data from 1987-2007 indicates that the 10-year T-note’s yield “should” be 4.25-5.75% in 2008. If that model is at all relevant, the 10-year T-note’s yield is unlikely to decline much further and could rise as recession-related fears diminish and as inflation fears build.   The chance that longer-term interest rates could rise implies that investors should keep their fixed income (bond) portfolio maturities somewhat shorter than normal.   What is the outlook for the stock market? Concern about common stocks continues to be reflected in the estimation that the stock market is undervalued relative to interest rates. This is important because past bear markets started when real interest rates were above the 450 basis point “tipping point” level – which is not the case now – or when the stock market was overvalued in the extreme – which is also not the case.   Interest rates could rise sometime in 2008 but seem quite unlikely to soar anytime soon. Profits could increase more slowly than in the recent past but the level should not collapse unless a deep economic recession occurs – and recession seems improbable for the reasons discussed above. It should also be noted that bull markets in common stocks have tended not to end as soon as “undervaluation” was eliminated. The usual pattern is that the stock market continues to rise until it becomes overvalued in the extreme – usually by more than 40%. (Figure 5.)   The current targeted real federal funds interest rate level is 76 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 stock market’s downside risk to a “correction” and support its renewed advance on balance in future months and quarters.   What does this mean for investors and their asset allocations? Based on fundamental relationships that have been reliable over the decades, economic and stock market prospects remain better than the consensus fears. This warrants a somewhat cautious approach toward bonds because long-term yields would rise in such 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 the occasional correction. This relative optimism seems all the more warranted from a contrarian’s standpoint because economic forecasts and investor sentiment seem tilted sharply toward bearishness.   Since the most important and reliable fundamental forces that have warned us about recessions and bear markets in the past are still positive on balance, it seems inappropriate to underweight stocks or overweight bonds relative to planned asset allocations. Investors with well-formed asset allocation plans should check on the need to rebalance their portfolios. Periodic rebalancing is a discipline that can help investors buy lower and sell higher much better over time than reacting to the media headlines ever will.   Clare W. Zempel, CFA Economic and Investment Strategies Consultant

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