Rob Savino : Northwestern Mutual - Economic Commentary - November 2007 : Article: Economic Commentary

Economic Commentary - November 2007

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

Overview

Concerns that problems in housing finance and oil prices near $100 per barrel could lead to recession undercut the stock market in November.

It is undeniable that steep declines in housing activity have indicated recessions in the past. The normal pattern has been that a sharp rise in interest rates hurt housing first and then the weakness spread to other sectors. The current housing downturn is different because it is much more a reaction to runaway home-price increases and overbuilding than to higher interest rates or tighter credit conditions.

It is also undeniable that steep increases in oil prices contributed to causing the last five recessions. The current oil-price rise’s impact has been less severe than feared because the percentage of their incomes that consumers spend on energy has remained below the average since 1959.

Housing problems and high oil prices pose risks but it should be remembered that the major cause behind recessions and bear markets has been restrictive Federal Reserve policies. 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 serious financial crisis or recession occurred, and Real GDP (Gross Domestic Product) rose as fast as or faster than its trend.

The causes behind bear markets in common stocks were restrictive Federal Reserve policies 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 happened but no bear market ensued.

The real federal funds interest rate was 334 basis points before the Fed’s recent rate cuts and is now about 267 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 seem improbable. Commodities prices’ failure to fall and unemployment claims’ failure to rise much support this view.

Home construction could well weaken further but other economic sectors should remain robust. Credit has become costlier and harder to obtain for some but this seems to mark a return to more normal terms rather than a crunch. Recession is possible but improbable and the economic expansion should continue. And the stock market should suffer no worse than a correction even if the Fed does not cut interest rates further.

It is not the case that there are no problems or threats, but the downside risks have been heavily discounted in the marketplace, and the usual bear-market precursors – high real rates and extreme overvaluation – are still not present. Rebalance as needed to correct portfolio imbalances but otherwise adhere to well-considered asset allocation plans.

Economic and Market Update: The Continuing Discussion

Housing continues to weaken and oil prices continue to soar. Is it not true than this has resulted in economic recessions in the past? Housing starts fell before recessions in the past and a rise in oil pricesdid precede the last five economicdownturns. But housing starts havesometimes fallen and oil priceshave sometimes risen without arecession. The deciding difference– the fundamental cause behind pastmajor economic downturns – has been“restrictive monetary policy.” Andmonetary policy has not been restrictivesince 2000. (Figure 1.)

How do we know when monetary policy is truly restrictive? Realor inflation-adjusted interest ratelevels measure the extent to whichthe Federal Reserve’s policies arerestrictive or not. The federal fundsinterest rate is most important rate towatch. This is the rate that applies tofunds that banks with excess reservessell to other banks that need them tosupport their loans and investments.This is also the interest rate that theFederal Reserve raises and lowers toimplement its policies.

The Fed lowered the fed funds rate 50 basis points from 5.25% to 4.75% in mid-September, and lowered it another 25 basis points to 4.50% in late-October. The 4.50% level where federal funds now trade is called the “nominal” interest rate level. (Figure 2.)

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 1.8%. Hence, the real fed funds rate is about 2.7% or 270 basis points – the 4.5% nominal fed funds rate minus the 1.8% inflation rate.

The reason it is important to know that the real fed funds rate is around 270 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 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 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 recession in 2001. The real fed funds rate peaked around 334 basis points last summer. It is about 270 basis points now and there is no reason whatsoever to expect the Federal Reserve to raise it anytime soon. (Figure 3.)

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 thatlow real interest rates are working tosupport economic expansion. First, theweakness in residential constructionhas been much more a reaction to theextreme run-up in home prices in 2001-2005 than to a rise in interest rates orotherwise restrictive credit conditionsthat would threaten the broadereconomy. (Figure 4.)

Second, despite the surge 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 explains why the economy has remained solid outside housing. (Figures 5 - 6.)

Third, if recession is imminent, then 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 on balance so far in 2007. The fact that jobless claims have not soared is important evidence that recession fears have been overdone. (Figure 7.)

Fourth, if recent real interest rate levels are restrictive, commodities prices should have plummeted. The CRB Raw Industrials Commodities Price Index – a spot index that excludes food and energy prices – has tended to fall whenever recessions approached and unfolded in the past, but it has not done so now. Commodities prices slipped somewhat in August but then rebounded to peak levels in November. Commodities prices’ failure to collapse is consistent with the idea that no recession has started or is about to do so. (Figure 8.)

Do these numbers matter when the financial markets are in turmoil? Could the crisis in the financial markets this summer cause a recession even without the usual statistical preliminaries? Shocks and crises have been commonin financial market history. There havebeen a dozen major financial crises since1970 – 13 with the current mortgage relatedepisode.

About half the shocks and crises since 1970 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 resulted from economic downturns that in turn resulted from restrictive Federal Reserve policies. (Figure 9.)

Most other shocks and crises resulted from loans or investments that were made based on interest rate expectations that proved to be incorrect. This includes 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. It alone neither came from nor resulted in an economic recession. The crises that arose overseas – Mexico (twice), Asian/PacRim, Russia and Brazil – were far from trivial but had rather limited economic and market effects here. (Figure 10.)

On balance, the evidence does not support the idea that financial shocks and crises cause recessions and bear markets. Rather, such shocks and crises either resulted from recessions, 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 has to the current one – with interest rate reductions and otherwise easier credit policies.

Will the economy be able to grow if the housing sector weakens further? Real GDP (Gross Domestic Product)– the total value of goods and servicesproduced and sold – is the most comprehensive inflation-adjustedeconomic output measure available. Real GDP rose 2.6% over the four quarters that ended in September

2007. That is an improvement from the 1.6% increase in the year that ended in March, but it is weaker than 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 1.3% from Real GDP’s advance. The other sectors in Real GDP – consumption, government spending, business investment in plant and equipment, and net exports – added 3.9%. Hence, if residential and inventory were to just stop declining, Real GDP’s overall advance could rise above the 3.3% trend. (Figure 11-12.)

In the past, when 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, the current consensus forecast that Real GDP will rise just 2.4% in both 2007 and 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 approached

$100 per barrel in recent weeks. 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 remain much lower than usual.

The nominal yield on the 10-year T-Note seems to have averaged about 4.2% so far in November. Subtracting the 1.8% “core” inflation rate, the real 10-year T-Note yield was just 240 basis points. This is about 130 basis points lower than its trend since 1987, and much lower than it was in the past when the real fed funds was around its current 270 basis point level.

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 flatto-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 quite positive. Business investment and exports should continue to lead the expansion. (Figure 13.)

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

Will the Federal Reserve lower rates further? The Federal Reserve easedits policies in August, September andOctober specifically to counter “creditcrunch” conditions in the marketsfor 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 4.50% – 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. Information will be much more important in this process than further interest rate reductions.

This is neither the first shock to the financial system nor the first time that the Federal Reserve has cut interest rates in reaction to a 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 threatened to continue to rise. (Figure 14.)

As noted earlier, unemployment claims have remained more or less stable so far in 2007. This is important evidence that economic momentum remains positive outside the residential real estate sector. In combination with its concerns about the dollar’s weakness and some potential for inflation to rise, this implies that the Fed will not rush to lower interest rates much further.

The fact that real interest rates are far below the “tipping point” levels that resulted in 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 4% late in November. A model constructed with data from 1987-2006 indicates that the 10-year T-note’s yield “should” be 4.5- 6.0% in 2007-2008. If that model is at all relevant, the 10-year T-note’s yield is unlikely to decline much further and could rise as 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 fixed-income securities.

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. Interest rates would have to soar – the BAA corporate bond yield would have to rise from around 6.4% to more than 8.25% – or corporate profits would have to drop more than 15% – in order to eliminate the estimated undervaluation at current market price levels.

Interest rates could rise in 2008 but seem 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 when “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 15.)

The current targeted real federal funds interest rate level is 270 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 renewed advance on balance in future months and quarters.

Investor bullishness was not at “irrationally exuberant” levels when the recent downturn started. And sentiment was quick to become bearish in the extreme as the market declined. This supports the idea that the recent decline will be limited in depth and duration to a “correction.” (Figure 16.)

What does all 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. If this is correct, then widespread expectations that the Federal Reserve will slash interest rates much further will be disappointed. This warrants a somewhat cautious approach to bonds, because long-term yields and quality spreads could both well 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 investor “bullishness” was limited when the current downturn started and quick to become quite bearish as it unfolded.

The most important and reliable fundamental forces that have warned us about recessions and bear markets in the past are still positive on balance. 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 remain focused on fundamental forces and not the all-too-often alarmist headlines.

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