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Commentary
"We are at rest five miles behind the front. Yesterday we were relieved, and now our bellies are full of beef and haricot beans. We are satisfied and at peace."–Erich Remarque
Quiet on the Western Front?
At a 2.1% annualized pace during the fourth quarter, the latest PCE core price deflator registered a contained reading—enough to have the Federal Reserve characterize inflation prospects as having “improved modestly.” Still, it remains to be seen if last summer’s run-up in prices has sufficiently declined to contain inflationary expectations.
The Fed’s slight bias appears to remain on the tighter side of the equation. Job gains have been moderate, but unthreatening. Productivity (the relationship between output per hour and unit labor costs) during the fourth quarter increased at an annualized rate of 3.0%—a substantial improvement from -0.1% during the third-quarter. Higher productivity reduces pressure on companies to raise prices in order to preserve and expand profit margins—and that lessens the incentive to increase interest rates.
Other signals corroborate a sustainable growth scenario: stabilizing signs in the housing market, a smaller trade gap, energy prices that have retreated from their high, and a moderate 111,000 gain in January’s non-farm payrolls (on the heels of large upward revisions for the two previous months). A revised GDP growth figure of 3.5% for the fourth quarter accounted for the bulk of the up-tick in productivity. Paradoxically, should GDP growth wane, and unit labor costs disproportionately increase, the Fed could find itself in the uncomfortable position of a stronger bias toward tightening. There is always the possibility of another substantial downward revision in fourth-quarter GDP for such reasons as overestimation of inventory build-up and an underestimation of the trade deficit.
Marked by a surge of 4.4% in personal consumption, fourth-quarter GDP growth was largely ascribed to the consumer and export sectors. Investment in equipment and software showed annualized declines. Residential construction spending fell by almost 20%. Capital spending levels remain an open question. Capacity utilization, at 81.8% remains strong and conducive to an upturn in spending, and businesses seem to have the cash on their balance sheets. Nonetheless, the recent spate of missed earnings targets looms in the shadows.
The forward markets continue to forecast a “watch-the-paint-dry” scenario, with an unchanged Fed funds rate over the next six months. Back in December, the markets were virtually certain of a rate cut over the ensuing three months.
Tough Time for Subprime
Historically, most housing downturns have been caused by rising interest rates that spurred recessions and stalled the market. Today’s housing market features a high-profile increase in subprime delinquencies and new home construction declines. The spread on a credit derivative, the ABX Index (which emulates BBB-rated subprime mortgage-backed securities) has traded in excess of 1,000 basis points over LIBOR in recent days. That represents a widening of over 750 basis points since last autumn. The subprime issues that are now making the headlines have been festering for some time in the wake of increased lending to those with weak credit histories. With easier credit, came increased speculation. Add tightened underwriting standards into the mix, and you see that the “flipper” phenomenon has reached its logical conclusion: speculative homes stopped moving, and home builders start trimming production. We would start worrying about the broader housing market should the employment situation deteriorate. Few signs are presently pointing in this direction.
As For Housing...
In a historical context, the level of existing home sales on an annualized basis is now similar to the level of activity in 2004. Nationwide, home prices are about where they were one year ago. Because of continued wage growth and stable long-term rates, the National Association of Realtors Housing Affordability Index for the month of December stood at 109.2. Yes, it is lower than recent years, but it still implies that the average American is able to afford a median-priced home. Things are not quite as rosy in the West, where the Index was a mere 71.0.
Figure 1. Historical Single-Family Homes Sales for Eight-State Seattle Bank Region
2006.III p: results as of 9/30/06 presented on an annualized basis
There’s been a bit of an up-tick in the nation’s vacancy rate for homeownership housing. As reported by the Department of Commerce, homeownership housing saw a vacancy rate of 2.7% during the fourth quarter. That’s up from 2.0% during fourth-quarter 2005. We can see why new home starts declined by 13% during 2006.
Tougher Lending Standards
The Federal Reserve’s January 2007 Senior Loan Officer Opinion Survey makes an interesting read. Among the findings that pertained to domestic banks regarding changes in the lending environment that took place during fourth-quarter 2006:
- Tightening credit standards for commercial real estate loans and residential mortgages
- Weaker demand for commercial real estate loans and residential mortgages
- Flat C&I loan demand; increases from acquisition activity; decreases from plant and equipment spending, along with accounts receivable
- Weaker demand for consumer loans
A Weak Yen, Surging Exports; Wider Trade Deficits
Japan’s currency has been weakening by the day, in large part due to continued rate levels not far above zero. In fact, three-month Japanese Treasuries still yield a mere 25 basis points, with the 10-year yields no more than 1.75%. As such, pressured by escalating pension liabilities, Japanese fund managers continue to deploy the “one-way carry trade” and invest in Euro and Dollar-denominated securities. Add the weak Yen and low interest rates in Japan to the list of why the U.S. has seen continued demand for its paper—and kindness from strangers.
The U.S. trade deficit widened by 6.5% during 2006. That’s in spite of surging exports and a weaker currency. Not surprisingly, the culprit continues to be imports from China, which just replaced Mexico as the U.S.’s number two trading partner behind Canada. Rising oil prices throughout the year were also of no help. The financial markets are forecasting improvement in the trade deficit throughout 2007 due to the imminent prospect of increasing Yuan’s value and recovering export markets.
Mind Your Risk Premium!
While current indicators show an economy that is perhaps at the mid-point of its cycle and poised to post moderate growth in the range of 2.0% to 3.5% per year, any one of a litany of potential surprises could upset the current balancing act: geopolitical issues, consumer retrenchment, currency instability, or a hedge fund incident. Not a bad environment in which to mind your risk premiums. As was the case with the subprime market last week, these premiums can adjust with high magnitude and in little time!
John P. Biestman, CFA, is Director of Business Development at the Federal Home Loan Bank of Seattle.
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