Economy Should Bottom this Quarter, but Headwinds Stir

The Rate Debate
This week's trading activity was not driven so much by economic indicators but another run-up and run-down in 10-year Treasury rates and increases in commodity prices.

The economic community is torn as to the interpretation. Some economists believe that the higher rates are just a return to normalcy. These observers argue that panicked investors, who were buying Treasuries at any price, are now deploying their capital in a more normal pattern. This has increased the demand and reduced the yields for corporate bonds and decreased the demand and increased the yields on Treasuries. Some economists in this camp would go so far as to say that this increase is a good thing, as it demonstrates strong investor confidence in the future. Others believe that the stimulus and fears about government spending are driving rates higher. Smart people could argue this all day, but the fact that corporate rates have not gone up nearly as fast as Treasury rates lends more credence to the return to normalcy argument.

Nevertheless, the higher rates on the 10-year Treasuries (up from about 2% to a spike of about 4% recently) have driven up mortgage rates from the mid-4's to the mid-5's in short order. The effect of higher rates has shown up immediately in new mortgage applications, which have been down several weeks in a row. The impact has been much greater on the refinance market than the new purchase market. Even with higher rates, housing affordability (which factors in both prices and interest rates) remains near record levels. Perversely, a move to a higher rate as well as the potential expiration of some housing tax credits may finally push some on-the-fence buyers back into the market.

Pink Slip and Retail Relief
The only two typically market-moving economic reports this week were both modestly positive: the retail sales report for May and initial unemployment claims for the week ending June 6. I was glad to see a benign retail sales report, as this indicator has been very negative for the previous two months and caused major short-term sell-offs in the stock markets. While not usually market-moving, other reports indicated that the consumer balance sheet is no longer in a free fall, inventories have begun the stabilization process, and our trade balance continued to look pretty good despite increases in oil imports.

Weekly initial unemployment claims continued to fall, albeit at a snail's pace, from 625,000 last week to 601,000 this week. We are well off the 674,000 peak of March 28. Interestingly, job losses are improving considerably faster (from 741,000 net monthly job losses in January to 345,000 losses for May). That is because new hiring is improving faster than layoffs, which is a bit unusual. More typically one would see layoffs slow first, then hiring pick up.

May retail sales were up 0.5% after two disastrous months that were originally announced as down more than 1% each. The trend in retail sales now looks much better with two consecutive months of improvement. Restatements of prior months, a meaningful jump in gasoline prices, and a lack of an inflation adjustment make interpreting this metric a bit difficult, but it now appears that we have arrested the meaningful declines in March and April that so spooked the market. Retail sales was one of our indicators that was not confirming the improvement we had seen in new orders from purchasing managers, real hourly wages, and initial unemployment claims. So even though the details of this month's release are a bit difficult to read, the trend is now much more supportive of my other indicators, albeit after a couple of revisions. However, given that this series has been subject to big revisions lately, we place less faith in it than usual, in either direction.

Consumer Coming Around?
The Federal Flow of Funds Report indicated the consumer's balance sheet saw only minor declines after a few really bad quarters. The consumer overall showed a net loss of just $1.3 trillion to $50.4 trillion for the first quarter. While the number is still down considerably from its high of $63 trillion in the fourth quarter of 2007, we have moved from the world of several trillion losses each quarter to just $1 to $2 trillion. Given the improved savings rate as of late and the dramatic improvement in the stock market since March 9, it is possible that the consumer will actually show an improved net worth in the June quarter. This phenomenon may be a good part of the reason why consumer confidence improved again in early June as reported in the mid-month Consumer Sentiment indicator from the University of Michigan Survey. I eventually hope to see some of this increased confidence flow into increased retail sales.

Taking Inventory
It is a good news, bad news situation with business inventories as reported this week. Inventories, ex-autos, declined by 1% as reported by the Census Bureau for May. This compares with a decline in sales of just 0.3%, indicating a net draw-down  in inventories. Although still elevated, the inventory to sales ratio appears to have stabilized and even declined modestly. As sales increase, inventories will need to move back, too, creating long-term demand potential. The bad news is that reduced inventories weigh on the quarterly GDP numbers that include an inventory adjustment. Although we doubt the second-quarter inventory hit will be as high as the 2% effect in the first quarter, it may be a bit worse than the neutral effect that we had been anticipating. But this will create more potential in future quarters.

I remain bullish on the economy based on the stimulus package, reduced business inventories that need to be restocked, and improved consumer confidence. This quarter will likely mark the bottom of the recession, though the decline in the quarter is likely to be at the higher end of our 2%-3% (seasonally adjusted annual rate) forecast due to inventories. The Consumer Price Index is likely to remain benign through the next several quarters as slack capacity plus low rents depress this well-followed measure. However, I will remain extra vigilant as many of my favorite tailwinds, such as lower gasoline prices and home refinancings, have turned into headwinds over the past month or two.