Carl Polhemus : Northwestern Mutual - Economic Commentary - June 2008 : Article: Economic Commentary

Economic Commentary - June 2008

Clare Zempel

Economic and Investment Strategies Consultant

Overview

The markets have turned more positive on economic prospects in recent months. The stock market has risen even when confronted with weak economic and corporate profit reports. From its March low to its May high, the broad stock market rose about 12.5%. A similar shift occurred in the fixed-income markets. The 2-year T-Note yield jumped from 1.4% to 2.5%. The yield on the 10-year T-Note rose from 3.3% to 3.9%. The yield on riskier corporate bonds fell from 11.1% to 9.9%. And the federal funds futures market, which had expected the federal funds rate to drop to 1.5% next March, now expects it to rise from its current 2.0% level to above 2.5% next May.

The rise in stock prices and most interest rates means that the markets expect better economic conditions – less recession risk – and less need for the Fed to ease in the months ahead. This shift fits with what the more reliable indicators emphasized here told us to expect. Real interest rates – which have not been near recession-inducing levels since before the 2001 recession – have fallen to levels that spurred economic recoveries and reaccelerations in the past. Unemployment insurance claims – which soar whenever recessions take hold – have risen but still not much. The stock market’s valuation relative to interest rates – which rises to extremes before bear markets – has been nowhere near such worrisome levels since 1999. Bearish sentiment – which tends to peak when the stock market bottoms – reached its highest level since 1990 in mid-March.

These indicators have been reliable over almost five decades. Based on them, the fears that still dominate the headlines seem unfounded. A recession remains unlikely. If one does occur, it should be quite mild in depth and duration. The stock market suffered a severe correction last winter but a deeper and more protracted bear-market decline seems improbable.

Could rising oil prices undercut the recent shift toward optimism? Spikes in oil prices did not result in recessions in the past unless the real fed funds rate was above 450 basis points – and the real fed funds rate is below zero now. Moreover, the recent sharp rise in oil in part reflected a steep decline in the dollar’s value, which in turn reflected expectations that the Fed would lower interest rates further. The new view that the Fed will not lower rates further should help stabilize the dollar and contain or lower oil prices in the future. And spikes like the recent one have tended to occur just before oil’s price mounted extended declines.

On balance, the numbers that matter most still lean toward bullishness. Investors should continue to adhere to well-formed asset allocation plans, adding common stocks as needed to correct portfolio imbalances.

Economic and Market Update: The Continuing Discussion

Investors need to know if a recession will occur because most bear-market declines in common stock prices start before recessions take hold. There have been exceptions to the rule that bear markets are associated with recessions. The stock market fell in 1962 in reaction to two major political developments – President Kennedy’s confrontation with the steel industry over price increases and the Cuban Missile Crisis. The stock market fell in 1966 in connection with restrictive policies that induced a slowdown that was shallower and shorter than a true recession. The stock market “crashed” in 1987 from an overvalued level but no recession ensued. All other major stock market declines anticipated material economic downturns. (Figure 1.)

If we could predict recessions, then, we could protect ourselves from most bear market declines in stock prices. The definition popularized in the press is that a recession occurs when Real GDP (Real Gross Domestic Product – the most comprehensive inflation-adjusted economic-output measure available) declines over two or more consecutive calendar quarters. That rule applies to most recessions since World War II but not to the last one in 2001 (Real GDP fell in the first and third quarters but rose in the second period).

The National Bureau of Economic Research (NBER) is the private (non-governmental) academic research organization that is the accepted authority on defining recession periods. The NBER stresses that it considers more than just Real GDP when it declares that a recession has occurred. The four additional data series that it mentions are: Real Personal Income Less Transfer Payments; Nonfarm Payroll Employment; the Industrial Production Index; and Real Manufacturing and Trade Sales. These four data series are the components in the Coincident Index. (Figure 2.)

More than a few economists have declared that a recession has started or is imminent but the NBER has not done so to date. The Coincident Index “peaked” last October but it had fallen less than 0.4% by April. Similar small declines in this index that were unrelated to recessions have occurred 34 times since 1959. The pattern in the Coincident Index seems consistent with the idea that economic momentum has slowed if not stalled. But the decline also seems much too small to support a confident declaration that a recession has in fact started.

The perspective here is that real interest rates provide the most reliable clues about recession risk. 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 for this purpose. This is the rate that 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 funds rate was lowered to 2.0% on April 30.

The real fed funds rate is the difference between the nominal interest 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 2.1%. Hence, the real fed funds rate is about -0.10% or -10 basis points – the 2.0% nominal fed funds rate minus the 2.1% inflation rate. (Figure 3.)

The reason it is important to know that the real fed funds rate is minus 10 basis points or so 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 last recession in 2001 (the real fed funds’ highest level since then was 334 basis points last summer).

There should be no recession now because the real fed funds rate never approached the level seen before all recessions since 1960. But it also seems important to note that the real fed funds rate has fallen near levels that ended past recessions. This implies that whatever economic weakness exists or develops in the near term should prove quite limited in depth and duration.

Can we be sure that what mattered in the past remains relevant? Could the severe weakness in residential construction or the sharp rise in oil prices pull the economy down into recession despite low real interest rates?

The best answer to these questions lies with initial or first-time unemployment insurance claims. Jobless claims soared 20% or more when recessions took hold in the past. So far in the current episode, claims have risen less than 18% above their trailing 12-month lows – a rise that is consistent with a severe economic slowdown but not with a recession.

The fact that jobless claims have not risen more is important evidence that recession fears have been overdone. Unlike almost all other economic data, claims are available almost in real time and are seldom revised much. Since no recession has started until after claims soared more than 20%, and since claims have risen less than 18%, the idea that a recession has already started seems unfounded. (Figure 4.)

Could rising oil prices turn the slowdown into a recession and a correction into a bear market? This is possible but improbable. Sharp increases in oil prices did not result in recessions in the past unless the real fed funds rate was above 450 basis points – and the real fed funds rate is nowhere near this “tipping point” level now. Moreover, the sharp rise in oil prices has in part reflected a steep decline in the dollar’s value in international exchange, which in turn reflected expectations that the Federal Reserve would lower interest rates even further. Better-than-expected economic and corporate profits reports have caused expectations to shift to the idea that rate cuts are all but done. That has helped to stabilize the dollar and should help contain or lower oil prices in the not-too-distant future.

The rise in oil prices over the year that ended in May is the third sharpest 12-month increase since 1980. The record shows that outsized advances in oil prices – 12-month increases that surpassed 77.5% – have tended to occur around the time that oil’s price level peaked. Subsequent declines in oil prices surpassed 30% in depth and 14 months in duration. There can be no assurances but an end to the upward spiral in oil prices seems to be near. (Figure 5.)

A recession would pose a serious threat to the stock market but the rise in jobless claims supports the view that real interest rates are too low to cause one. Absent a recession, stocks tend to rise unless real interest rates soar – which is not an issue now – or unless the market soars and becomes overvalued in the extreme – which is also not an issue. Stocks also tend to rise when pessimism prevails – and consumer sentiment has now dropped to its lowest level in 28 years. (Figure 6.)

We tend to think that the “thing that most affects the stock market is everything” but a few numbers seem to provide all the information that matters for the most important investment decisions. Real interest rate levels tell us much about the risk that a recession or a

bear market will occur. Initial unemployment insurance claims tell us if a material economic slowdown or a recession has taken hold or not. The stock market’s relative valuation level tells us if it is vulnerable even when real rates and recession do not threaten.

Here and now, real interest rates do not threaten a recession or a bear market, unemployment claims are consistent with a slowdown but not a recession, and the stock market is not so overvalued that it threatens to fall under its own weight. Add to this mix the well-founded contrarian concept that extreme bearishness is bullish, and it seems clear that the numbers that matter the most still point in a positive direction.