Weekly Economic and Financial Commentary
U.S. Review
Team Bernanke Takes The Lead
After trailing big-time, policymakers have finally taken the lead in their battle with the credit crisis. The Fed, Treasury, and OFHEO all turned in strong performances this week and this team will now most certainly advance to the next round.
The Fed's moves were particularly impressive. They took Bear Sterns out of the game in the nick of time and opened the discount window to investment banks. The Fed also cut the discount rate by a quarter percentage point Sunday night and then cut both the federal funds rate and discount rates by three-quarters percentage point on Tuesday.
Meanwhile, Treasury Secretary Hank Paulson has been out recruiting. Meeting with Abu Dhabi and Singapore, Paulson helped develop a voluntary guideline of investment principals which states that “investment decisions should be based solely on commercial grounds, rather than to advance, directly or indirectly, the geopolitical goals of the controlling government”. SWFs have played a key role in raising new capital for major financial institutions but not without controversy.
March Madness Continues
The new guidelines should help assuage fears that there are any sinister motives behind the investments of SWFs and should help head off protectionist rhetoric and legislation. More importantly, the growing comfort with SWFs should help ensure the continued flow of capital, which is still needed in order to re-energize capital markets in Europe and the U.S.
The Office of Federal Housing Enterprise Oversight (OFHEO) came of the bench yesterday and provided a key assist. The regulator, which has jurisdiction over Fannie Mae and Freddie Mac, reduced the required amount of capital that they each needed to hold against their mortgage portfolio. The move should free up $200 billion to purchase mortgages in the secondary market, which should add some much needed liquidity to the mortgage market. The move has already proven somewhat successful, in that the spread between the 10-year Treasury and 30-year fixed mortgage almost immediately narrowed by a few basis points.
There is so much going on in the financial markets that you honestly need a bracket sheet to keep score. Just keeping up with all the liquidity measures taken by the Fed is a formidable challenge. In addition to the 300 basis point reduction in the federal funds rate, the Fed has taken actions to reduce the stigma attached to borrowing from the discount window and brought out a cacophony of borrowing facilities, including the Term Auction Facility (TAF), the Term Securities Lending Facility (TSLF), and most recently the Primary Dealer Credit Facility (PDCF). The moves are all designed to boost liquidity by allowing banks and brokerage firms to use a wider range of collateral to borrow from the Federal Reserve.
The Federal Reserve announced some modification to the TSLF yesterday afternoon. The Federal Reserve Bank of New York announced that they will conduct the TSLF auction on March 27. The auction will be for $75 billion in securities for a term of 28 days and the Fed will loan Treasury securities against a broader than originally thought range of capital. The most important addition is that the Fed will now accept agency collateralized-mortgage obligations (CMOs) and AAA/Aaa-rated commercial mortgage-backed securities (CMBS).
The Fed is clearly in tune with the parts of the financial markets where liquidity is constrained the most and is working diligently to restore liquidity there. While the credit crunch will most certainly outlast the Final Four, we should see some tangible benefits from the Fed's actions by the time the National Champion is crowned.
U.S. Outlook
Existing & New Home Sales • Mon./Wed.
Home sales have continued to drift lower in 2008. Sales of new homes dropped 2.8 percent in January to an annualized rate of 588K units while sales of existing homes fell 0.4 percent to an annualized rate of 4.89 million units.
Conditions for improvement in the housing market have been slow to come. Inventories remain high, lending standards are tight, foreclosures are rising and the 30-year fixed mortgage rate has recently trended higher. We don't expect significant relief anytime soon.
We expect existing home sales to drop for the seventh consecutive month to an annualized pace of 4.82 million units in February. Bloated inventory levels will continue to pressure home prices lower through most of the year.
Previous: Existing 4.89M
Consensus: Existing 4.85M
Wachovia: Existing 4.82M
Consumer Confidence • Tuesday
Falling to its lowest level since the start of the Iraq War, consumer confidence, as measured by the Conference Board, declined a little over 12 points to a level of 75.0 in February from 87.3 in January. Before then, this was the lowest reading since November 1993.
No doubt about it, consumers are feeling pressure from lots of fronts. Jobs are increasingly getting hard to get as evidenced by the last two employment reports. Consumers are also very pessimistic on the outlook for the overall economy and their income prospects. Volatility in the financial markets is likely playing with consumers' psyche as well. With many economic and financial indicators signaling that we may already be in recession, we do not expect consumer confidence will change tunes anytime soon.
Previous: 75.0
Consensus: 74.7
Wachovia: 70.0
Personal Income & Spending • Friday
Weakness in income growth is something that is very different from the relatively brief 2001 recession. During that eight-month downturn, real income actually grew at a one percent annual rate. By contrast, real after-tax income has fallen at a 0.7 percent annual rate over the past three months. Moreover, household wealth declined during the fourth quarter, reflecting falling home values and stock prices. The first two months of 2008 have seen an even sharper pullback in both. Consumers are definitely feeling the heat of this downturn, even though the unemployment rate remains relatively low.
Real disposable personal income (DPI) growth is expected to remain lethargic in the first quarter from high inflation and negative employment growth. However, real DPI should bounce back in the second and third quarters as a result of the tax rebate checks which get mailed out in late May/early June.
Previous: 0.4 %
Consensus: 0.2 %
Wachovia: 0.1 %
Global Review
Growth in Brazil Remains Strong
As shown in graph at the left, real GDP in Brazil grew at an annualized rate of 6.6 percent in the fourth quarter of 2007 relative to the preceding quarter. The 5.4 percent annual average growth rate that Brazil achieved in 2007 was only exceeded once in the last decade.
Although the current expansion, which did not really gather pace until 2004, started out as an export-led recovery, it has broadened into a sustainable expansion based on domestic demand. Indeed, net exports exerted a drag on overall GDP growth last year as import volumes grew nearly three times as fast as export volumes. Strong domestic demand, which pulls in imports, and a strong currency are usually a recipe for declining net exports.
The genesis of Brazil's strong growth over the past year or so was good macroeconomic policies. To wit, the central bank was able to bring down CPI inflation from double-digit rates in 2003 to a low of about 3 percent last year. As inflation subsided, the central bank subsequently cut its policy rate by nearly 900 basis points between 2005 and 2007. In addition, the administration of President Lula has been running very responsible fiscal policy for the past few years, which has resulted in a marked decline in public sector debt from 85 percent of GDP in 2002 to about 65 percent at present. Consequently, long-term interest rates in Brazil have also retreated.
As noted above, the decline in interest rates has contributed to a revival in domestic demand. Car sales rose more than 25 percent last year and, more generally, growth in overall retail sales has been clipping along at a very strong pace (see top chart). Fixed investment spending has also grown at a double-digit rate over the past two years. Unemployment has dropped to only 8 percent, a truly remarkable accomplishment in a country where double-digit rates were historically the norm.
However, there are signs that some of the economic fundamentals are starting to deteriorate at the margin. The overall CPI inflation rate has risen from 3 percent last year to nearly 5 percent at present. As noted above, the trade surplus has been shrinking (see middle chart). The country has posted current account surpluses for five consecutive years, but most analysts look for a modest deficit this year due to slower global growth and the strength of the currency. That said, the Brazilian economy is much better placed to withstand a marked slowdown in global growth than it was in previous cycles. Not only are the domestic economic fundamentals strong, but the country's foreign exchange reserves, which currently stand at $180 billion, give the central bank plenty of ammunition should the currency come under pressure.
Speaking of the currency, Brazilian authorities probably would not mind some modest depreciation of the real. The government recently announced some steps to make it easier for domestic investors to send money to foreign countries, and some taxes were raised on foreign investment in Brazil. Both sets of measures should encourage less net capital inflows, which, everything else equal, should lead to currency depreciation. Indeed, our forecast calls for the real to depreciate modestly versus the dollar in the quarters ahead. (For details, see our Monthly Economic Outlook.)
Global Outlook
Canadian Retail Sales • Tuesday
Growth in Canadian retail sales has been rather strong over the past few years. Canada is a major producer of many “hard” and “soft” commodities and the rise in commodity prices over the past few years has improved the country's terms of trade. In addition, the Canadian dollar has appreciated significantly. Both phenomena have helped to raise real income in Canada, giving a boost to growth in consumer spending.
The market consensus forecast anticipates that retail spending grew 0.9 percent in January (month-over-month) following the 0.6 percent rise registered during the preceding month. The Bank of Canada, which has cut rates by 100 basis points since December,
Previous: 0.6 % (month-over-month)
Consensus: 0.9 %
German Ifo Index • Wednesday
The Ifo index of German business sentiment, which is closely watched by market participants because it is highly correlated with growth in German industrial production, has declined over the past year. That said, the index remains at a level that is consistent with continued solid growth in industrial production. Although the dislocations that have swept through credit markets since last summer have slowed growth in German, it appears that overall economic activity continues to expand.
The Ifo index, which will print on Wednesday morning, will give investors some insights into the current state of the German economy. Continued signs of solid growth would give the ECB little reason to cut rates at its next policy meeting on April 10.
Previous: 104.1
Consensus: 103.5
Japanese Unemployment • Friday
The usual monthly barrage of Japanese economic data will start to print at the end of the week. Data on the unemployment rate, which has edged up from the cycle low of 3.6 percent that was reached in July will give investors some insights into the current state of the labor market. Relatively solid labor market conditions could help to bolster consumer spending.
Speaking of consumer spending, data on retail sales in February will also print on Friday. Will January's stronger-than-expected outturn be repeated in February, or will there be some statistical payback? Data on CPI inflation will also print on Friday. Regardless of next week's outturns, the Bank of Japan likely will keep policy unchanged for the foreseeable future.
Previous: 3.8 %
Consensus: 3.8%
Point of View
Interest Rate Watch
A Perspective on Credit
Once a generation we as economists get to witness the evolution of a credit market. In the 1970s there were mutual funds, in the 1990s there were high yield bonds and today we have subprime lending. How do we set a framework for a marketplace that allows itself to undergo a quiet evolution but ends in speculation and credit revulsion?
America's latest credit cycle, subprime lending, is not a unique experience but rather the latest variation of a traditional cycle of innovation, excess and correction compounded by public policy laxity followed by overreaction. Indeed there is very little new or creative in the whole subprime saga. This is disappointing because the subprime credit patterns we observe are so typical that they suggest much of the recent experience could have been avoided. In the end, the whole experience brings forth several core public policy issues that are more often avoided rather than faced.
Supply and demand set the framework for the subprime credit market. What was interesting this cycle was how these fundamentals evolved with the cycle itself. Mortgage demand morphed into speculation as home price expectations, not household income, drove demand. Meanwhile, the supply of mortgage credit evolved away from portfolio lending to transaction/securitization lending.
Dynamic changes in the fundamentals of credit markets, whether high yield bonds or residential mortgages, signal changes in the risk/return profile of each market. Unfortunately, decision-makers were caught up watching the show and not the fancy footwork.
Topic of the Week
Hot Cocoa? Not Anymore
Cocoa bean futures, which had been on a tear and only last week traded at over $2900 per metric ton, have been ground down to $2304 - a loss of 21 percent. Cocoa is just one of 19 commodities that comprise the Reuters/Jefferies CRB Index. Headlines this week were dominated with the Bear Sterns announcement and volatility in the equity markets, but the CRB index sold off 8.32 percent in the holiday-shortened trading week. This is the largest one week decline in the index since the Commodity Research Bureau in Chicago began calculating the bellwether of commodity prices back in 1957. In addition to the drop in cocoa, crude oil came down to $101 from highs over $110/barrel, while the price of gold slipped $114/ounce to finish the week at $924.
Commodities had experienced a substantial run-up in recent weeks, fueled by a confluence of factors. Strong global growth, a weakening dollar, and flows of new capital as investors sought an alternative to other asset classes hurt by the credit crunch all did their part to push prices higher. The CRB Index was up more than 16 percent before this week's sell-off.
The tables were turned this week as the factors that had propelled commodity prices changed course. Investors and speculators alike came to terms with the reality of slowing growth and the growing chorus of economists calling for a U.S. recession and what that could mean for global growth. Combine that with a strengthening U.S. dollar, and the hope that the worst of the credit crunch might be behind us, and you've got a recipe for falling prices - oh - and don't forget the cocoa
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Wachovia Corporation
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Disclaimer: The information and opinions herein are for general information use only. Wachovia Corporation and its affiliates, including Wachovia Bank, N.A., do not guarantee their accuracy or completeness, nor does Wachovia Corporation or any of its affiliates, including Wachovia Bank, N.A., assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or any foreign exchange transaction, or as personalized investment advice. Securities and foreign exchange transactions are not FDIC-insured, are not bank-guaranteed, and may lose value.
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