Weekly Economic and Financial Commentary

U.S. Review

Still Walking On Eggshells

Last week's commentary made note of the slightly improved economic performance during the first quarter and slightly better tone of recent economic news. We noted then, that our more upbeat tone should not be confused with optimism about the economy. Overall growth is still excruciatingly sluggish and significant downside risks remain in place. That said, we still believe the economy will eke out modest growth in the current quarter.

The two key risks for the economy remain tight credit conditions and soaring oil prices. The credit markets have actually shown some tentative signs of improving and a few well known prognosticators, like Alan Greenspan, have stated they believe the worst is now behind us. Oil prices, however, continue to hit new record highs and we fear we may see a sharp eruption in prices this summer due to supply or even purely speculative factors.

Higher oil prices are already causing significant discomfort. Spending for discretionary items has been reined in and many retailers are struggling. Spending at discounters has increased.

Testing The Limits Of Consumers' Resiliency

Consumers face a one-two punch from soaring energy costs and a weaker job market. In addition, with home prices faltering and the stock market struggling, household wealth likely declined by more than $1 trillion during the first quarter. So far, however, consumer spending has continued to increase, although spending on discretionary items has clearly been scaled back.

The latest chain store sales figures show spending at discount stores and warehouse clubs posted strong gains in April, while sales at department stores and specialty chains languished. Restaurants, particularly in the fast casual dining segment, also continue to struggle. That said, the overall chain store numbers came in slightly ahead of expectations, which points to at least modest growth in the retail sales data due out this coming week.

The better than expected chain store sales figures along with this past week's stronger ISM non-manufacturing survey indicate that the economy held up better than expected in April and further bolsters our case that real GDP will remain in positive territory in the second quarter. The ISM non-manufacturing survey rose 2.4 points to 52 in April. While the increase is welcome, the composition of the survey's various components is consistent with very modest economic gains and merely confirms what recent reports on GDP and employment told us. The most encouraging aspect of the report was a 3.9 point rise in the employment index to 50.8. New orders declined slightly to 50.1 but order backlogs lengthened and inventories decreased.

The other major reports released this week were stronger-than-expected productivity growth and a much larger-than-expected improvement in the trade deficit. Nonfarm productivity increased at a 2.2 percent annual rate in the first quarter and is now up 3.2 percent over the past year. Manufacturing productivity increased even more dramatically, climbing at a 4.1 percent pace. The stronger productivity data should help keep overall growth in positive territory, even as job and income growth slows. Stronger productivity growth should also help restrain inflation, even in the face of soaring commodity prices.

The nation's trade deficit posted a larger-than-expected $3 billion drop in March, which will likely result in an upward adjustment to first quarter GDP. Any adjustment will be tempered, however, by a reduction in inventories. All of the improvement in the trade gap is due to falling imports, which tumbled by $6 billion in March. Exports fell by $3 billion during the month. Exports should rebound in coming months, helping further narrow the trade gap.

U.S. Outlook

Retail Sales • Tuesday

Economic fundamentals, particularly contraction of employment and confidence, have not been supportive of retail sales growth in 2008. That being said, consumer spending is now expected to hold up slightly better this spring, thanks largely to the accelerated pay-out of the tax rebates. While there has been considerable discussion about how much of the $110 billion tax rebate will be spent, we expect at least two-thirds of the rebate to be spent over the next three to four months. Most of this increase will likely show up in the third quarter GDP figures, when we expect consumer spending to climb at a 4.2 percent pace.

Looking specifically at April, we expect to see total retail sales post a modest increase despite the significant drop in motor vehicle purchases.

Previous: 0.2%
Consensus: -0.1%
Wachovia: 0.1%

Consumer Price Index • Wednesday

After registering a surprising flat reading in February, headline CPI rose 0.3 percent in March as gasoline prices jumped 7 percent. Excluding food and energy, prices increased 0.2 percent, bringing the year-over-year measure to 2.4 percent.

As economic growth has slowed, core CPI has remained in the 2.0 to 2.5 percent range over the past six months. Food and energy prices, however, have continued to climb. We expect to see solid increases in both in the April report. A rebound in medical care and airfares has the potential to push core CPI slight above trend.

With bombarding headlines across all types of media outlets, inflation expectations, as measured by the University of Michigan, have shot up to elevated levels. Weak economic growth should help slow inflation but many see downside risk to that assessment.

Previous: 0.3%
Consensus: 0.3%
Wachovia: 0.6%

Housing Starts • Friday

Starts continue to trend broadly lower, with transitory increases in a few months followed by another down leg a month or two later. Multi-family starts have also seen volatility and the beginnings of a decline. We think starts still have another 10 percent to fall before bottoming out sometime in the summer of 2008, but this means the vast majority of the declines in starts are behind us.

Permits in the worst housing markets are rapidly approaching or are already at near zero levels. As a result, the downside risks to permits on a national level are somewhat limited. That being said, as the financial and mortgage market crisis drags on, the big national builders began cutting back in all of their markets. Permits may turn as early as late Spring. However, a rapid return in new activity is unlikely even after construction bottoms out, as excess inventory and funding concerns will both curtail new construction for some time to come.

Previous: 947K
Consensus: 940K
Wachovia: 875K

Global Review

Korean Won Weakens

The Korean won strengthened nearly 50 percent versus the dollar between mid-2002 and late 2007 (see chart at left). However, the won weakened a bit at the beginning of this year, and its rate of depreciation has picked up over the past week or two. Indeed, the won has slid about 10 percent against the greenback since the end of last year. What does the recent behavior of the won say about the current state of the Korean economy?

In short, economic fundamentals in Korea have deteriorated a bit recently. As shown in the top graph on page 4, real GDP growth slowed in the first quarter. Real consumer spending continued to expand in the first quarter, albeit at the slowest pace in nearly three years. Fixed investment fell in the first quarter as business spending on facilities edged lower and construction spending posted a 4 percent loss. The volume of exports, which grew at double-digit paces in 2006 and 2007, declined 1.5 percent in the first quarter, no doubt a victim of slower growth in the rest of the world. However, net exports made a large positive contribution to GDP growth in the first quarter because the volume of gross imports tumbled 7 percent.

Not only is growth slowing, but inflation is picking up. As shown in the middle chart, CPI inflation is currently running a bit above 4 percent. Although some of the increase in the overall rate of inflation is attributable to food and energy prices, which can be quite volatile on a monthly basis, the core rate of inflation recently rose to a 6-year high of 3.5 percent. In other words, the Korean economy is suffering from a mild case of stagflation at present.

The Bank of Korea conducts monetary policy to keep inflation within a 2.5 percent to 3.5 percent range over the next two years. The Bank is forward-looking, and the current inflation rate does not necessarily mean rates need to be hiked further. However, the Bank likely will not ease until it is convinced inflationary pressures will subside. Therefore, the growth rate of the Korean economy could sink below trend later this year if the Bank of Korea drags its feet in cutting rates.

As shown in the bottom chart, Korea has posted trade surpluses over the past ten years. However, the balance has swung into a modest deficit so far in 2008. Korea imports essentially all of its oil needs (more than 2 million barrels per day) and the sharp increase in energy prices this year has led to the deterioration in the trade accounts, which usually is associated with currency depreciation. Moreover, the rise in energy prices could weigh on real consumer spending, which would impart another slowing effect on the economy.

Whither the Korean won? The won has fallen rather far in a relatively short period of time, so some pullback seems inevitable. That said, it's hard to envision a lasting appreciation of the won as long as petroleum prices remain elevated. Indeed, oil prices and the won/dollar exchange rate have been very highly correlated recently. If, as we project, petroleum prices eventually recede from their current peaks, then the won should regain its footing. However, the won probably won't revisit the 10-year high it set last year due to deteriorating economic fundamentals.

Global Outlook

Chinese CPI Inflation • Monday

Chinese CPI inflation shot up to a 12-year high of 8.7 percent in February, and it remained elevated in March. Much of the increase in the overall CPI inflation rate reflects sharp increases in food prices over the past year. Although the food-price effect should fade over the course of the year, the Chinese government is worried that inflation may remain elevated due to significant increases in other commodity prices and acceleration in wages.

Other data releases next week will give investors additional insights into the state of the Chinese economy at present. Data on retail sales in April are on the docket on Tuesday, and the consensus forecast looks for the year-over-year growth rate to step down only a tad from the 21.5 percent rate that was registered in March. International trade data for April also will print at some point next week.

Previous: 8.3% (year-over-year)
Consensus: 8.2%
Wachovia: 8.3%

Euro-zone GDP •Thursday

Real GDP growth in the Euro-zone has weakened over the past year. That said, growth remained positive through the fourth quarter or last year, and most analysts, ourselves included, reckon that the economy posted another positive growth rate in the first quarter as well. Real GDP estimates for some of the largest Euro-zone economies (Germany, France, Spain and the Netherlands) will also be released next week.

Data on the core rate of CPI inflation in April will also elicit attention next week. Preliminary data showed that the overall rate of CPI inflation edged down in April. Did the underlying rate of inflation tick down as well? If it did, some investors may begin to anticipate ECB easing later this year.

Previous: 1.4% (annualized)
Consensus:
Wachovia: 1.5%

Japanese GDP • Friday

Japanese real GDP grew at a solid pace in the fourth quarter (3.5 percent at an annualized rate relative to the previous quarter). Although the economy likely downshifted a notch in the first quarter, growth probably did not turn negative either. Although business fixed investment spending likely contracted in the first quarter, personal consumption expenditures and net exports probably added positively to growth.

Speaking of net exports, data on the current account balance in March will be released on Wednesday. Perhaps of more importance to investors, data on machinery orders, a good leading indicator of capex, will print on Thursday. This series will offer some insights into the pace of capex in the next quarter or two.

Previous: 3.5% (annualized)
Consensus: 2.5%
Wachovia: 1.33%

Point of View

Interest Rate Watch

Is The Credit Crunch Ending?

There have been a number of reports in recent weeks suggesting the worst of the credit crunch is behind us. Even Alan Greenspan opined on the subject, noting that while the worst had likely passed, economic growth would remain sluggish and home prices still had further to drop.

For the most part, credit spreads do not support the notion that the worst of the credit crunch has passed. Spreads remain unusually wide across virtually every category and the TED spread, which is a proxy for confidence in the banking system, is particularly wide.

One area where spreads have come in has been commercial real estate. The CDX has narrowed by 75 basis points relative to the 10-year Treasury since late February, as investors have gobbled up CMBS paper and whole loans sold a discount. The same cannot yet be said for residential mortgages, auto loans, credit card loans, or home equity loans.

Even if spreads on other types of loans come down a bit they are likely to remain relatively wide for some time. The latest survey of Senior Loan Officers by the Federal Reserve shows credit conditions having tightened considerably in recent weeks. So even if the worst is over, we still have plenty of room for improvement.

Barring a substantial further deterioration in economic activity, the Fed will likely remain on hold through the summer. Fed funds futures actually show the federal funds rate rising slightly by the end of the year. We doubt that will happen.

Concerns about inflation may return to the Treasury market. We expect the headline inflation numbers to pick up as the recent run-up in gasoline prices begins to show up in the official inflation reports.

Topic of the Week

Global Growth Should Slow to Trend

Global real GDP growth averaged nearly 5 percent per annum between 2004 and 2007, the strongest four-year period of growth in decades. Rising inflation rates led to a tightening of macroeconomic policies during that period, which caused some deceleration in global economic activity in 2007. Dislocations in credit markets caused by the subprime mortgage debacle in the United States appear to have weighed on growth rates in many economies at the end of 2007. Looking forward, we project that global growth will fall a bit below its long-run average in 2008. Growth rates in many major economies may be sluggish this year. However, economic activity in many developing countries, which are less affected by dislocations in credit markets than their major economy counterparts, should remain rather solid, albeit less robust than in the past few years.

The U.S. dollar has followed a downward trend against most major currencies for six years. Indeed, the greenback has recently dropped to all-time or multi-year lows versus many major currencies. The greenback could fall even lower versus most major currencies in the near term. As long as investors question the U.S. economic outlook, which will keep expectations of further Fed easing alive, it's hard to envision a sustained rise in the value of the dollar. However, as it becomes apparent later this summer that the Fed's easing cycle has indeed come to an end, investors will begin to anticipate eventual monetary tightening. At that point, the greenback should begin to strengthen on a sustained basis against most major currencies. To see our full report, please go to the “Monthly Global Chartbook” link on our website.

Wachovia Corporation
http://www.wachovia.com

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