Weekly Economic and Financial Commentary

U.S. Review

Independent Thinking For The 4th

As expected, the European Central Bank (ECB) raised their overnight lending rate by a quarter percentage point this morning. The reaction in the foreign exchange market was a bit of a surprise, with the dollar strengthening. This should curb some of the calls for the Federal Reserve to follow the ECB higher.

The thinking has been that higher rates in Europe would weaken the dollar and drive oil and other key commodity prices higher. Such thinking has several flaws, the largest of which is the absence of anyone asking why the ECB is raising interest rates at all.

The statement that accompanied the ECB's decision helped temper fears of a dollar collapse. ECB president Jean-Claude Trichet said he has no bias on future interest rate policy and he expects economic growth to slow in coming months. So even if the ECB's actions differ from the Fed, their view on future economic conditions are about the same.

We never thought the Fed would follow the ECB higher. The Federal Reserve is pretty diligent about guarding their independence and we doubt they would back off that on the eve of the Fourth of July

Higher Energy Prices Are Taking A Toll On Economic Growth

This week's economic reports were fairly weak. Nonfarm employment declined by 62,000 jobs in June, marking the sixth consecutive monthly drop. Declines for the two previous months were also slightly larger than previously thought. The unemployment rate, which jumped 0.5 points in May, remained unchanged at 5.5 percent. Job losses were fairly broad based, with notable declines in construction, temporary services, and manufacturing. In addition, financial services and retail trade continue to shed jobs in areas closely tied to housing.

The U.S. economy lost a total of 438,000 jobs during the first half of 2008. Construction and manufacturing losses during this time period actually exceed overall losses, totaling 496,000 jobs.

Total hours worked fell 0.1 hour in June and declined at a 0.9 percent annual rate during the second quarter. Nonfarm productivity has averaged around a 1.7 percent pace for the past three years, indicating that second quarter real GDP growth likely remained in positive territory. Our current point estimate for second quarter real GDP growth is 2.2 percent, reflecting improvement in the nation's trade deficit and the beneficial impact from the economic stimulus checks.

Hours worked in manufacturing fell even more, declining 0.5 percent in June and at a 7.1 percent annual rate during the second quarter. The weakness reflects sharp declines in output related to construction and parts of the economy adversely impacted by higher energy prices. Output of heavy trucks is notably weak, as is printing and publishing, which is getting hit with a one-two punch from weaker home sales and faltering motor vehicle sales.

The drop in hours worked as well as the sharp decline in temporary staffing employment, suggest job losses will continue and possibly worsen in coming months. Another piece of worrisome news released this morning was a surprising 16,000 jump in first-time claims for unemployment insurance. Weekly first-time claims now total 404,000, which moves this timely measure closer to where it typically is in a recession.

Both ISM reports were released this week. The manufacturing index rose 0.6 points to 50.2. The subcomponents were not as strong as the headline, however, with new orders and employment both declining sharply. The ISM non-manufacturing index came in below expectations, with the overall index falling 3.5 points to 48.2. New orders and employment were once again notable weak spots. These two components are the most leading parts of these two surveys.

U.S. Outlook

Consumer Credit • Tuesday

As consumers search for ways to sustain their current spending habits, consumer borrowing has understandably increased. Growth is quiet apparent in the credit card arena where the year-over-year measure has been trending higher since mid-2006 and currently stands up 6.0 percent.

Consumers will likely continue to move towards maxing out their current credit lines on home equity and credit cards as they struggle to pay their rising gasoline and food bills. While consumers would like to expand their credit lines even more, growth will be limited as financial services firms remain wary about extending more credit.

Previous: $8.9B
Consensus: $7.0B

Initial Claims • Thursday

Since last August, initial unemployment claims have trended from the low 300+ level to the last week's 400+ level. While elevated, the four-week moving average remains below levels of the past two recessions. The recent increase, however, is consistent with the six consecutive monthly declines nonfarm employment has recorded so far this year.

Initial claims are likely to remain under pressure in the coming months. Significant job loss should continue in the hardest hits sectors of the economy – construction, manufacturing and retail trade. Layoffs in the financial services sector should intensify as firms continue to squeeze expenses and justify current headcount.

The upward trend in claims suggests we are likely to see continued moderate declines in nonfarm employment (50-100K range) in the coming months.

Previous: 404K
Consensus: N/A

International Trade • Friday

Despite a substantial gain in export growth, record petroleum imports helped lift the April trade deficit by $4.4 billion to -$60.9 billion.

While imported petroleum products will continue to rise in April, we should see growth in non-petroleum imports begin to wane as domestic demand has turned sluggish. Exports should continue to post another significant gain in May

The real trade deficit, which is important in the calculation of real GDP, continues to narrow. This is a positive for economic growth as a narrowing of the trade deficit is counted as a contribution. It appears net exports are on track to provide another positive contribution to second quarter real GDP growth. For an economy that is currently struggling, this continued contribution is key to keeping overall growth in positive territory.

Previous: -$60.9B Wachovia: -$62.5B
Consensus: -$62.1B

Global Review

Tankan Index Signals Slowdown in Japan

As shown in the graph at the left, the Tankan index of Japanese business sentiment, which has been edging lower for the past few quarters, fell in June to its lowest level since September 2003. Not only does the index measure sentiment among large manufacturers, but it is also highly correlated with Japanese real GDP growth. Although the Japanese economy expanded at an annualized rate of 4.0 percent in the first quarter, the Tankan index suggests it will be hard pressed to repeat that performance in the second quarter. Indeed, we think real GDP may have contracted slightly in the second quarter.

As shown in the top chart on page 4, growth in industrial production has weakened since the beginning of the year, although it still remains positive. So why has IP growth weakened? For starters, it appears slower growth in the rest of the world is starting to have an effect on the Japanese economy. Exports of goods and services were very strong in the first quarter, growing at an annualized rate of 17 percent. However, growth in the volume of exports down-shifted in the April-May period from the strong rate registered in the first quarter. As shown in the middle chart, Japanese exports to the United States, which is suffering from its own bout of sub-par growth, have weakened recently.

Final domestic demand (i.e., consumer, capital and government spending) expanded at a solid pace of 2.5 percent in the first quarter, but it too appears to be softening. “Core” machinery orders, a good leading indicator of capital spending, have weakened recently (see middle chart on page 5). In addition, consumer spending may be softening. The value of retail sales in the first two months of the second quarter edged down relative to the average in the preceding quarter. Like their counterparts in other advanced economies, Japanese consumers may be feeling the effects of higher energy prices.

BoJ To Remain on Hold Due to Benign Core Inflation

Speaking of higher energy prices, year-over-year CPI inflation in Japan has risen to the highest rate since the increase in the consumption tax in 1997 caused the overall inflation rate to breach 2 percent that year (see bottom chart). Unlike the previous episode, however, the recent rise in CPI inflation has not been broad based. Indeed, the core rate of inflation, which excludes food and energy prices, remains in negative territory. And due to subdued growth in wages, the core rate of inflation is not likely to increase sharply anytime soon. In other words, Japan hardly has an inflation “problem” at present. In our view, downside risks to growth and benign core inflation will keep the Bank of Japan, which has maintained its policy rate at 50 basis points since February 2007, firmly on hold.

Since the extreme bout of risk aversion in mid-March caused the Japanese currency to soar to a 13-year high versus the dollar, the yen has slowly lost ground. Looking forward, we project the yen will continue to depreciate gradually vis-à-vis the dollar as investors anticipate eventual Fed tightening.

Global Outlook

Japanese Machinery Orders • Wednesday

As noted in the main body of the text, the Tankan index of business sentiment suggests real GDP growth slowed in the second quarter. Although machinery orders, a good leading indicator of capital spending, rebounded 5.5 percent in April from the previous month, the trend in the volatile series appears to be rolling over. Slower economic growth and more challenging operating conditions likely will lead to weak capital spending this year.

Other data releases on the docket next week will give investors more insights into the current state of the Japanese economy. The index of domestic corporate goods prices will offer some insights into the outlook for CPI inflation. Data on the trade balance in May and consumer confidence in June should help analysts firm up their estimates of overall GDP growth in the second quarter.

Previous: 5.5%
Consensus: N/A

Bank of England Policy Meeting• Thursday

The Bank of England holds its monthly policy meeting on Thursday, and there is universal agreement among market participants that the Monetary Policy Committee will keep its main policy rate unchanged at 5.00 percent. On the one hand, growth is clearly weakening, which makes a rate hike seem ill-advised. On the other hand, however, inflation is well above the MPC's target of 2 percent at present, which makes a rate cut seem unlikely. Therefore, the MPC likely will keep rates on hold.

How much did the economy grow in the second quarter? A number of important data releases, including industrial production on Monday, consumer confidence on Tuesday, and the trade balance on Wednesday, will help investors answer that question.

Current BoE Rate: 5.00% Wachovia: 5.00%
Consensus: 5.00%

Canadian Labor Market Report • Friday

Despite slower growth over the past few quarters the labor market in Canada remains rather resilient, and investors generally do not believe it fell apart last month. The consensus forecast anticipates that 10,000 net new jobs were added in June, which would be equivalent to a 100,000 rise in U.S. non-farm payrolls. As long as the labor market remains resilient, Canadian consumer spending should generally remain solid.

Although the labor market report should be the economic highlight in Canada next week, May data on housing starts (Wednesday) and international trade (Friday) will give market participants more insights into the state of the Canadian economy in the second quarter.

Previous: 6.1%
Consensus: 6.1%

Point of View

Interest Rate Watch

Economic Data, Credit Dictate No Fed Tightening

Despite the interest rate increase that has been discounted in the market for some time, our view remains that the Fed will leave the funds rate alone at least through the August and September meetings. The domestic private economy is in recession as evidenced by the rising initial jobless claims, employment declines and the non-manufacturing survey data released this week.

Below trend economic growth remains our expectation for the rest of this year as it has been since January. There is no easy way out for this economy. While rebates should temporarily boost consumer spending in the third quarter, we expect growth of one to two percent for the rest of the year. Any strength will come from exports and federal government spending.

Meanwhile, inflation, as measured by the core PCE deflator, is expected to remain above the Federal Reserve's perceived two percent target ceiling. Therefore, the balance of the growth/inflation outlook suggests that the Federal Reserve will remain on hold for the rest of this year.

Credit Spreads Widen Again; No Time For A Fed Tightening

Three wild cards reinforce the expectation for the Fed to remain cautious on policy. First, credit markets have improved and yet the extent of that improvement remains very sensitive to perceptions of quality in the capital markets. In recent weeks persistent rumors have led to a back-up in the TED spread as well as high-grade and high-yield spreads. Meanwhile slower income and profit growth in the U.S. suggest higher federal budget deficits during the next two years.

Topic of the Week

Boat Sales: Consumer Headwinds Rocking the Boat

It's boating season and boat sales are foundering. Declines in boat sales are fairly common during downturns as consumers cut back on purchases of discretionary items, particularly big-ticket items.

This year, consumer headwinds like rising gasoline and diesel prices, tighter lending standards, and the housing slump created additional headwinds for boat sales. Boats are considered luxury items and are one of the most discretionary items consumers can buy. When consumers spend more on food, gasoline and fuel oil, they have less to spend on luxury items.

Manufacturers are also being hit with rising prices. The rising price of crude oil and fiberglass will increase the average new boat price. According to the National Marine Manufacturers Association average new boat price, boats are expected to be roughly 7 percent more than a year ago. With the price of new boats increasing, many buyers are turning to the used boat market for less costly boats. This activity will further depress new boat sales.

Additionally, boat sales and housing are highly correlated. Home sales and construction are showing some tentative signs of bottoming out in some of the weakest markets. Our current estimate is that the slide in home prices will bottom out in early 2009, but we still have a way to go before the market is back in balance. Not to mention, boating tends to lag the housing market and will continue to decline even after housing rebounds. Additionally, boating states like Florida and California will take longer to find its footing.

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Wachovia Corporation
http://www.wachovia.com

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