Weekly Economic and Financial Commentary

U.S. Review

Obama Rolls into Washington

The inauguration of Barack Obama dominated was this week's big economic news. The transition of power was smooth as was expected. Wall Street was not impressed, however, and stocks sold off heavily after the President's acceptance speech. The new President is expected to give a short-term boost to consumer confidence but have no meaningful impact on the near-term economic outlook.

President Obama is off to a strong start. With both houses of Congress under Democrat control there have been few confirmation battles. Work on the $825 billion stimulus package is rapidly moving forward and the package should be on the President's desk by February 15.

While the stimulus package may be enacted quickly, the impact will take quite some time to filter through to the economy. The bulk of infrastructure spending will not kick in until late this year or early 2010. Tax cuts and changes in withholding schedules may show up a little earlier but are expected to have only modest impact. The biggest lift to the economy may come from the psychological boost the program likely will engender.

Mamas Don't Let Your Babies Grow Up To Be Homebuilders

Homebuilders continue to endure a monumental struggle against flagging demand previous overbuilding. The Wells Fargo/NAHB Housing Market Index declined 1 point to 8.0 in January, marking a new all-time low for the series. Current sales activity fell 2 points to 6.0, while the future sales activity rose a point to 17.0. Prospective buyer traffic remains just above its all-time low at 8. The numbers are just plain awful and likely reflect the free-fall in employment that occurred during the fourth quarter, when more than 1.5 million jobs were lost. Employment losses more than offset any beneficial impact from lower mortgage rates, which are having a much larger impact on refinancing activity than sales.

Housing starts continue to plummet. Starts plunged 15.5 percent in December to a 550,000-unit annual rate. Both single-family and multi-family starts fell sharply, with single-family dropping 13.5 percent and multi-family down 20.4 percent. Permits fell 10.7 percent in December and permits are still running slightly below starts. Builders are under intense pressure to work down their inventories and raise cash. Many smaller builders have entered bankruptcy and stopped all new development activity.

As bad as December's data are, we believe housing starts will fall even further in the first quarter. This winter has been a little colder and wetter than usual, particularly in the South which accounts for more than half of all new home construction. The credit crunch is making it extremely difficult for builders to access credit and should continue to do so through all of 2009. We now expect housing starts to bottom out somewhere around 490,000 units during the first quarter and to total just 580,000 for all of 2009. This would make 2009 the worst year for homebuilders since records were kept back in the 1950s.

First-time claims for unemployment insurance bounced back this week, with claims rising 65,000 to 589,000. The increase brings initial claims to their highest level in 26 years. Continuing claims also trended higher. The drumbeat of layoff announcements grew louder this week, as several major firms, including Intel, Microsoft, and Pfizer, announced cutbacks along with their quarterly earnings announcements.

Container cargo shipments through the Port of Long Beach plunged 11 percent in 2008, marking the single-largest decline in more than 20 years. The sharpest drops occurred during the later part of the year, when consumer spending plummeted. The trade data are a real wildcard for the fourth quarter GDP data. Domestic demand likely fell much more than GDP during the quarter.

U.S. Outlook

Existing Home Sales • Monday

Existing home sales had been holding in a relatively tight range over the past year or more, but finally broke to the downside in November. Since existing home sales represent closings (as opposed to contract signings in the new home sales figures) these data represent sales contracts from the height of the credit crunch in late September and October. The National Association of Realtors again noted that nearly half of all sales were foreclosure related or “distressed.” The support that foreclosure sales provide may wane in coming months, but a trend will be difficult to establish with so many distressed assets being sold.

Previous: 4.49M Wachovia: 4.40M
Consensus: 4.40M

Consumer Confidence • Tuesday

Consumer confidence, as measured by the Conference Board, deteriorated to a record low reading in December as consumers grapple with rising unemployment, plunging home prices, and a continued credit crunch.

This particular measure of consumer confidence has historically had a significant correlation with the health of the labor market. Labor conditions clearly deteriorated in 2008 as the unemployment rate increased 2.3 percentage points to the current reading of 7.2 percent. We expect deterioration in the labor market to continue with the unemployment topping out at around 9.5 percent in 2010. Given, that the labor market will remain severely challenged for all of 2009, we expect consumer confidence will remain depressed for the foreseeable future putting considerable downward pressure on economic growth prospects.

Previous: 38.0 Wachovia: 41.0
Consensus: 38.9

Real GDP • Friday

Real economic activity fell off a cliff during the fourth quarter, producing a sharp drop in employment, output and spending. More than 1.5 million jobs were lost during the period and total hours worked plummeted at a 7.7 percent annual rate. Real GDP did not likely decline that much, as faltering demand in the U.S. cut demand for imports and thus exported a good part of the U.S. weakness. We expect real GDP to decline at a 5.3 percent annual rate during the fourth quarter. While GDP growth likely did not fall as much as had been feared, a decline of 5.3 percent is still a pretty ferocious drop and we expect declines will persist for five consecutive quarters, the longest period of consecutive declines on record. While we see real GDP bottoming this summer, a strong sustainable recovery is not likely to take hold until sometime in 2010.

Previous: -0.5% Wachovia: 5.3%
Consensus: -5.0%

Global Review

As shown in the botStorm Clouds Darken in Canada

Cracks are showing up in the Canadian economy and GDP growth probably contracted during the fourth quarter. The Bank of Canada (BoC) is now forced to reconcile the risk of enabling inflation against the reality of an economy falling into recession. What are the challenges facing Canada's economy today and what can we reasonably expect for the future?

So far in the new year, economic data in Canada have been largely worse than expected. This week was no exception as wholesale sales, manufacturing shipments and retail sales all came in well-below consensus estimates. It appears Canada's export-driven economy is finally succumbing to the effects of a broader global slowdown and the contraction in spending abroad. While the United States is the primary export partner for Canada, exports to Europe are down as well.

Exports Still Primary Concern, But Domestic Economy also Weak

With just about every developed economy in the world now mired in a recession, there is little hope for a quick turnaround.

While challenges to exports present the greatest obstacle to Canadian economic growth, domestic demand is weakening as well. Retail sales fell 2.4 percent in November, a larger-than-expected decline and the largest monthly drop in more than a decade. Part of the weakness was caused by prices; sales at gas stations led the declines with a contraction of nearly fifteen percent on the month. The other culprit in November was sales of autos, which was off more than seven percent. Other components like food and beverage, supermarkets, and pharmacies actually picked up in November. But we suspect the worsening employment situation in Canada will present significant headwinds to future growth in retail sales across the board. Another sign of softening in the domestic economy in Canada is the index of leading economic indicators which declined 0.6 percent in December, led by declines in stock prices and housing.

The Bank of Canada (BoC) cut its policy rate to 1.00 percent this week, bringing the cumulative policy easing since December 2007 to 350 basis points. The BoC's primary objective is to maintain a stable inflation rate near two percent. In its official release this week, the Bank acknowledged “significant upside and downside risks to the inflation projection,” essentially recognizing that the inflation outlook is heavily influenced by the state of the global economy. The whipsawing of energy and commodity prices makes it very difficult for central banks to get a handle on inflation. The Consumer Price Index declined 0.7 percent in the month of December, but is up 1.2 percent year over year. We expect Canadian CPI to increase at only a 0.9 percent rate in all of 2009, which will likely include some negative year-over-year numbers during the summer. The spike in oil prices around the middle of July 2008 will present a high basis for comparison in July 2009.

We project the Canadian dollar will weaken a bit further against the greenback as the BoC continues to cut rates in the next few quarters. Further out, however, the loonie could stage a comeback against the U.S. dollar as sluggish economic growth in the United States keeps U.S. interest rates very low for some time.

Global Outlook

German Ifo Index • Tuesday

The Ifo index of German business sentiment, which is highly correlated with growth in German industrial production, has dropped off a cliff in recent months. Indeed, the index fell in December to its lowest level ever, at least since the pan-German series began in 1991. The marked decline in industrial production through November indicates that the German economy contracted very sharply in the fourth quarter. Sadly, the consensus forecast anticipates that the Ifo index fell further in January.

Other data releases on the docket next week will give investors further insights into the current state of the German economy. Data on the unemployment rate in January, which is projected to have edged up, print on Thursday and retail sales data for December are slated for release on Friday.

Previous: 82.6
Consensus: 81.0

Australian CPI Inflation • Thursday

The sharp global economic downturn that is underway has made CPI inflation less important to investors than it was a few months ago. That said, consumer prices in Australia rose 5 percent in the third quarter, well above the 2 percent to 3 percent target that the Reserve Bank of Australia (RBA) is mandated to achieve over the “medium term.” The RBA has already cut rates by 300 bps by early September, and it likely will ease policy further in the months ahead. If inflation remains stubbornly high, however, the RBA may cut rates at a slower pace than many investors currently expect.

An important indicator of business confidence is also slated for release next week. The NAB index dropped to the lowest level since the series began in 1997, consistent with a sharp slowdown, if not outright downturn, in the economy. Further weakness in the index in December would suggest the economy weakened more in December.

Previous: 5.0% (year-over-year rate)
Consensus: 3.6%

Japanese Industrial Production • Friday

Japanese industrial production has essentially collapsed over the past few months, indicating the onset of a very deep recession. Indeed, IP tumbled more than 11 percent between September and November (8.5 percent between October and November alone). Did industrial production take another steep drop in December? Data released on Friday will answer this question.

Other data from December that will be released on Friday, including the labor market report and housing starts, will give investors more insights into just how much the Japanese economy contracted in the fourth quarter. Data on retail sales in December, which will print on Thursday, will show how consumer spending is faring.

Previous: -8.5% (month-on-month)
Consensus: -9.0%

Point of View

Interest Rate Watch

Recession Concerns to Dominate Fed Focus

This week's Federal Open Market Committee meeting will likely focus on the weak economy and therefore keep policy on the easy path. Our outlook is that the recession continues and along with that housing and credit markets continue to struggle. Looking ahead, these factors will keep the Fed on its liquidity provision path until mid-spring of next year. This suggests that short-term interest rates will remain low for an extended period of time.

Moreover, we have seen in recent weeks an improvement in private market rates such as LIBOR. This suggests that credit supply may be coming back into the market and that the worse of the credit problem may have passed - at least at the short-end of the curve.

However, At the Other End of the Maturity Street

Financial markets have evidenced only modest improvement in credit spreads and credit supply at the long end. In addition, the benchmark ten-year Treasury yield has drifted upward since the start of this year.

In the credit sphere, the recession/poor earnings fears continue to limit issuance in the face of a skeptical market buyer. As a result, we have seen very little improvement in the bond spreads over Treasuries. Over the next three months we also expect very little improvement. Certainly the Fed has been helpful in areas, such as MBS, where they have been direct buyers but such help has not spread any wider.

We remain concerned about the middle to long-end of the Treasury curve. For now the safe haven trade appears to be working. Longer-term, we are concerned that fiscal deficits, inflation expectations and anti-China/trade rhetoric dictate rising rates.

Topic of the Week

New President, New Solutions?

There has been much speculation as to how our newly inaugurated President will solve the riddle of the recession currently griping the U.S. economy. Since the fall of Lehman Brothers, the financial system has been highly unstable, and the Federal Reserve and Treasury have worked tirelessly to avoid collapse. Beyond the financial system, consumers are struggling with rising unemployment, declining home values and a significant loss of wealth, which the new administration intends to address through fiscal stimulus. One concern that the President and his economic team will have to consider is the considerable lag time associated with funds appropriated for the construction of infrastructure, which is likely to be a major element of the package. This may not contribute to GDP until the economy is already on the upswing. The law of diminishing returns is another concern. Billions spent on the construction of infrastructure will certainly provide jobs in that industry; however, a rapid short term increase in demand for these goods and services could sacrifice efficiency - even more so if shortages were created, lifting prices and wages unevenly. Consumers may be helped by tax policy changes, but temporary, one-time tax rebates like we saw last spring are not nearly as effective in stimulating spending as a perceived long-term change such as tax cuts. Further, the economy is being stimulated through drastic monetary easing, new lending programs and backstops, as well as the ‘hidden' stimulus of cheap oil and other commodities, and eventually the ripple effects of other nations' proposed fiscal stimuli. Ultimately, the efficacy of the stimulus will ultimately depend on its final composition.

Wachovia Corporation
http://www.wachovia.com

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