U.S. Weekly Financial Notes: Don’t Stop Believin’

Professor Ben Bernanke showed a little optimism in the classroom, stating that he thinks the U.S. economy will return to its annual long-term growth rate of about 3% despite ongoing risks--one of them being the eurozone debt crisis. Other economic releases this week include:

• January S&P/Case-Shiller 20-city home price index fell 3.8% year-over-year.
• U.S. GDP grew at an annualized rate of 3.0% in the fourth quarter, the quickest pace since the second quarter of 2010, according to the Bureau of Economic Analysis's third estimate.
• February personal income rose 0.2%, while consumer spending rose 0.8% over January.
• The Conference Board's U.S. consumer confidence index fell 1.4 points to 70.2 in March.
• Thomson Reuters/University of Michigan's consumer sentiment index for March rose to 76.2 points in the final reading, the highest in more than a year, from 75.3 points in February.
• U.S. February durable orders rose 2.2% over January.
• The Chicago ISM/PMI index fell 1.8 points to 62.2 in March.
• Initial jobless claims fell 5,000 to 359,000 in the week ended March 24, still below the 400,000 benchmark, signaling that the job market is continuing to heal. Continuing claims fell 41,000 to 3.340 million during the week ended March 17.
• Oil prices fell $3 to $103/barrel during the early afternoon on Friday.

Happily Spending

People didn't pinch their pennies in February, despite their still-slim paychecks. Personal income rose 0.2% in February, which was half of the 0.4% gain expected by consensus. Personal income for January was also revised down to a 0.2% gain from the 0.3% month-over-month gain previously reported. Wages and salaries climbed 0.3% in February, while interest income was essentially unchanged for the second month in a row.

In light of the meager pay raise, consumers spent much more than expected. Consumer spending jumped 0.8% in February, which was stronger than the 0.6% rate expected by consensus, though in line with our forecast. January's consumer spending was upwardly revised to a 0.4% gain from the previously reported 0.2% increase. Last month, consumers did spend their money broadly on various goods and services, especially on new wheels, clothes, and appliances. February vehicle sales came in at annualized 15.1 million units, the highest level since February 2008, and are expected to show a solid figure for March. The surge in consumer spending pushed the February saving rate down to 3.7%, the lowest level since August 2009, from 4.3% in January (revised from 4.6%).

But higher gas prices are cutting into how much money people have left over to spend in the malls after they fill up their tanks. Energy costs jumped 3.6% month-over-month in February, the biggest increase in nearly a year. Furthermore, the personal consumption expenditures price index (PCE) increased by 0.3% over January, while prices, excluding food and energy, edged up by 0.1% in February. Overall PCE has risen 2.3% year-over-year in February, down from 2.4% yearly growth in January. The core PCE has climbed 1.9% during that span--just under the Federal Reserve's long-run inflation target of 2.0%, but outstripping the gain in wages.

Higher prices are eroding consumer purchasing power. Disposable income rose 0.2% in February, a stronger gain than the flat reading seen in January (which were revised down from a 0.1% gain). But when we adjust for inflation, real personal disposable income fell 0.1% month-over-month in February, the third decrease in the past four months.

People were still happy, despite the gas pump tax. The University of Michigan's consumer sentiment index rose to 76.2 in March, beating estimates of 75 and the 74.3 reported earlier in March (February was 75.3). It is at its highest reading since the 77.5 figure report last February. Current economic conditions increased to 86.0 from 83.0 seen last month while the future outlook index fell to 69.8 from February's 70.3 figure.

The improving jobs-situation and happier consumers may partly explain why people felt encouraged to spend. Initial jobless claims fell by 5,000 to 359,000 in the week ended March 24, still below the 400,000 benchmark, signaling that the job market is continuing to move into recovery territory.

Falling Prices

Home prices continued their decline in January, despite the better economic news. The 3.8% year-over-year drop in the January S&P/Case-Shiller 20-city home price index was in line with the 3.8% drop we expected. The index is down 34.4% from its July 2006 peak of 206.52, a new record low. Eight cities saw their average home prices hit new record lows. On a year-over-year basis, Denver, Detroit and Phoenix are the only cities to see positive returns, up 0.2%, 1.7%, and 1.3%, respectively. Atlanta reported the largest year-over-year drop in average home prices, down 14.8% over last January. On a month-over-month basis, the 20-city home price index was down 0.8% over December (unadjusted), with 17 of the 20 cities reporting declines.

We expect that the excess supply of unsold homes, particularly distressed properties, will continue to weigh on prices. However, we think that prices are close to hitting their 'final' bottom. We now expect S&P/Case-Shiller prices to drop another 3% from the current level to a new record 36% trough from the July 2006 peak later this year.

There are signs that sales may start to heat up soon. The National Association of Realtors' (NAR) Pending Home Sales Index, a forward-looking indicator based on contracts signed in February, eased 0.5% month-over-month, to 96.5. But, it is near January's 97 reading, which was the highest reading since April 2010, when buyers were rushing to take advantage of the home buyer tax credit. While a good sign, contract failures remain elevated and since we expect sales growth to be concentrated in lower-priced homes, as the shadow inventory of distressed homes enters the market. Overall prices are likely to stay down.

Stocked Shelves

In the BEA's third estimate, U.S. GDP held at an annualized 3.0% pace in the fourth quarter, after a 1.8% gain in the third quarter. It was four times stronger than 0.7% in the first half of 2011, though in line with consensus expectations. The inventory buildup largely explained the overall boost in growth, though it was downwardly revised, indicating that a fewer items than expected were left on the shelves. While the growth in most other components was still weak, we did see upward revisions in some segments, with a particularly nice pop in equipment spending. GDP grew 1.7% for the entire year, consistent with the slow pace of recovery that we expect.

Inventories were revised down, contributing $54.2 billion rather than $56.3 billion previously. While less than the 1.94% contribution that the BEA reported in the first estimate, inventory accumulation still contributed a whopping 1.81% to GDP in the fourth quarter. If inventories were flat, GDP would have been a mere 1.2%. Final sales were up only 1.1% though, after a sizable 3.2% gain in the third quarter. The buildup in inventories, which didn't diminish during the holiday season, means bad news for first-quarter growth prospects, as businesses won't need to stock up shelves, since they're already full.

While spending picked up as the holidays approached last year, it was still modest. Consumer spending rose by 2.1% in the fourth quarter, unrevised in the third release, the strongest reading this year, though much smaller than the 3.6% rate seen in the fourth quarter last year. Services were downwardly revised to a 0.4% gain (was up 0.7%). However, it was offset by upward revisions for both durable and nondurable goods, to a 16.1% and 0.8% pace, respectively (was up 15.3% and 0.4%).

Equipment spending was a bright spot in the report. Equipment spending was upwardly revised to a 7.5% rate in the fourth quarter (was up 4.8%), after a 16.2% gain in the third quarter. The 2.6% drop in nonresidential construction spending was upwardly revised to a 0.9% drop, and comes after two solid quarters of double-digit gains. Residential construction jumped 11.6% in the fourth quarter (was 11.5%), a rate not seen since second quarter 2010. However, net exports subtracted more off of GDP than the BEA's earlier estimates; subtracting $8.0 billion off of fourth-quarter growth (was a $1.6 billion subtraction).

The cuts in fourth quarter government spending weren't as bad as earlier estimated. But state and local municipalities still continue to shed programs (and jobs)--for the sixth consecutive quarter--in an effort to balance budgets. The risk of fiscal tightening, policy uncertainty, amid negative real household income, could undercut growth this year.

February orders for durable manufactured goods grew by 2.2% over the January rate. It was still worse than the 2.7% increase expected by consensus and only partially offset the 3.6% drop seen in January. Total orders are still up a hefty 13.5% year-to-date. Transportation orders rose 3.9% over January, largely due to respective 6.0% and 12.5% gains in nondefense and defense aircraft orders, mainly owing to strong Boeing orders. However, auto orders were also up 1.6% for the month.

It wasn't just an aircraft issue. Excluding transportation, orders still rose 1.6% month-over-month and are up 10.3%, year-to-date. Moreover, core capital goods orders (excluding defense and aircraft)--a key leading indicator for business investment—rose 1.2% month-over-month in February, though they only partially offset the 3.7% drop the month before. They remain up 10% year-to-date. Core shipments were also up 1.4% and up 9.2 year-to-date. Inventories rose 0.4%, and are up 8.6%, year-to-date. The softer-than-expected orders data suggests a weaker equipment spending component for first quarter GDP.

Contributor: Sonika Tyagi.

Financial Market Highlights

Below are the financial market highlights for the week ending Month XX, 201X.

Treasury yield curve

The 10-year Treasury yield fell to 2.15% on Friday (early afternoon) from 2.24% last week, as investors sought safety in U.S. debt, after the Fed Chairman Ben Bernanke's commented on the uncertainty around the recent pace of improvement in the labor market. This kindled worries about the longer-term prospects for U.S. economic health. The rate on three-month Treasury bills dropped to 8 basis points (bps) this week. The two-to-10-year spread rose 8 bps to 187 bps over the week and was 80 bps lower than a year ago. The 10-year Treasury spread above inflation-protected bonds (TIPS), a measure of inflation expectations, fell 8 bps to 169 bps over the past week and was 10 bps below the previous year.

Table 1

Chart 1

Credit markets

Risk aversion rose in all market segments this week because weak global economic data dampened investor sentiment. The equity market volatility index (VIX), a measure of the market's uncertainty, increased slightly to 15.48 from 15.16 the previous week. The T-bill-to-eurodollar (TED) spread, a measure of banks' willingness to lend, rose 1 bp to 39 bps this week and was up 18 bps from a year ago. Fixed mortgage rates declined to 3.99%, down from 4.08% the previous week. Mortgage applications dropped 2.7% in the week ended March 23, after falling 7.4% in the previous week. The refinance index fell 4.6%, after declining 9.3% the previous week. The purchase index gained 3.3%, after dropping 1% the previous week.

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Fed policy and interest rate outlook

The U.S. Federal Reserve's March 13 Federal Open Market Committee meeting statement said that the Committee had decided to keep the federal funds rate at near-zero, and that economic conditions "are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014." It noted that the "economy has been expanding moderately" and--although labor conditions have improved-- the unemployment rate "remains elevated." The Fed said that "strains in global financial markets have eased" though they still pose "significant downside risks to the economic outlook". The Fed noted that "inflation has been subdued in recent months", and "although crude and gasoline prices have increased lately, longer-term inflation expectations remain stable". The FOMC anticipates inflation to trend down to at-or-below the rate "most consistent with its dual mandate." In December, the Fed released its new economic projections, which were weaker than the June forecasts. The Fed cut the "central tendency" projection of 2012 GDP growth to 2.2%-2.7% from 2.5%-2.9%, with the core consumer deflator forecast up 1.5%-1.8% (from 1.5%-2.0%). Previously, policymakers were split on what type of accommodative monetary tools the central bank should use to try to kick start the economy. While there were a number of opinions on the inflation outlook, most judged that inflation risks were roughly balanced with little risk of deflation. The Fed decided to extend the maturities on its balance sheet (this is called Operation Twist), although two officials wanted to do more and others wanted to hold open the option for QE3. However, the members generally anticipated a pickup in the pace of the recovery although they saw "significant" risks to growth, with the recovery more vulnerable to shocks. The Feb. 29 Beige Book compendium of reports from the 12 Federal Reserve district banks reiterated that economic activity is advancing "at a modest to moderate pace--" which was expected. The report noted that regional economies in Philadelphia and Atlanta are expanding faster than other regions. Overall, the report highlighted slight improvement in labor markets, banking conditions, and housing, while retailers reported that warm winter weather had hurt seasonal sales.

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Global interest rates

Government long-term bond yields were largely up this week. Key central banks remain cautious in their outlook. Recent trends include:

• The European Central Bank (ECB) maintained its benchmark refinancing rate at a low of 1% on March 7 because of rising inflation worries, while it assesses the result of injections of cheap cash into euro-area banks last week. The ECB lowered its eurozone growth forecast to 0.5% this year.
• The Bank of England held its bank rate at 0.5% at its March 7 meeting and maintained the level of its asset purchasing scheme, totaling £325 billion with Britain at risk of a recession.
• The Bank of Japan kept its monetary policy on hold on March 13. It expanded a loan scheme targeting growth industries by 2 trillion yen ($24 billion) to 5.5 trillion yen, but overruled further monetary easing.
• The People's Bank of China lowered the required reserve ratio by 50 bps, effective Feb. 24 because Europe's debt crisis and a cooling property market threaten China's economic growth. The ratio for large banks was thus reduced to 20.5%.
• The Bank of Canada held its target overnight rate at 1% on March 8 because of signs of improvement in the global economic recovery and underlying momentum in the Canadian economy (that remained around trend).
• The Norges Bank reduced the deposit rate by 50 bps to 1.75% during its meeting on Dec.14 in order to guard the economy against deteriorating global growth.
• Sweden's Riksbank reduced its seven-day repo rate by 25 bps to 1.50% on Feb. 14, hoping to prevent the Swedish economy from falling into a recession as Europe's debt crisis erodes export demand.
• The Swiss National Bank cut its interest rate target band to 0.00%-0.25% from 0.00%-0.75% to stem the rise of the Swiss franc.
• Poland's central bank left its seven-day reference rate at 4.50% on March 8, as the Polish economy grows faster than the euro-region average and inflation remains above target.
• The Reserve Bank of Australia (RBA) kept its official cash rate target at 4.25% this week. It hinted that it may cut rates if Australia's economy weakens further, while mentioning that Europe will remain a potential source of shocks "for some time yet."
• The Reserve Bank of New Zealand left its key rate unchanged at 2.5% on March 7, citing slower-than-expected domestic economic growth in 2012 due to delays in the earthquake reconstruction process and easing in inflation.
• South Korea's central bank left its key interest rate unchanged at 3.25% on March 7 for the ninth straight month, to balance the risk of a possible spike in inflation against the still-sluggish global economic recovery.
• The Bank of Thailand held its benchmark overnight rate at 3.00% on March 21, pausing after two consecutive rate cuts on rising inflationary pressures.

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Foreign exchange rates

The dollar dropped this week against other major currencies following comments from Federal Reserve Chairman Ben Bernanke that suggest that the door is still wide open for further monetary easing. The euro rose to $1.334/€ on Friday (early afternoon) from $1.3177/€ last week, after eurozone finance ministers agreed to temporarily boost of the currency bloc's bailout lending limit to €700 billion. The yen rose to ¥82.39/$ on Friday (early afternoon) from ¥82.42/$ the previous week. The U.S. trade deficit widened to $52.6 billion in January, up from a revised $50.4 billion deficit in December (was $48.8 billion), the widest it has been since October 2008. Imports rose by $4.7 billion to $233.4 billion in January, while exports rose $2.6 billion to $180.8 billion. Excluding petroleum, the deficit was $22.9 billion, narrower than it was--$23.2 billion--in December.

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Commodity price indices

Commodity prices tumbled this week as disappointing U.S. and European economic data weighed on investors' risk appetite. Oil prices dropped to $103.26/ barrel on Friday (early afternoon) from $106.94/barrel last week, amid higher U.S. crude inventories, speculation that Western nations will tap into their strategic oil reserves, and Saudi Arabia's pledges to ensure adequate supplies. Brent crude oil price rose to $123.34/barrel from $125.64/barrel and remains high relative to West Texas Intermediate (WTI). Natural gas prices increased this week to $3.343/mbtu from $3.382/mbtu last week. Gold prices increased slightly to $1,666/ounce on Friday (early afternoon) from $1,661/ounce a week earlier boosted by expectations that U.S. interest rates will remain low for an extended period of time and weakness in the dollar. Livestock prices fell by 1.0% this week and are down 8.6% over the past year.

Table 8

U.S. equity market

Modest U.S. economic data weighed on investor sentiment during the week. However, stocks were trading higher on Friday, buoyed up by a positive consumer spending report and the eurozone finance ministers' agreement to raise the region's bailout lending limit. The S&P 500, Dow, and Nasdaq were mixed and trading at 1,408, 13,200, and 3,096 respectively, on Friday (early afternoon). Stocks were in a bear market from October 2007 until March 2009. Despite recent losses, they have now recovered much of those losses. All market indices have been up during the past year. The S&P 500 is now up 11.9% from the end of 2012 level of 1,258 and is up 108.28% from its March 9, 2009 low of 676.

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U.S. equity market by sector

Equity sectors remained mixed this past week, through Thursday. Health care stocks led the gainers, up 1.2%, after the U.S. Supreme Court began hearings on the federal health-care law. Information technology stocks followed closely, up 1.1%. Energy stocks, down 2.1%, led the decliners amid reports that that France, the UK and U.S. will engage in a coordinated oil release from strategic reserves to help ease high prices at the pump. Information technology and consumer discretionary stocks saw the largest 12-month gains, up 19.3% and 16%, respectively. Energy stocks, burdened by supply concerns, posted the largest 12-month decline (down 8%).

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Global Standard & Poor's stock indices

World equity markets remained volatile this week, through Thursday after weaker than expected global economic data, while investors eyed a boost to the eurozone's bailout resources. European and Japanese markets led the decliners, down 1.7% and 0.7%, respectively. In contrast, Australian markets led the gainers, up 0.9%. All major global equity markets, except the U.S. markets, have now turned negative for the 12-month period, led by Asia-Pacific (down 12.9%).

Table 11

Global equity market performance by sector

International sectors remained mixed this week, through Thursday. Information technology stocks saw the biggest gain, up 1.2%, closely followed by health care stocks, up 1.1%. In contrast, falling commodity prices punished energy stocks, which were down 1.1%. During the past year, information technology and consumer staples stocks posted the largest gains (up 13.6% and 11.3%, respectively). In contrast, material stocks dropped the most during the past year (down 16.6%), followed by financial stocks (down 11.8%).

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Sources: Global Insight and S&P.

Data tables and text provided by Kaustubh Pandey at Standard & Poor's/CRISIL