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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(December 8, 1997) FINANCIAL INSTRUMENTS: INTEREST RATES–BEWARE OF BONDS WHEN THE ECONOMY IS ROBUST–For a brief moment last week, the long bond traded under 6% as worries about Asia's financial crisis and falling commodity prices dominated the market. However, Friday's unemployment report calls into question just how far the Asian crisis can carry the market in the context of a robust domestic economy.
Over the course of the past few months, the bond market has ignored signs of strength in the domestic economy in favor of focusing on the Asian financial crisis. With inflation already subdued, expectations have been that Asia's problems will slow U.S. growth and further reduce inflation in 1998. So, the recent signs of strong growth and rising wage pressure were ignored while falling commodity prices and on-going turmoil in Asia were the favored indicators. This line of reasoning carried bonds to 6% and flattened the yield curve. In the past few weeks we have been warning that there was no room for error in this forecast with yields at 6%. The market has already discounted a slowdown in 1998 U.S. growth to the 2.0% to 2.25% region deemed acceptable by the Fed and a further easing in inflation pressures. Therefore, the risk, as we see it, is that the impact is not as great as anticipated.
It is too early to know just how much the problems in Asia, Latin America, Russia and Eastern Europe will affect the U.S. But given that the U.S. is a relatively “closed” economy in that exports represent only 12% of GDP, we continue to believe that the impact is probably in the 0.5% to 0.75% region. The issue is whether this expected decline in GDP will be enough to keep the Fed on hold longer term and support the current market structure. An unnamed Fed official quoted on the news wires Friday morning indicated that the Fed is forecasting a slowdown in GDP growth in 1998 to the “potential” level of 2.0% to 2.25% as a result of Asian contagion and that this will keep the Fed on hold for the foreseeable future. However, it is worth noting that the Fed's forecast for GDP growth has underestimated the expansion for the past three years. In fact, they have been forecasting a return in growth to the potential level throughout this expansion.
DOMESTIC ECONOMY SHOWS NO SIGNS OF SLOWING–Despite all of the commentary to the contrary in the newspapers, there is little evidence to suggest the U.S. economy is slowing. Fourth quarter GDP will probably grow by 3.0% to 3.5% which is a bit of a decline from the sizzling pace of earlier in the year but overall it looks like 1997 is another 4% growth year for the U.S. Moreover, the leading indicators of economic activity don't appear to support the slowdown theory.
Housing activity, which tends to lead the business cycle is strong and actually accelerating. New home sales are still quite strong. In addition, existing home sales hit a record level of 4.4 million units in October with prices up 6.4% on a year-over-year basis. Housing starts and permits are at the highest levels since February and also near cyclical highs. Meanwhile, mortgage applications are running at near record levels as well suggesting that there is more home buying in the pipeline. And why not? Employment and income growth are strong and mortgage rates are near their lows for the decade. Consumers are as confident about their finances as they have been in thirty years. In this environment, it is very difficult to see the average U.S. home buyer worrying about the Asian markets when contemplating a new home purchase. The manufacturing sector also looks quite healthy. Industrial production is running at a 6.5% pace even though there are bottlenecks at Boeing and in the railroads.
Some analysts have latched onto lackluster weekly retail department store surveys as an indication of a slowdown, but that ignores the fact that department store sales are only a small component of overall consumption. Auto sales rebounded in November as the last remaining Americans without sport utility vehicles rushed to buy the new models. Chain store sales posted a healthy 3.8% increase and spending on services such as airplane trips, hotels, amusement parks, haircuts and legal help all continue to rise steadily. We don't expect a repeat of the third quarter's 5.7% jump in consumption but even at a moderate pace, nominal demand in the fourth quarter appears to be strong.
Then, of course, there is the employment situation. Unemployment has dropped to 4.6% in November, the lowest reading since 1970, on the back of record labor force participation. Just about every potentially employable person looking for work has found it. In many sectors of the economy, finding skilled workers is getting very difficult. As a result, the laws of supply and demand are working and wages are rising. Last month, hourly earnings rose a sharp 0.6% to a 4.1% year-over-year rate. This was the second consecutive monthly gain of that magnitude and wages are accelerating a phenomenon which typically precedes an upturn in core inflation by about eighteen months. Not surprisingly, the strongest gains are seen in wholesale trade and financial services. Moreover, the gain in nonfarm payrolls of 404,000 was the largest one-month gain since February 1996 and about twice the consensus expectation. The household survey also showed a huge gain of 671,000. Moreover, the gains in employment were broad based across industries. Construction, manufacturing, financial services, retail and health services all posted large gains. Private sector hours worked rose a huge 1.1% with the workweek extending to 34.8 hours. These gains point to a jump in personal income in November which in turn can fuel spending for several more months.
Looking at the fourth quarter, GDP growth will probably come close to the 4% level, again defying predictions of a slowdown. With income growth in the quarter likely to come in at a healthy 6% pace, spending seems very unlikely to slow. Production should continue on the current pace given the low level of inventories. Moreover, the outlook for the first quarter looks good. Bonuses this year, which are typically paid in the first quarter, should be very strong, adding to consumption. There is no monetary restraint on the economy to be seen. Yields remain near cyclical lows and money supply growth is accelerating to the upside.
ASIA NEXT YEAR–None of the domestic data matter to the market however in the context of expectations for a global slowdown in 1998. Asia's problems and the spread of financial market panic to Latin America, Eastern Europe and Russia are the significant driving forces for the market. The expectation of a slowdown in exports is the driving force coupled with the disinflationary impact of falling import prices due to the devaluation in currencies in Asia. To date, it is too early to tell how much of an impact there has been from Asia's debacle. The NAPM export order index after falling in September has rebounded in October and November and remains comfortably above the 50% level. Moreover, the recent trade data show export volumes still rising at a healthy level. Slower growth in Asia should slow U.S. exports, but may be offset to a large degree by ongoing strength in Canada and Mexico which are the largest trading partners for the U.S., as well as improving growth in Europe.
The dollar has risen about 8% on a trade-weighted basis, using the Dallas Fed's real trade weighted index. However, the dollar has risen sharply against the newly industrialized country currencies in the Pacific Rim (PACNIC) but remains about unchanged versus the western hemisphere countries. On an overall basis, the dollar continues to be strong. The upshot is that the strong dollar continues to help keep inflation in check. Every 10% increase on a trade-weighted basis is believed to shave nearly 1% off CPI. The 8% rise in the dollar over the past two years combined with the adjustments to CPI by the Bureau of Labor Statistics probably account for most of the decline in the past two years. In order to further reduce inflation through declining import prices, the dollar will need to post another sharp increase. That is clearly within the realm of possibility but not assured. We are currently forecasting a peak in the dollar in the first quarter of 1998 at about 1.8300 DM and 135 yen. Going forward then, the market needs to see both a slowdown in U.S. exports and a rise in the dollar to keep the declining inflation trend intact.
FED CAN STAY ON HOLD–We continue to believe the Fed will remain on hold into the first quarter of 1998. Absent the problems in Asia, the Fed would probably have already raised rates and would probably be preparing another rate hike soon. However, in light of the international events of the past few months, the Fed can easily continues to experiment with how strong growth can be before inflation pressures materialize.
As far as the market is concerned however, the bullish trend will have to be fueled with evidence of slower growth through declining exports and falling inflation to push the bond through 6%. It is doubtful that there will be anything more than anecdotal evidence for several more weeks or even months. U.S. Treasurys remain the asset choice for foreign investors seeking safe haven, but a further extension of the rally in the face of strong U.S. demand is unlikely unless the evidence of slower growth materializes soon.
For now, we would anticipate a new range in the bonds with 6.05% the lower end and 6.25% the upper end through the end of the year. We favor selling volatility on the assumption that the news over the course of the next several weeks will not be decisive and therefore the market will remain range bound. Going into early 1998, however, the risk is that the market is over estimating the impact of Asia's problems on the U.S. at current yields, but that remains to be seen.
Kathy Jones
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