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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(August 18, 1997) FINANCIAL INSTRUMENTS: TREASURYS STAGE A COMEBACK –BUT FOR HOW LONG?–Treasurys recovered some of the recent losses during the past week on good inflation news and a weak stock market. The yield curve steepened and yields were generally range bound during the week. Now that the market has returned to an apparent equilibrium level, the question is which way will the next major move be?
GOOD INFLATION DATA–BUT ENERGY PRICES HIKES STILL IN THE PIPELINE–The economic data released last week provided assurances of good inflation prospects, PPI fell 0.1% overall and excluding food and energy which was better than the modest increase expected. The decline in PPI leaves wholesale prices 3.1% below year-ago levels. It appears that the recent increases in food and energy prices were not captured in the report which puts the August figures at risk. In addition, the general upward trend in core crude and intermediate goods remains intact. However, at current levels, there is no worry about wholesale prices. Similarly, the CPI figures were benign posting increases of 0.2% overall and at the core level. Here too, the rise in gasoline prices was not captured and should show up in next month's numbers but the overall outlook for inflation near term remains supportive to the market.
Meanwhile, the economy continues to grow at a healthy rate. In the manufacturing sector, the Atlanta Fed index gained to 23.3 from 15.3 with increases in nearly every sub index including production, orders and vendor deliveries. Prices paid and received advanced as well, suggesting that there is some pricing power in the manufacturing sector. Industrial production was more tame, rising only 0.2% in July, reflecting the downtime in the auto sector for retooling. The major auto makers have already indicated that they are boosting production in the third quarter to meet rising demand, so these figures are likely to rebound. Capacity utilization edged slightly lower as well. Given the rising trend in all of the regional Fed indices and the sharp uptrend in the NAPM report, the industrial sector looks likely to continue to run at healthy pace in the third quarter.
On the consumer front, retail sales posted a healthy gain of 0.6% overall and 0.5% excluding autos in the month of July. There were also upward revisions to the May and April figures which indicates that the July gain was even stronger than it first appears. It appears that consumer spending is back. The retail department store surveys have been pointing to gains in spending since June after the March-May slump. With income and job growth strong, we look for consumer spending to remain robust in the third quarter, boosting GDP growth above the 3% level.
Q2 LOOKING BETTER ALL THE TIME, Q3 ON TRACK TO RISE–Overall, the economy looks quite healthy. In fact, Q2 looks better and better all the time as the numbers come out. When the next estimate is released August 28th, it will probably indicate that growth topped 2,5% in the second quarter which is not exactly weak by the Fed's standards, With Q3 poised to grow at an even stronger pace, the outlook for the economy remains healthy.
Going forward, the issue is whether growth can continue at this pace without generating inflation pressures or triggering a tightening by the Fed. The market still is inclined to believe that 3%-4% growth with no inflation is possible long term without inflation, even without justification from the productivity numbers. In fact, the productivity figures for Q2 were fairly dismal indicating a slowdown in the pace to 2.3% from 2.5% in the first quarter. Although it is generally believed that the government's statistics do not capture productivity gains in the service sector well, and therefore are greatly understating the real rate, it is also possible that the gains in GDP have largely been the result of the squeeze on labor costs over the past few years. In that case, the UPS strike will carry added weight in this debate.
The UPS strike, now into its second week carries fairly widespread long- and short-term implications. In the short run, it is going to make the economic figures difficult to interpret. The August labor report is likely to appear quite weak as 185,000 workers will appear out of work from UPS alone. Add in the temporary layoffs associated with manufacturers and retailers who can't get inventory to sell and the decline in payrolls could be quite sharp, There will also likely be an associated drop in hours worked, which will subtract from the expectations for GDP.
However, the flip side is that the UPS strike may be the first major indication that the labor market is getting tight enough to cause wages to rise more sharply. Wages have been rising gradually for two years, but the pace has been slow compared to previous expansions, particularly in the manufacturing sector. Industrial restructuring and global competition have clearly been contributing factors. In comparison, wages in the service sector have been rising more rapidly as there tends to be less competition, However, with the UPS strike, it may now be that labor is getting organized and recognizing its scarcity. Moreover, it hits right at the issue of restructuring. That is, the argument is about part time versus full time work, the very issue of labor market flexibility which has helped keep labor costs down. Depending on the outcome, the UPS strike may be seen as a harbinger of things to come.
Meanwhile, we are of two minds about the market near term. Next week's economic data will not likely be particularly significant or damaging to the market. Moreover, it is virtually unanimous that the Fed will leave rates on hold at next week's meeting which should be a positive for market sentiment. Finally if the decline in equity prices continues, then there will clearly be some asset allocation into bonds and perhaps flight to safety at the short end of the curve. It would not be surprising to see yields in the bond testing the 6.50% region again and short rates fall another 5 to 10 basis points as well.
MONEY MATTERS–Longer term, barring a major downturn in the equity market, the economy still looks likely to post stronger than potential growth at a time when labor markets are tight and excess slack is limited. Since inflation is a monetary phenomenon and is manifested in excess demand, it is worth noting once again that money supply growth continues to run at a very strong pace. With last month's numbers in, M2 growth is now above the Fed's 2% to 5% target range. Moreover, the monetary base is also rising steadily suggesting that there is ample liquidity to fuel stronger economic activity. Fed Chairman Greenspan noted that M2 has shown “signs of reestablishing” its relationship to nominal GDP and that the Fed may return to targeting money supply growth in the future. It appears that velocity is returning to a more stable level and with money growth at 5% or above, the Fed is setting the stage growth in excess of 3% in the year ahead. As San Francisco Fed President Parry put it recently, “anyone who thinks the economy can grow at 3% over the long term with no inflation has a lot of proving to do.”
THE WEEK AHEAD: A MORE STABLE MARKET–In the week ahead, the market is likely to start out on a firm note, responding to the weakness in equities and the likelihood of asset allocation models increasing fixed income exposure, The short end of the yield curve should be well supported. Moreover, the markets will undoubtedly respond positively to a Fed decision to leave rates on hold. The economic reports are sparse with only trade figures and the Philadelphia Fed index of much importance.
Bond yields in the 6.50% to 6.60% appear to reflect the underlying fundamentals fairly well for the time being. If the economy picks up as much as anticipated in the next few months, then we would anticipate a cyclical advance in yields back towards the 6.80% to 7.0% region. However, for the near term, the market has done a lot of work in a short amount of time and a trading range near current levels seems likely. Stay with short September T-bond positions from 116-12 with stops moved down to 114-12. Otherwise, look for a range trade.
Kathy Jones
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