Focus
The Economy
Despite the fact that the US economy in June and July seems to have hit a “soft patch”, we believe that by the time investors read this commentary, the Fed will have made good on its promise to remove its accommodative monetary policy stance “at a pace that is likely to be measured.” By that we mean that at the August 10 FOMC meeting, the Fed Funds rate will have been raised 25 bp to 1.50%. As Alan Greenspan stated in his speech to the International Monetary Conference in London in June, “That conclusion is based on our current best judgment of how economic and financial forces will evolve in the months and quarters ahead. Should that judgment prove misplaced, however, the FOMC is prepared to do what is required to fulfill our obligations to achieve the maintenance of price stability so as to ensure maximum sustainable economic growth.”
In his diplomatic way, Chairman Greenspan has described the knotty problem facing every central banker. In his more direct way, Paul Kasriel, chief economist at Northern Trust described the Fed’s dilemma: “If [the Fed] does not get the Funds rate above the inflation rate, it runs the risk of generating even higher inflation. However, if the Fed does continue to raise the Funds rate, it runs the risk of bringing down the US house of credit cards.”
When Chairman Greenspan made his speech in London on June 8, he was looking in a rear-view mirror that showed an economy appearing to gain strength. First quarter GDP had been strong, the employment reports had been robust, and the manufacturing sector was picking up steam. Inflation data were picking up. At that time, his reference to the FOMC having to “to do what is required” was an allusion to the possibility of even faster tightening should conditions warrant it. Making that same speech today, his language could be interpreted as quite the opposite: that if “economic and financial forces” prove weaker than expected, the measured pace will become even slower.
Indeed, several indicators that came out in July point to a softening in the economy. Specifically, consumer spending dropped 0.7% in June, the biggest decline since September 2001. Personal incomes rose 0.2% in June, down from 0.6% in May, the weakest growth in incomes for more than a year. The core personal consumption expenditures index, which is the Fed’s preferred inflation measure, rose 0.1% in the month and 1.5% in the last 12 months, indicating that inflationary pressures may be moderating. Supporting this statistic were the modest CPI data—topline rose 0.3% in June, half of May’s pace, and the CPI ex-food and energy rose just 0.1%—and the weak PPI numbers—topline actually fell 0.3%, while the core PPI rose just 0.2%. Retail sales in June dropped 1.1% after a 1.4% gain in May. Industrial production dropped 0.3% in June, and factory capacity utilization had its biggest month-to-month drop since April 2003, falling from 77.6% to 77.2%. The nonfarm payroll figures released in July and now August point to a softening employment environment. Perhaps underscoring the softening of the economy was the release of the second quarter GDP estimate, which showed real GDP grew at an annual rate of 3.0%, down from the 4.5% growth in the first quarter (revised upwards from the 3.9% previous estimate). The primary reason for the slower pace of growth in GDP was the slower pace of growth of consumption, which accounts for 70% of GDP. In the second quarter, consumption grew 1.0%, a significant decline from the 3.6% and 4.1% growth of the fourth quarter of 2003 and the first quarter of 2004, respectively. And of the three major components of consumption—durable goods, nondurable goods and services—durable and nondurable goods consumption actually declined in the quarter. Durable goods consumption declined 2.5%, the first decline since the first quarter of 2003, and nondurables fell 0.1%, the first decline since the third quarter of 2002. Investment, which accounts for 17% of GDP, was up 12.8% in the quarter (particularly strong was the 15.4% increase in residential investment expenditures).
Economic data are never uniformly bad or good. The latest data from the Institute of Supply Management show that factory activity in the US increased in July, as new orders and production were strong. July was the sixth straight month that the ISM Composite Index was above 60 (an index level above 50 indicates an expanding economy). Northern Trust points out that this is the longest span above 60 since the 12 month period from July 1972-June 1973. Consumer and business confidence is strong and new home sales showed resilience. Also boding well for economic activity is the positive news on the Japanese economy and the Eurozone.
The question, then, for policymakers is whether the softness we are seeing is just a reversion to the mean in economic activity or whether it is the first step in a slide into recession. The key may be the consumer, who over the past two years has contributed mightily to the economy thanks to a combination of tax cuts, equity extraction from their homes and generally falling prices for many popular durable goods like cars and computers. These tailwinds to consumption have been generous, but they may be played out, and an environment of higher interest rates and rising prices—particularly oil and its collateral commodities and activities—could turn into a headwind for consumption. One troubling aspect of the financial condition of the consumer is the fact that over the last three years of dramatically declining interest rates, the consumer’s debt service burden has gone up, not down. (In the graph below, the household debt service ratio is an estimate of the ratio of debt payments to disposable personal income. Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt. The financial obligations ratio adds automobile lease payments, rental payments on tenant-occupied property, homeowners’ insurance, and property tax payments to the debt service ratio.)
The Mortgage Market
Mortgage prepayments continued their slowdown for the month of June (July reporting period), with aggregate fixed rate speeds declining by about 18% from May’s numbers. July numbers should continue to show a downward trend in prepayment speeds as most dealer forecasts are calling for a 10% to 15% decline. However, leading prepayment indicators in June point to a slight up-tick in speeds for August. For example, the MBA Refinancing index trended upward in the month, going from 1387 at the end of June to 1600 at the end of July. Further, Freddie Mac’s Primary Mortgage Market Survey Commitment rate declined slightly during the month to an average of 6.02%, 27 bps below June’s average rate. Consequently, since it typically takes four to six weeks for refinancings to flow through as prepayments, August is expected to show a minor pickup in speeds. Nevertheless, any further threat of a major increase in fixed-rate prepayments is unlikely as long as the yield on the 10-year Treasury remains above 4.00% as, according to Bear Stearns research, this would push over 50% of outstanding fixed-rate MBS into the refinancing window.
Despite declining fixed rate speeds, prepayments on adjustable-rate mortgages (ARMs) remained relatively fast or even increased. ARM borrowers, fearing a rate hike would cause their monthly payments to spike and due to their typical short horizon, have taken advantage of continually low mortgage rates and strong housing appreciation to refinance or cash in on their increased home value. Street research on ARM prepayments points toward a slowdown over the coming months, yet the lack of historical data on ARM prepayments often makes these forecasts subject to variability. As the dynamics surrounding prepayments of ARM securities are better understood, however, they become an even more attractive asset class to invest in for our strategy. We continue to remain positive on the sector and are monitoring their prepayment speeds to assess the impact on returns.
The Markets
In July, the bond market was relatively quiet, as the Fed move on June 30 merely confirmed the repricing that had occurred in advance of it. Bonds traded in a tight range, with the two year finishing the month exactly where it started. Stocks, on the other hand, declined in July after two up months. The dollar strengthened slightly. Gold had a volatile month, and the oil market saw spikes in price at the end of the month.
