Scott A Royal : Northwestern Mutual - Economic Commentary - September 2008 : Article: Economic Commentary

Economic Commentary - September 2008

Clare Zempel

Economic and Investment Strategies Consultant

Overview

No informed investor would claim that we suffer from too little information. The problem is that too much information sometimes creates uneasiness or even fear. Uneasiness can lead to paralysis and fear can lead to rashness.

We can cope with several variables – recession risk or inflation risk or even both. But add a few more and it becomes difficult to remember them all, let alone to assess their probabilities and implications. And there are more to add all the time: falling home prices, rising credit problems, record oil prices, the elections, Iran, Russia, climate change…

Fortunately, monetary analysis provides a reliable framework for putting other variables into perspective. Monetary analysis starts with interest rates and adjusts them for inflation to arrive at their “real” or economically meaningful levels. The real or inflation-adjusted federal funds rate peaked around 325 basis points in mid-2007 and has since fallen to -30 basis points. That 325 basis-point peak was well below levels associated with recessions in the past. The current -30 basis-point level is around or below levels associated with economic recoveries and expansions. The former implies that there should be no recession. The latter implies that inclinations toward recession should be limited and that an upturn is near. The charts that follow add evidence to the hope that trends should improve soon.

The drop in real interest rates did not prevent the recent decline in stock prices from crossing the line that separates “corrections” from “bear markets.” The S&P 500 fell 22.4% from its peak last October to its low in July. A comparable 22.2% decline occurred in 1966 after the real fed funds rate reached the same 325 basis-point peak that was recorded in 2007. There was a slowdown but no recession in 1966-1967 – and the S&P 500 Index was up 32.9% within 52 weeks.

Rather than abandon hope, investors should review their asset allocations and rebalance their portfolios to fit their objectives. That could involve shifting funds into common stocks. Based on the evidence in the charts, such a shift seems warranted.

Economic and Market Update: The Continuing Discussion

How does the world work in economic terms? Do business conditions and inflation walk some unpredictable random path? Or is it possible to anticipate trends with sufficient accuracy to be useful for investment purposes?

The view here is that perfect economic and market forecasts are unobtainable. One reason is that we do not have perfect information to work with. Almost all reported data arrive late and are subject to major revisions. And much desirable data is not even available. Another reason is that human behavior varies widely. It is well known that asset prices (stocks, bonds, commodities, real estate, collectibles) move between optimistic and pessimistic extremes, but the details about why and when such peaks and troughs occur remain mysteries. Political and natural calamities are even less well understood and susceptible to precise prediction.

But all is far from lost. The Federal Reserve’s monetary policies, reflected in real or inflation-adjusted interest rate levels, continue to provide useful if somewhat imprecise clues to both broad and specific future economic developments. The proof is in the charts for all to consider.

Real or inflation-adjusted interest rates are determined by subtracting inflation from the rates quoted in the marketplace. For example, the yield on the 10-year T-Note has been around 3.8% recently, the federal funds rate has been 2% since April, and the current “core” personal-consumption inflation rate is 2.3%. (“Core” inflation excludes food and energy prices. With food and energy included, “total” inflation is 4.1%. Either measure could be used for our purposes.

The results would differ in detail but not in principle.) (The inflation rates used here are based on the Personal Consumption Expenditure Deflator, which is similar to but more comp-rehensive than the CPI.) Subtracting inflation from the rates in the market-place,

the real T-Note yield is about 1.5% or 150 basis points, and the real fed funds rate is about -0.3% or -30 basis points. (Figure 1.) (Figure 2.)

There are two reasons why it is important to know where real interest rates stand. First, there has never been a recession in the past until after the real fed funds rate rose to – and usually above – 450 basis points. The last time that the real fed funds rate was above this “tipping point” was in the months preceding the 2001 recession. The highest level that the real fed funds rate has reached since then was about 325 basis points in June 2007. A similar level was associated with a sharp economic slowdown and a severe stock market “correction” in 1966-1967. There was no recession back then and the stock market was

quick to recover. (Figure 3.)

The second reason why it is important to know where real interest rates stand is that low levels have always ended recessions and spurred recoveries in the past. And the real fed funds rate’s current -30 basis point level is in line with or below the levels that prevailed when all seven recessions that have occurred since 1960 ended. From this perspective, a traditional recession has been and remains improbable – because the real fed funds rate never broached the historical tipping point. And if a recession starts anyway, it should be shorter and milder than usual – because the real rate has already fallen so low.

Real rates are not all that matters but their impact has

been both powerful and pervasive. For example, the recent decline in nonfarm jobs conforms to the historical relationship between jobs and the real fed funds rate. Nonfarm employment has fallen by 463,000 since it peaked this past January. Its 12-month growth rate has declined from 1.9% in May 2006 to 0% this past July. The relevant pattern here seems to be that job growth tends to peak when the real fed funds rate rises above 325 basis points. More important for the future, job growth tends to trough as the real fed funds rate approaches zero. The fact that the real fed funds rate has been below zero since April implies that employment trends should stabilize and recover soon. (Figure 4.)

The peak in nonfarm job growth in the current cycle –

1.9% in May 2006 – was well below previous peaks since 1960. Real rates do not explain this disappointment, which seems to owe more to the collapse in housing and to the explosion in oil prices.

The downturn in housing can be traced to a small extent to the real fed funds rate. The pattern has been that housing starts tend to stop rising as the real fed funds rate rises above 325 basis points, to plummet if the real rate continues to rise above 450 basis points, and to recover as the real rate falls toward zero. With the real fed funds rate now below zero, housing should start to stabilize soon. (Figure 5.)

The caveat is that the collapse in housing starts since January 2006 was due much more to the rise in home

prices to unaffordable levels than it was to an increase in interest rates. Further increases in household income and further declines in home prices should stabilize housing construction within 6-12 months if credit is available.

Real GDP is reported to have risen 2.4% in 2007. Had housing conditions not declined, Real GDP would have risen 3.4%. Over the four quarters that ended in June 2008, Real GDP rose 1.9% with housing included and 2.9% without it. Housing does not have to recover to lift Real GDP. Overall economic conditions would improve dramatically if housing just stopped declining.

Rising oil prices have also been depressing business conditions for quite some time. This has not caused a recession because real interest rates never broached 450 basis points and have now fallen below zero. Oil prices nonetheless remain a critical “wild card” in the outlook. The per barrel oil price has fallen from around $145 in early-July to around $114 in late-August. A not-impossible further decline toward or below $100 would do much to relieve downward pressures on both pocketbooks and sentiment. (Figure 6.)

The decline in the real fed funds rate should help the stock market stabilize and rebound. It is true that the S&P 500 Common Stock Index fell 22.4% from its peak last October to its recent low in July. It is also true that a 20% decline is the conventional definition for a “bear market.” It is furthermore true that this writer had contended that a “correction” was more probable than a “bear market” decline in stock prices. (Figure 7.)

The recent 22.4% decline in stock prices – a drop that coincided with a shift toward extreme bearishness in investor sentiment – is in line with the 22.2% peak-to-trough decline that occurred in 1966. As indicated earlier, the real fed funds rate had reached about 325 basis points in 1966. The results then included a sharp economic slowdown – but not a recession –

and a stock market decline that fit the “technical” definition for a bear market. Over the 52 weeks that followed the stock market’s 1966 low, however, economic conditions improved – and the S&P 500 Index rose 32.9%.

Low real interest rates should help revive the economy, investor sentiment and the stock market in the months ahead. Based on the historical relationships displayed in the charts, the improvement could start quite soon. (Figure 8.)

Bearishness is pervasive but that is not a reason to abandon hope. Extremes in bearish sentiment tend to mark market lows, not peaks. Rather than abandon hope, investors should check their current asset allocations and rebalance their portfolios as needed to match their objectives. Rebalancing now could well require shifting funds into common stocks. Based on the evidence shown in the charts, such a shift seems to be warranted.