Daily Insight

U.S. stocks rallied on Wednesday as investor sentiment was sparked by a greater-than-expected rise in personal consumption (the largest segment of GDP) even as the overall economic reading showed the contraction over the past six months was the deepest since the 1957-58 recession. A massive inventory liquidation in the first quarter also gave the market hope the economy will expand in the current quarter as firms will be forced to increase production in order to rebuild stockpiles – I’m not sure about this one, we’ll need more data to confirm the view, but the inventory dynamic will surely boost GDP by the third quarter if not the second.

That 900 mark on the S&P 500 we’ve talked about is certainly in reach, the top end of this trading range is 935.

Financials led the rally, as the S&P 500 index that tracks these shares jumped 4.77%. Industrial, energy and material shares – the areas that jump on reflation hopes – also outperformed the overall market.

Nine of the 10 major industry groups ended higher, telecommunication shares being the sole loser.


Mid cap stocks, as measured by the S&P 400, gained 2.81% on the day and small caps, as measured by the Russell 2000, jumped 3.94% -- the other major small cap index, the S&P 600, added 3.66%.

Market Activity for April 29, 2009

Mortgage Applications

The Mortgage Bankers Association’s mortgage applications index fell 18.1% during the week ended April 24 as both purchases and refinancings fell even though fixed mortgage rates remain extremely low.

As you can see via the table below, refis (which make up close to 80% of all applications – and not evident in the table) dropped 21.9% last week. We’re not able to tell if some are waiting for an additional decline in rates or that simply most of the market has already refinanced by this point. No matter, we’ll get to a point in the not-too-distant future in which the index will have to rely on purchases again and with the labor market still very fragile we could go through a period in which this index endures a series of negative readings.


First-quarter GDP

The Commerce Department reported that first-quarter GDP came in at a worse-than-expected -6.1% (in real terms at an annual rate) and follows the 6.3% contraction in the fourth quarter. This marks the worst back-to-back quarterly contraction since the 1957-58 recession – easily surpassing (in terms of deterioration) the 1981-82 recession that endured back-to-back negative readings of -6.4% and -4.9% and the 1980 contraction that saw -7.8% followed by -0.7%.

However, the reading was met with optimism as the personal consumption component of GDP bounced back to rise 2.2% after big negative readings in the prior two quarters. This rise in consumer activity has people juiced that the gains are sustainable, but I think they’re are setting themselves up for a major disappointment. (I’ve got to say, it’s strange how the press and consensus seems to react to certain conditions. The financial press believed, on several occasions, during the period that ran 2004-2008 that the consumer was “tapped out,” even as the private sector components of the personal income data were growing at very healthy clips. Now, the consensus seems to believe consumer activity is back even though all private sector income readings are in decline. Government transfer payments is the only segment of the personal income data that is growing and this does not make for a sustained move in consumer activity. Then you have what’s occurring with regard to credit-card lines being cut and the decline in household wealth.)

Anyway, this personal consumption number for the first quarter is an estimate, as we have yet to receive the personal spending figure for March (we’ll get it today along with revisions to the February data), and I don’t think we can ignore the possibility of a downward revision. We knew, based on personal spending figures from January and February, that consumer activity had bounced from the previous six-straight months of decline, but it seems a bit high based on those results.

One wonders what the GDP number would have posted without this estimated rise in consumer activity, which added 1.50 percentage points to the overall figure. Gross private investment was just crushed, down 51.8% in the first quarter – fixed business investment was down 37.9% and residential construction posted its largest decline during this nearly three-year housing correction, down 38.0%.

The plunge in private fixed investment (plant and equipment) subtracted 6.04 percentage points from GDP and residential investment subtracted 1.36 percentage points. (If this were back in 2005 when housing made up 6.5% of GDP at the peak of the real estate boom it would have subtracted 2.47 points but since it has been reduced to just 3.4% of GDP, the subtraction was not as harsh. I bring this up just to give you some color, not trying to infer anything)

The change in real (inflation-adjusted) private-sector inventories was the other major drag on the figure. Inventories were estimated to have declined $103.7 billion last quarter, which is the biggest decline since records began in 1947. This component subtracted 2.79 percentage points from GDP.

The largest contributor to GDP was net exports as imports plunged at a faster rate than did exports – exports fell 30.1% and imports slid 34.1%, not exactly an inspiring development even as it added to growth.

What we’ll need is to foment confidence on the business side in order to get this economy rolling again. Yes, optimism regarding the consumer got a boost but, again, this area is going to remain weak overall as the two major savings vehicles (houses and stocks) have gotten hit hard and unemployment has hit its highest level in 26 years, and rising. Thus the consumer will feel the need to continue boosting cash savings and will remain cautious due to labor market conditions. This does not mean we won’t see pops in consumer actitvity, but I don’t see how a sustained rebound gets going until some of these drags on consumer confidence reverse course. It will just take some time.

Therefore, we’ll need to really lean on the business side to fuel growth. One thing that is very likely is the inventory dynamic will begin to catalyze growth a couple of quarters out – that is, inventory liquidation has been so substantial that the production needed to rebuild stockpiles will help GDP by the third quarter in our estimation. U.S. businesses are running as lean as they can and it won’t take much of an increase in demand to foster a production upswing. The slash-to-the-bone cost-cutting that’s occurred also bodes well for corporate profits a quarter or two out.

What is less clear is the direction of business-equipment spending. If firms believe the sapping of funds from the private sector, as the government pushes public-sector spending as a percentage of GDP from 20% to 30% over the next few years, will keep a lid on growth potential they may not spend as they generally do as the economy does bounce back. We will need the business community to have confidence in the future or they’ll hold off on activity, which would not be helpful as the consumer has a number of quarters yet to work through their issues.

The inflation gauge within the GDP report (the GDP Deflator) showed a surprising increase, jumping to 2.9% from 0.5% in the fourth quarter. However, this is a bad measure of inflation as it subtracts import prices. That is, this number will move in the opposite direction of energy prices, since we import 70% of our energy needs these days thanks to restrictions on domestic production. A more accurate gauge is the gross domestic purchases figure, which measures all prices paid by U.S. residents – it fell 1.0% last quarter.

As you all know, I expect inflation to kick up 12-18 months out, but this has not begun yet even though the jump in the GDP Deflator appears to signal so.


FOMC Decision and Statement

The FOMC (the Fed’s monetary policy decision-making committee) announced they would leave their fed funds target rate unchanged at a range of 0%-0.25% and economic conditions will likely warrant exceptionally low levels of fed funds rate for an extended period.

They also stated their plans to purchase Treasury and mortgage-backed securities would remain unchanged, but will continue to evaluate economic and financial market conditions and may shift the timing and overall amounts of these purchases as these conditions evolve.
(The bond market may be sending an early message to the Fed as they pushed Treasury prices lower, driving the yield on the 10-year note meaningfully above 3.00% for the first time since the FOMC initially announced to be contemplating Treasury and mortgage-backed purchases back n January. The Treasury will be issuing enormous levels of debt this year and next – and surely beyond – and if the market pushes yields substantially higher as a result you can be sure the Fed will move in quickly to state they are increasing purchases.) If the bond market begins to play with Bernanke, and pushes the 10-year Treasury yield even to a still historically low level of 3.50%, say, the following picture will really begin to roll:


Regarding the FOMC statements on the economy:

• Pace of contraction appears to have slowed
• Household spending has shown signs of stabilization but remains constrained by ongoing job losses, lower household wealth and tight credit
• Economic activity is likely to remain weak for some time
• Policy (fiscal and monetary) will contribute to the gradual resumption of economic growth and price stability
• In light of increasing economic slack inflation will remain subdued and could persist for a time that is below rates that are best to foster economic growth over the long term
  (when they mention “slack” they refer to high levels of unemployment and low capacity utilization rates – exactly the kind Keynesian focus that gets them in trouble; they better pay close attention to commodity prices as a mechanism to guide policy instead of this Phillips Curve-type model because inflation very likely will get rolling well before the unemployment rate hits more normal levels)
  

Have a great day!


Brent Vondera, Senior Analyst