Will confidence recover? Econoday Simply Economics 9/30/05 By Evelina M. Tainer, Chief Economist

Recap of US Markets
STOCKS
The equity market showed mixed results on Friday. The results are also mixed when one looks at equity performance to date - since the beginning of the year. The Dow Jones Industrial Average is the most sluggish performer - with a 2 percent drop since year end. The Nasdaq composite index is also down from year end with a 1.1 percent drop. The Wilshire 5000 - which encompasses the entire market - is the best performer with a 2.7 percent gain, closely followed by the Russell 2000 with a 2.5 percent gain. The S&P 500 is up 1.4 percent since year end. It is ironic that the small cap index is performing so well since many analysts had expected the small cap market to under perform this year after doing well in the past couple of years.

BONDS
The Treasury yield curve has changed dramatically over the past year. Notice that today's yield curve (red line) is quite flat and not very different from the June 30 close - except that yields are higher across the board - mostly in line with the Fed's rate hikes. In contrast, long rates were higher on March 31 as well as December 31, 2004. On those two dates, the yield curve was steeper than it is today.

While Federal Reserve chairman Alan Greenspan still calls the spread differential between short rates and long rates a conundrum, a Federal Reserve study found that the heavy buying of Treasury securities by foreign investors and foreign central banks have reduced the long rate by as much as 100 to 150 basis points. Put differently, the long rate would be well over 5 percent if foreigners weren't purchasing our Treasury securities. These results have some merit, and could be a reason why Greenspan doesn't believe that the flat yield curve is currently signaling recession.

Historically, a narrow spread (or an inverted yield curve) between long and short rates has signaled economic slowdown or recession. Yet most economists are not suggesting that today's yield curve is signaling a recession. Yet, one should not discount entirely the possibility that high gasoline prices as well as sharp increases in consumers' heating bills this winter won't stall retail sales.

Markets at a Glance

Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.

The Economy
DURABLE GOODS ORDERS ADVANCE
Durable goods orders jumped 3.3 percent in August after plunging 5.3 percent in July. A good chunk of the July drop was due to the volatile aircraft sector. Excluding transportation, new orders gained 4.2 percent in August, more than offsetting July's 3.7 percent drop. Even though new orders were revised down for July, the August figures helped boost total durable goods orders for the year - and in the first eight months of this year, the average monthly increase is 0.6 percent - up from 0.2 percent in the first seven months of the year! Thus far, the pace for 2005 is on track with 2004 (although not as strong as 2003).

If business confidence wanes in the aftermath of the one-two punch, which was Katrina and Rita, then new orders may not necessarily accelerate in the final months of the year. However, given the strong fiscal stimulus for rebuilding the hurricane-ravaged area, it is certainly possible that new orders could improve. But there is no question that business and consumer confidence will be key. Consumers are already concerned about the high energy prices that they will have to endure due to capacity constraints at refineries. If decision-makers at businesses are equally concerned about high energy prices, then the economy won't seem as resilient as everyone is now saying.

SEPTEMBER NAPM-CHICAGO SHOWS SIGNS OF GROWTH
The business barometer from the NAPM-Chicago jumped more than 11 points in September to reach a level of 60.5 after plunging to 49.2 in August. Market players like to use this Chicago purchasing managers index to predict changes in the ISM manufacturing index even though the Chicago index incorporates both manufacturing and non-manufacturing activity. While September's level is not as high as July's, it is an improvement over the May, June and August levels and does point to expansion in business activity during the month.

While most of the components of the Chicago survey posted healthy gains for the month, the employment index declined to 48.4 from 51.7. This is not a good sign. Furthermore, the prices paid index jumped to 76.3 - the highest level since January. It certainly justifies the Fed's worries about inflationary pressures.

Don't expect the ISM manufacturing survey to jump as sharply as the Chicago index. The chart above shows that the NAPM Chicago typically increases and decreases more dramatically from one month to the next than the ISM index. But it is likely that Chicago's prices paid index will serve as a good predictor for the prices paid component in the ISM surveys. The three price series (NAPM-Chicago, manufacturing and non-manufacturing ISM surveys) move in tandem each month.

CONSUMER CONFIDENCE: AN INDICATOR TO MONITOR THESE DAYS
Consumer attitude surveys are complicated to interpret. At times, they do a good job of predicting spending; at other times they are reflecting the "CNN effect". Consumer confidence began to decline sharply after the stock market bubble burst in 2000. Another sharp drop occurred during the 2001 recession. Confidence plunged again in early 2003 as terror alerts and imminent war with Iraq spooked consumers. Retail sales did moderate during the recession, but not as much in early 2003 when factors other than income and jobs governed shifts in confidence.

Consumers today are highly impacted by higher gasoline prices, but watching the horrific events of Katrina unfold on TV 24/7 clearly added another element of pessimism. The question now is whether the drop in consumer confidence reverses in October as Katrina and Rita fade to the background or whether high gas pump prices stuck near $3/gallon keep consumers on edge. There is no question that the fiscal stimulus from Katrina and Rita rebuilding will help boost economic growth. But there is also no question that consumers cannot pay $3/gallon indefinitely without cutting back on spending on other goods and services. And we haven't even seen our heating costs yet. More sticker shock will certainly add to the pessimism.

So, while it is true that consumer attitude surveys do not tell us how much consumers will spend each month, they do give us some indication of the path of consumer spending. If consumer attitudes remain depressed, retail sales will suffer. If consumer attitudes recover in the next month or two, then reasonable retail spending will continue.

AUGUST INCOME & CONSUMPTION EXPENDITURES DROP
Personal income dipped 0.1 percent in August after posting average gains of 0.3 percent per month in the three previous months. While wages and salaries increased 0.2 percent in August, the Bureau of Economic Analysis incorporated estimates for Hurricane Katrina damage. Proprietors' income declined by $6.2 billion with decreases in both farm and nonfarm income. More dramatic was the $92 billion drop in rental income which reflects uninsured losses of residential and business property. "Other current transfer receipts from business (net)" was increased by $70 billion, reflecting insurance benefits paid to persons.

Personal consumption expenditures declined 0.5 percent due primarily to an 8.9 percent plunge in durable goods spending. Remember that motor vehicle sales dropped sharply in August despite healthy incentive packages. September motor vehicle sales will be reported on Monday. Anecdotal evidence suggests that sales were not robust, as consumers were not inclined to buy large SUVs in the face of high gasoline prices.

HOME SALES - SLOWING DOWN?
Sales of existing homes increased 2 percent in August, not quite reversing July's 2.7 percent drop. Despite the rise in August, it is worth noting that both June and July sales were revised down slightly. New single-family home sales plunged 9.9 percent in August after increasing 5.3 percent in July. Both June and July sales were revised down in this report as well.

The existing and new home sales report are not at odds since new home sales are counted as a sale when a contract is signed while existing home sales are counted as sold at closing. Thus, the August existing home sales report reflect July sales (and these rose for new homes as well.)

Despite the decline in new home sales in August, the overall level of home sales remains quite high, although the chart below suggests we have reached a plateau this summer as interest rates have started to tick up. Mortgage rates are still relatively low by historical standards, though.

Clearly, housing activity will remain strong in the South due to the rebuilding in the aftermath of Hurricanes Katrina and Rita. However, the rebuilding will be spread out over many months and may not be noticeable in the aggregate data. If consumer attitude surveys continue to show discontent, it is very possible that housing activity (outside the rebuilding zone) will show signs of moderation. Certainly one would have expected interest rates to increase with Fed tightening, but since mortgage rates are tied to long-term rates, and these have remained low, we may continue to see historically low mortgage rates for months to come. Granted, mortgage rates have picked up over the month of September.

JOBLESS CLAIMS SHOOT UP AFTER HURRICANE; HELP WANTED INDEX FALLS BEFORE HURRICANE
New jobless claims jumped in the week ended September 10 and September 17 due to job losses from Hurricane Katrina. Claims fell back in the week ended September 24 since we are not yet seeing the impact from hurricane Rita. Some bond investors are discounting the claims that are related to job losses due to the hurricane and suggesting that the economy outside of the devastated regions is performing strongly. That is the wrong way to look at it. While it is true that part of the economy may be performing well, but that doesn't mean that the job losses are meaningless. A strong segment of the population was hurt from the hurricane - and it may take a long time for these people to find jobs. Granted, it is better to have such a shock happen when the economy is strong than when it is weak, but the job losses are real - and will be felt on the economy.

Indeed, notice that The Conference Board's help wanted index fell four points in August (pre-Katrina) to a level of 35. Notice the trend over the past year. This index reached a peak of 41 in January and then proceeded to deteriorate over the course of the year. While I believe that fewer companies are placing job ads in newspapers, this is a reason that the index never recovered to its pre-recession levels. However, in the past year, we should have seen improvement in this index, not deterioration. It suggests that the labor market may not be as strong as many believe. And this reinforces our view that new jobless claims related to Katrina -or Rita in coming weeks - should not be entirely discounted.

The Bottom Line
Natural disasters are never positive for an economy. Even though economic activity may accelerate for a brief time as consumers and businesses rebuild, losses are not retrievable. While the federal government stands ready to spend $200 billion to soften the blow, these funds will not come out of thin air - the federal government will have to spend less elsewhere - or income taxes will eventually have to rise. If neither happens, the federal budget deficit will go deeper in the red.

In the meantime, the Federal Reserve must fight inflationary pressures - and inflationary expectations. Since the housing market has been red-hot thus far, the massive rebuilding efforts will easily create price pressures for home building materials.

At the same time, high energy prices are causing consumers to re-think their spending habits. Over the past year, we have been continuing to buy the same amount of gasoline at higher prices, and still have spent on other goods & services, reducing funds going to savings. At some point, consumers (soon to be hit with high heating oil and natural gas bills) will have to cut back on something.

A good chunk of the Gulf coast population has been displaced. Little towns have been totally obliterated. Consider all the services and jobs in these towns have disappeared. While the mayor of New Orleans has been pushing to get his citizens back in town, many of these jobs also have been lost. How long will it take to get these jobs back?

It is true that the majority of Wall Street economists are currently quite sanguine about the post-hurricane recovery period. Most have merely reduced their forecasts for growth by 0.5 to 1 percentage points in the third and fourth quarters of this year keeping the negative impact primarily on the hurricane ravaged regions. A minority, however, is putting greater emphasis on the negative impact that continued high gasoline prices will have on the nation as a whole.

I will leave you with two more conflicting thoughts. Historically, those who predict recession are often early - because the economy is large and doesn't stop on a dime. Historically, very few economists have correctly predicted recessions - preferring to forecast continued growth ad finitum. Even Fed chairman Alan Greenspan didn't anticipate the 2001 recession.

Looking Ahead: Week of October 3 to October 7

Monday
The ISM manufacturing index decreased 3 points to 53.6 in August, back to the lows seen earlier this spring. September data will incorporate the impact of Katrina and Rita, so this reading should be interpreted cautiously.

ISM manufacturing index Consensus Forecast for Sept 05: 52
Range: 49.5 to 56

Construction spending was roughly unchanged in July after decreasing in two of the three previous months. August figures are pre-Katrina and Rita and will be discounted to some extent by market players.

Construction spending Consensus Forecast for Aug 05: 0.5 percent
Range: -0.1 to 0.8 percent

Domestic motor vehicle sales plunged to a 13.3 million-unit rate in August from July's 17 million-unit rate despite the fact that incentives were still going strong. Consumer confidence plunged in September, but we often believe that motor vehicle sales are a better indicator of consumer optimism (or pessimism) that consumer attitude surveys.

Auto sales Consensus Forecast for Sept 05: 5.5 million-unit rate
Range: 5.3 to 5.6 million-unit rate

Light truck sales Consensus Forecast for Sept 05: 7.5 million-unit rate
Range: 7.4 to 7.7 million-unit rate

Tuesday
Factory orders declined 1.9 percent in July, after posting two monthly gains. Given the 3.3 percent hike in durable goods orders in August, total orders will increase sharply as well, although to a lesser degree. Lately, orders are benefiting from strong Boeing orders, which did rise in August.

Factory orders Consensus Forecast for Aug 05: 2.2 percent
Range: 0.6 to 3.2 percent

Wednesday
The business activity index from the ISM non-manufacturing survey jumped nearly 5 points in August to 65. The non-manufacturing sector has shown stronger economic activity in the past several months than the manufacturing sector. Katrina and Rita will impact this month's figures.

Business activity index Consensus Forecast for Sept 05: 59.7
Range: 55 to 64

Thursday
New jobless claims dropped 79,000 in the week ended September 24 to 356,000. Labor Department officials believe Katrina-related job losses will lead to upward revisions in claims to previous weeks since many workers filed away from their home base. Job losses due to hurricane Rita will be smaller than those from Katrina, but new jobless claims will once again swell in the next couple of weeks.

Jobless Claims Consensus Forecast for 10/1/05: 350,000 (-6,000)
Range: 330,000 to 450,000

Friday
Nonfarm payroll employment increased 169,000 in August after posting larger gains in the two previous months. Excluding the impact of Katrina, economists are predicting nonfarm payrolls to have increased 190,000 for the month. The civilian unemployment rate inched down to 4.9 percent in August; a year ago the jobless rate stood at 5.4 percent during the month. The Bureau of Labor Statistics posted information on their web site on how they plan to account for Katrina (and Rita).

Nonfarm payrolls Consensus Forecast for Sept 05: -150,000
Range: -80,000 to -300,000

Unemployment rate Consensus Forecast for Sept 05: 5.0 percent
Range: 4.9 to 5.3 percent

Average workweek Consensus Forecast for Sept 05: 33.6 hours
Range: 33.5 to 33.7 hours

Average hourly earnings Consensus Forecast for Sept 05: 0.2 percent
Range: 0.0 to 0.4 percent

Consumer installment credit increased $4.4 billion in July after surging in June. With slower auto sales in August, credit usage may have remained more subdued for the month.

Consumer credit Consensus Forecast for Aug 05: $5 billion
Range: $1.0 to $8.9 billion