Economic Commentary - September 2007

By Clare W. Zempel, CFA
Economic and Investment Strategies Consultant

Overview
The financial markets were quite volatile in August when most major stock market indexes recorded their sharpest declines in 4 1/2 years. Concern that the residential real estate recession and the related subprime loan problems would worsen and spread to other sectors was the major force behind the initial sell-off. That concern fulfilled itself when investors shifted funds from riskier securities into U.S. Treasuries. The Federal Reserve’s response to the resultant "credit crunch" for some mortgage lenders and mortgage investors was reassurance in word and deed that it would provide whatever funds were needed for the markets to function. The stock market rebounded after the Fed acted in mid-August but anxieties remain elevated.

Some caution is in order but it remains doubtful that a more serious credit crunch or financial crisis is in process or imminent. The fundamental cause behind most crunches and crises – and the recessions and bear markets that followed them -- was restrictive Federal Reserve policies. The Fed’s policies were restrictive when the real or inflation adjusted federal funds interest rate rose above 450 basis points. Until and unless the real fed funds rate rose above that level, no serious financial crisis or recession occurred, and Real GDP (Gross Domestic Product) rose at or above its trend.

In similar fashion, the causes behind bear markets in common stocks were restrictive Federal Reserve policies and/or extreme market overvaluation relative to interest rates. Until and unless the real fed funds rose above 450 basis points, and/or until and unless the stock market became overvalued in the extreme relative to interest rates, corrections occurred but no bear market erupted. The real federal funds interest rate is now around 335 basis points – well below the 450 basis points reached before past recessions and bear markets. And the stock market is undervalued -- not overvalued in the extreme like it was before past market peaks. With real interest rates and stock market valuation nowhere near their respective "tipping point" levels, severe credit crunch, financial crisis, recession and bear market are possible but improbable.

Home construction could weaken further but other economic sectors should remain robust. Credit will become costlier but this marks a return to more normal terms rather than a crunch. The economic expansion should remain solid on balance and could even reaccelerate somewhat -- and the stock market should suffer no worse than a correction -- even if the Fed does not cut interest rates. The trends should remain favorable – and much more so than feared -- until and unless the Federal Reserve raises interest rates sharply. And there is no reason whatsoever to expect the Fed to do that soon.

It is not the case that there are no problems on the economic and investment fronts, but the downside risks do seem to be overstated in the media. Investors should not let short-term turbulence distract them from the still-favorable fundamental trends. Rebalance portfolios if needed but otherwise remain true to well-founded asset allocation plans.

Economic and Market Update

Shock and crises have not been uncommon in financial market history. The major ones since 1970 were these:

1970 Penn Central Railroad Bankruptcy

1974 Franklin National Bank Failure

1980 First Pennsylvania Bank Failure

1981 Mexican Crisis and Penn Square Failure

1984 Continental Illinois Bank Problems

1987 Wall Street’s "Black Monday"

1990 General Banking Crisis

1994 Mexican Crisis and Orange County Bankruptcy

1997 Asian/PacRim Crisis

1998 Russian Debt Default and Long-Term Capital Management Crisis

1999 Brazilian Devaluation

2002 Corporate Financial Scandals

2007 Mortgage Defaults and Funding Problems

About half the shocks and crises listed above occurred in or after recessions. The Penn Central Railroad bankruptcy in 1970, the Franklin National Bank failure in 1974, the First Pennsylvania Bank failure in 1980, the Penn Square failure in 1981 and the banking crisis in 1990 – all these resulted from economic downturns. The recessions themselves resulted from restrictive Federal Reserve policies.

Most other shocks and crises resulted from loans or investments that were based on incorrect interest rate expectations. This applied to the Continental Illinois Bank’s problems in 1984, Orange County’s bankruptcy in 1994, the Long-Term Capital Management crisis in 1998, and the current mortgage default and funding problems.

Wall Street’s "Black Monday" neither came from nor resulted in an economic recession. The 1987 "crash" occurred after the stock market reached an extremely overvalued level. On balance, the crises that arose overseas had rather limited economic and market effects here.

The evidence does not support the fear that the current mortgage-related problems have made a recession and/or a bear market in common stocks inevitable. To better judge those downside risks to investors, we need to turn to other indicators.

Recession Risk
Recession risk is important to investors because most deep and sustained stock market declines have occurred in conjunction with economic downturns. Most investors know this to be true and would reduce their exposure to common stocks if a recession seemed imminent. (Figure 1)

But how can we know when a recession lies ahead? The headlines have warned us about the economic threats inherent in the sharp rise in oil prices since 2003, the five-fold increase in short-term interest rates since mid-2004, the steep slide in home construction since 2005, and now the mortgage loan default and funding problems. To be sure, the economic expansion has decelerated since 2005 but no recession has occurred so far.

The one factor that has never failed to produce a recession – or a bear market in common stocks -- is a high "real" or inflation-adjusted short-term interest rate level. A real interest rate is determined by subtracting inflation from the "nominal" interest rate level that is quoted in the marketplace.

To illustrate, the Federal Reserve has targeted the federal funds rate at 5.25% since June 2006. Based on the Federal Reserve’s favorite benchmark (the Personal Consumption Expenditure Deflator Excluding Food and Energy Prices), the "core" inflation rate is now 1.9%. Hence, the real federal funds rate is 3.35% - the 5.25% nominal fed funds rate minus the 1.9% inflation rate - or 335 basis points. (Figure 2)

The critical lesson from how the real fed funds rate has behaved over time is this: recessions have not occurred in the past until after the real federal funds rate had risen above 450 basis points. It follows that a real fed funds rate above 450 basis points has been the "tipping point" – the level where the Federal Reserve’s policies became sufficiently "restrictive" to halt economic expansions – the level where recession risk became material.

If the historical benchmark still holds, then recession risk remains low now – and the Federal Reserve’s policies remain stimulative to further economic expansion -- because the current 335 basis point real fed funds rate remains well below the historical recession-inducing level.

But does this historical real-rate benchmark still hold? Ever since the Federal Reserve started raising the federal funds rate from its 1% low in mid-2004, pessimists have warned that increased debt burdens combined with high energy prices would make the economy more vulnerable to rising interest rates than was true in the past.

But the rise in the federal funds rate to 5.25% has not stopped the economic expansion and job creation so far. And the sustained rise in the Commodities/Claims Ratio indicates that the increased real fed funds rate has not even caused the economic expansion to lose much speed outside the housing sector.

The top number in the Commodities/Claims Ratio is the CRB (Commodities Research Bureau) Spot Raw Industrial Commodities Price Index. This index measures prices for metals and raw industrial materials other than oil and food-related commodities. This number has soared since 2002 and it remains near the record level it reached in July. An upward trend in industrial commodities prices almost always coincides with increased production demands and sustained economic expansion. (Figure 3)

The bottom number in the Commodities/Claims Ratio is Initial Unemployment Insurance Claims – a number that counts those who have just lost their jobs and filed for unemployment insurance for the first time. Unemployment claims rose somewhat last winter but then fell to a 15-month low in May. Monthto- month fluctuations aside, jobless claims have remained in a downward trend since 2002. A downward trend in unemployment claims almost always coincides with improvements in job creation and in economic conditions overall. (Figure 4)

The Commodities/Claims Ratio has been an especially sensitive economic indicator because its two components have been quite quick to reflect shifts in the demand for the basic inputs to industrial production – raw materials and labor. Whenever a recession (1960- 61, 1969-70, 1973-75, 1980, 1981- 82, 1990-91, 2001) – or even just a pronounced economic slowdown (1966- 67, 1984-86, 1995-96) - loomed in the past, this indicator was always among the first to decline and warn that an economic downturn was on the horizon.

The fact that the Commodities/Claims Ratio has not fallen to date is powerful evidence that interest rates have not reached levels that have made a recession - or even just a severe and extended slowdown - inevitable. (Figure 5)

Growth Prospects
Real interest rates have been and remain low and stimulative to economic expansion, even with the rise in oil prices to record levels. In the past, when interest rates were rising and the real federal funds rate was about where it is now, Real GDP rose at an above-trend 3.6% annualized rate over the next 4-5 quarters. Were all else equal, current consensus expectations that Real GDP will rise just 2.2% in 2007 and 2.6% over the next four quarters would seem to be somewhat too pessimistic. (Figure 6)

But all else is certainly not equal. Something should almost be subtracted from Real GDP’s future expansion rate for the fact that oil prices soared above $75 per barrel last summer and this summer. But, if something should be subtracted from Real GDP’ for high oil prices, then something should probably be added for the fact that real long-term interest rates remain much lower than usual.

The nominal yield on the 10-year T-Note averaged about 4.7% in August. Subtracting the 1.9% "core" inflation rate, the real 10-year T-Note yield was 280 basis points. This was more than 90 basis points below the trend since 1987, and some 80-90 basis points lower than it was in the past when the real fed funds was around its current 335 basis point level.

Below-normal long-term interest rates should help stabilize residential construction and continue to stimulate business investment. This makes it seem possible that Real GDP will rise at least as fast and quite possibly faster than the consensus expects. At a minimum, lower-than-normal long term interest rates, in combination with a real fed funds rate that is well below its historical "tipping point" level, should mean that recession or even just a severe economic slowdown is improbable.

But can Real GDP rise at all if housing continues to decline? Housing is important but there have been times in the past when problems in that sector did not preclude a solid expansion in Real GDP overall. One such period was 1989-1995 – an extended period that encompassed declines in home prices in New England and Pacific states, and all-but-flat home prices in Middle Atlantic states.

The 1989-95 period did include a mild recession in 1990-91. Federal Reserve tightening had raised the real fed funds rate above 500 basis points in 1989 to set the stage for a serious economic slowdown. That slowdown became a recession when Saddam Hussein invaded Kuwait in August 1990. But before and after that recession, expansion in business investment and elsewhere more than offset weakness in housing to keep Real GDP’s advances moderately strong. (Figure 7)

Real GDP should expand around 3% over the next 4-6 quarters because real interest rates remain low. Sustained job creation should continue to support consumer spending. Sustained job creation should also combine with flat-to-lower home prices to help stabilize residential real estate markets.

Economic leadership will continue to shift toward exports and business investment. Corporate profits and cash flow should support increased business investment in plant and equipment. The dollar’s decline has kept our export products competitive and the world’s economic prospects remain quite positive.

There is a chance that the correction in residential real estate or increases in oil prices could combine to hold Real GDP’s expansion to 2% in 2007. But there seems to be an equal chance that low real interest rates here and robust economic expansion abroad could still combine to lift Real GDP’s advance somewhat above 3%.

Much more important than Real GDP’s precise pace, recession remains quite improbable. And low recession risk is positive for the stock market.

Asset Allocation Implications and Considerations

Fixed Income Investments
The 10-year T-note’s yield was near 4.6% late in August. A statistical model built with data from 1987-2006 indicates that the 10-year T-note’s yield "should" be 4.7- 6.4% in 2007. If that statistical model remains relevant, the 10-year T-note’s yield is unlikely to decline much further and could well rise as mortgage related fears diminish. (Figure 8)

The 10-year T-note yield has tended toward the lower end of the model’s predicted range since mid-2005. The "savings glut" that accumulated in Asia since the 1997-98 "Asian-PacRim crisis" helps to explain that. So does the notion that worldwide economic conditions have become "safer" - less volatile in real terms and less inflation-prone on balance – and made bonds more attractive to investors.

The T-note yield has also remained low because central banks around the world were creating excess liquid assets that have been used to purchase bonds. When most other central banks started to follow the Federal Reserve’s shift toward less accommodative policies, this particular support for bond prices seemed sure to weaken. But the recent "credit crunch" has undercut that view and the market now expects the Federal Reserve to ease.

Will the Federal Reserve cut the federal funds rate in September? It will not have to if its efforts to add liquidity to the financial system through open-market operations and discount-window lending continue to rebuild confidence in the financial markets. (Figure 9)

Should the Federal Reserve cut the fed funds rate? Two facts support the view that inflation risk exceeds recession risk and that the Fed should not be quick to ease: real or inflation-adjusted interest rates remain well below levels that preceded past recessions, and economic conditions outside residential real estate remain robust.

Nonetheless, the Fed would be quick to ease if the unemployment rate soared above 5% (from 4.6% in July), if the Purchasing Manager Indexes plummeted, and if other reliable indicators confirmed a marked deterioration in economic conditions.

Absent hard evidence that a much deeper economic slowdown than now seems probable in 2007-8 has commenced, the federal funds rate is unlikely to be cut from its current 5.25% level, and the 10-year T-note yield could well rise toward or even above 5.25%. The chance that longer-term interest rates could rise implies that investors should keep their fixed income (bond) portfolio maturities somewhat shorter than normal. The likelihood that risk spreads will widen from recent historic lows implies that investors should continue to favor higher-quality bonds.

Common Stock Investments
Skepticism toward common stocks continues to be reflected in the estimation that the stock market is undervalued 5-12% relative to interest rates. Interest rates would have to soar - the BAA corporate bond yield would have to rise from around 6.6% to more than 8.75% - or corporate profits would have to drop more than 20% - in order to eliminate the undervaluation at current market price levels. (Figure 10)

Interest rates could rise but should not soar. Profits could increase more slowly than in the recent past but the level will not collapse unless an economic recession occurs -- and recession remains improbable.

It is important to note that bull markets in common stocks do not end just because "undervaluation" has been eliminated. The usual pattern is that the stock market rises until it becomes overvalued in the extreme - usually by more than 40%.

The current targeted real federal funds interest rate level is 335 basis points -- well below the 450 basis point level that induced both recessions and bear markets in the past. This plus its estimated undervaluation should limit the market’s downside risk to a "correction" and support its further advance on balance in future months and quarters. (Figure 11)

Asset Allocation Implications
Based on fundamental relationships that have been dependable over the decades, economic prospects remain better than the consensus expects. If so, then the current belief that the Federal Reserve will slash interest rates could be disappointed. This implies that some caution on bonds remains warranted, because both long-term yields and quality spreads could well rise in those circumstances (better-than-expected economic expansion and no rate cut).

The low real federal funds rate and the stock market’s undervaluation relative to interest rates seem to make the stock market vulnerable to no worse than a short-term correction.

This seems all the more plausible now, because "third years" in the election cycle have been favorable, and because investor "bullishness" is nowhere near "irrationally exuberant" levels. (Figure 12)

The recent sharp declines in most major stock market indexes - the sharpest in 4 1/2 years – were associated with concerns that both the residential real estate recession and the subprime loan problems associated with it could worsen. Fear that debt problems could surface in other sectors was another reason for the sell-off in common stocks. Current subprime loan problems confirm that mortgage lenders took excessive risks in the past. Recent difficulties in selling debt to finance taking major public corporations private confirm that bond buyers have become more concerned about credit risks in general.

The terms on which loans will be made and bonds purchased will become costlier and more restrictive to borrowers in the future. But those terms will still be much cheaper and less restrictive than in a past credit crunches. This should remain true until and unless the Federal Reserve raises interest rates sharply. But the Fed is easing now, by adding liquidity to the financial system through open-market operations and discount window lending. And there is no reason whatsoever to expect the Fed to raise rates sharply anytime soon.

With real interest rates and the stock market’s valuation below their "tipping point" levels, the stock market’s recent decline should prove to be a "correction" and not the first phase in a bear market slide. Investors with well-considered asset allocation plans should check on the need to rebalance their portfolios but should otherwise adhere to their plans. Those without such plans should develop and implement some as soon as possible.

Remain focused on the fundamental forces and not the near-hysterical headlines. The most important and reliable fundamental forces that have warned about recessions and bear markets in the past are just not present. The most important and reliable fundamental forces are still positive.