On Hold for Now

Everybody’s on hold; from the Space Shuttle Atlantis, to the Federal Reserve. While NASA hopes to launch today at 11:40 after a three year hold, we hope it will take considerably less time to re-launch the economy. The Fed has decided to hold further rate increases until it gets a better picture of the economy’s health. The Bank of Japan, the Bank of England and the Bank of Korea announced a similar strategy this week. Even OPEC is expected to hold oil production steady when they meet next week to see what happens. Doing so would help avoid a supply-driven run-up in prices. So the world watches the economic data to learn just how fast the US and the global economies are slowing.

A welcome sign for the US economy is the declining price of oil and gasoline. After a calmer summer than expected, oil prices have fallen from a high of $77.03 a barrel on July 14th to yesterday’s close of $67.32. Gasoline, according to AAA is expected to drop to $2.50 a gallon or less in the next four to six weeks. My daughter, at Ole Miss (near the Gulf Coast’s gasoline refineries) tells me that gas is already selling for $2.25 in Oxford,Miss. Falling energy prices ease concerns on two fronts. The pressure they put on other prices and inflation is eased as crude oil falls. And, the consumer has more dollars of discretionary spending as his energy costs decline, thereby helping to sustain the economy’s growth.

A significant worry for economists and investors has been the collapsing housing market. Houses represent the largest asset for the vast majority of consumers. When those prices are rising there is a “wealth effect” that helps to promote and sustain spending. People feel that as their home rises in value, so does their savings.

According to a poll of 48 economists taken by the Wall Street journal, the Office of Federal Housing Enterprise Oversight’s home-price index will increase just 0.43%, well short of the current rate of economy-wide inflation. OFHEO’s prices index has never posted an annual decline in its 31-year history, and the last time that the index trailed inflation was in 1996, when home prices rose 2.6% compared to a 2.9% inflation rate.

The WSJ reports that prices are expected to rise 3.5% for houses this year, well behind the 13% appreciation of 2005 and the 12% gain seen in 2004. So consumers might feel less inclined to spend if their “savings accounts” aren’t growing.

WSJ reports that the industry is slowing dramatically as well. The National Association of Realtors expects new-home sales to fall 16.1% while existing-home sales will likely drop 7.6% this year. The realtors also predicted that the median existing-home price will increase only 2.8% this year and that the median new home price will inch up 0.2%, capping a long period of impressive home-price gains that have propped up consumer spending, and broader economic growth, by making homeowners, even those with heaps of debt, feel wealthier. Speculation is also being wrung out of the real estate market as sales and price growth slow dramatically.

So what’s the bigger picture? Is recession in our future? According to the WSJ survey, most economists believe that growth will remain steady from here, but at the same time they increased their chances for recession over the next 12 months. The inverted yield curve (short term rates higher than long rates) calls for recession too.

But each time the experts called for slowdown, the economy (i.e., the consumer) rose to the occasion and surprised on the upside. We believe the Fed is out of the way – that they are finished raising rates.  We also believe that inflationary pressures will soon subside and the Fed can look at potential easing. Oil prices are falling, home prices are falling, and broad commodity prices are falling and easing pressures on inflation. But on the worry side of the ledger, industrial metals prices and labor costs are still rising significantly. Productivity is rising too, up 1.6% for the second quarter, but whether it will be enough to offset higher labor and material costs will only be answered in the coming months.

We remain cautious on the near term, but do not expect the malaise to last too long. We are holding between 15 and 20% cash in our models and are conservatively invested in each. But there are opportunities for appreciation and we believe they will improve later this year. Our strategy of extending bond maturities is working out well as long-term bonds continue to extend their rally. The Lehman 20+ Year Treasury Index is up 5% from its low reached on May 12th. During that period, the yield on the 30-year US Treasury has fallen from 5.28% to 4.9%.

We will continue to watch and keep you informed.