Rough Patch Ahead

Since Greenspan made his comment in February of this year that theUScould be in recession by the end of this year investors and economists have largely taken the rosier view; that is until the last few of weeks. Oil flirting with $100, the dollar in freefall, anemic retail sales, housing in the depths, and a sub-prime mess, the extent of which is still unknown, have seemingly aligned forces against this economy. The majority view remains on the favorable side, but comments from the minority have grown louder and bolder. 

Today as reported by Bloomberg, Goldman Sachs announced their view that the slump in global credit markets will force banks, brokerages and hedge funds to cut lending by $2 trillion, triggering the risk of a “substantial recession” in theUS. Losses related to record US home foreclosures may be as high as $400 billion for financial companies, Jan Hatzius, chief economist at Goldman inNew Yorkwrote in a report released yesterday. The effects may be amplified tenfold as companies that borrowed to finance their investments scale back lending, the report said. 

To put it in perspective, Goldman’s forecast is equivalent to 7% of total US household, corporate and government debt, hurting an economy already beset by the slowing housing market and higher oil prices. Yesterday, Wells Fargo & Co. Chief Executive Officer John Stumpf said that the US housing market is the worst since “the Great Depression.” 

In a calmer yet still pessimistic tone, Federal Reserve Governor Randall Kroszner said in a NY speech today that “the current stance of monetary policy should help the economy get through the rough patch during the next year, with growth then likely to return to its longer-run sustainable rate.” The pointed and explicit nature of his comment clearly implies that the Fed thinks their two rate cuts of .75% are sufficient at this time to sustain the economy. Traders have almost unanimously assumed that the Fed would cut rates again on December 11th as futures have indicated a 90% chance of a cut. After Kroszner’s remarks futures backed off to 84%. 

Kroszner went on to note the Fed’s other mandate of guarding against inflation. He echoed Bernanke’s and the FOMC’s recent comments by noting that “the downside risks to economic growth now appear to be roughly balanced by the upside risks to inflation.” He added that “inflation expectations have remained reasonably well anchored [while] the prices of oil and other commodities continue, of course, to be a source of major uncertainty for the overall inflation outlook.” Bond investors have demonstrated their fears that inflation risks are greater as indicated by the difference in yields between 10-year Treasuries and notes indexed to inflation. The spread reached 2.44 percentage points Nov. 6, the widest since June according to Bloomberg. 

Data released in the past few weeks beyond the dismal housing industry have become more negative suggesting further slowing. Today, it was reported that industrial production in the USunexpectedly dropped in October by .5%, the largest decline since January. It follows a .2% gain in September. Capacity utilization, which measures actual production as a share of the maximum potential, fell to 81.7% from 82.2%. The slowdown in production was broad based and suggests that the housing slump and credit crunch are spilling into the greater economy. The report indicates that the business side of the economy with strong exports may not be sufficient to offset the slumping consumer economy. Still it cannot be ignored. Record exports in October helped the trade gap narrow in the third quarter, contributing 0.9% to economic growth after a 1.3 point contribution in the prior quarter, according to Commerce Department figures released Oct. 31st

Cisco, which on November 7th triggered the biggest sell-off in technology stocks in nine months by saying that declining orders from automobile and financial companies are curbing its growth, made some conciliatory comments to investors today. The company boosted its stock buyback plans by as much as $10 billion to revive the shares after disappointing investors. The amount translates to about 6% of outstanding shares. The company also announced that it is investing more in emerging markets, making acquisitions and pushing into new products such as television set-top boxes. 

FedEx Corp., an excellent gauge of an economy increasingly dependant upon shipping at every level of the production cycle, cut its outlook for a second time in three months today citing rising fuel costs and weak freight demand. Earlier, the company stated that it expects record shipments next month in its small-package business and a 6.9% increase in 2008 rates for express deliveries by air. Yesterday, J.C. Penney Co., the third-largestU.S.department-store chain, cut its fourth-quarter outlook a day after retailer Macy’s Inc. did the same. Caterpillar Inc., the world’s largest maker of bulldozers, trimmed its full-year 2007 forecast in October. 

What about the dollar tailspin? No doubt a cheaper dollar is helping American made goods fly off foreign shelves at a record pace, but it is a sword with two edges. While the lower dollar abroad makes our exports more affordable, a cheaper dollar at home makes imports (like oil and cars) more expensive. If consumers continue to buy the upward pressure on prices may become systemic and enduring. 

Our trading partners are growing impatient with the rapidly falling dollar. Treasury Secretary Henry Paulson who is on a six-day tour of Africa is expected to discuss exchange rates at the Nov. 17-18 meeting of the G-20, which includes the largest developed nations and emerging markets such asChinaandIndia. He has been saying that the dollar will rebound from record lows and predicts it will reflect the “long-term strength” in the American economy. 

The shift in trade patterns has threatened to slow growth in Europe, Canadaand Japan, and their governments have responded in the last few days with thinly veiled threats. As reported by Bloomberg, European Central Bank President Jean-Claude Trichet last week said “brutal” currency moves are “never welcome,” reprising language he last used when the euro climbed in 2004. French President Nicolas Sarkozy told American lawmakers Nov. 7th that the U.S. must support the dollar or risk triggering a trade war.

InCanada, where a drop in exports caused the nation’s trade surplus to dwindle to its smallest since 1998 in September, Finance Minister Jim Flaherty said last week that he was “concerned” about the soaring Canadian dollar. Bank of Canada Senior Deputy Governor Paul Jenkins said Nov. 14 that theU.S.currency’s drop threatens “rising protectionist sentiment.” Japan’s new prime minister, Yasuo Fukuda said the yen’s gains aren’t desirable and warned against speculative currency bets in an interview with the Financial Times published three days ago. 

If the US is going to support a stronger dollar, it means that interest rates will not likely go any lower for the foreseeable future or until other central banks lower their rates. The likelihood of reductions on their part seems remote at present. So here’s the question; is the current interest rate policy established by the Federal Reserve sufficient to keep the economy out of recession? 

The last official recession began March of 2001, ending a 10-year period, the longest-ever run of economic prosperity. In an unscheduled announcement on January 03, 2001 the Fed reduced their benchmark rate by one half of a percent to 6% from a peak of 6.5% set the preceding May. Their statement was as follows: 

“These actions were taken in light of further weakening of sales and production, and in the context of lower consumer confidence, tight conditions in some segments of financial markets, and high energy prices sapping household and business purchasing power. Moreover, inflation pressures remain contained. Nonetheless, to date there is little evidence to suggest that longer-term advances in technology and associated gains in productivity are abating.” 

The primary differences today are that inflation pressures may not be as “contained,” gains in productivity are not as certain, and the cheap dollar may preclude further rate reductions. Back in 2001, the Fed continued to drop rates at each meeting by 25 to 50 basis points until they reached a low of 1% in June of 2003. Of course there were additional shocks to the economy including 9-11 and the war inIraq. Still, we find ourselves now at 4.5%. Is that low enough to sustain this economy? Doubtful 

In earlier Briefs, we have recognized the slowingUSeconomy and wondered whether the global economy was sufficiently strong and diverse to pick up the slack of a US recession. Recently the growing magnitude and reach of the sub-prime losses have caused considerable doubt that a global slowdown can be avoided. Whether we officially have a recession in this country or not, it seems apparent that a US and global slowdown are likely, suggesting a shift in our tactical allocations away from our emphasis on growth and toward greater yield and safety. We have probably seen the markets’ highs for a time, though we do not rule out another rally. 

Taking advantage of some recent strength we have removed most of our allocation to emerging markets. Given the large exposure of financial institutions in our DJ EuroPacific Select Dividend Index we are reducing that as well. We will continue to move our domestic exposure to more defensive staples and healthcare issues and away from cyclical industries. As always, if you have any questions please give us a call.

Have a good weekend.