04 Jan 2008 The Last Shoe Just Dropped

Call it a slump, a slowdown, or a recession, whatever you want, but its here. The last shoe has dropped – employment. Today’s government report of hiring slowing faster than forecast and unemployment rising to a two-year high, employment one of the last strengths of the economy is faltering.

Strains in credit markets over the last half of 2007 are ruining employers’ enthusiasm for hiring new workers. It was the creation of new jobs that kept alive hopes that the economy could skirt the problems of high energy costs, a severe housing slump, and reduced access to credit, but today’s data knocks the wind out of those sails.

The consumer, who represents two thirds of the economy, is now fully surrounded. His house value is declining, access to credit is significantly constrained, and the prices he pays for fuel and gasoline are steadily rising. It’s not a leap to say that the consumption engine of the economy is sputtering or stalling altogether.  

The early reads from the Christmas selling season come from online sales. According to Bloomberg, Internet sales byU.S.retailers during the holiday season rose at the slowest pace on record. Online spending from Nov. 1 through Dec. 27 increased 19% compared to 26% growth last year. Shoppers withheld spending until after Christmas, seeking deeper discounts by Wal-Mart Stores and Best Buy.

Exports, or goods sold by US companies to buyers abroad, are the one remaining hope to help maintain the momentum of the economy. The next report on trade numbers comes a week from today. But today’s report from the Institute for Supply Management which showed that its index of non-manufacturing businesses fell to 53.9 does not provide much optimism that exports will be a huge surprise on the upside.

All this bad news improves the chances the Fed will cut their benchmark rate by as much as a half a percent. Today, futures traders raised the odds for a cut to 52% from 34% yesterday and no chance a week ago, according to Bloomberg. Their next meeting is the end of January, but policy makers could possibly cut before then. So far the stock market is ignoring that possibility, choosing instead to focus on the question of how much the economy will slump and whether the Fed can slow the decline.

We believe there are certain sectors of theUSand global economies that will hold up best and possibly even continue to grow in the present conditions. These areas include healthcare, telecommunications, utilities, and technology. We like consumer staples too, but find them to be richly valued at P/E ratios above the market and equal to companies growing considerably faster. If economic conditions worsen from here we will further lighten our equity positions, but for now we think we are sufficiently defensive.