United States: Review and Preview

A sharp drop in the manufacturing ISM below the 50 boom/bust line and a decline in private sector payrolls suggested that a recession may have begun in December – in line with our forecast for a modest contraction in GDP growth in the first two quarters of 2008 – sparking a huge front-end-led rally in the Treasury market and a major dovish repricing of the Fed to start off the new year. The non-manufacturing ISM, despite the headline index strangely holding at a relatively high level, also showed significant underlying weakness, with nearly half of the industry groups reporting contraction in December. The fourth quarter as a whole appears to have held up reasonably well, as a significantly better-than-expected construction spending report and a bit of upside in manufacturing inventories in November led us to boost our 4Q GDP forecast to +1.7% from +1.2%. The construction results showed an accelerating collapse in housing, with clearly no end in sight, which was fully offset by surging non-residential building. But a sharp drop in non-residential construction payrolls in December suggested that this offset, which has been seen through much of the housing market collapse, may not last into 2008. And, in general, it’s clear that the expected 1.7% growth rate in 4Q was concentrated in upside early in the quarter. A significant fall-off at the end last year left 2008 starting on a very soft footing – both in the economic data and in major markets, with both stocks and credit tumbling on the week and LIBOR strains reintensifying. The main bright spot in this picture was surprisingly resilient motor vehicle sales in December. The upcoming week’s key economic news will be the monthly sales reports from most retail companies on Thursday, when we’ll see whether this stability in auto sales extended into broader retail spending. If the poor December results reported a week early by the major drug store chains are any early indication of broader chain store sales, Thursday’s reports could be ugly.

Benchmark Treasury coupon yields plunged 16-40bp over the past week and the curve steepened hugely to new multi-year highs. The 2-year yield fell 40bp to 2.72%, the 5-year 36bp to 3.165%, the 10-year 24bp to 3.86%, and the long bond 16bp to 4.36%. TIPS’ relative performance was extremely strong in the face of such a big rally. The benchmark 5-year inflation breakeven dipped just 2bp to 2.32% and the 10-year was unchanged at 2.31%. In addition to the direct impact of the economic data in stoking recession fears, the market was also supported by the big negative impact these worries had on stocks and credit. Stocks are off to one of their worst starts ever to a new year, with the S&P 500 tumbling 4% in 2008’s first three trading sessions. Credit markets did just as badly. In late trading Friday the 5-year HiVol CDX index was 31bp wider on the week at 232bp and the investment grade index 11bp wider at 89bp. These were the worst levels seen yet for both and up massively from closes (for the now off-the-run series 8 versions) of 104bp and 42bp, respectively, at the end of June before the financial market meltdown began. The higher rated subprime ABX indices – AAA (68.93 versus 74.69), AA (38.36 versus 44.76) and A (26.46 versus 31.31) – were also crushed on the week, reversing almost all of the improvement that had been seen from the lows hit around Thanksgiving.

There was a massive dovish repricing of the Fed. A 19bp surge in the February fed funds contract to 3.835% left the market pricing in a 50bp rate cut to 3.75% at the upcoming FOMC meeting instead of 25bp – that is, if the Fed even waits that long, as there’s little chance that the 4.145% level on the January contract can be fully explained by expectations that effective fed funds will undershoot the target so drastically this month. The April contract gained 26bp to 3.605%, pricing the likelihood of a 3.50% funds target after the March meeting, and the July contract gained 35bp to 3.215%, pricing in at least a 3.25% funds target by mid-year. The low-rate Dec 08 and Mar 09 eurodollar contracts gained 35.5bp to 3.08% and 38.5bp to 3.06%, shifting the expected funds rate trough down to 2.75%. The biggest eurodollar gains were posted by the Sep 09, Dec 09 and Mar 10 contracts, which rallied 47bp to 3.26%, 49bp to 3.415% and 48bp to 3.58%, respectively, suggesting that the market sees little prospect for a cyclical recovery of any significance in 2009 after the expected 2008 recession. The extraordinarily low 0.845% yield on the 5-year TIPS is sending a similar message of an expected prolonged period of economic misery to come.

If the bad data weren’t enough, interbank lending conditions resumed their worsening after the steady and significant improvement that had been seen through December. Term LIBOR did move significantly lower over the course of the week, with 6-month falling 18bp to 4.45%, 3-month 11bp to 4.62% and 1-month 11bp to 4.52%. But these declines didn’t come close to keeping pace with the Fed repricing, so the more important measures of stresses in the interbank market moved in the wrong direction. The 3-month LIBOR/3-month OIS (which measures average expected fed funds over the next three months) rose 8bp on the week to 74bp. In light of this renewed deterioration, the Fed’s Friday announcement that the sizes of the two upcoming TAF auctions would only be increased to US$30 billion from US$20 billion was disappointing. There was some good news in the money markets, however. The incredible 20-week uninterrupted run of declines in outstanding asset-backed commercial paper finally came to an end, with a significant increase in the first week of the new year. Term ABCP rates and spreads versus LIBOR also improved massively from the severely strained levels seen heading into year-end, and our desk noted a significant shift back towards term funding after the pre-year-end concentration in overnight issuance. This significantly improved tone in the ABCP market was mirrored in a big sell-off at the very short end of the Treasury market, with the four-week bill’s bond equivalent yield up 72bp on the week to 3.22%.

Non-farm payrolls rose just 18,000 in December, the unemployment rate jumped to 5.0% from 4.7%, the average workweek was steady at 33.8 hours, and total hours worked were flat. All of the payroll gain was accounted for by another strong rise in government jobs (31,000); private sector payrolls fell 13,000, the first drop since mid-2003. Manufacturing (-31,000), construction (-49,000), retail (-24,000), and writers’ strike-impacted information (-13,000) were particularly weak. Notably, the construction drop was about evenly split between residential and previously resilient non-residential jobs. The one positive in the report was the income numbers. Average hourly earnings posted a solid 0.4% gain for a 3.7% year-on-year rise, and aggregate weekly payrolls – a proxy for total wage and salary income – rose 0.5%. Of course, with energy prices back to surging to new highs again, even such solid gains in nominal income aren’t going to amount to much when retail gasoline prices start to catch up with the spike at the wholesale level.

In addition to private sector payrolls contracting, the manufacturing sector appears to have fallen into recession in December. The manufacturing ISM composite diffusion index plunged to 47.7 in December from 50.8 in November, the first sub-50 reading since the first part of 2003. Weakness was concentrated in significant drops into contraction territory by the key orders (47.7 versus 52.6) and production (47.3 versus 51.9) indices. Employment (48.0 versus 47.8) was little changed, also holding below the 50-breakeven level. Only 7 of 18 industry sectors reported growth in December. The report noted that industries “close to the housing market appear to be struggling more than others, and those involved in exports seem to be doing better”. The prices paid gauge (68.0 versus 67.5) posted a surprisingly small increase, with a number of energy items still reported up in price in addition to metals and plastics. As strong as the export situation has been (although that could now be at risk, judging from a sharp 6-point drop in the export orders index in December to 52.5, though this gauge is far from a reliable indicator for actual export performance), we had expected that the manufacturing sector would come under pressure but hold up much better than in a typical recession during the mild downturn we expect over the first half of 2008. So, if this weak report for December is a harbinger of a more severe and lasting retrenchment moving into this year, downside risks to the overall economic outlook would certainly be increased. Indeed, this surprisingly weak ISM result could be an early warning sign that the ex-US global picture is not nearly as rosy as many believe. In contrast to the manufacturing weakness, the non-manufacturing sector at first glance appears to have held up much better. The headline business activity index in the non-manufacturing ISM survey dipped slightly in December but held comfortably in growth territory at 53.9. This result was rather bizarre, however, considering the industry results, which were far weaker. Only five of 18 sectors reported growth in December. Eight reported contraction.

While the fourth quarter clearly certainly seems to have ended weak, thus providing a poor starting point for 1Q08, 4Q as a whole appears to have held up reasonably well, as we boosted our GDP forecast to +1.7% from +1.2% coming into the week. A better-than-expected construction spending report was the main reason. Construction spending rose 0.1% in November, and October (-0.4% versus -0.8%) and September (+0.3% versus +0.2%) were revised higher. Both the November uptick and the prior revisions showed a stark contrast between collapsing homebuilding and strength elsewhere. Overall residential construction fell 2.5% in November, with the key single and multi-family new homebuilding components plunging a combined 4.2%, the biggest drop in the 15-year history of the data. This severe weakness was offset, however, by a 1.7% gain in private non-residential spending, which, combined with upward revisions to prior months, pointed to a sharp gain in business investment in structures in 4Q, and a 2.5% gain in government spending. Incorporating these results, we now forecast a 28% plunge in residential investment in 4Q (this would be the worst quarter since the housing market collapse that followed the huge rate hikes instituted by the Volcker Fed in the early 1980s), a 19% surge in business investment in structures and an 11% gain in state and local government construction that would be a meaningful contributor to an expected 4.0% gain in overall government spending.

The November factory orders report contained no revisions to a weak trend in non-defense capital goods ex-aircraft shipments, so even with this sharp expected gain in structures investment, we see overall business investment in 4Q rising only 4%, with the equipment and software component expected to be down 1%. Overall manufacturing inventories did come in a bit higher than we expected in November and October was revised up marginally, which had a slightly positive additional impact on our 4Q GDP estimate on top of the more substantial construction spending upside. We still see inventories subtracting 0.7pp from 4Q growth, however, and look for a drag at least that big again in 1Q08.

The major data focus in the coming week will be Thursday’s chain store sales reports from most major companies, which will provide a more complete view of the holiday shopping season after the surprisingly sharp gain in ex-auto retail sales in November (which appeared to partly reflect some seasonal adjustment problems with the timing of Black Friday). Early indications for December sales results have not been good, both in some early warnings from individual companies and dismal same-store sales results reported by the major drug store chains a week ahead of most other companies. On the other hand, December motor vehicle sales proved surprisingly solid, holding steady at a 16.2 million unit annual sales pace. Incorporating this result, we boosted our 4Q consumption estimate a tenth to (all things considered) a very solid +2.9%. The bulk of this upside, however, would be attributable to a very robust November. A reversal of that strength in December would put 1Q08 on pace for a far weaker result. Other data due out in the coming week include the trade balance and Treasury budget on Friday:

*We look for the nominal trade deficit to widen US$1.5 billion in November to US$58.3 billion, but mostly as a result of higher oil prices; the real deficit should narrow slightly. We forecast a 1.1% gain in exports, with good upside in industrial materials and ex-aircraft capital goods partly offset by some moderation in aircraft, as indicated by industry figures, after another record high was posted last month.

Meanwhile, we look for a 1.6% gain in imports. This is mostly expected to be attributable to another sharp, price-driven rise in petroleum products, but port data also suggest some upside in non-energy goods imports after soft recent results.

*We estimate that the federal government ran a US$52 billion budget surplus in December, US$10 billion higher than in the same period a year ago. The bulk of the improvement is attributable to strength in withheld tax payments. Also, corporate tax revenue held up somewhat better than in the prior quarter. On the spending side, the impact of spectrum auction proceeds in the year ago period was about offset by a calendar shift that helped to hold down benefit payments in the latest month. We have updated our budget forecast to reflect our baseline economic scenario for a mild recession and now look for a budget deficit of US$225 billion (or 1.6% of GDP) in FY 2008.

By Ted Wieseman & David Greenlaw New York
Morgan Stanley
January 7, 2008