S&P Economic Forecast - Week of July 27, 2010

Growing Pains
By David Wyss and Beth Ann Bovino

Federal Reserve Chairman Bernanke kicked off his testimony to the Senate Banking Committee by noting that although the economic expansion is “proceeding at a moderate pace,” the economy is “unusually uncertain” and the Fed is “prepared to take further policy actions.” We also believe the recovery will continue--more likely at half speed. Economic releases this week included:

• Housing starts fell another 5.0% in June to a 549,000 annualized pace from a downwardly revised 578,000 (was 593,000) in May. The drop was concentrated in multifamily starts.



• Existing home sales fell 5.1% to a 5.37 million annualized pace in June after a 2.2% drop in May. Sales still exceed the 4.89 million recorded in June 2009.



• The S&P/Experian Consumer Credit Default Index fell to 3.44% in June from 3.61% in May.



• Federal Housing Finance Agency (FHFA) home prices rose 0.5% in May after a 0.8% gain in April. Home prices are down 1.2% from May 2009 and are down 12.3% from their April 2007 peak.



• U.S. leading indicators dropped 0.2% in June to 109.8, better than the 0.3% decline expected.



• Initial claims for unemployment insurance compensation rose 37,000 to 464,000 in the week ended July 17 after two consecutive large declines. Continuing claims plunged 223,000 to 4.487 million in the week ended July 10, in part from auto retooling distortions. The insured unemployment rate was 3.5%, down 0.2% from 3.7% the week before. Emergency benefits under the stimulus program were being paid to 3.848 million people in the week ended July 3, down 404,000, which was expected to expire at the end of July.



• The House, however, passed the $34 billion extension of unemployment benefits, which already passed the Senate. President Obama signed on Thursday. The program is retroactive to those whose benefits expired on June 2, and it will extend out through November.

No Building

Builders continue to pull back, as indicated by a significant decline in activity from the April peak (owing largely to the tax credit). Housing starts fell 5.0% in June to a 549,000 annualized rate, lower than the expected 580,000 pace and after May starts were downwardly revised to a 578,000 rate (previously 593,000). Starts are now lower than the 583,000 a year earlier and are at their lowest level since October 2009. The pullback shows that tax benefits heavily influenced the recent strength, though the June drop stemmed primarily from large declines in the multifamily sector. The question remains how long the weakness will last? We need to see how much sales drop to assess what buyers are doing, and that will take a few months after the tax-credit boost is completed.

The product breakdown suggests that the tax credit didn’t play as big a role in June. The month-over-month drop was concentrated in multifamily starts--a sector that is more rental based and thus less sensitive to the tax credit--which plunged 19.3% in June after a 4.8% increase the month before. Single-family starts are down just 0.7% from May, though this follows an 18.8% drop the month before. Multifamily starts remain down 8.3% from a year ago. In contrast, single-family starts are down 4.6% versus June 2009.

Although nothing started in June, builders were certainly finishing projects, with housing completions up 26.2% during the month after a 6% drop in May. Single-family completions were up 31.3% and multifamily was up 11%. However, permits, normally a leading indicator for starts, rose an encouraging 2.1%, to 586,000. Multifamily permits surged 20.8% over May to 145,000 and are up 16.9% for the year, suggesting some recovery in that sector. Single-family permits fell 3.4% to 421,000 and are down 6.7% for the year.

All regions reported month-over-month declines in starts. The sharpest drop was in the Northeast (down 11.3%) and the smallest declines were in the South (2.4%). The South is the only region to report year-over-year gains (up 2.6%). The Northeast reported the largest year-over-year declines in starts, down by 20.3%. The Midwest and West are down 10.5% and 11.2%, respectively.

And No Buying

U.S. existing home sales continued to drop in June, with sales down 5.1% over the prior month to a 5.37 million annualized pace in June after a 2.2% decrease in May. Existing home sales are registered at the close rather than at the time of contract, which translates into a peak that is hard to identify for existing home sales. Indeed, the National Association of Realtors' noted that “June sales still reflect a tax credit impact with some sales not closed due to delays, which will show up in the next two months.” In contrast, the April contract deadline for new home sales caused a clear spike in new home sales through April, followed by a 32.7% crash in May to a record-low 300.000. Existing home sales are 9.8% above the 4.89 million pace in June 2009. Single family sales dropped 5.6% in June, with sales down in four of the past six months. Condo/coop sales were down 1.5% in June.

Existing home sales showed month-to-month declines in all regions expect the Northeast, which rose 7.9% after plunging 18.3% the month before. The other regions saw sizable single-digit declines, with the Midwest, the West, and the South down 7.5%, 9.3%, and 6.5%, respectively. The percentage of first-time homebuyers fell to 43% in June from 46% in April. Investors accounted for 13% of June sales, close to the 14% level from a month ago. Distressed sales edged up to 32% from 31% in May.

The FHFA purchase-only home price index reported gains. Home prices rose 0.5% in May after a 0.8% increase in April. Prices are down 1.2% from last May and 12.3% from their May 2007 peak. Seven of the nine Census regions posted monthly gains, led by the Pacific and Mountain divisions (up 1.8% and 1.7%, respectively). The East North Central saw the biggest decline, down 0.6% month over month in May. Over the past 12 months, only two divisions reported gains, the Pacific and West South Central, up 3.8% and 1.6%, respectively. Prices are down most in the Mountain states, by 3.5%.

The Realtors median sales price for existing homes rose to $183,700 in June from a downwardly revised $174.600 in May (previously $179,600), and is 1% higher than a year ago. Home prices likely will decline further given large levels of unsold homes on the market and the end of the tax credit boost.

One problem for prices is the jump in homes for sale. The Realtors reported that the inventory of unsold homes rose 2.5% in June to 3.99 million. The supply of unsold home rose to an 8.9-month supply at the current sales rate, up from 8.3 in May. However, inventory remains down from its peak of 4.58 million units in July 2008. We had expected the inventory to rise because owners are likely to put their homes back on the market now that they think sales are possible and prices are improving. In addition, the homes in the process of foreclosure will add to unsold inventory as they clear the foreclosure process. Distressed sales (foreclosures plus short sales) accounted for 32% of June sales, up from 31% in May.

Less spending on homes perhaps improved household balance sheets. The S&P/Experian Consumer Credit Default Index fell to 3.44% in June from 3.61% in May, led by a drop in first mortgage defaults to 3.27% from 3.45%. A year earlier, the default index was at 5.46% and first-mortgage defaults were at a 5.58% rate. Most default categories showed lower rates in June, with auto loans the lowest, at 1.69% (from 1.76% in May and 2.18% in June 2009). The index shows that consumers are successfully improving their debt positions, although the default rates on everything except car loans remain high.

U.S. leading indicators were down 0.2% in June to 109.8, though they were still better than the 0.3% drop that markets had expected. Four of the 10 components showed declines, led by declines in the workweek and ISM deliveries (down 0.33% and 0.26%, respectively).

Central Banks Weigh In

To cap off the week, Federal Reserve Chairman Ben Bernanke, in his written testimony prepared for the Senate Banking Committee said that the economy is “unusually uncertain” and that the Fed remains “prepared to take further policy actions as needed to foster a return” to full employment with low and stable inflation. He mentioned a tools the Fed would use though he didn’t sound like he was in a rush to use them, he did confirm speculation that the Fed would consider these options if necessary.. He still said that the economic expansion “is proceeding at a moderate pace,” which is in line with our expectations for a half-speed recovery.

This contrasted somewhat with the testimony back in the beginning of 2010, which anticipated various mostly technical steps in the "normalization" of extremely accommodative monetary policy, while keeping rates low in the meantime. It also made it clear that Bernanke was comfortable with the Federal Open Market Committee’s aggressive accommodation as fiscal stimulus measures unwind and growth becomes sluggish, despite the recently upbeat earnings reports.

The European bank stress tests came out largely as expected Friday afternoon, with one bank failure in Germany and Spain registering the most bank failures. The reading was about as expected, but markets were skeptical over the credibility of the tests, which considered only bank trading book bond losses and not sovereign debt defaults.

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Financial Market Highlights: For Week Ended July 22, 2010

Treasury Yield Curve: The 10-year Treasury yield held at 2.96% on Friday (midday) after the European bank stress test results released Friday afternoon came out largely as expected. The extension of unemployment benefits by President Obama also increased investor demand for Treasuries. The rate on three-month Treasury bills rose one basis point through Thursday. The two-to-10-year spread edged down 3 bps to 236 bps, 20 bps below the 264 bps a year ago. The 10-year Treasury spread above the inflation-protected bonds (TIPS), a measure of inflation expectations, also fell, by 7 bps to 119 bps, stable from a year ago and still indicating little fear of inflation.

Credit Markets: Risk aversion eased slightly this week through Thursday, with signs of economic recovery picking up in Europe. This was partly offset by the speculation of Hungary being downgraded as well as the decline in U.S. existing home sales. The Treasury-to-Eurodollar (TED) spread, a measure of banks’ willingness to lend, slipped 3 bps this week, 4 bps above 31 bps a year ago and somewhat wider than usual. The equity-market volatility index (VIX) fell to 24.63 from 25.14 a week ago. The 30-year mortgage rate fell one basis point through this week. Mortgage applications jumped 7.6% in the week ended July 16. The purchase index rose 3.4% after a 3.1% slip last week. The refinancing index surged 8.6%. The CRI credit default swap index from Credit Derivatives Research, calculated as the average five-year credit default swap (CDS) for the 14 names in which notional CDS counterparty risk is overwhelmingly concentrated, fell to 137 bps Thursday from 139 bps a week ago but is above 131 bps a year ago. The Credit Default Swap index for the S&P 100, covering mostly nonfinancial companies, produced by the Standard & Poor’s index group, fell to 55 bps from 57 bps last Thursday and remains down from 67 bps a year ago.

Fed Policy And Interest Rate Outlook: Federal Reserve Chairman Ben Bernanke said in his written testimony prepared for the Senate Banking Committee, that the economy is “unusually uncertain” and that the Fed “remain prepared to take further policy actions as needed." The Fed lowered its outlook for growth by 0.2 percentage points in 2010, to a 3.0% to 3.5% range. The Fed kept the federal funds rate at its current 0% to 0.25% range at its June 22-23 FOMC meeting, stating “financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad.” The statement again kept the phrase “exceptionally low rates for an extended period,” and Kansas City Fed President Hoenig again dissented. Minutes from the June meeting noted the incoming data as “consistent with a continued, moderate recovery in economic activity." Participants also agreed that both employment and inflation would likely be below levels in line with their dual mandate. The Fed has stopped asset purchases under the various facilities and is discussing asset sales. Most FOMC members favored deferring asset sales “for some time.” The Fed raised the discount rate 25 bps, to 0.75%, on Feb. 11. Banks have either paid back or committed to pay back almost all of their Troubled Asset Relief Program (TARP) borrowing. The Senate passed the financial reform bill, sending it to the President for his signature.

Global Interest Rates: Government long-term bond yields were somewhat mixed this week. One-year LIBOR rates were also little changed. Key central banks are through loosening. Financial market turmoil appears to be calming, reducing quantitative easing in the near term. Recent trends and expectations include:

• The Bank of Canada raised its target overnight rate to 0.75% on July 20. The BoC expects the recovery to be more gradual then it expected, with its 2010 and 2011 respective growth forecasts of 3.5% and 2.9% from its April forecasts of 3.7% and 3.1%.



• The Bank of Japan kept interest rates steady at 0.1% at its July 15 policy meeting on moderate signs of recovery. In June, the bank unveiled details of a $33 billion low-interest lending scheme to fuel economic growth and fight deflation.



• The ECB kept its benchmark refinancing rate unchanged for the 15th month at 1.0% on July 8, as rising borrowing costs and the credit crisis pose a threat to the region’s economic recovery. Estonia was admitted as the 17th country in the eurozone.



• The Bank of England held its repo rate at 0.5% at its July 8 meeting for the 16th month and maintained the size of the asset-purchase program at £200 billion. It earlier said further purchases are possible "should the outlook warrant them."



• The U.S. Federal Reserve kept the federal funds rate at its current 0% to 0.25% range at its June 22-23 meeting, reiterating its decision to maintain “exceptionally low levels for an extended period.”



• Iceland’s central bank trimmed its benchmark rate to 8.0% on June 23 after the International Monetary Fund was assured about the island’s efforts to restore financial stability. The bank also reduced its deposit rate to 6.5%.



• The Swiss National Bank maintained its expansionary monetary policy while keeping the three-month LIBOR target unchanged at 0.25% (within the 0.0% to 0.75% range) at its June 17 meeting.



• Norges Bank raised its deposit rate to 2.0% on May 5, resuming the tightening policy, despite a stronger krone as the economy is picking up as expected.



• Sweden’s Riksbank raised its seven-day repo rate to 0.5% at its July 1 meeting (as signaled before), as domestic stimulus and recovering demand for its exports fuel growth.



• Denmark’s central bank held its key lending rate at 1.05% on May 26 and trimmed its certificate of deposit and current account rates to 0.5% and 0.4%, respectively.



• Poland’s central bank held its seven-day reference rate at a record-low 3.5% for the 12th month at its June 30 meeting as inflation pressures remain subdued.



• Hungary’s central bank held its two-week deposit rate at 5.25% on July 19 following the suspension of a regular review of Hungary’s financing program by the IMF and European Union.



• The Russian central bank kept its refinancing rate unchanged at 7.75% on June 30 as the economic recovery gains momentum and inflation slows after a 14-month easing cycle.



• Turkey’s central bank shifted its benchmark to repo lending rate from borrowing rate in May 2010. On July 15, the bank kept its repo lending rate and borrowing rate unchanged at 7.0% and 6.5%, respectively, amid increased debt concerns in Europe.



• The People’s Bank of China raised its bank's reserve requirement ratio by 0.5% on Feb. 12. China increased its interest rate for a second time this year, by 4 bps, to 1.4088% on Jan. 20.



• At its meeting on July 6, the Reserve Bank of Australia held the cash rate at 4.5% for the second month, remaining cautious amid uncertainty in the global economy.



• The Reserve Bank of New Zealand raised its rates for the first time in three years, to 2.75%, at its June 10 meeting. The bank also signaled that it could further hike interest rates this year.



• On July 2, the Reserve Bank of India raised its key interest rates for the third time this year by 25 bps each, the reverse repurchase rate to 4% and the repurchase rate to 5.5%. The bank held the required reserve ratio at 6.0%.



• Indonesia’s central bank kept its interest rates at 6.5% on July 5, holding steady for the 11th straight month.



• Taiwan’s central bank raised its key rate for the first time since 2008, to 1.375%, on June 24. On June 30, the bank also raised the interest rates on reserves from demand deposits and time deposits to 0.178% and 0.855%, respectively.



• South Korea's central bank raised its key interest rate after 16 months on July 9 to 2.25%.



• On June 24, the Hong Kong Monetary Authority kept its base rate unchanged at 0.5%, in line with the U.S. Fed.



• Brazil’s central bank raised its benchmark rate to 10.75% at its July 21 meeting on diminishing inflation risk.



• Chile’s central bank raised its overnight rate to 1.5% on July 15, as inflation increases.



• On July 16, Mexico’s central bank held its benchmark interest rates at a 6.5-year low of 4.5%.

Foreign Exchange Rates: The dollar weakened slightly against most major currencies this week. It is up 1.8%over the past year. On Friday (midday), the euro fell to $1.283 from $1.289 a week earlier, after European bank stress tests results came in about as expected. The dollar strengthened slightly, to ¥87.29 from ¥86.95 versus the yen, on speculation about Japan seeking to weaken the yen. The U.S. trade deficit widened to $42.3 billion in May from $40.3 billion in April, wider than expected. The continued U.S. trade deficit and high unemployment will maintain downward pressure on the dollar as the European credit issues continue to calm down.

Commodity Price Indices: Commodity prices were mostly up this week. Through Friday (midday), oil prices edged up to $79.6/barrel from $79.3/barrel last week, a three-week high, on growing optimism about a global recovery on the stronger-than-expected European economic data. Energy Information Administration inventory data showed a 0.4 million-barrel increase in crude stocks during the week ended July 16, much higher than the 1.5 million-barrel drop expected. Gasoline stocks rose by 1.1 million barrels, just over the 1 million barrel increase expected. We expect oil prices to stabilize, but geopolitical risk makes the forecast highly uncertain. Natural gas futures rose to $4.64/mbtu from $4.59/mbtu last week. Through Thursday, gold futures edged down to $1,196/ounce from $1,208/ounce last week. Agriculture prices fell slightly this week, by 0.6%, but are above 0.4% for the year. Livestock prices rose 1.1% for the week and are up 3.2% for the year.

U.S. Equity Market: U.S. equity indices were down this week. The S&P 500, Dow, and NASDAQ fell to 1,095, 10,334, and 2,244, respectively, Friday afternoon. Stocks were in a bear market from October 2007 until March 2009 but have recovered more than half of the losses. All market indices remain up over the past 12 months; the S&P 500 is up 62.0% from the March 9, 2009, low of 676 but is down 2.8% from the year-end 2009 level of 1,127.

U.S. Equity Market by Sector: Equity sectors in the U.S. were mostly up over the past week. Material stocks reported the biggest gains (up 2.0%), followed by industrials and telecom stocks, which are up 1.5% and 1.4%, respectively. Consumer discretionary stocks remained flat, while health care and financials slipped 2.9% and 2.0%, respectively, over the week. All the sectors are up from a year ago. Industrials, consumer discretionary, and financial shares reported the largest 12-month gains (25.6%, 24.4%, and 15.8%, respectively). On the other hand, telecom stocks were up only 0.9%, and energy stocks rose 2.2% from the previous year.

Global S&P Stock Indices: World equity markets were mostly down this week through Thursday. Japan (down 3.8%) reported the biggest loss, followed by Australia (down 1.6%). Asia-Pacific reported the smallest loss, down 0.1%, while Latin America and Europe were up 1.0% and 0.6%, respectively. Over the past 12 months, only Japan reported a loss, down 8.6%. Latin America is the largest winner (up 22.3%), followed by Europe (up 14.9%).

Global Equity Market Performance By Sector: International sectors were mostly down this week through Thursday. Consumer discretionary stocks reported the biggest losses, down 3.0%, followed by financials, which was down 1.1%. Consumer staples reported the smallest loss (down 0.2%) over the week, while materials stocks reported the biggest gains (up 2.2%). Industrials, consumer staples, and consumer discretionary stocks rose the most over the past year, up 20%, 14.2% and 14.0%, respectively. However, utilities and energy stocks have lost 0.8% and 0.7%, respectively, over the past year.

Sources: Global Insight and S&P.
Data tables provided by Kartikey Kaushik and Farah Parveen Khan at Standard & Poor's/CRISIL.

U.S. Economic Calendar – July 26 through Aug. 6, 2010

Note: All times are U.S. Eastern Time. Consensus estimates from Action Economics.