September 12, 2003
U.S. EconomyWe expect the FOMC to hold the line on the Fed Funds rate at its September 16 meeting. The latest Fed informal survey (Beige Book) points to an increase in activity levels, suggesting that the FOMC is not likely to insist on further cuts to the Funds rate. We also think the Fed does not intend to raise the Fed Funds rate for the remainder of this year. In effect, this will contribute to a very steep yield curve.
As we have predicted in previous StratAlerts, the long end of the yield curve has been rising. The yields on both the 10 and 20 year Treasury bonds touched bottom in March of this year at 3.81percent and 4.82 percent respectively. Since then, the yields have moved up to 4.45 percent and 5.39 percent (based on the August average). Mainstream analysts explain the rise in yields to disappointed market participants who had purchased bonds in anticipation of the Fed’s announced intention to lower the long-end of the yield curve. Since the Fed’s "magic trick" did not work, investors failed to cash in on their expected investment bonus, and thus sold off their bond holdings. However, the rise in the yield curve can be better explained by fundamentals: first, a lingering and upward trending inflation rate; and second, a surge in the U.S. economy’s financing requirements with increasing hesitation by foreign investors. Based on our projected whopping current account deficit of 6.0 percent of GDP for 2004, combined with a fiscal deficit of about 4.5 percent of GDP, the markets are already building in a risk premium in the long-end of the yield spectrum to reflect their concerns about the huge financing requirements at a time when businesses will be tapping financial markets for their own expansion plans. Based on medium-term inflation expectations of 3.0 percent, the 10 and 20 year bonds should trade in the 6.00 - 6.50 percent range. We anticipate these yields will reach 5.00 percent for the 10 year and 6.00 percent for the 20 year bonds by the end of this year.
An upward revision of the second quarter GDP growth rate to 3.1 percent was welcomed news. Consumer spending on durable goods jumped 24.1 percent, which reflects the very volatile nature of this expenditure component; however, on a year-over-year basis durable goods spending grew 5.1 percent (IIQ03/IIQ02). Spending on motor vehicles jumped 33.5 percent in the second quarter; although the year-over-year growth rate was 9.2 percent. One encouraging sign from the second quarter results was business fixed investment, which grew 6.9 percent; spending on both structures and equipment picked up. Residential investment expanded by 4.5 percent.
One area where Fed policies have really helped during this past recession has been in the housing sector. The dramatic cut in the Funds rate beginning in January 2001, triggered a wave of mortgage refinancing with substantial cash outs, which consumers used to purchase durable goods as well as other items. On the other hand, the surge in mortgage refinancing has also contributed to a significant rise in the ratio of consumer debt service to disposable personal income, which averaged 14 percent last year. As long-term rates continue their ascent, demand for housing and specially for refinancing of existing mortgages is likely to cool off. Thus putting greater reliance on other demand components to pull the economy.
We expect GDP to average 3.6 percent growth during the second half of this year; although many analysts are calling for even higher growth. The Wall Street Journal survey calls for 4.3 percent growth during the second half of this year. Industrial production appears on the verge of a moderate recovery. Retail sales are up and shipments of non-defense capital goods are also picking up. Nevertheless, as the Fed has indicated, the economy will continue to expand at below its potential. Our projection of a much weaker dollar by the beginning of next year is expected to lower the growth rates for 2004.
While direct labor costs are still held back by persistent layoffs, indirect labor costs combined with higher energy prices as well as the cost of other inputs is keeping inflation at around 2.3 percent (based on a 12 month moving average). We expect the rate to move closer to 2.5 percent during the first quarter of next year. Apparently the Fed’s latest Beige book questions the validity of the Consumer Price Index (CPI) as well as all other price indicators. Based on an informal survey of businesses, the Beige book states that "most product prices are reported to be stable or lower;" yet the CPI reports an annual average inflation rate of 2.3 percent. As we mentioned in previous briefings, we welcome data from the Fed that show consumer prices falling in a persistent fashion as indicated by their concerns about a deflationary cycle.
With the economy gathering momentum, the external deficit will continue to swell to worrisome levels. The expansion in the U.S. economy will drive up imports, and thus the trade deficit could reach $650 billion in 2004, or close to 6 percent of GDP. During the second quarter of this year, the volume of exports fell 2.0 percent, while imports increased by 13.3 percent. As we have been predicting for some time, the surging external deficit will continue to put downward pressures on the dollar as foreign investors withdraw their U.S. holdings in anticipation of further dollar depreciation. Unfortunately, from a U.S. perspective the dollar has always been considered an afterthought for U.S. economic policy; but we think the dollar will take center stage by the end of this year and early 2004. As the dollar weakens further, interest rates are bound to go higher. We also think it will take what economists refer to an "over-shooting" of the exchange rate in order to put a dent on the hemorrhaging of the external deficit. As a result, the value of the Euro is expected to climb as high as US$1.28 / Euro by the end of this year or early 2004. It will take a sizeable drop in the value of the dollar to bring about the necessary structural adjustments to the external imbalances. On the other hand, the magnitude of the trade deficit reflects fundamental structural imbalances in the U.S. economy that are not going to be resolved by simply adjusting the exchange rate. The risk to this outlook is a political backlash in the U.S. and other countries to growing trade imbalances resulting in increasing trade restrictions, particularly in an election year.
Latin American Economies
Argentina
’s GDP grew by 6.5 percent in the first semester of this year. In the January - July period exports grew by 17.1 percent and the trade surplus reached US$10 billion. A rebound in industrial production and domestic demand suggests that the economy is back on track. On the external front, the Government did not make its scheduled $3 billion payment to the IMF due September 9. President Kirchner is hesitant to service the Government’s external debt at the expense of social programs, even though the country counts with ample international reserves. This move drives home the message that this Administration will take a tougher stand on the renegotiation of its external debt.Barbados
’ economy was growing by 2.4 percent in the first semester, with tourism expanding by 8.6 percent.Brazil’s
trade surplus in the first seven months of the year amounted to US$12.5 billion. Up to June, exports were growing by 31.7 percent. Imports remained basically stable with an expansion of just 1.0 percent, due to slow domestic demand.Chile
registered GDP growth of 3.2 percent in the first semester. Agriculture grew by 4.7 percent; mining 5.7 percent; manufacturing 3.3 percent; utilities 5.9 percent; construction 1.6 percent; commerce 3.4 percent; and transportation and communication 3.6 percent.Nine ministers have resigned in
Costa Rica, since October of last year, reflecting lack of cohesion in the government of president Abel Pacheco.According to the Bank of International Settlements, US$1.4 billion left
Dominican Republic last year. Exports rose by 7.7 percent in the first semester, with free zone sales abroad rising by 9.1 percent. In the first five months of the year, 39 new free zone enterprises received approval to operate.The IMF mission that reviewed
Ecuador’s recent performance in August announced that fiscal targets have not been met. In addition to the adverse impact on revenues resulting from a slow economy, oil revenues fell below estimates, due to strikes and a rupture in the government-owned oil pipeline.Economic activity in
El Salvador remains weak, so far this year.Exports rose by 6.0 percent in the first semester in
Honduras, while economic activity expanded by 3.3 percent.Mexican exports between January and July reached only 1.8 percent growth. Oil exports increased strongly by 38.6 percent, but non-oil exports fell by 1.6 percent.
The Venezuelan economy continues in a deep recession. The main issue now is the convocation of the referendum to vote on the continuation of the Chavez government. The Electoral Court has been appointed that will review the arguments on both sides pertaining to the validity of the recall process.