Markets & the Economy / Weekly Update

Transcription

1 HIGHLIGHTS The FOMC gives no hint that it has signed on to an extended easing cycle, especially now that it has lowered its funds rate to ¼%. It s basis points of easing is only significant in absolute but not relative terms. For one thing, its easing began from a position that, with the benefit of hindsight, probably was somewhat restrictive. For another, the Fed s cuts have not matched the decline in long-term risk free interest rates, the best measure of the natural level of interest rates. In that sense, Fed policy remains neutral at best. Market participants reason that Fed policy needs to shift to an accommodative stance, particularly with employment trends weakening. That is why forward interest rate markets continue to reflect more Fed rate cuts that eventually will take the target funds rate below long-term interest rates. Real estate excesses are rapidly correcting. From one perspective, house prices relative to gross income per household, house prices have erased % of the excess since. The key to the consumer in lies with the health of the job market. Real consumer spending growth is likely to slow to % in, the slowest pace since, but not contract. (FOR CONSUMERS NOT SO GREAT IN ) slow but no recession. (APPENDIX II. THE MEDIUM- TERM ECONOMIC AND MARKET FORECAST ) NEAR-TERM ECONOMIC OUTLOOK Annualized % change in period, or as noted Q Q Real GDP.. Final sales.. Consumer Spending.. Inventory change ($ bil, ann.) -$ $ US demand*.. Exports.. Nonfarm payrolls (%).9. (Average Monthly Change) 9,, Unemployment (% at end)..9 Chain PCE prices..9 Food.. Energy. -. Core chain PCE prices.. CPI.. Core CPI.. WTI petroleum ($/barrel at end)) 9 Gross domestic purchases that is, US demand for both foreign- and domestic-made goods and services. NEAR-TERM MARKET OUTLOOK Percent FOMC Meeting: Jan Mar 9 Federal funds rate.. -year Treasury note yield.. Market indicators: Federal funds futures contracts.. Eurodollar futures.. JPMorgan Chase Bank, New York James E. Glassman --- jglassman@jpmorgan.com

2 FOR CONSUMERS NOT SO GREAT IN Some perspective. When it comes to the impact on consumer spending, a % decline in house prices is equivalent to a % drop in the stock market or a reduction in hiring of about, monthly for a year. In other words, the hiring slowdown was almost as much of a restraint on consumers as a % fall in house prices. With house prices rapidly renormalizing, job market trends will trump all other factors for the consumer in. % of real estate excesses may be corrected House prices rose % between spring and the end of but gross income per family rose %. That % excess is disappearing quickly: gross income per family is House prices are down -% from the end- peak Prices of existing houses (percent change from months earlier) Case-Shiller monthly repeat sales price index of metropolitan areas Chase-Shiller monthly repeat sales price index of metropolitan areas (astericks) NAR's median price index of existing single family units OFHEO's index (purchase only) - Case-Shiller national repeat sales price index (shaded area) Sources: OFHEO; National Association of Realtors; Standard and Poor s

3 and, with incomes growing, are rapidly renormalizing Gross per household income and house prices (ratio to 9 Q level) 9 Existing house prices (Case-Shiller National Index) Gross nominal income per household Sources: US Department of Commerce; NAR; Standard and Poor s is up % since the end of, while house prices are down %. Corrections often go to overboard, but the current trends in house prices and incomes will restore real estate values to normal levels by next spring. For sure, falling house prices are a threat consumer spending and the economy but they are also the cure to the real estate overhangs. They are a threat to the economy, because they have the potential to trigger foreclosures for those who bought homes in recent years and have lost any equity they had in the house. They are a threat to the economy, because they destroy wealth and indirectly dampen consumer spending. At the same time, falling house prices are the only way or, at least, the fastest way to put the housing excess behind. A drop in house prices has seemed inevitable since early, when credit for subprime borrowers dried up. The re-

4 duction in demand by marginal buyers touches all markets. So, a return to traditional methods of financing implies that prices likely will revert to the past in relation to gross family income, a benchmark that approximates housing affordability at a given interest rate level. The correction of housing prices is well under way. Given the present trends in income and house prices, real estate excesses of the past five years will have vanished by spring (figure on previous page). The national level of house prices appears to have declined - % in, following no change in. With household income growing ¼% on average in each of the past two years, this means that house prices nationally have declined ½ - ½% cumulatively relative to gross per household income. By the end of, the average level of existing house prices was nine times the level of prices in 9 and double the level ten years ago. Household income was only. times its 9 level and. times gross income per family in 99. Much of the housing drag has already occurred. Further price declines risk new foreclosures but new home building has already fallen to below-normal levels in response to expectations of a grim. In fact, depressed new home construction has been retarding economic growth since spring, shaving a full percentage point of growth from real GDP since then. New home building is likely to remain a drag on the economy in, but that drag is likely to diminish from a one point drag on growth this year to a. percentage point drag in. The wealth shock will be slow moving The erosion of home equity wealth has the potential to slow consumer spending, although so far consumer response has been muted. The consumer response may not be dramatic, because it will unfold gradually over time and could be tempered by a strong stock market. The impact of an erosion in home equity on consumers can be exaggerated. Yes, almost % of households own their homes and so have a stake in real estate price trends. And the sheer magnitudes of real estate equity are substantial: households own $. trillion of real estate, so a % drop

5 in housing values would represent a substantial loss of wealth. Typically a $. trillion loss of real estate equity, owing to a % decline in house prices, would be expected to lower the level of real consumer spending by about one percent. A one percentage point reduction in consumer spending would be significant, if it occurred in a relatively short period of time. But any response by the consumer likely would transpire gradually over several years. Real estate may be the largest single asset for most households. Nonetheless, it represents a relatively small proportion of total household net worth. Although real estate comprises about one-third of all household assets, net of the outstanding mortgages, which accounts for % of all debt owed by households, real estate net worth represents only $ trillion, or % of total household net worth. A % decline in house prices would be significant, but still would be dwarfed by swings in other assets, including the Household wealth comprises more than housing Saving (percent of income) - Saving rate, the line (left) Components of household net worth (ratio to disposable personal income) Ratio of net worth to income (right) Value of real estate holdings (right) Real estate net worth (right) Sources: US Department of Commerce; Federal Reserve Board

6 stock market (figure on previous page). A % drop in house prices is a shock, but would be counterbalanced by a % rise in the value of household financial assets or a % rise in the stock market. The figure on the previous page implies that a % drop in house prices would, at stock prices, return the household sector s net worth-to-income ratio to about. from., where it stood in spring. Sometimes homeowners are portrayed as living on the equity in their homes, treating the equity in their houses as an ATM. This characterization confuses the typical, and rational, response by consumers to changes in their wealth, realized or unrealized. Equity extraction is merely one way consumers can adjust their spending to wealth gains. They can also choose to save less (spend more). Either response has the same impact on saving, whether capital gains are realized or unrealized. One more consideration many homeowners may view Disposable income growth trumps all else for consumers Real income and consumer spending (percent change from months earlier) - Real consumer spending Real disposable personal income Sources: NBER recession bars; US Department of Commerce

7 the building capital gains in their homes as a down payment on a future purchase. If so, they could view a decline in the value of their homes to be a wash, if prices in other areas they would choose to live fall too. In that case, a decline in house prices would not lead to a reduction in consumer spending. Income fundamentals trump everything for consumers At the end of the day, the shape of consumer trends will be shaped by trends in real disposable personal income. That s been the key story for years (figure on previous page) and it will be the story that sets the tone for the consumer in. When it comes to the growth of real disposable income, labor compensation, which represents almost % of the disposable income, is key (the blue-shaded region in the Labor compensation usually drives real disposable income Real consumer spending and income (percent change from months earlier) - Real consumer spending Real disposable personal income Real compensation Sources: NBER recession bars; US Department of Commerce

8 Wages and salaries are the fuel for discretionary spending Real consumer spending and income (percent change from months earlier) - Real consumer spending Real compensation Real wages and salaries Sources: NBER recession bars; US Department of Commerce figure on previous page; real disposable personal income is the red shaded area). There are exceptions to this. The most notable was - period when the tax cut initiatives gave households substantial relief that supplemented cyclical weakness in labor income. Furthermore, as far as consumer spending goes, it is the growth of wages and salaries that provides the fuel for discretionary spending. Employer-provided benefits are real for consumers (figure above), but can t be cashed in to be spent on other items. Workers can t spend Social Security benefits, contributions to the unemployment insurance system, employer contributions to health care plans, vacation and sick leave, all benefits that cost money for employers. Wages and salaries what workers see and what gets deposited into checking accounts is what is available to be spent. Wages and salaries are the most relevant income measure for tracking consumer spending.

9 Employment is the key driver for discretionary income Foreign investment in dollar assets ($ billions over the most recent four quarters) - Shaded Areas: Real compensation Real wages and salaries Lines: Hourly compensation rate Nonfarm payroll growth Sources: NBER recession bar; US Department of Commerce; US Department of Labor Wage and salary gains have been steady and solid in recent years, since, when the economy s recovery took hold. For example, real wages and salaries have been growing almost % annually for four consecutive years, as the economy has been recovering from the slump early in the decade. The greatest challenge to consumer spending in comes from the potential for real wages and salaries to slow in, reflecting the cyclical slump in the job market. With wages and salaries reflecting gains in both hourly pay as well as the pace of hiring (see the figure above), the slowdown in hiring that emerged this year has the greatest potential to curb real wages and salaries. Job growth slowed in half this year, according to all three key measures of employment, including nonfarm payrolls (the count of jobs), household employment (a count of people with jobs, regardless of how many jobs they hold), and the measure 9

10 Claims on household budgets Allocation of consumer purchases (percent of total household spending) % 9% % % Saving Discretionary spending Nondiscretionary spending % % % % Energy outlays Other contractual % % % Net interest Source: US Department of Commerce of employment that is based on the household survey and that makes adjustments to be comparable to the wellknown monthly nonfarm payroll figures. In contrast, hourly pay gains remain moderate, but are not likely to slow as promptly to emerging weakness in new hiring. In addition to slower growth in discretionary income, contractual claims on household budgets for example, shelter costs, some transportation expenses, non-mortgage debt service expenses, energy expenses, health care bills, educational expenses, a selection of personal and business services, and basic food expenses are limiting resources available for discretionary purchases such as vehicles, restaurants, some types of apparel, and home furnishings. The burden of growing contractual spending is subtle it has emerged slowly over the course of the last few years but very real. The figure above, which illustrates consumer trends over the past five years, indicates that discretionary

11 purchases have fallen two percentage points, from.% to.% of total household spending. That represents a $ billion annual decline in spending for discretionary purchases that could have been made had contractual obligations not become more onerous over the past five years. Although many households are saving less today than in the past, because they have benefited from wealth gains in real estate and equities, a portion of the recent decline in household saving probably also reflects pressures on budgets related to rising contractual payments. Developments on the energy front have the potential to bring some relief for consumers. If oil prices fall back toward $- per barrel, obviously this could be a key counterbalance to other drags on consumer spending. Taking all of these factors into consideration, consumers are likely to face a challenging year in. Nonetheless, real consumer spending is forecast to only moderate to % pace over the four quarters of, down from.% in. This would represent the slowest year for consumers since, but likely would not trigger a recession.

12 APPENDIX I. HIGHLIGHTS ON THE ECONOMIC CALENDAR Last Week This Week House prices likely fell % in, following no change in, based on the various surveys of house prices, including the most comprehensive Case-Shiller index of national house prices through Q, the monthly Case-Shiller house price indexes through October, the OFHEO indexes through Q, and the National Association of Realtors index of existing house prices through November. In normal circumstances, house prices would rise roughly %, in line with income. This means that the price correction is quite advanced specifically, the excess of house prices relative to gross family income has dropped about %. Asset backed commercial paper outstanding continues to shrink and now is $ billion below the August peak. Commercial Paper Commercial paper outstanding ($ billions),,,9,,,, Financial companies (top) Nonfinancial companies (middle) Asset backed commercial paper (bottom),,,9,,,, High-frequency hints about the job market are pointing to a slim, plus or minus, employment gain in December. Jobless claims have edged up and the number of people drawing unemployment benefits is up. Survey responses regarding perceived job market conditions have weakened too. The unemployment rate likely stepped up visibly as well. (Market significance: A) FOMC minutes will be interesting only to understand why the Fed chose to be so cautious at its December FOMC meeting amid growing strains in the credit markets. (Market significance: B-) Analysts expect December vehicle sales to be around million units at a seasonally adjusted pace. If so, this would represent a significant weakening, considering that December sales typically are blowouts. (Market significance: A-) A drop in the December ISM manufacturing index to a below- reading is possible and would be consistent with a slow -% Q real GDP growth pace. The nonmanufacturing survey is likely to signal moderation too. (Market significance: A) * Note: a grade of A signifies that the report will be highly important for market participants and a D means the information would not be expected to be market moving. 9 9 Source: Federal Reserve Board New home sales fell sharply in November but that is to be expected in the wake of the credit crunch. The magnitude of prospective house price declines holds the key to the housing outlook. Durable goods figures exposed greater weakness than expected for capital spending.

13 APPENDIX II. THE MEDIUM-TERM ECONOMIC AND MARKET FORECAST Although real GDP growth has slowed only gradually until very recently all indications are that the economy slowed to a -% annualized pace in the fourth quarter, and this would mark a significant moderation in the economy s pace if growth estimates are correct employment growth has moderated significantly (figure below). Friday s December report likely will show that the hiring pace continues to cool. If payrolls expanded only, or so in December, hiring would have slowed to a, average monthly pace in, down from 9, in. Payroll taxes are volatile, but are useful, because they are comprehensive and timely. Employment taxes withheld from paychecks and deposited in the Treasury s accounts imply that employment continues to slow. Employment trends are still easing Employment indicators (percent change from months earlier) Nonfarm payroll employment (left) Household survey adjusted to nonfarm payroll concepts (left) Household survey employment, line with diamonds(left) - Withheld income and employment taxes (right) - Sources: Treasury Department; US Department of Labor

14 Key themes Growth predictions are not informative without reference to potential growth assumptions. Unemployment forecasts take account of both actual and potential growth and best describe views. Unemployment is forecast to rise through 9, signaling a period of subpar growth ahead. Inflation is forecast to fall in with core inflation steady conditional on a drop in oil prices. Key features of the medium-term economic forecast Percent change over the four quarters of the year, unless noted otherwise 9 Real GDP.... Unemployment (percent in final quarter of the year).... Chain PCE prices Food.... Energy Core chain PCE prices..9.. CPI Core CPI.... Petroleum, WTI ($/barrel at year end) $9 $ $ $ Federal Reserve forecasts FOMC (October, ) Real GDP Unemployment (% at period end) Chain PCE prices (range) Core chain PCE prices (range) FRB Staff (October, ) Real GDP subpar above-trend Unemployment creep up Chain PCE inflation about same as core same as core Core chain PCE inflation slow over H move down slightly Key features of the medium-term interest rate forecast Percent FOMC Meeting Jan 9/ Mar /9 May Jul/ Aug Sep Oct /9 Dec 9 Jan / Federal funds rate year Treasury note yield Fed funds futures contracts

15 Selected details of the medium-term economic and market forecast Economic Growth 9 Q Q Q Q Q Q --- % Change from Previous Quarter, Annualized --- Domestic Output (Real GDP) Final Demand for US-Made Output (Final Sales) Consumer Spending Real Disposable Personal Income Household Saving Rate (% of Income at End of Period) Home Building Construction of Business Structures Business Equipment and Software Spending Government Spending Net Exports ($ Billion at an Annual Rate at Year End) Imports Exports Memo: Current Account Deficit (Billions of Dollars at End of Period) Current Account Deficit (% of GDP at End of Period) Ch. in Private Inventories ($ Billion at an Annual Rate)* Annualized Percentage Change* Vehicle Output Contribution to GDP Growth (Pct. Pts.) Residential Construction Contribution to GDP Growth (Pct. Pts.) Employment and Production Nonfarm Payrolls (Establishment Survey) Employment (Household Survey) Nonfarm Payroll Equivalent (Household Survey) Industrial Production Manufacturing Production Demand of US Residents Gross Demand for All Output (Gross Domestic Purchasers) Final Demand for All Output (Final Sales to Domestic Purchasers) Economic Slack Unemployment Rate (Percent of Labor Force at End of Period) Factory Capacity Use (% of Capacity at End of Period) Inflation GDP Chain Price Index Core GDP Chain Price Index PCE Chain Price Index PCE Food Chain Price Index PCE Energy Chain Price Index Core PCE Chain Price Index CPI Core CPI Corporate Profits % Change from Four Quarters Earlier S&P After-tax Operating Profits Percent of GDI Pre-tax GDP Profits (from Current Production) Percent of GDI After-tax GDP Profits (from Current Production) Percent of GDI Federal Budget Balance Billions Percent of GDP Financial Markets --- % Change Q/Q Last Day of Period Shown Federal Funds Rate Target Year Note Year Note Year Note Year Conventional Mortgage Rate (FHLMC) $/Euro Yen/$ 9 Wilshire (Index of All Publicly Traded Shares) S&P Annual Percent Change..... After-tax Reported Earnings Per Share After-tax Operating Earnings Per Share Memo: Write-downs in Dollars Per Share Price-Earnings Ratio......

16 Analysts Compensation: The research analysts responsible for the preparation of this report receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factors and overall firm revenues. The firm s overall revenues include revenues from its investment banking and fixed income business units. Principal Trading: JPMorgan and/or its affiliates normally make a market and trade as principal in the securities discussed in this report. Legal Entities: JPMorgan is the marketing name for JPMorgan Chase & Co. and its subsidiaries and affiliates worldwide. J.P. Morgan Securities Inc. is a member of NYSE and SIPC. JPMorgan Chase Bank, N.A. is a member of FDIC and is authorized and regulated in the UK by the Financial Services Authority. J.P. Morgan Futures Inc. is a member of the NFA. J.P. Morgan Securities Ltd. (JPMSL) is a member of the London Stock Exchange and is authorized and regulated by the Financial Services Authority. J.P. Morgan Equities Limited is a member of the Johannesburg Securities Exchange and is regulated by the FSB. J.P. Morgan Securities (Asia Pacific) Limited (CE number AAJ) is regulated by the Hong Kong Monetary Authority. JPMorgan Chase Bank, Singapore branch is regulated by the Monetary Authority of Singapore. J.P. Morgan Securities Asia Private Limited is regulated by the MAS and the Financial Services Agency in Japan. J.P. Morgan Australia Limited (ABN /AFS License No: ) (JPMSAL) is a licensed securities dealer General: Information has been obtained from sources believed to be reliable but JPMorgan does not warrant its completeness or accuracy except with respect to any disclosures relative to JPMSI and/or its affiliates and the analyst s involvement with the issuer. Opinions and estimates constitute our judgment as at the date of this material and are subject to change without notice. Past performance is not indicative of future results. The investments and strategies discussed here may not be suitable for all investors; if you have any doubts you should consult your investment advisor. The investments discussed may fluctuate in price or value. Changes in rates of exchange may have an adverse effect on the value of investments. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. JPMorgan and/or its affiliates and employees may act as placement agent, advisor or lender with respect to securities or issuers referenced in this report. Clients should contact analysts at and execute transactions through a JPMorgan entity in their home jurisdiction unless governing law permits otherwise. This report should not be distributed to others or replicated in any form without prior consent of JPMorgan. U.K. and European Economic Area (EEA): Investment research issued by JPMSL has been prepared in accordance with JPMSL s Policies for Managing Conflicts of Interest in Connection with Investment Research. This report has been issued in the U.K. only to persons of a kind described in Article 9 (),, and 9 of the Financial Services and Markets Act (Financial Promotion) Order (all such persons being referred to as relevant persons ). This document must not be acted on or relied on by persons who are not relevant persons. Any investment or investment activity to which this document relates is only available to relevant persons and will be engaged in only with relevant persons. In other EEA countries, the report has been issued to persons regarded as professional investors (or equivalent) in their home jurisdiction. Australia: This material is issued and distributed by JPMSAL in Australia to wholesale clients only. JPMSAL does not issue or distribute this material to retail clients. The recipient of this material must not distribute it to any third party or outside Australia without the prior written consent of JPMSAL. For the purposes of this paragraph the terms wholesale client and retail client have the meanings given to them in section G of the Corporations Act. Korea: This report may have been edited or contributed to from time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul branch. Copyright JPMorgan Chase & Co. All rights reserved. Additional information available upon request.