NEWS / Foreign Exchange

The "R" Word Is Cropping Up

U.S. Review

The ???R??? Word Is Cropping Up

This week saw a relatively light calendar of economic reports but most of what was reported was on the downside. Sales of existing homes plunged much more than expected and orders for capital goods declined. Weekly first-time claims for unemployment insurance fell slightly, but remain firmly in an upward trend. To cap it all off, the Wall Street Journal ran a story which basically said that we were already in recession.

Is such pessimism truly warranted? We do not think so. There is no question economic growth will slow in the current quarter but the economy went into the period with an incredible amount of momentum. We expect third quarter real GDP to come in slightly above our October forecast of 3.5 percent. Strong gains in consumer spending and a significant rise in exports more than offset a larger decline in residential construction. Inventories also likely posted a small drop during the quarter, which sets the stage for a bounce back in production later on.

Despite the strong third quarter numbers we still expect the Federal Reserve to cut the federal funds rate

Lower Interest Rates Will Help Fight Off A Slowdown

by a quarter percentage point at the October 31 meeting. We expect another cut in December and remain open to the possibility of further cuts in early 2008. Right now we do not think that will be necessary. While overall growth will likely slow to a 2 percent pace over the next couple of quarters, an outright recession should be avoided.

While we see the economy avoiding a recession, we certainly understand why concerns have increased. The decline in housing is turning out to be far worse than most people had expected. The collapse of the subprime mortgage market has severely reduced the number of households that can qualify for a mortgage. The associated turmoil in the financial markets is also reducing credit to commercial construction. Moreover, the problems in these sectors will likely persist, at least through the middle of next year, producing a significant drag on overall growth.

Nearly all this week??™s economic reports came in toward the soft side. Sales of existing homes tumbled 8.0 percent to a 5.04 million unit pace, as the collapse of the subprime mortgage market left many would be homebuyers without a viable borrowing option. The result was a surge in cancellations and plunge in closings. Sales of single-family homes fared even worse than the headline figure, with sales plunged 8.6 percent to a 4.38 million unit pace.

The median price of an existing single-family home fell 4.9 percent on a year-to-year basis, which is the largest year-to-year drop ever recorded. While the decline makes intuitive sense, it is probably exaggerated. We believe the sharp jump in interest rates on jumbo mortgages caused buyers to pull back in the upper end of the market, which is one reason why home prices plunged as much as they did. In other words, fewer high priced homes were sold in September, which caused the median price to fall sharply. The average price of a home sold in September fell a more modest 3.8 percent.

Sales of new homes technically moved higher to an annualized rate of 770K, however, the previous three months were revised downward by a total of 167,000. Inventories remain elevated in the new home market, and the percentage of completed homes in inventory moved to a new record. With difficulties in mortgage markets hampering buyers, and credit markets still troubling builders, we expect renewed declines in sales in coming months.

Durable goods orders fell 1.7 percent on the headline, but this is weaker than the underlying series suggest. Non-defense capital goods orders ex-aircraft rose 0.4 percent on the month.

Global Review

Data released this week showed that growth rates in many foreign economies have slowed recently. As shown in the chart at the left, real GDP in China rose 11.5 percent in the third quarter. As extraordinary as that year-over-year growth rate sounds, it actually was a bit slower than the 11.9 percent growth rate the economy achieved in the second quarter.

Why did Chinese growth slow a tad? China does not provide a breakdown of real GDP into its underlying demand components, so an answer can only be inferred from monthly nominal spending data. Although growth in nominal retail sales strengthened in the third quarter, real spending may have decelerated a bit because CPI inflation was significantly higher in the third quarter than in the second (see top chart on page 4). Interestingly, growth in industrial production remained very solid in the third quarter. Perhaps some ofthis production was shipped abroad. However, there is also the possibility that inventories rose in the third quarter. If so, Chinese GDP growth could slow further in the future as businesses pare back stocks. Indeed, we expect the Chinese economy will grow ???only??? 9-?? percent in 2008 due to tightening measures that have already been announced. And with inflation running at a high rate, more tightening is probably in the cards. That said, most countries can only dream of growth rates equal to our ???slow??? forecast for China next year.

In Japan, industrial production fell 1.4 percent in September relative to the previous month, partially reversing the 3.5 percent rise that was chalked up in August. However, businesses estimate that production will bounce back 3.8 percent in October before dropping back 0.7 percent in November. If those forecasts were to be realized (we should point out that forecasts have turned out to be a bit overly optimistic over the past few months), then industrial production in the September-November period will have risen nearly 5 percent relative to the same three-month period last year (see middle chart). However, the strength of real exports, which rose at an annualized rate of 18 percent in the third quarter relative to the previous quarter, and relative weakness in retail spending, suggest that much of this increase in Japanese production may be attributable to strong growth in the rest of the world.

Growth in the Eurozone also appears to be slowing. As shown in the bottom chart, the Ifo index of German business sentiment fell to a 20-month low in October, which suggests that growth in industrial production probably slowed further this month. Preliminary estimates of Euro-zone PMI??™s suggest that growth in overall Euro-zone industrial production slowed in October, but that service sector activity remained rather solid. In sum, it appears that Euro-zone growth has slowed over the past few months, although it generally remains positive.

Indeed, that statement seems to apply to most countries in the world. Major central banks tightened policies earlier this year, and the slowing effect of these rate hikes is starting to show. Recent dislocations in credit markets should also weigh on growth. That said, we expect growth in most foreign countries to remain firmly positive over the next few quarters.