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July 01, 2004

25 Basis Points Down, How Many More?
by Chad Hudson

Just as about everyone expected, the Federal Reserve increased interest rates by 25 basis points. Of the 143 forecasts that comprised Bloomberg's estimate, only five differed from the 25 basis point increase consensus. Three predicted a 50 basis points increase with two forecasting no change. The Fed also said that, "policy accommodation can be removed at a pace that is likely to be measured." The Fed acknowledged that inflation is "somewhat elevated" but it is due to "transitory factors." Now the focus turns to Friday's employment report.

Consumers are feeling better about the economy. The Conference Board's tally of consumer confidence increased by 8.8 points to 101.9 in June, this was the highest level since June 2002. The biggest gain came from the current situation sub-index. It leaped 14.3 points to 104.8, also the highest since June 2002. The improved labor market has helped consumers feel better about the economy. Eighteen percent viewed jobs as being plentiful. While well below the 50% level in 2000, if has decisively bounced off the 10% level reached last year. Plus only 26.5% think jobs are hard to find, the lowest level since September 2002. Business conditions were viewed as being much better as well. Twenty-five percent think business conditions are good compared to 17.5% that see conditions as bad. The last time business conditions were viewed this favorably was in August 2001. The ABC News consumer comfort survey has increased during the last two weeks.

Personal income increased 0.6% in May from the previous month and has increased 5.8% from a year ago. The year-over-year pace was equal to April's increase and is the largest increase since December 2000. Personal spending increased faster, both on a month-over-month (up 1.0%) and on a year-over-year (up 6.7%) basis. Excluding the bounce back in October 2001, the year-over-year increase was the largest increase since October 2000. It is important to note that the PCE (personal consumption expenditure deflator rose 2.5% from last year, the largest increase since May 2001.

There have been a few economic reports that on the surface appeared to indicate that the economic growth slowed. Durable goods orders dropped 1.6% in May, which was the second consecutive decline. This led some to conclude that economic growth is coming to an end. Unfortunately after about ten seconds of analysis, it is apparent that durable goods orders remain strong. On a year-over-year basis, orders increased 12.6% and the absolute level of orders was the third strongest (only the two previous months were better) since the end of 2000.

The latest Chicago Purchasing Managers Survey fell 11.6 points to 56.4. This was 8.6 points lower than economists expected and the lowest reading since October last year. While, this does signal that the economy might be downshifting from its recent pace, it has to be remembered it is a dispersion index and last month was the highest reading July 1988. The biggest drops came in the production and new orders components. Production fell 17.2 points to 53.9 and new orders fell 17.6 points to 56.8. It is important to note that 34% of respondents reported that production was higher than last month when 61% said it was higher and 42% said new orders increased after 59% reported that orders increased last month. There were 14% of the respondents that indicated production slowed with 16% saying new orders declined, both were the highest this year. It is important to remember that these declines were off very elevated levels, but with that said, anything that appears to signal that the economy is slowing should be closely monitored. Additionally, the component that increased the most was prices paid, which increased 4.5 points to 84.5. This was the highest since August 1988. This might be one reason new orders declined. Another possible cause for the decline in orders is the increase in inventories. Inventories increased 3.8 points to 56.4. This was the fourth consecutive month of inventories expanding.

Retail sales have started to slow. The weekly ICSC Chain Store Sales Index has increased less than 5% year-over-year for each of the past two weeks. This is much earlier than expected. Since there was little evidence that consumers would actually retrench and slow spending, analysts were expecting the growth in spending to decline once the year-over-year comparisons got more difficult. Last year retail sales were slow from March through June. There was a noticeable up tick in consumer activity in July and by August growth in retail sales was above 4% all the way until now, according to the ICSC Chain Store Sales Index. The government's data on retail sales does not reveal the downturn during the period, but the acceleration starting in July is apparent. Retail sales less autos increased 4.4% in June, 5.3% in July and accelerated every month to the current 9.8% increase.

Also pointing to slower retail sales are the two leading discount retailers that warned June same store sales would be lower than their previous plan. On Monday, Wal-Mart announced that June same store sales would be between 2% to 4%, lower than its previous plan of 4% to 6%. The world's largest retailer blamed wet weather as its seasonal categories were weak and said that Father's Day sales were unchanged from last year. The next day, Target said its sales would be lower than previously communicated, although it didn't provide any reasons.

Also this week, GM announced that "the planned surge in demand never quite materialized" and June sales were "somewhat below our projections." It appears that GM's attempt to wean consumers off zero-percent financing might not have been as successful as hoped. In April and May, GM's major incentive program, Truckfest, offered cash back and zero-percent financing on most light trucks. In June, GM offered cash back totaling as much as $5,000 to current GM owners. GM still expects the industry to sell 17.1 million units in the US this year. If this happens it will reverse the trend of declined sales that started in 2001.

There is starting to be conflicting economic data, which usually happens at turning points. Consumer confidence is high and rising, yet consumer spending appears to be decelerating. Auto sales are weakening, but home sales are at record highs. If consumers are starting to cutback spending at the same time as the year-over-year comparisons are difficult, there will be quite a few shocked investors trying to figure out how retailers are posting negative same store sales growth. I'm not calling for the consumer to retrench at this point, but the recent data and reports from retailers certainly make it imperative to closely monitor consumer spending.

Chad Hudson
Mid-Week Analysis
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