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September 01, 2005

Growth Wanes, Yields Collapse
by Chad Hudson

Second quarter GDP growth was revised down by 10 basis points to 3.3%. However, the deflator was also revised down by 10 basis points, so nominal GDP growth remained at 6.1%. Personal consumption was revised down to 3.0% from 3.3%. This is the slowest increase in personal consumption since the second quarter last year when it rose only 1.9%. Purchases of durable goods increased 7.7% (revised down from 8.3%), buoyed by auto sales. Spending on services increased by 1.9% (revised down from 2.3%). Private investment and government spending were both revised up. Gross private investment declined 3.3%, but was initially estimated to have fallen 4.9%, due to a larger trade deficit. Fixed investment was revised lower to 8.9%, due to lower growth in nonresidential expenditures. Residential construction increased 9.8% during the second quarter. Government consumption rose 2.7% after first being estimated at 2.0%.

The manufacturing sector has decelerated over the past few months. Last week, the Commerce Department reported that durable goods orders dropped 4.9% in July. Excluding transportation, orders dropped 3.2%, which was the largest drop since April 2004. Earlier this week, it was reported that factory orders dropped 1.9% in July. The first indications reveal that conditions may have deteriorated in August. On Monday, The Chicago PMI plummeted 14.3 points to 49.2 in August. It was the largest decline since May 1980 and was the first reading under 50 since October 2002. The decline was led by new orders (down 23.1 to 46.5), production (down 14.3 to 56.2) and backlog (down 10.4 to 45.7). Only inventories and prices paid rose. The survey from the Kansas City Fed did not show the same deterioration. Production increased to 15 from 1 last month, this was the highest since March. Prices paid jumped to 42 from 27 and managers expect prices to rise over the next six months. The component that measures expectations of future prices rose to 60 from 36. It is the highest level since January 2005. The ISM manufacturing survey will be released on Thursday and will give a broader measure on the health of the manufacturing sector.

Consumer spending has also started to show signs of slowing. The International Council of Shopping Centers (ICSC) forecasts that same store sales increased by 4% in August. But Michael Niemira, ICSC's chief economist, cautioned that, "On the surface it's good, but when you look beneath the surface it's not a strong report." He said that considering same store sales only increase 1.3% last August, which was the smallest gain since March 2003, growth would be easier to achieve this year. So far this year, same store sales have increased on average by 3.7%, compared to last year's gain of 5.1% on average for the first seven months of the year. According to a survey conducted by the ICSC, 58% of households have reduced their discretionary spending due to higher gasoline prices.

Dollar General reported second quarter earnings per share increased by a penny to $0.23 compared to last year. This was two cents better than Wall Street estimates. Revenue increased 13% helped by a 3.9% increase in same store sales. Earlier this year, the company added consumable items including food. As its customers have been impacted by higher energy prices, this shift has allowed the company to address its customers "needs" rather than "wants." Sales of highly consumable merchandise increased 16%. Even with the merchandise shift the company is still subject to the health of the lower end consumer. The company expects August same store sales to increased by only 0.5% - 1.0%, and commented that, "Consumer discretionary spending has been greatly impacted in August due to the combination of fuel prices and aggressive back-to-school marketing and discounted pricing by competitors." Interestingly, the company said that the fastest growing segment is customers with incomes greater than $70,000 per year. The company believes that higher energy prices have caused these customers to seek value priced merchandise.

Dollar Tree Stores also noted that energy prices have affected its customers. The retailers reported that second quarter earnings fell about 8%. The company noted that same store sales dropped 1.5%, due to a 2.6% drop in consumer traffic. The company noted that its higher mix of discretionary product verses consumables is the reason it underperformed its competitors. The company said that, "it is evident that our customers continue to feel the strain of rising fuel cost." This is similar to comment from Wal-Mart stating that food sales have been stronger than merchandise sales.

The high-end retailers have fared much better as wealthier shoppers have not had as high of a percent of their discretionary income crimped by higher energy prices. Tiffany & Co., one of the highest-end retailers that is publicly traded, reported that its sales increased 11% and US sales increased 8% helped by a 6% increase in same store sales.

The situation along the Gulf Coast is the most pressing development. The closure of the refineries appears to be more precarious than the loss of oil production. The region accounts for about 47% of the refining capacity of the country. The most recent Bloomberg news story said that 1.79 million barrels a day of capacity, about 10% of the nation's total, is shutdown. With capacity utilization already over 90% there is not enough slack in the system to make up for the outages.

The higher energy prices resulting from Hurricane Katrina has reduced expectations that the Fed will raise interest rates in each of the next three meetings. At the end of last week January 2006 Fed Fund futures contracts closed at 95.85 to yield 4.15%. This meant that traders were pricing in about a 60% probability that the Federal Reserve would raise rates in each of the next three meeting to 4.25%. Now, the January 2006 contract is trading at 96.045, yielding 3.955%. This means that the chance of the Federal Reserve will raise rate three more times this year are negligible. Additionally, based on the Eurodollar market, traders are starting to price in the chance of rate cuts in 2006.

Over this summer the manufacturing sector had started to moderate. Consumer spending had remained strong on both coasts, but had started to slow in the center of the country and the lower-income households; both are the two demographics that have not enjoyed the benefit of soaring home prices. If the refining capacity cannot get back online in a timely manner, higher energy costs will place additional pressure on consumers and companies. Similar to other periods of perceived economic weakness, the bond market has rallied, pushing yields back near two-year lows. As we have said before, this keeps liquidity flowing to consumers, perpetuating the housing bubble along with consumption.

Chad Hudson
Mid-Week Analysis
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