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November 03, 2005

5% Fed Funds?
by Chad Hudson

Personal income bounced back in September, rising 1.7% from August and was up 6.3% from a year earlier. Except for August, which was depressed due to Hurricane Katrina, personal income has increased more than 6.0% on a year-over-year basis every month since October 2004. For the first time in several months, spending growth lagged income growth. Personal spending rose 0.5% after falling 0.5% last month. While retail spending was clearly depressed following the hurricanes, consumers have starting spending again. The personal consumption expenditures (PCE) deflator increased 3.8% from last year. This was the largest year-over-year increase since October 1991. Of course the focus was on "core inflation," which was only up 2.0% from last year.

Retail sales have rebounded over the past month. Wal-Mart said its same store sales grew by 4.3% in October, surpassing its guidance of 2% - 4% growth. Additionally, the company said general merchandise was stronger than it food sales, which is the first time since June. The ICSC index of chain store sales increased 4.4% from last year. That was the largest gain since the last week of July. The trade organization also increased its estimate for October same store sales to 4.0% from 3.0%.

Federated reported that October same store sales dropped 0.7%, lower than the 1.5% increase analysts were anticipating. The company maintained its guidance for 1% - 2% increase for the fourth quarter. American Eagle Outfitters reported that same store sales rose 17.3%. This was much stronger than the 10.5% increase analysts were forecasting. The company also boosted its third quarter earnings guidance by two pennies to $0.45 - $0.46 per share.

Similar to consumer spending, the manufacturing sector also paused after the hurricanes. It has also picked back up at the same time as consumer spending. Last week, the Richmond Fed survey jumped eight points to twelve. This was the highest level since May 2004. This week the Chicago PMI and the ISM both showed the manufacturing sector has continued to expanded. The manufacturing ISM index slipped 0.3 points to 59.1, but was almost two points higher than estimates. While the production and new orders declined, they both remained above 60. Employment rose 1.9 points to 55, which was the highest it has been since February. Prices posted the largest increase, rising six points to 84, the highest level since May 2004.

Vehicle sales downshifted, falling to an annual rate of 14.7 million vehicles in October. This was the slowest pace of auto sales since August 1998. Ford and GM bore most of the brunt as sales for each of them plunged 26%. DaimlerChrysler was the best performing domestic automaker with sales dropping only 2.8%. All the manufacturers had a difficult month. Toyota, which has been running over most other nameplates, increased sales by 1.3%. Honda increased sales by only 0.4%. The drop in sales was the result of automakers reining in incentives. According to CNW Market Research, the average incentive dropped 9.2% from September to $3,519.

Procter & Gamble still expects higher commodity costs, namely for raw materials, energy and transportation. Along with cutting costs to offset these increases, the company is raising prices on its products. Some examples the company mentioned in its conference call include: increasing Prilosec OTC prices by 10% in September, raising the list price of Charmin and Bounty by 6.7% on January 31, and increasing tissue prices by 5% in January. The company noted that it has not seen any significant reductions in market sizes or major shifts away from premium price products as they have increased prices.

Masco, one of the leading manufactures of home improvement and building products, reported that sales gained 6% but missed earnings estimates due to higher raw material costs. The company also lowered full year earnings estimates to $2.20 - $2.24 per share from $2.30. At the beginning of the year the company anticipated earning as much as $2.50 per share. Last month, the company said the rapid pace of homebuilding hampers its ability to get price increases as homebuilders tend not to increase the price of houses already under contract.

Several companies have mentioned strength in commercial construction. Construction has rebounded along with occupancy. This week, Equity Office Properties said that its occupancy rate has climbed to 89.3%, up from 86.5% last year. It also commented that construction costs have increased by 10% - 20%, depending on the market. General Growth Properties, one of the largest REITs that focus on retail space, said that its total sales increased 6% and same store sales were up 3.5% in the third quarter. It is not as optimistic as the National Retail Federation regarding holiday spending. It is forecasting that holiday sales will increase 3.0% - 3.5%, compared to the NRF forecast of 5.1%. Its occupancy rate increased to 92.2% from 90.8%. There has been a lot of department store space come available recently and will increase as May Department Stores are closed following the merger with Federated. The company mentioned it plans to convert some existing department store space into other uses like big-box retail, theaters, and you guessed it - residential housing.

Last Friday, the Commerce Department reported that the economy expanded by 3.8% in the third quarter. This was a little stronger than economists expected, mostly due to stronger personal consumption. Personal consumption increased by 3.9%, economists were expecting an increase of only 3.3%. On a nominal, year-over-year basis, the economy expanded by 6.5%. To put that strength in context, there have only been seven quarters since 1990 that nominal growth was stronger. Four of those were the four quarters last year. Until consumer psychology changes and everyone quits trying to outspend their neighbor, consumption will be governed by inflating housing prices and personal income. Housing prices are obviously increasing at a rapid rate across most of the nation, at least the two coasts. Additionally, personal income has been growing at a very respectable rate over the past year. With the scare of $3.00 gasoline in the rear view mirror, consumers will likely go back to their old habits.

The Federal Reserve raised rates by a quarter-point for the twelfth time this week to 4.0%. With the economy displaying significant strength and residency, more economists are predicting fed funds reaching 5.0%. Traders are pricing in the possibility of fed funds reaching 4.75% at the March 2006 meeting. Higher rates are needed to curb the runaway credit growth, namely mortgage, which has created imbalances throughout the economy. Unfortunately, a large portion of consumption has been financed and once rates get high enough to have the desired effect, consumption will likely decelerate very quickly. This would cause a much more severe recession than the previous two.

Chad Hudson
Mid-Week Analysis
PrudentBear.com

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