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December 01, 2005

Economy Chugs Along
by Chad Hudson

We have discussed on several occasions the resiliency of the economy. It was put to the test during the third quarter as two major hurricanes wreaked havoc through the Gulf Coast and caused energy prices to soar. On Wednesday, the Commerce Department reported that third quarter real GDP grew by 4.3%. This was significantly stronger than the initial estimate of 3.8% growth. The largest revisions were in gross private investment, which grew 5.8% compared to earlier the estimate of 2.3%. Construction was also stronger. Residential construction grew 8.4%, almost double the initial estimate of 4.8%, and nonresidential structures increased 2.7% compared to a drop of 1.4% that was initially reported. A larger amount of imported goods caused a slight drag on economic growth. On a nominal basis, the economy expanded by 6.6% from last year. This marked the eighth consecutive quarter that the economy has expanded by 6.0% or more on a year-over-year basis.

The Federal Reserve published the latest Beige Book on Wednesday. Most districts reported that the economy expanded in the respective region. Most districts reported positive retail sales growth. Sales of luxury items along with electronics and food were the strongest categories. Sales of winter apparel were generally weaker across the country. Most retailers were optimistic about the holiday shopping season, but were cautious due to high energy prices. Auto sales were reported weak throughout the country. The shift to more fuel efficient vehicles was also cited along with strong sales of imported autos. Most districts have reported that residential real estate has moderated. There were several reports of building inventory, slower price appreciation, and slower new construction. Conversely, commercial real estate continued to strengthen in most districts.

The manufacturing sector continued to expand across the country. Only St. Louis reported that manufacturing activity was mixed. Concern remains over rising material and energy costs. Most districts reported tight labor markets. There were several comments about labor shortages in energy, trucking and construction. Cleveland and Richmond were the two districts that seemed to have the weakest labor markets along with the auto sector in Chicago district. Along with the tighter labor market, the reports noted "modest upward pressures on wages."

Over the past year, the Beige Book has reported that consumer prices have "remained stable" or increases have been "modest." But pressures have been building over the past year. The Dallas and Minneapolis districts reported that manufacturers plan to raise prices in 2006. We have discussed numerous times that there is generally a lag in rising consumer prices.

Confirming the anecdotal evidence of an expanding manufacturing sector, durable goods orders picked up in October. After dropping 2.0% in September, orders increased 3.4% in October. Compared to last October, orders were up 11.4%. A large portion of the strength came from aircraft orders. Excluding aircraft orders, orders were up only 0.3%. Orders for non-defense capital goods excluding aircraft, which provides the best measure of business investment, rose 1.3% and are up 11.0% from a year ago. Additionally, the Chicago PMI indicated continued expansion. While the index retreated by 1.2 points in November, it continued to show expansion with a reading of 61.7. New orders and production declined, but remained over 60. Prices paid went through the roof reaching the highest level since October 1979. This is notable since investors have generally been relieved as oil prices have retreated over the past two months. It seems to be forgotten that oil remains 16% higher than at the end of November 2004.

Consumer confidence soared in November according the latest survey from the Conference Board. Consumer confidence rose 13.7 points to 98.9. This was the largest jump in two years and has almost rebounded to levels prior to the hurricanes. Plans to purchase an auto within the next six months dropped to 4.9%, which was the lowest since last November and the second lowest since June 1995. Expectations for wage growth rebounded. After dropping the previous two months from 19.7% to 17.4%, 20.9% of respondents expect higher income in the next six months. This is the highest reading this year and the fourth highest month since September 2002. As we have discussed in the past, income growth and rising home prices have kept consumers feeling flush to maintain spending.

November painted a mixed picture on residential housing. Existing home sales dropped to an annualized pace of 7.09 million units. This was a 2.7% drop from the previous month, but is 3.7% higher than the annualized pace last October. Even as transactions moderated, the median price jumped 17% compared to last year's $218,000. This was the largest increase in 26 years. The Northeast experienced the largest decline in sales, 7.4%. The South was the hottest area of the county. Sales rose 5.2% and the median price soared 18.1%. Also raising concern was the increase in the number of homes for sale, up 96,000 to 2.868 million.

New home sales dropped in August and didn't rebound in September. While existing home sales dropped in October, new home sales surged 13% in October to 1.424 million units. The number of new homes for sale continued to creep up as well. The median price of a new home increased only 0.9%, but that is compared to an 18.1% increase last October.

Looking at the first weekend of holiday sales, it appears that sales were better than last year. Visa said spending on credit and debit cards increased 12%, part of this is due to a shift from cash and checks to credit and debit cards. Visa also said that electronic items were the hot area and accounted for 19% of sales volume. Estimates from ShopperTrak RCT were much lower than other estimates. It said that sales were down 0.5% during the first two shopping days. One reason its results were lower is because it does not include discount stores in its estimates. The ICSC reported that chain store sales increased 5.1% last week compared to last year. Wal-Mart was extremely aggressive this season and estimates that same store sales for the month of November were up 4.3%. Wal-Mart's aggressive promotions have caused concern among investors that the retail environment is too promotional. While sales will be robust, investors are concerned that profits will be under pressure.

Last week, the minutes of the November FOMC meeting were released, which hinted that the Federal Reserve will stop raising rates sooner than most were expecting. The April fed fund futures contract dropped from about a 60% chance of 4.75% being reached by the March meeting to about a 30% chance. The strong economic data this week has caused traders to reassess how high the Fed will raise interest rates. The market is again pricing in a 60% probability that the Fed will raise rates to 4.75% at the March meeting. The market is also pricing in that it is a slim chance that rates go above 4.75%. With continued economic strength combined with growing pricing pressures, it's likely the Fed will have to keep raising rates further than the market currently anticipates.

Chad Hudson
Mid-Week Analysis
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