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Weekly Economic and Financial Commentary

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What A Week!

Mon, Sep 22 2008, 11:19 GMT
by Wachovia Research Team

Wachovia

U.S. Review

Dramatic swings in the financial markets more than offset the handful of major economic reports released this week. The Fed, central banks around the world, and the U.S. Treasury pulled out all the stops this week to inject liquidity into the financial markets and put a backstop around the global financial system. While it is still too soon to say the financial crisis has passed, the determination of Treasury, Congress, the Fed, and the Administration have all clearly bolstered confidence and provided a credible path for a recovery.

Treasury Secretary Hank Paulson announced plans to bolster the strength and stability of the financial markets. The Treasury announced that they will provide a temporary one-year guarantee on money market mutual funds and also announced a major plan to deal with the root cause of the financial turmoil, which is the illiquidity of the mortgage market. The Treasury, along with Fannie Mae and Freddie Mac, will increase their purchases of mortgage-back securities and find ways to remove many of the other “illiquid assets clogging the financial system.”

It’s The Economy, Stupid!

The Treasury’s plan will require congressional action, which is going to be negotiated over the weekend. Hank Paulson noted the total cost of the program will be in the “hundreds of billions” of dollars. The Treasury, Fed and Congressional leaders met Thursday night and are expected to reach an agreement to fund and implement the Treasury’s proposals over the weekend.

Even with a plan in place to clean up the mortgage mess and restore confidence in the financial system, serious challenges remain for the financial markets and broader economy. Lenders remain extremely risk averse and lending will likely remain constrained for some time to come. Moreover, the latest news on the economy, which was hardly noticed this week, has generally been weaker than expected. Industrial production fell much more than expected during August and housing starts plunged to their lowest level since 1991. First-time claims for unemployment insurance rose by 10,000 to 455,000 in mid-September and the Index of Leading Indicators fell 0.5 percent in August.

While many people have been quick to say that the economy is in recession, the actual economic data have not supported that view just yet. Real GDP grew at a 3.3 percent pace during the second quarter and the next revision to that number, which will be released next week, is expected to be modestly stronger than that. More recently, the economic data have looked far more threatening.

Industrial production fell sharply, led 1.1 percent lower by big losses in manufacturing output. The domestic auto industry continues to struggle mightily and production of motor vehicles & parts are off over 12 percent in the last year. We do not expect to see any near-term improvement in automotive output, major manufacturers have already announced weaker production schedules for the fall in an attempt to meet the continuing weak sales environment.

While automotive output has been weak, as have other consumer facing sectors, those with export and business exposure have been fairing better. Computer and machinery production, while not stellar, have been steady. Export growth may slow in coming months, but we do not expect a collapse. Capacity utilization for finished goods fell to just over 75 percent. Lower capacity utilization is a double-edged sword, while we expect less inflationary pressure, especially core inflation, lower utilization will also put downward pressure on corporate profits in coming months.

Global Review

Emerging Markets Take a Beating

Since peaking in October 2007, the S&P 500 has declined about 20 percent. However, as shown in the graph at the left, a widely followed index of emerging market stocks has dropped even more than the S&P 500. Indeed, some emerging stock markets have been absolutely hammered lately. For example, the Russian MICEX index has plunged almost 50 percent since mid-May. What in the world is going on in emerging markets?

Part of the recent drop in emerging market stocks may simply reflect pullback from the sharp run-up over the past few years. Between early 2003 and October 2007 the Morgan Stanley Emerging Market Free index rose more than three-fold as investors piled into emerging market stocks. As emerging stock markets started to retreat, get-rich-quick investors undoubtedly streamed for the exits.

Although a pullout by short-term investors may have added to the downward pressure on emerging stock markets, the rout that started last autumn needed a spark. That catalyst was prospects for slower growth in the developing world. For example, growth in Chinese industrial production has slowed visibly over the past year (see top chart). Similar slowdowns are apparent in most other developing countries as well. Not only have slowdowns in major economies contributed to deceleration in emerging economies, but tighter economic policies in many developing countries, in response to the sharp rise in inflation this year, have also acted to slow growth. Slower economic growth usually translates into smaller increases, if not absolute declines, in stock markets.Stresses in emerging markets are visible in other financial prices as well. Yields on government bonds in most developing countries, which trended higher over most of the summer, shot up sharply this week. That said, spreads over U.S. Treasury yields have not blown out to the same extent that they did earlier this decade when global growth slowed sharply. As shown in the middle chart, most emerging currencies have weakened versus the dollar recently. Indeed, the Fed’s “Other Important Trading Partners” index, which measures the value of the dollar versus 19 non-major currencies, has risen more than 5 percent over the past two months.

As noted above, yield spreads of developing countries’ government debt generally remain well short of levels reached earlier this decade. In our view, economic fundamentals in most developing countries are better today than they were a decade ago. As shown in the bottom chart, developing countries generally incurred current account deficit a decade or so ago. Although Middle Eastern counties (i.e., OPEC countries) account for much of the massive surpluses at present, current accounts are largely under control today (some Eastern European countries may be the exception to the rule). Fiscal deficits in many developing countries have largely been brought under control as well. Due to improved economic fundamentals, capital flight, which has plagued many developing countries in the past, should not be a problem in the current cycle. Although we look for further modest depreciation against the greenback in the quarters ahead, we are not expecting a generalized collapse of emerging currencies.

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Published on  Mon, Sep 22 2008, 11:30 GMT