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Weekly Economic and Financial Commentary

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Another Momentous Week

Mon, Oct 6 2008, 10:42 GMT
by Wachovia Research Team

Wachovia

U.S. Review

The incredible volatility in the financial markets has eclipsed virtually everything else, including the underlying economy, the presidential race and the start of Major League Baseball playoffs. For those that missed it last night, the Cubs are down two games to none. The Cubs troubles are the only thing this fall that comes close to resembling normalcy. The volatility in the financial markets, the congressional debate, and global financial instability are truly without precedent.

While the financial markets have garnered considerable attention the performance of the underlying economy has taken a definitive turn for the worse. This week’s major indicators included a 6.4 point plunge in the ISM manufacturing survey, a 4.0 percent drop in factory orders, and a 159,000-job drop in nonfarm employment. In addition, car sales turned in one of their weakest performances in decades and sales traffic through dealer showrooms during the last ten days of October was reported the worst since records began being kept back in 1986. Together, this data suggest the economy is already in recession.

The Underlying Economy Is Weak, Congress Needs To Act

The Underlying Economy Is Weak, Congress Needs To Act As we have noted in previous commentaries, passage of the financial rescue package will not immediately reverse the troubles we are currently seeing in the economy, but they will prevent them from becoming even worse. In addition to the credit problems which are severely affecting motor vehicle sales and making it more difficult for dealers to finance their inventory, we are beginning to see serious cracks in other areas. The Los Angeles Times reported this morning that the State of California may need to seek financing from the federal government and several other states and municipalities are running into funding problems. Interest rates on variable rate municipal debt have skyrocketed and new bond deals for many states have been shelved.

Many businesses are also experiencing financing difficulties. Even some of the healthiest firms in the country have had trouble raising money in the commercial paper market. Conditions began to improve marginally after the Senate overwhelmingly passed the rescue package. House passing finally occurred today. With a bill in hand, we expect credit conditions to improve in coming weeks.

Improvement in the credit markets is necessary in order for the economy to recover but we expect the economy to endure at least three quarters of declining real GDP, despite passage of the rescue package. September’s employment numbers are emblematic of the challenges currently facing the economy. Nonfarm employment declined by 159,000 and the unemployment rate remained unchanged at 6.1 percent. Job losses were broad based during September, with large declines in construction, manufacturing and retailing. Auto dealers and department stores were two notable weak spots.

Retailing and hospitality are two areas vulnerable to credit crunch. Many stores are likely to have difficulty securing credit to stock up for the holiday season, which accounts for the bulk of their profits. If they do not have the goods to sell, they do not make any profits and many will likely shut their doors early next year. Restaurant chains are also vulnerable, with a number of franchisees reportedly having trouble attracting financing.

The ISM manufacturing report declined 6.4 points to 43.5, which is roughly in line with where it would be in a typical recession. New orders and order backlogs both declined sharply, indicating more weakness is in the pipeline. The non-manufacturing survey held up slightly better but both surveys occurred before the onslaught of the credit crunch and will likely weaken further in coming months.

Global Review

Recession in the United Kingdom?

After economic growth in the United Kingdom slowed to a virtual standstill in the second quarter, a slate of other negative economic news this week offered further evidence that the British economy may be slipping into recession. In fact, the European Commission issued a report this week predicting that by the end of this year the United Kingdom, Germany and Spain would all fall into recession.

The manufacturing PMI for September cratered to a record low of 41, falling from an already-low reading of 45.3 in August; a troubling sign for the struggling manufacturing sector. The same report recorded the lowest readings for new orders, output and employment since the survey began in the early 1990s. All of which present significant challenges to growth. Meanwhile, the services PMI came in at 46.0, which was considerably weaker than expected.

Economic Crisis is Increasing Pressure for Government Action

As it is in the United States, the U.K. housing market continues to struggle as higher unemployment and tighter lending standards weigh on home prices. Indeed, data this week confirmed the gloom many homeowners are feeling with nationwide house prices down 12.3 percent year over year, the largest annual decline since the last recession in 1991. There is little sign of hope for a near-term turnaround in housing. The construction PMI was lower in September reflecting dour sentiment on the part of U.K. homebuilders.

Given these weak numbers out of the United Kingdom, it is little surprise that sterling weakened further this week and is testing multi-year lows.

Against this backdrop of general weakness and nearly universal assessment that recession is right around the corner without some sort of action, we suspect there would be little resistance should Bank of England (BoE) Governor Mervin King and the monetary policy committee decide to ease rates, despite the fact that inflation is climbing toward 5 percent. In the minutes from its September meeting, the committee acknowledged that a case could be made for a reduction or an increase in the bank rate, but decided to stay on hold with the provision that “the Committee would continue to make its judgment each month on the basis of the changing evidence.” One of the eight voting members voted in favor of a fifty basis point ease in September. It is quite possible when the committee meets again next week, other members may find the recent deterioration in the economy could alleviate their concerns about the risks posed by inflation. Indeed, we expect the BoE will ease at their meeting next week. While a 50 basis point rate cut isn’t off the table, and 25 basis point cut seems more likely.

The crisis in financial markets is increasing pressure on Prime Minister Gordon Brown to extend the guarantees on British savers’ bank deposits after Ireland announced measures to shore up the debts and savings accounts of its six largest lenders, and the U.S. Congress passed a bank rescue. The prime minister responded by floating the idea of increasing the level at which savers’ deposits were guaranteed from £35,000 to £50,000 but said he wanted to wait for things to simmer down in the wild financial markets.

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Published on  Mon, Oct 6 2008, 10:49 GMT