Weekly Economic and Financial Commentary

Pricing In A Deeper Recession

Mon, Nov 24 2008, 07:11 GMT
by Wachovia Research Team - Wells Fargo Investments, LLC | View company's profile

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Pricing In A Deeper Recession

We had been assuming the November data would post a slight rebound following October’s plunge. Those hopes appear to have been dashed, however, as economic conditions continue to deteriorate. Most of this week’s reports came in worse than expected and it is now abundantly clear that fourth quarter real GDP will decline more than even our most recent forecast projected.

The financial markets are clearly pricing in a deeper recession. Thursday’s stock market sell-off and dramatic decline in bond yields was driven by increased concerns about the financial system and the ongoing difficulties at domestic automakers. The problems in the financial markets and many old line industries are not likely to be fixed quickly and significantly increases the odds this recession will be longer and deeper than either of the past two downturns.

The only good news this week was the better than expected inflation figures. Plunging oil prices sent both the headline PPI and CPI down sharply in October. Even more surprising, the core CPI declined 0.1 percent.

Talk of Deflation is Way Too Premature

Even with these declines, the year-to-year change in the major price indices remains elevated. The overall Producer Price Index plunged 1.9 percent in October, following a 0.4 percent drop the prior month. Most of that drop was in energy costs, which plummeted 24.9 percent in October. Even with these declines, however, the overall PPI remains 5.2 percent above its year ago level. Excluding food and energy prices, the core PPI rose 0.4 percent in October and remains up 4.4 percent year-over-year.

The Consumer Price Index was also in negative territory, with the overall index falling 1.0 percent and prices excluding food and energy items declining 0.1 percent. The 0.1 drop in the core CPI marks the first monthly drop in this series since the early 1980s. That drop set off a great deal of discussion about deflation, and particularly a debt-deflation spiral. There is at least a grain of truth to these concerns. Debt laden car manufacturers, retailers and homebuilders are all slashing prices in order to clear out inventories in the face of incessantly weak consumer demand.

While consumer prices will likely post some modest declines in coming months, most of these drops are simply due to plunging commodity prices and oversupply issues. We do not believe a problematic deflation spiral is likely. Inflation will slow, however, and we expect the core CPI to return to levels well below the Fed’s target zone and remain there for the next few years.

One other seemingly good bit of news was the 1.3 percent rebound in industrial production during October. The gain follows a 2.3 percent plunge in September and was largely due to disruptions in petroleum products and petrochemicals production surrounding Hurricane Ike. Excluding the rebound in energy output, the report was very weak. Output of motor vehicles plunged 3.5 percent in October and output declined sharply in most major components, including primary metals, wood products, apparel, and machinery. The early data for November show conditions continue to deteriorate across a broad front. Early indications from auto dealers hint that November will be worse than October. In addition, the NAHB/Wells Fargo Housing Market Index fell to its lowest level ever in November, as buyer traffic has all but vanished amid the credit crunch. Manufacturing activity also appear to have weakened further, with both the New York and Philadelphia Fed reporting substantial drops in activity in November. And finally, weekly jobless claims rose much more that expected, surging by 26,000 to 542,000. With the jump, our estimate for November nonfarm employment now calls for a decline of 350,000 jobs.

Global Review

Japan: Another One Bites the Dust

Data released this week showed that real GDP in Japan fell at an annualized rate of 0.4 percent in the third quarter (see chart at left). Coupled with the 3.7 percent drop that occurred in the second quarter, Japan has now experienced two consecutive quarters of negative GDP growth (technically a recession) for the first time since 2001. As we wrote in this report last week, the Euro-zone has also slipped into recession. With output in the United Kingdom dropping like a stone and with the U.S. economy likely to pull Canada under as well, every G-7 economy is already in or soon to slide into recession. Can you say “global downturn”?

Why is the Japanese economy contracting at present? After all, most Japanese banks did not have large exposure to U.S. subprime mortgages, and the credit crunch does not seem to have been as severe in Japan as in other major economies. Japan, however, does have exposure to the U.S. economy via exports, and shipments destined for the United States have clearly weakened over the past few months (see top chart). Although total exports of goods and services rose at an annualized rate of 2.8 percent in the third quarter, it was hardly enough to offset the 10.2 percent drop registered during the previous quarter.

In addition, non-residential investment spending, which helped to pace Japanese economic growth between 2002 and 2006, is also starting to fade. “Core” machinery orders, a good leading indicator of investment spending, fell more than 10 percent in the third quarter, which does not bode well for capex in the current quarter (see middle chart). Finally, growth in consumer spending, which was never very strong anyway, has slowed over the past few quarters (it not yet turned negative though), as the earlier rise in energy prices and deteriorating labor market conditions weighed on real disposable income growth.

Whither the Japanese economy? In our view, real GDP growth likely will remain negative for the next quarter or two, and the total contraction in the Japanese economy could approach 2 percent. Although certainly painful, this recession may not be quite as deep as the downturns in the late 1990s and the earlier years of this decade. For starters, the Japanese banking and corporate sectors are financially stronger today than they were during the previous downturns. Growth in important trading partners in Asia clearly will weaken, but a mass collapse in regional economic activity à la 1997-98 is not likely. Finally, Japanese authorities have announced plans to support the economy via a ¥5 trillion (about 1 percent of GDP) fiscal stimulus package.

The sharp run-up in energy prices earlier this year caused the overall CPI inflation rate to shoot up to an 11-year high this summer (see bottom chart). However, core inflation remained very low, and the overall rate should quickly recede to the core rate now that energy prices have collapsed. The Japanese yen, which rose to a 13-year high in early October as the global financial system tottered on the verge of collapse, remains the currency of choice among risk averse investors. Once risk aversion starts to subside, the value of the yen should start to trend lower.

Download Full Weekly Economic and Financial Commentary

Published On Mon, Nov 24 2008, 07:17 GMT

About this Report

Wells Fargo Investments, LLC

https://www.wellsfargo.com/

sam.bullard@wachovia.com

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The Moderate Economic Recovery is Still Underway
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Fri, Feb 3 2012, 20:08 GMT
Less Strength Than Meets The Eye
Mon, Jan 30 2012, 05:24 GMT
Good News on Manufacturing, Inflation and Housing
Fri, Jan 20 2012, 20:12 GMT
Week Two Brings a Little Less Enthusiasm
Mon, Jan 16 2012, 06:17 GMT

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For example, you place an order to sell stock you own at a stop limit of $67. If the stock drops to $67 or less, the trade becomes a limit order and your trade will only be executed at $67 or better. Glossary All or None (AON) A stipulation of a buy or sell order which instructs the broker to either fill the whole order or don't fill it at all; but in the latter case, don't cancel it, as the broker would if the order were filled or killed. Day Order A buy or sell order that automatically expires if it is not executed during that trading session. Fill or Kill An order placed that must immediately be filled in its entirety or, if this is not possible, totally canceled. Good Til Canceled (GTC) An order to buy or sell which remains in effect until it is either executed or canceled (WellsTrade® accounts have set a limit of 60 days, after which we will automatically cancel the order). Immediate or Cancel An order condition that requires all or part of an order to be executed immediately. The part of the order that cannot be executed immediately is canceled. Limit Order An order to buy or sell a stated quantity of a security at a specified price or at a better price (higher for sales or lower for purchases). Maintenance Call A call from a broker demanding the deposit of cash or marginable securities to satisfy Regulation T requirements and/or the House Maintenance Requirement. This may happen when the customer's margin account balance falls below the minimum requirements due to market fluctuations or other activity. Margin Requirement Minimum amount that a client must deposit in the form of cash or eligible securities in a margin account as spelled out in Regulation T of the Federal Reserve Board. Reg. T requires a minimum of $2,000 or 50% of the purchase price of eligible securities bought on margin or 50% of the proceeds of short sales. Market Makers NASD member firms that buy and sell NASDAQ securities, at prices they display in NASDAQ, for their own account. There are currently over 500 firms that act as NASDAQ Market Makers. One of the major differences between the NASDAQ Stock Market and other major markets in the U.S. is NASDAQ's structure of competing Market Makers. Each Market Maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares. Once an order is received, the Market Maker will immediately purchase for or sell from its own inventory, or seek the other side of the trade until it is executed, often in a matter of seconds. Market Order An order to buy or sell a stated amount of a security at the best price available at the time the order is received in the trading marketplace. Specialists Specialist firms are those securities firms which hold seats on national securities exchanges and are charged with maintaining orderly markets in the securities in which they have exclusive franchises. They buy securities from investors who want to sell and sell when investors want to buy. Stop An order that becomes a market order once the security has traded through the designated stop price. Buy stops are entered above the current ask price. If the price moves to or above the stop price, the order becomes a market order and will be executed at the current market price. This price may be higher or lower than the stop price. Sell stops are entered below the current market price. If the price moves to or below the stop price, the order becomes a market order and will be executed at the current market price. Stop Limit An order that becomes a limit order once the security trades at the designated stop price. A stop limit order instructs a broker to buy or sell at a specific price or better, but only after a given stop price has been reached or passed. It is a combination of a stop order and a limit order. These articles are for information and education purposes only. You will need to evaluate the merits and risks associated with relying on any information provided. 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