Weekly Markets Commentary – May 5, 2008

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Uncertain Economy

The advance estimate of economic activity in the first quarter showed gross domestic product expanding at an annual rate of 0.6 percent, matching the rate of last year's fourth quarter. The economy's performance is proving to be just strong enough to avoid recession, but weak enough to embolden those who insist that a recession is already upon us.

The Federal Reserve now seems willing to believe it has done its part in avoiding an economic contraction. In lowering the overnight rate another quarter-point to two percent, it signaled a desire to be guided by incoming data going forward, while leaving the door open for a range of policy direction in the future.

Since the advance estimate of GDP is often subject to revision, some caution is still warranted when analyzing these numbers. The report includes estimates of final month results for inventories and exports, two pockets of strength this time around that collectively were the difference between growth and contraction.

These categories do matter, contrary to the arguments of some. For example, inventory rebuilding contributed 0.8 percent to the growth rate, meaning without it, the overall growth rate would have been negative. By this same logic, however, the fourth quarter rate would have been 2.4 percent, since an inventory drawdown subtracted 1.8 percent from its growth rate.

The most ominous component of the report was a decline in personal consumption to an annualized rate of one percent, down from a less-than-robust 2.3 percent in the fourth quarter. Clearly, consumers are pulling back, hurt by increasing energy costs, higher food prices and falling home values.

Business investment also fell, while residential construction once again subtracted 1.2 percent from the overall growth rate.

The question for the second quarter is whether the existing stimulus in the pipeline will be enough to push the growth rate higher. Rebate checks are on the way, and tax refunds are running well ahead of last year, suggesting that some help for consumers is on the way, possibly enough to drive personal consumption back to fourth-quarter type levels.

We also expect to see a rebound in business investment. However, in order to achieve the close-to-trend, second-quarter growth rate that we are anticipating, we will need to see a decline in the drag being exerted by housing.

After showing some signs of stability in January and February, housing starts plunged 12 percent in March to their lowest level since 1991. The April results will not be available until May 16.

The April employment report was similar to the result for the economy as a whole. It was certainly nothing to get excited about, but it could have been a whole lot worse.

A total of 20,000 non-farm jobs were lost, but that was significantly better than the anticipated decline of 80,000, the average loss of the previous three months. Still, it was the fourth month in a row of losses, hardly indicative of a healthy jobs market.

Markets Rise

On balance, investors reacted positively to last week's economic reports. Stocks rose for the third week in a row, as both the S&P 500 Index and the Dow Jones Industrial Average added 1.2 percent, and the Nasdaq Composite Index climbed 2.2 percent.

The S&P 500 is now 11 percent higher than its March 10 low, and is now lower on the year by 3.7 percent. The index also managed to close above the 1,400 level, thought by many to represent the upper bound of a trading range, and suggesting that the next point of resistance may be near the 200 day moving average of 1,433.

The dollar climbed one percent last week, as measured by the DXY index, and is now three percent higher than its April 22 low.

From that same date, the MSCI EAFE index in local currency terms has risen 3.9 percent, but only 1.2 percent in dollar terms. During that same interval, the S&P 500 has risen 2.8 percent.

In another measure of improving investor sentiment, the spread between the 10-year Treasury note and the Merrill Lynch High-Yield Master II Index narrowed by an additional 20 basis points, to 685. This was the fifth weekly improvement in the last six, during which time the spread has contracted from a mid-March high of 886 basis points.