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"Considerable" Justification

The focus for the week was the Federal Reserve's FOMC meeting on Tuesday. The Fed not only left the Fed Funds rate at 1%, but kept the much discussed phrase "that policy accommodation can be maintained for a considerable period" in the statement. The other noteworthy change was the wording regarding inflation. For the first time in recent history, the Fed said that the risk of inflation was equal to the risk of deflation. While this is quite a change, the Fed had to try and win back creditability. Throughout the entire second-half of the year, the Fed has given excuses for keeping rates at 1%. We have already discussed how absurdly low the current Federal Funds Rate is, and there is little economic reasoning to leave the rate at 1%, especially "for a considerable period."

Everyone knows by now that the economy was white-hot in the third quarter. This forced the Fed to shift its reasoning from maintaining low rates from an economy that has "yet to exhibit sustainable growth" as described in June to the "labor market has been weakening" in September. This shift in focus coupled with the "considerable period" statement should have signaled that the Fed is going out of its way to keep rates low. Now, the bar has been set even lower. In the statement this week, the Fed said "the labor market appears to be improving modestly." Since this was the key reason to keep rates low the Fed either had to start signaling that rates were poised to rise, maybe even increased (sorry momentary lapse of reason), or find another aspect of the economy that is weak to focus on. Instead of signaling that rates were poised to increase, the Fed shifted its focus stating that "resource use slack." Manufacturing utilization rates plummeted in 2001 to 20-year lows to around 75%. Capacity utilization has only started to rebound over the past four months as the manufacturing sector has seen expansion, but remains at 75%. Not only is it mystifying that the Fed has to continually justify its reasoning, but that it chooses a data series that has little representation of the current economy. The fact that there is a glut of manufacturing capacity stems from the credit bubble that allowed everyone access to capital in order to finance any project. Additionally, the US is far from the low cost producer of goods, which has led manufacturers to locate plants in China, Mexico and other countries. The fact the Federal Reserve resorts to pointing out that "resource use slack" proves that Federal Reserve is simply doing attempting to justify low interest rates. If the utilization rate starts picking up, the Fed will probably shift its focus to sugar prices.

Consumers have been the backbone of the economy and after a brief rest in October, spending accelerated in November. Last week, retailers released November sales results. While most analysts focus on same store sales, attempting to separate which retailers are performing the best, it is important to monitor total sales as to gauge the strength of the consumer. During the third quarter, total sales for a basket of 22 large retailers climbed 10% on a year-over-year basis each month. Following this spending spree, October sales slowed to 7.9%, which was just slightly below the average of 8.2% over the past three years. Similar to other data, November sales perked back up to 8.7%. This was on top of a similar 8.7% increase last year.

The rebound in November spending is also confirmed by the Bank of Tokyo-Mitsubishi chain store sales. The leading retail survey said chain store retail sales increased 4.8% in November, up from 4.3% in October. While spending did accelerate in November, it remains substantially lower than the 7.1% and 6.0% growth posted in August and September. However, this accelerating appears to be starting to sputter again. As discussed last week, the weekly retail sales data from the Bank of Tokyo-Mitsubishi (BTM) showed sales for the week ending December 6, 2003 fell 2.5%, the largest drop since December 2, 2000. The majority of the weakness was due to the winter storm that hit the Northeast. The year-over-year change only dropped to 4.9% from 5.2% since there was a storm that affected the Northeast last year as well. It should be noted that the year-over-year growth in retail sales has declined every week since November 15. It is interesting that while BTM said there is plenty of time for retailers to make up for lost sales; it reduced its growth forecast by 50 basis points to 3.5% to 4.0%. Next week will be crucial. After sales fell last year, the following week rebounded to almost 2% growth.

The recent deceleration in consumer spending does not translate to the consumer rolling over. It also needs to be remembered that consumer consumption increased 3.3% during the third quarter according to the latest GDP report. This was the quickest pace since March 2002. The biggest increase was in purchases of durable goods, which was up 17.7%. Plus, it should be remembered that 4% year-over-year growth should not be considered weak. Investors have bid up shares of retailers and other stocks associated with consumer spending. Any apparent slowdown in consumer spending should prompt concern for those forecasting that the consumer can continue spending at a rapid pace.

One of the impetuses behind consumer spending has been the record amount of refinancing activity this year. This has subsided significantly since this summer. The Mortgage Bankers Association Mortgage Application Index dropped 12.19 points this week as both purchase applications and refinance applications fell. The headline index dropped to its lowest level since June 14, 2002 mostly from the decline in refinancing as it is at the lowest level since June 7, 2002. We have discussed the rise in adjustable rate mortgages as an indication that the housing market is getting extended. This week the percent of applications that were for adjustable rate mortgages rose to 29.3% the highest lever since February 18, 2000. The two previous surges in ARMs coincided with an increase in interest rates. In 1994, the percent of applications that were ARMs increased from 15% to 35% as 10-year rates moved from 5.5% to 8%. Similarly, the increase in 1998 corresponded to an increase in 10-year rates from 4.5% to 6.5%. The increase this year has occurred as 10-year rates have gone from 4% to 4.5%. Obviously the smart buy is to buy an ARM when interest rates are high and will likely be adjusted down. The logic certainly has to be questioned getting an ARM when economists are forecasting that rates will be rising next year.

The first casualty of the decline in refinancing activity was Washington Mutual. The second-largest US mortgage lender slashed estimates for 2003. The company said that it expects to earn between $4.15 and $4.25 per share for the year. While this is only about 5% lower than estimates, since Washington Mutual is in it fourth quarter the entire shortfall will be in the current quarter. The company has already earned $3.36 per share, so instead of earning $1.06 this quarter it will only earn around $0.84 per share or about 21% less than expected. The company said its mortgage volume in the fourth quarter will decline by about 50% sequentially. Additionally, the profitability per loan diminished. Instead of an average gain per loan of 47 basis points it experienced in the second quarter, it dropped to only 10 basis points in the fourth quarter.

The tailwinds are abating, but will still exist until next summer when it will become a headwind. Consumers benefited from a decline in interest rates, which set off a massive refinancing and home equity loan boom, a reduction in taxes, and soaring stock market. While none of these items are going to reverse, the results will be difficult comparisons for companies to post double digit earnings gains. The way the market is currently priced, investors are expecting strong growth to last into next year.

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