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Fed Tightening = Financial Crisis?


While personal income dropped in January from December, wages and salaries increased 0.6%. Overall income soared in December due to the dividend that Microsoft paid. The year-over-year increase in wages and salaries increased 5.8% and private sector wages increased 6.3%. This was the fastest pace since the end of 2000 and significantly above the growth over the past two years. Last January, private industry wages increased by 4.5% year-over-year, while during January 2003 it was only a 1.7%. We have discussed the rapid increase in raw material prices for the past several months. Its likely that higher wages will lead to either higher prices or thinner margins. Personal spending in January was flat from December, but increased 5.7% from a year ago. Spending on durable goods increased by 3.4% with larger increases in nondurable goods spending (7.6%) and service sector spending (5.3%). The increases in nondurable goods and services were the slowest increase since last summer.

Retail sales have slowed from the pace from late 2003 and early 2004. Analysts expect retailers to report that same stores sales increased by 3% in February. This would be on top of the 6.7% gain last February. Target said its sales were running above its 4%-6% plan through the third week of the month. Wal-Mart expects to be at the high end of its range.

While retail sales have cooled over the past year, manufacturing activity rebounded. This rebound has shown signs of slowing recently. The manufacturing ISM fell 1.1 points in February to 55.3. This was the lowest it has been since September 2003. Only supplier delivery and export orders increased and backlog was flat. Even though most of the components fell, all but the two inventory indexes remained above 50. Prices paid fell 3.5 point to 65.5. The steady decline in the manufacturing ISM has started to worry economists. Economists are usually forecasting quarter-over-quarter changes in GDP and other economic measures. I use the economic data to gauge how companies might be doing and if they will be able to meet earnings expectations. This means I'm much more interested in year-over-year changes as opposed to sequential changes. The ISM surveys focus on the month-over-month sentiment from purchasing managers. Since they have indicated that each month was better than the previous month, it would seem that business conditions are much better than they were a year ago. Construction spending increased 10.6% in January from a year ago. Growth was broad-based. There was double-digit growth in: residential, lodging, commercial, health care, communications, highway, and manufacturing. This strength in construction spending is proving to boon for Caterpillar. The leading manufacturer of construction equipment announced it will raise prices by up to 5%. This increase, which follows a 3% hike in January, will take effect in late spring. Additionally much of the recent slowing could be a reflection of the lower production volumes from the US automakers.

Automakers sold 16.3 million units on an annualized basis in February. Just slightly above the 16.2 million unit rate last month and just below last year's 16.4 million. The refrain continued for another month, the domestic automakers, specifically Ford and GM lost ground to the Asians. GM sales declined 12.7% and Ford's sales slipped 3.0%. Chrysler proved to be the exception, posting an increase of 5.5%. This resulted in the US manufacturers losing 190 basis points in market share to 57.9%. GM's market share fell to an all-time low of 24.4%. The Asian automakers gained 200 basis points in market share to 36.1%. Toyota's sales jumped 11.1% and Nissan's increased 10.1%. Honda saw sales decline 7.2%. The lower than expected sales forced GM and Ford to further reduce production. GM now expects to build 1.18 million vehicles during the first quarter, 50,000 units below the forecasts given last month and 12% below last year's levels. Ford lowered its projected production by another 10,000 vehicles to 910,000.

Lower production volumes are impacting the auto suppliers as well. This week, Lear Corp. announced that it now expects first quarter earnings to be breakeven v. the $0.50 to $0.70 per share it previously forecasted. Not only are the auto suppliers having to contend with lower production volumes, but raw materials have not abated from last years rapid raise. Michael Ward, an analyst at CreditSights wrote that higher raw material prices will reduce earnings in the auto supply industry by over $1.2 billion this year. Higher raw material costs do not appear to subsiding soon. China's largest steelmaker agreed to pay 72% more for its iron ore.

On a year-over-year basis nominal GDP increased 6.4% in the fourth quarter. GDP deflator was 2.4% in the fourth quarter. This was the largest gain since December 2001, which was 2.5%. Economists have been raising their forecasts for first quarter GDP. Our friends at ISI have boosted their estimate for first quarter GDP growth by 50 basis points in each of the past three weeks. On February 7, the leading economic research firm's first quarter estimate for GDP growth was 3.0%. Last week, they raised their forecast to 4.5% saying they are "getting out of the way of the truck." In the same note, Ed Hyman reminded us that every Fed tightening cycle has brought a financial crisis. Here is his list.

Fed Tightening Cycle

Financial Crisis


Penn Central


Franklin National


First Penn / Latin America


Continental Illinois


Black Monday


S&L Crisis




Pac Rim / Russia / LTCM



The financial crisis that transpired with the tightening cycle is usually tied to what the "hot trade" was during the economic expansion. Could mortgage finance be the financial crisis of 2005? According to the fourth quarter report from OFHEO, the average US home price rose 11.2%, the largest increase since 1979. Of course, in 1979 inflation was running at a double-digit rate.

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