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Inflation Remains a Concern

Last week, the Labor Department reported that 180,000 jobs were created in March, which was significantly more than the 130,000 economists forecasted. Additionally, the revisions to the previous reports added another 32,000. Given the drop in the housing market, it was surprising that there was an increase in the number of construction jobs. Employment in the construction industry increased by 50,000 jobs to 7.713 million in February. This was only 12,000 lower than the peak reached last September. So far construction employment has been resilient despite the drop in residential construction. While commercial construction has offset some of the drop, it seems likely that there will have to be a rationalization of the construction workforce. Prior to the drop in construction, residential construction was twice the size of nonresidential. Housing starts have already dropped back to the levels of the late 1990s. If employment levels followed, there would be job losses of over one million workers. In fact, when the housing market contracted in the early 1990s, there were about 900,000 jobs lost.

The Federal Reserve released the minutes from the March FOMC meeting this week. The market focused on the comment that "further policy firming might prove necessary to foster lower inflation." It certainly appears that the market overreacted last month when the Federal Reserve removed the phrase "additional firming" from its press release. In the minutes the Fed said that, "in light of the increased uncertainty about the outlook for both growth and inflation, the committee also agreed that the statement should no longer cite only the possibility of further firming." The economic assessment provided in the minutes is essentially the same as has been discussed over the past few months. It did reduce its forecast for first quarter GDP based on weaker business equipment spending and federal defense spending. Economic growth should accelerate during the second half of the year according to the Fed. The FOMC minutes noted that while the stress in the subprime loan market "would likely constrain home purchases by some borrowers, perhaps retarding the recovery in the housing sector," "there was no sign of spillovers from the subprime market to the overall mortgage market." Since the meeting there have been a few stories that have indicated that the rest of the mortgage market has started to see signs of stress.

The market has started to grow more risk adverse over Alt-A loans. Over the past two week M&T Bank and American Home Mortgage announced that they have had to write down the value of the loans because they either had to buy back loans or received bids lower than expected. Delinquencies have also started to increase. While substantially lower than the jump in delinquencies in subprime loans, Alt-A loans delinquencies increased in February to 2.6% from 1.22% last year.

The National Association of Realtors reported today that the "subprime loan debacle" will cause higher loan standards that will in turn slow the housing recovery. The trade group expects sales will only "dampen sales a bit" with existing home sales rebounded stronger than new home sales. Existing home sales are expected to be higher in 2008 then in 2006. While new home sales are expected to rebound next year, sales are expected to be 935,000. This would be over 10% lower than the 1.05 million new homes sold last year.

D.R. Horton announced that orders for its second quarter were 37% lower than last year. Average selling prices dropped 6% to $260,373, which caused the dollar value of orders to drop 41%. Additionally, the homebuilder did not experience any relief in cancellations. Its cancellation rate was 32%, even with last quarter. Similar to statements from the rest of the industry, Donald Horton, CEO or D.R. Horton, said that the "spring selling season has not gotten off to a strong start."

Retail sales have shrugged off the housing woes and have been stronger than a lot of pundits forecasted. The ICSC reported that sales increased 4% during the first week of April. An earlier Easter would have benefited retailers last week and the comparisons will be more difficult for the rest of the month since Easter fell a week later last year. While most retailers will report March results on Thursday, a few reported today. American Eagle Outfitters reported that March comparable sales increased 20%. The teen apparel retailer also increased its earnings per share guidance to $0.34 to $0.35. Previously, it had expected to earn $0.31 to $0.33 per share. Looking to April sales, the company is forecasting that the combined March/April sales will be up in the low double-digit range. The slowdown in sales will be quite dramatic. Target reported same store sales increased 12% in March, which was inline with estimates. It expects April sales to be lower on a year-over-year basis.

The start of earnings season is kicked off with Alcoa, and the largest aluminum producer reported first quarter earnings from operations of $0.77 per share, which exceeded analysts' estimates by two pennies. Sales increased 11%. The company noted that its flat rolled business in the US was weak due the lower shipments in the commercial transportation and the building and construction markets. This weakness was offset by strength in its aerospace, consumer durables and the European building and construction segments. Looking out for the rest of the year, Alcoa forecasts that US demand will be flat, but 23% growth in China, 10% in India and strong growth in Europe will result in overall aluminum consumption up 7.7% for 2007. This has been similar to the macroeconomic backdrop we have discussed over the past few months and should be similar to the trends companies discuss over the next two weeks.


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