The Oser View

Happy Holidays?

The Labor Department announced this morning a considerably higher than expected rise in consumer prices in November.  The Consumer Price Index (CPI) jumped 0.8% for a year-over-year increase of 4.3%.  Looking back 15 years, the year-over-year CPI increase has been 4% or more only seven times out of 180 readings.  Economists tend to focus on so-called “core” CPI, which excludes food and energy costs.  Core CPI increased a less-alarming 0.3% and is up just 2.3% year-over-year.  Food and energy prices can be very volatile, month to month.  Taking them out is supposed to smooth out the data and provide a clearer long-term picture.  But this only makes sense if total and core CPI converge over the long run.  For example, in the ten years between 1993 and 2002, the average difference between core and total CPI changes was less than one-tenth of one percent.  Over the last five years, however, the change in total CPI, year-over-year, has been on average 0.8% higher than the change in core CPI.  Of course, energy prices are mostly to blame.  The cost of a barrel of oil has nearly quadrupled, from $25 to close to more than $90.  Food prices have risen sharply as well.  Wheat futures have doubled in just one year; soybean prices are at a 34-year high; and the price of corn has doubled since 2005.  Part of the problem is that, as the price of oil rises, farmers are diverting more of their crops to ethanol and biodiesel fuels, creating more scarcity and thus higher prices. 

Rising food and oil prices are not inflationary in the technical sense, since everyone has to eat and use energy.  Money spent on essentials is money that can’t be spent elsewhere.  While retail sales were strong in November, they have fallen off in December.  Sales fell 4.4% in the week after Thanksgiving and 2.7% in the first week in December, according to the research firm ShopperTrak.  On-line sales are also well below predictions.      

It’s impossible to say how these trends will play themselves out.  They certainly are not conducive to calm in the financial markets and will undoubtedly make the Fed’s job even harder.

Deus ex Machina

In a surprise concerted move, the Central Banks of Canada, England, the European Union, Switzerland, and the United States, announced new measures to inject much-needed liquidity into the financial markets.  The Federal Reserve is initiating a series of auctions of term funds to banks, under a new program called the Term Auction Facility (TAF).  The first TAF auction will be held on December 17th and will be provide $20 billion in loans with 28-day terms.  Three more TAF auctions are scheduled for later in December and January.

The significance of today’s announcement can hardly be overstated.  The Fed is not only creating a brand new financial market, it is also seeking to change its traditional posture as a lender of last resort to a lender of first resort.  Perhaps even more stunning is the Fed’s acknowledgment that something has been seriously wrong with the financial markets for months, especially given yesterday’s lackluster FOMC decision.  It’s as if the Fed went from clueless to genius overnight.  Maybe there really is a tooth fairy.

The reaction in the financial markets has been immediate and violent.  The Dow Jones Industrial Average rose more than 200 points in the first 10 minutes of trading.  The rout in the Treasury market is the worst in six years.  Bond prices have given up all of yesterday’s huge gains and then some.  Since stocks like good news and bonds like bad news, this should be seen as a positive development. 

Still Behind the Curve

The Federal Open Market Committee (FOMC), the Fed’s policy arm, voted 9-1 to reduce the fed funds target 25 basis points to 4.25%.  Boston Federal Reserve Bank President, Eric Rosengren, voted to reduce the target to 4.00%.  Since September 18, the FOMC has reduced the funds target three times by a total of 100 basis points. 

In a statement discussing its decision, the FOMC noted that “strains in financial markets have increased in recent weeks,” but offered as comfort that its 25-basis point cut in overnight loan rates, “should help promote moderate growth over time.” The Committee’s equanimity rings hollow on a day when the CEO of Freddie Mac reports that losses will continue and could well be worse in the 4th quarter than in the 3rd.  It rings hollow on a day when Fannie Mae’s CEO predicts that the housing and mortgages markets will not fully recover until at least 2010.  It rings hollow on a day when Washington Mutual, the nation’s largest thrift, announces a $1.6 billion write-down and a plan to cut 6% of its workforce. 

Today’s action was widely anticipated but nonetheless disappointing.  Stocks, which had been up on the day, are now selling off sharply and bonds, which thrive on bad news, are rising.  These markets are sending a message to the Fed:  “You are still a long way behind the curve!”   

Spillover

This month’s commentary comes down to a hunch, merely a guess or, to use Thomas Friedman’s words in The World Is Flat, “a leap of faith.”  Getting there is a round about journey that begins with a question economists and policy makers have been mulling over for more than a year: “What will be the spillover effects of the housing crisis?”

That housing is in crisis is beyond question.  Home values have fallen 4.5% over the past year and are expected to drop at least another 7% in 2008.  Existing home sales have fallen more than 30%, from a peak of an annualized rate of 7.21 million units in September 2005 to just 4.97 million units in October.  The inventory of existing homes available for sale has stretched to 10.8 months from 3.6 months in January 2005.  The median sales price has fallen to $207,800, its lowest since March 2005.

California, as it so often does, leads the country.  Existing single-family home sales fell almost 15% between August and September and another 2.4% in October.  Year-over-year, sales decreased more than 40%.  The median home price in the state fell 9.9% in September and 6.4% in October.  Still, at $497,000, the median California home price remains well above the Fannie Mae/Freddie Mac conforming loan limit.  According to the California Association of Realtors, sales of higher-priced homes declined “as even well-qualified buyers were affected by the lack of funds available for jumbo loans.”

New home sales fared even worse than existing home sales, dropping to an annualized rate of 728,000 units in October from a high of 1,389,000 in July 2005.  Nationally, the median sales price is down 13% year over year to $217,800.  There is an 8.5 months supply, up from a low of 3.5 months in June 2003.  The National Association of Realtors expects a further drop of 13% in 2008.   Property values are projected to fall $1.3 trillion.  Not surprisingly, the homebuilding industry is already far beyond mere recession.  The S&P index of the 15 largest publicly traded homebuilders has lost 58% so far this year and 72% from its summer 2005 high.  Several major homebuilders are in or near bankruptcy, including Levitt and Sons LLC, builders of the first planned suburb in America Levittown on Long Island.

Mortgage delinquency is spiraling out of control.  The subprime delinquency rate, which was not measured separately until 1998, stands at an all-time high of 16.3%.  Delinquency is the adjustable rate sub-sector of subprime is 18.8%.  More than 15% of subprime adjustable rate mortgages are more than 90 days delinquent or already in foreclosure.   The total US delinquency rate for all mortgages excluding those in foreclosure hit 5.59% in the third quarter, the highest since the second quarter of 1986.  The following chart puts these statistics in perspective:

                                       Third Quarter 2007 Second Quarter 1986
Mortgage Debt Outstanding    $11.1 trillion       $1.7 trillion
Delinquency                            $620 billion         $95 billion
Delinquency Rate                    5.59%                 5.68%
GDP (as of prior year-end)      $13.2 trillion       $4.46 trillion
Mortgage debt as a % of GDP  84%                    38%
Delinquency as a % of GDP      4.70%                 2.13%

The dollars are nominal—that is, not adjusted for inflation—but the percentages show how much bigger and more central mortgages are in relation to the US economy than they were 21 years ago. A similar delinquency rate not only involves far more dollars, but a much higher percentage of Gross Domestic Product.  Perhaps more than any others, these statistics reveal the magnitude of the problem.

And yet…for all the pain and distress in housing, the economy keeps on cranking out new jobs, one and a half million the last 12 months, for a growth rate of 1.1%.  The unemployment rate, at 4.7%, remains comfortably below the post-World War II average of 5.6%.  Certainly, some occupations—manufacturing, construction, and more recently, selling and mortgaging real estate—are losing jobs.  But other sectors are doing very well.  Health care and social services, which represent about 13% of the non-governmental work force, have added nearly half a million jobs this year.  Jobs in leisure and hospitality, about 12% of the workforce, added almost 400,000 positions.  At a more granular level, there was impressive job growth in the following categories: (Numbers are in thousands):

Industry                                                    Nov 2006   Nov 2007   $ Change     % Change
Electronic Markets, Brokers & Agents            788.5       809.1          20.6             2.6%
Air Transportation                                       484.5       499.5          15.0             3.1%
Internet Publishing & Broadcasting                 36.3        45.3             9.0            24.8%
Securities, Commodities, Investments          829.2      854.4           25.2            3.05%
ISPs, Search Portals, Data Processing            384.9      398.1          13.2             3.4%
Architectural & Engineering                        1,407.2   1,454.9         47.7             3.4%
Computer Systems Design                          1,296.2   1,378.6          82.4             6.4%
Management & Technical Consulting              949.3   1,024.1         74.8             7.9%
TOTALS                                                    6,176.1   6,464.0         287.9            4.7%

These job categories represent about 5.5% of total non-government payrolls, but they accounted for nearly a quarter of total net non-government payroll growth.  Health care and leisure provided most of the rest.  Now, you may think that I am about to make the rather simplistic point. US job growth is strongest in fields requiring specialized and usually technical expertise.  Such jobs are said to have “high value added,” because each worker significantly increases the profitability of the service or goods her company produces.  As a consequence these are high paying jobs.  Since more and more of them are being created all the time, we should feel a reasonable degree of comfort that problems in housing, serious as they are, will not lead to a full scale recession.  (Highly paid workers travel often, and frequently eat in restaurants, which helps explain job increases in leisure and hospitality businesses.)  While I do think this is true, to draw the conclusion from the data presented so far, begs the question: “Why are some parts of the economy doing so well, when such a key component as housing is doing so poorly?” 

Here is where things get a little round about, so please bear with me.  On November 27, Bloomberg News published three unrelated stories that caught my interest.  The first was headlined, “JP Morgan, Deutsche Bank Keep Mum on Indian Intellectual Capital.”  It told how money center banks and big investment firms have begun outsourcing investment research to companies in India.  Some, like Fidelity, have even started captive Indian research companies.  The second story bore the headline, “Ireland’s Crystal City Shattered as Waterford Shifts East.”  This article explained that the iconic Irish maker of fine crystal, Waterford Wedgwood PLC, was outsourcing 20% of its production to Eastern Europe.  The headline of the final story read, “Dutch Fret over Irrelevance as ABN Deal Leads Sales.”  It seems that so many foreign investors are buying Dutch companies that the Dutch stock exchange is losing liquidity.  In 2007 alone, outside investors will buy 300 Dutch companies for more than $200 billion, including the marquee purchase of ABN–Amro Bank.

Three quotes, one from each story, sum things up.  You can probably tell which quote goes with which story, but, really, any of the quotes would fit with any of the stories. 

“Companies first resist outsourcing.  Many fear they’ll have to fire their own analysts.  But as they are getting pressured to do more, they keep the ones that they have, bring in Irvena [an Indian company] and they can produce so much more.”
“We can source things from the East under the Waterford franchise.  That’s not going to be an event that will change the perception of the brand.”
“This is clearly the effect of the European Union, the free movement of capital.  That’s life and I’m not feeling sad about it.”

Yes, the effects of globalization are everywhere, nothing really new here either.  But now comes the hunch.  In The World Is Flat, Thomas Friedman describes the challenges and benefits of globalization for the United States.  He notes that outsourcing, the Internet, and other manifestations of globalization get the blame for large factory layoffs.  They do not get the credit for the creation of even more and better “knowledge jobs” because these are often innovative or entirely new positions, popping up in ones and twos in many different places.  Friedman can’t prove his thesis; it takes, he says, a leap of faith.  It’s a leap I’m willing to take.  I think the low unemployment rate is telling us that thousands of new jobs are being invented all the time, some within existing corporate structures, but many by people working alone with a computer or in small collaborative groups.  And whether it’s someone who makes a living writing crowdware for Facebook, creating production-ready commercial graphics on a home computer, or selling used books through Amazon.com that person is a consumer too.  And as long as Americans keep consuming, our economy will keep expanding.   

Jobs on Target

The November employment picture came in pretty much as expected.  Non-farm payrolls increased by 94,000 net new jobs, somewhat offset by a downward revision of 48,000 for September and October.  The unemployment rate held steady at 4.7%.  Job losses continue in manufacturing, construction and financial services connected with real estate.  Job gains continue in education, health care, leisure & hospitality, and government.  Perhaps the biggest surprise was a 24,000 increase in retail sales jobs, a sector that had shed 26,000 jobs since June.  An early Thanksgiving, meaning an early “Black Friday”, is probably responsible for the jump.

The job situation remains healthy enough to keep recession at bay, despite the ever-mounting problems in housing.  The November employment numbers were neither strong enough to keep the Fed on hold, nor weak enough to spur heroic action.  Look for a 25 basis point reduction in the fed funds target when the Federal Open Market Committee meets on Tuesday.