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> From: Bennett, Amanda (Research) On Behalf Of Berner, Richard (Research)
> Sent: Friday, February 24, 2006 10:52 AM
> To: europeansales; econmail; e-fidcom; emall; eranlsts; erassocs; fxnews;
> intlsales; pwmall; equitydistribution
> Subject: Global Economic Forum: US -- How Big a Payback?
>
> How Big a Payback?
>
> Key Points
>
> *What's New: The "payback" for the early 2006, weather-assisted growth
> spurt
> is coming. Fading support from the post-hurricane rebound that began late
> last year may also exaggerate the coming deceleration. Volatile data mean
> it's difficult to track the economy's current underlying growth path, but
> I
> see it at 3½% and rising.
>
> *Conclusion: Assessing the magnitude of that payback is problematic.
> Weather shocks may take time to show up in the data, and the effects on
> discretionary income and spending of collateral energy-price swings will
> magnify those moves. As I see it, risks are still tilted towards stronger
> growth and upside risks to inflation.
>
> *Market Implications: The persistent inversion of the yield curve beyond
> two
> years implies that the Fed will reverse course soon after tightening ends.
> In contrast, I think that upside inflation risks and rising term premiums
> will re-steepen the Treasury yield curve, sending 10-year yields towards
> 5%.
>
> *Risks: A supply-driven energy price spike or a meaningful surge in
> inflation pose the biggest threats to this upbeat scenario. Contrariwise,
> if energy prices stabilize or revert to long-term levels, the risks of a
> stronger-growth, higher-inflation outcome are not insignificant.
>
> Details
> Try as I might, I can't seem to avoid analyzing the weather to understand
> the economy's direction. My son, now 23, recognized my occupational
> hazard
> when at age 5 he painted a picture that hangs in my office. The legend:
> "This is my Dad. His job is to be an economist. It means he has to get
> the
> weather right." That's been especially true over the past nine months,
> when
> unprecedented weather events wrenched the economy first far below and more
> recently well above what otherwise would be its growth trajectory.
> Volatile
> data are making it difficult to track the economy's current underlying
> growth path.
>
> January's events are a case in point: Record warm weather in that month -
> fully 8ºF above the norm - boosted housing and retailing activity
> unsustainably, and most investors now understand that a "payback" for this
> weather-assisted growth spurt is coming. Less widely appreciated, at
> least
> lately, is that a vigorous rebound in economic activity from the
> hurricane-cum-energy-shock depressed levels of late-summer 2005 has also
> contributed unsustainably to the first-quarter growth surge. Like the
> boost
> from warm weather, this post-hurricane recovery will also fade, and the
> combination could exaggerate the coming deceleration, once again fueling
> suspicions that the long-awaited slowdown has arrived. In contrast,
> taking
> that volatility into account, I see the economy's underlying growth
> trajectory at 3½% and rising. Like it or not, it's important to assess
> just
> how big that payback will be to make that call. Unfortunately, at this
> point, it's mostly guesswork.
>
> What to do? One simple approach is to smooth out the effects of the
> shocks
> by averaging growth over the affected quarters. Given our current
> estimates
> for revised fourth-quarter (1.6%) and first-quarter (5.6%) growth, the
> average of 3.6% certainly fits the first part of the script. And thus the
> dip to a slightly below-trend 3.2% growth rate in the second quarter fits
> the payback story. Of course, this approach makes the heroic assumption
> that the shocks and the rebounds or downdrafts from them neatly cancel
> each
> other out. As important, both are currently just estimates; there's a lot
> we don't yet know about coming revisions of past data and the way that the
> payback will shake out in the next few months.
>
> The good news is that the assumptions behind our estimate of 3.2% growth
> in
> the second quarter are conservative. For example, given January's
> weather-boosted level of housing starts, activity will have to fall by 16%
> in February and stay there to realize our first-quarter estimate.
> Likewise,
> we assumed light vehicle sales would fall to 16.3 million units in
> February;
> auto analyst Jonathan Steinmetz tells us that the tally will likely come
> in
> closer to 17.2 million. The potential for a smaller payback in those data
> makes us more confident that the second-quarter deceleration won't be
> sharp.
>
> A second approach is to compare today's experience for affected activity
> such as construction with weather-related shocks from the past to judge
> the
> likely payback. But the results are hardly conclusive, because factors
> other than the weather aren't constant. For example, a warm winter in
> 1990
> pushed the thermometer about 6ºF above the norm in January of that year,
> or
> 75% of the January 2006 deviation. But housing starts jumped by 300,000
> units, or 24% in January 1990, compared with "only" 14.5% in January 2006.
> Despite continued warm weather, a recession was brewing, and declines in
> starts in February-April 1990 erased the January jump. Similar patterns
> obtained in construction outlays and employment.
>
> Using weather shocks in the past to assess today's payback isn't exact
> because, courtesy of reporting lags, the effects may take time to show up
> in
> the data. For example, a warm winter in 1982-83 began in earnest in
> December, but the pop in housing starts was delayed until January of 1983.
> Unwinding the effects of a weather-related shock may take even longer;
> especially if the weather anomaly persists. And the effects on
> discretionary income and spending of collateral energy-price swings will
> magnify those moves.
>
> The upshot is that no foolproof method for parsing the effects of weather
> shocks on the economy exists. The shock from the hurricanes and the
> subsequent rebound were both larger than expected, but at least partly
> offsetting. Only careful attention to the fundamentals and the unfolding
> data will tell the tale. In my view, neither 5.6% growth in the first
> quarter nor 3.2% growth in the spring quarter represent the economy's
> sustainable strength. As we see it, risks are still tilted towards 3¾%
> growth in the second half of 2006, or slightly above trend (see "Betting
> on
> Sustainable Growth," Global Economic Forum, February 6, 2006). It's worth
> remembering that the difference between growth below and above trend is
> critical: The former would help contain inflation. But because slack has
> dwindled in both product and labor markets, and capacity is growing
> slowly,
> growth above trend will intensify pressure on resource utilization and
> tend
> to boost inflation risks.
>
> For investors, these differences are also critical. Market pricing
> suggests
> a move by the Fed to a 5% funds rate no later than June. We're not sure
> the
> Fed will be so aggressive, given the likely spring deceleration in the
> economy, the still-slow upcreep in inflation, and the notion that policy
> lags are uncertain - the full extent of policy firming may take time to
> show
> up. By comparison, the persistent inversion of the yield curve beyond two
> years implies that the Fed will reverse course soon after the tightening
> campaign ends. In contrast, we think that upside inflation risks and
> rising
> term premiums will re-steepen the Treasury yield curve, sending 10-year
> yields towards 5%.
>
> A supply-driven energy price spike or a meaningful surge in inflation pose
> the biggest threats to our upbeat scenario. The former would sap
> discretionary spending power. The latter would promote a more significant
> tightening in monetary policy, which would be bad news for both housing
> and
> consumers' financial-market net worth, and would raise the odds of a
> significant consumer 'ARM squeeze'. Contrariwise, if energy prices
> stabilize or revert to long-term levels, the risks of a stronger-growth,
> higher-inflation outcome are not insignificant.
>
> Richard Berner (New York)
> --------------------------------------------------------
>
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> analyst/research report. Unless indicated, these views are the author's
> and
> may differ from those of Morgan Stanley research or others in the Firm.
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