The Float

Q4 GDP: Headline Up, Internals Not So Hot

The U.S. Commerce Department released revised fourth-quarter GDP numbers yesterday. The headline figure was revised up from 2.2% to 2.5%, which is encouraging. But dig a little deeper and you'll find a few reasons for concern. Here are the key passages from Reuters:

U.S. economic growth at the close of 2006 was revised up, according to a government report on Thursday that identified rising stocks of unsold goods as a key reason and cast a shadow over future prospects.

The Commerce Department said gross domestic product, measuring total goods and services output within U.S. borders, grew at a 2.5 percent annual rate instead of the 2.2 percent reported a month ago, up from 2 percent in the third quarter....

The GDP report showed inventories rose more than first thought at the end of last year, which could lead businesses to hold back future production. In addition, spending on new-home building plunged again and investment by businesses softened more than thought earlier....

Business investment spending fell at a 3.1 percent annual rate in the fourth quarter rather than the 2.4 percent decline the government estimated a month ago. That contrasted with a 10 percent third-quarter jump.

Spending on new-home building plummeted at a 19.8 percent rate -- steeper than the 19.1 percent fall estimated a month ago -- after an 18.7 percent drop in the third quarter.

It was the fifth quarter in a row that residential spending has fallen and the steepest since a 21.7 percent plunge in the first quarter of 1991 when the economy was on the brink of recession....

There was a significant downward revision in spending on equipment and software, which dropped at a 4.8 percent annual rate in the fourth quarter instead of 3.2 percent. That was the biggest decline since 4.9 percent in the fourth quarter of 2002 and a sharp turnaround from the third quarter when equipment and software spending grew at a 7.7 percent rate.

Companies added to inventories at a $22.4 billion annual rate in the closing quarter of 2006 rather than the $17.3 billion rate it reported a month ago and that was the main reason for the upward revision in fourth-quarter GDP.

Source

Glenn Somerville, "U.S. Q4 GDP revised up on inventories," Reuters, U.S. News, March 29, 2007

Morning Reading

Three interesting pieces from this morning's reading...

• At Marketwatch, Robert Powell on the complex and important rules concerning the tax treatment of appreciated company stock in 401(k) plans. The issue here is "Net Unrealized Appreciation." If you have company stock in your retirement plan, this piece is worth a look.
• Also at Marketwatch, Chuck Jaffe on the ideal credit card--and a few of the ugly practices card issuers have engaged in over the years.
• Katie Benner of Fortune on the advantages enjoyed by money managers who are unconstrained by conventional "style boxes" (i.e., large-cap growth, mid-cap value, &c.). We couldn't agree more.

Bernanke on The Hill

Fed Chairman Ben Bernanke testified before the Joint Economic Committee today on Capitol Hill. He seemed to spook investors a little by walking back some of the widespread interpretation of the minutes of last week's meeting--an interpretation that sparked hopes of falling rates later this year and, in turn, a tidy little rally in the capital markets.

Inflation tends to be a lagging indicator, so evidence of unhelpfully rising prices may be yesterday's news. Alternatively, recent increases in oil prices may flow through to other segments of the economy, especially as seasonally higher gas prices hit this Summer.

But if this Fed behaves like its recent predecessors, the next move down in the Fed Funds Rate may come only after unmistakable evidence of a meaningful slowdown in economic activity. It's a brutally difficult job: promote growth, restrain inflation, get the timing right, make sense of endless streams of often conflicting data. Historically, Fed tightening cycles haven't ended especially well. Let's hope they get it right this time.

Here's the text of Bernanke's prepared testimony.

Oil Heading Higher

With tensions in the Middle East back on the front page, and some semblance of risk being priced back into the capital markets over the last few weeks, crude oil prices have moved decisively off their mid-January lows. This chart shows contract prices for West Texas Intermediate Crude over the last year.

This is exactly the sort of market episode when investors benefit from strategic exposure to commodities. Even if only modest, that exposure provides excellent portfolio diversifcation benefits, especially in an era when several other major asset class seems to be increasingly correlated with one another. (More on that phenomenon in a later post.)

Chart courtesy StocksCharts.com

Globalization Angst

Today's Wall Street Journal features an important piece on Princeton economist Alan Blinder (a former Vice-Chairman of the Federal Reserve Board of Governors and a member of President Clinton's Council of Economic Advisers in the mid-1990s) and his evolving views on trade and globalization.

Here's the short version: Blinder is as convinced as ever that international trade rooted in national competitive advantages yields benefits for countries at a macro level and many firms and individuals at a micro level. But he's increasingly concerned about trade's effects on those who experience the inevitable dislocations created by cross-border flows of goods, people, capital, information, and services. (See imports and exports as a percentage of GDP in the chart to the right.)

Now, blue-collar concerns about the movement of industrial production to other countries is not exactly stop-the-presses news. Where Blinder is probably opening some eyes among the Journal's readership this morning is with his concern that millions of skilled white-collar workers may face the kind of dislocations typically associated with those employed in industries such as steel, autos, and textiles.

Naturally there's tremendous uncertainty about the sort of broad, long-term projections detailed in the table to the right. The point here, as Blinder would readily concede, is not that his numbers are exactly right. The point is that he's onto something important about the position of the United States--and many of its skilled, educated professionals--as globalization marches on.

Source

David Wessel and Bob Davis, "Pain From Free Trade Spurs Second Thoughts," Wall Street Journal (subscription only), March 27, 2007

Graphics courtesy Wall Street Journal

"Sketchy Loans Abound"

In today's WSJ, Dennis Berman writes about the frenetic extension of corporate debt into "subprime-type risks." For several years, lenders and borrowers have created new categories of debt--the sort that works wonders when times are good, but can leave some serious wreckage in its path when economic conditions deteriorate.

Here's a revealing new category: "Covenant Lite," loans which, as Berman writes tactfully, "subject borrowers to few of the usual performance requirements that have been standard in the past. A borrower's earnings might falter or receivables balloon, and a lender's only recourse is a ponderous shrug." Miss a payment or two? No problem. Just call it a "covenant holiday."

These loans, already worth $41 billion in 2007, represent 37% of institutional loan value this year. In 2005? Just 1%. Seems like a meaningful change to us.

Why the weakening of traditional terms and conditions? All the operational details pale in comparison to what Berman shares in this passage:

"People inside the big banks are eerily candid about the credit cycle creeping to an end. They also candidly admit they don't want to get caught missing the next big deal. Their banks, and their own bonuses, might suffer. So they ply ahead." (emphasis added)

When bankers say they're still in the game because they don't want to miss the next (and, implicitly, maybe the last) big deal...well, let's just say this is a story we'll be watching very closely.

Source

Dennis K. Berman, "Sketchy Loans Abound: With Capital Plentiful, Debt Buyers Take Subprime-Type Risks," Wall Street Journal, March 27, 2006 (subscription required)

More Tough Housing News

Today's news that February new home sales fell from January levels by an unexpected 3.9% sent the stock market lower and reminds us that the U.S. housing market is undergoing a sustained adjustment--downward--in the aftermath of the last few years' wild run-up in prices.

Housing, like any market, is a function of two broad, inexorable forces: (1) the relationship between supply and demand and (2) the phenomenon of reversion to the mean.

In supply-demand terms, we have excess supply (in the form of significant inventories, though as always with housing the details vary from region to region) and shrinking demand (wary and increasingly patient buyers, tightened lending standards removing would-be buyers from the demand side, and the disappearance of speculative buying). That's a pretty straightforward formula for falling prices, especially in areas where prices have risen the most over the last several years.

In terms of reversion to the mean, the pace of the last few years--so different from the historical norm--simply wasn't sustainable. At some point the music would stop, and lots of sellers, speculators, financial institutions, builders, &c., were going to have a hard time finding a chair.

Homes aren't as liquid as stocks, so we don't expect to see sudden, precipitous declines. But we do expect continued weakness in housing and related sectors for some time to come.

Today's news was just another indication of this new reality.

UPDATE: Two important facts lurking underneath the headline: (1) Median new home prices fell 0.3% from February 2006 and (2) Year-over-year (comparing February 2007 to February 2006), new home sales tumbled 18.3%. Regionally, the West looks best (up 24.6%), the Northeast and Midwest looked worst (down 26.8% and 20%, respectively), and the South saw milder declines (down 7%).

Sources

Patrick Rucker, "New home sales fall; Some see Fed rate cuts," Reuters, U.S. News, March 26, 2007

Rex Nutting, "New-home sales fall to 7-year low in February," Marketwatch, March 26, 2007

Disclaimer and Disclosures

GENERAL DISCLAIMER--Readers should not construe any of the views expressed on The Float as investment advice. Interlake Capital Management, LLC, provides investment advice only in the context of contractual relationships between the firm and its clients. All investment-related content and commentary provided here is intended only to educate readers in a general sense about important topics in money management and personal finance.

MARKET POSITIONS--Generally, The Float does not and will not comment on specific securities. If we ever do mention a particular security, we clearly and fully disclose whether we individually, Interlake as a firm, or any of our clients have, or have had in the recent past, a position in that security.

SOURCES--We make every effort to disclose our sources and make such disclosure as clear as possible in each post where we use any source(s).

PURPOSE--The primary objective of this blog is to offer an independent perspective on various important topics in money management and personal finance. We aim to connect otherwise disconnected ideas and help investors pursue their financial and personal objectives as successfully as they can.

The Float's Afloat!

Welcome to Interlake's new blog, where we offer an independent perspective on money management, personal finance, Wall Street, and the capital markets.

If you're interested in receiving updates whenever we post a new item to The Float, we encourage you sign up for the feed of your choice.

There's much more to come, so stay tuned...