The economy managed to grow slightly in this year’s first quarter, the government reported today. GDP rose by an annualized 0.6% in this year’s first three months, matching the growth rate in Q4 2007. Given all the recession anxiety of late, that’s a victory of sorts. But this is no time for celebrating. As a closer reading of today’s GDP report shows, consumers are turning defensive in their spending habits in a big way.
Personal consumption expenditures (PCE)–which represent about 72% of total GDP– rose by a meager 1.0% (seasonally adjusted annual rate) in the first quarter–down from 2.3% in Q4 2007. That’s the lowest pace since Q2 2001, which also witnessed a 1.0% expansion. The reason for the current slowdown: two of PCE’s three major components posted declines in the first quarter. Spending on durable goods was particularly hard hit, dropping by a hefty 6.1%–the first case of red ink here since 2005. Nondurable goods also slipped in Q1, falling 1.3%. This marks only the fourth instance in the past 15 years that nondurable goods spending contracted in a quarterly reading.
The lone source of consumer spending salvation came via services expenditures; the only member of the three broad gauges that define consumer spending that posted a gain in Q1. Fortunately, services spending posted a healthy 3.4% jump. But that only reminds that consumer spending overall would be shrinking if it wasn’t for the resilience in services.
Nonetheless, no one should misunderstand what’s unfolding: Joe Sixpack’s sentiment to buy, buy, buy has taken a hefty blow, at least for the moment. And no wonder: prices are soaring for basic staples, i.e., energy and food. Meanwhile, the family home is worth quite a bit less and Joe’s investment portfolio probably suffers a similar discounting. Logic suggests that saving more and spending less is eminently reasonable at this juncture. The only question now: How long will the newly defensive sentiment last?
Clearly, it’s premature to say that the worst of the economy’s downshifting is past. Anecdotal evidence for the second quarter, which is barely a month old, suggests that the correcting process is still underway. Perhaps May and June will deliver better news, perhaps not. But based on the numbers presented in today’s GDP update, combined with an objective survey of finance and economic conditions in the month of April, there’s still a case for staying cautious and defensive in one’s investment strategy. The proverbial “other shoe,” it seems, is in the process of dropping as we write.

Perhaps it signifies nothing, but the timing is suspicious.
Last December, the Treasury Department announced that it was sharply reducing the annual limit on investments in the inflation-indexed series of U.S. Savings Bonds, a.k.a., I-Bonds, to $5,000 a year as of January 1, 2008–down from $30,000 a year previously. (The $5,000/yr limit also applies to conventional Savings Bonds as of January 1.)
No big deal in the grand scheme of finance, although we can’t help but notice that the new lower limit comes at a time when inflation-linked portion of payouts for I-Bonds look set to rise, as per the methodology that ties a portion of the bonds’ interest rate to the consumer price index.
The official reason for the reduced investment maximum, as per the Treasury’s press release, was rationalized this way: “The reduction from the $30,000 annual limit in effect for both series since 2003 was made to refocus the savings bond program on its original purpose of making these non-marketable Treasury securities available to individuals with relatively small sums to invest.”

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The Federal Reserve’s two-day FOMC confab begins tomorrow and the futures market’s expecting a 25-basis-point cut in Fed funds to 2.0% when the meeting concludes on Wednesday. After witnessing a string of cuts since last September, at a time when inflationary winds have been blowing harder, the chatter now is about whether this is the last reduction for this cycle.
Leaning toward the view that this will be the end of the cutting is Peter Berezin, Goldman Sachs’ global economist. “We expect this to be the last cut, but the Fed will be flexible in responding to economic conditions,” Berezin tells AFP. “Obviously if the turmoil resurfaces, they will be apt to cut rates again. But barring that, they would like to stabilize rates.”
Meanwhile, senior financial analyst at Bankrate.com Greg McBride tells AP: “We are entering the stage where it is time for the Fed to wind down and move to the sidelines. A quarter-point reduction is a nice segue to that transition. Short-term interest rates could stay low longer than many currently expect.”
Judging by long-dated futures contracts, Mr. Market’s calling for another 25-basis-point cut on Wednesday. The Dec ’08 contract, for instance, currently prices Fed funds at roughly 2.0%. If the Fed cuts by a quarter point, 2.0% Fed funds at the end of the year would represent the longest stretch of interest rate stability for this series since Bernanke and company kept rates at 5.25% for the 15 months through September 2007.
But let’s not get ahead of ourselves. First, let’s see what the monetary czars will do (and say) this week. While we’re waiting, let’s observe once more that cutting interest rates at this juncture may be politically intelligent; it may even look shrewd as the ongoing economic slowdown/recession gathers momentum. But it’s also risky with inflationary winds blowing. We’ll know if cutting is savvy or something else in a year or so. Meanwhile, it’s every investor for herself, forcing everyone into their own speculative craft to weather the macroeconomic seas as they come. With that in mind, let’s take a dip and consider one blogger’s view of the universe.

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Today’s update on durable goods orders reinforces the notion that the economy is slowing if not contracting. But then there’s the initial jobless claims news, which reports somewhat better numbers of late. So, what’s the deal?
In search of an answer, let’s start with the raw numbers. Durable goods orders slipped last month by 0.3%–the third month in a row of declines. Looking at the annual pace of durable goods orders shows weakness as well, as our chart below illustrates. Clearly, the trend is down, as it has been for some time on a rolling 12-month basis. Notably, red ink has been showing up with increasing frequency in the annual trend.
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What, then, should we make of new filings for unemployment claims? The Bureau of Labor Statistics reports that since new claims hit a recent peak of 406,000 for the week through March 29, 2008, filings have dropped to 342,000 through last week, as our second chart shows.
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It’s tempting to see the drop in new filings as a sign that the economic ills are now behind us. Nonetheless, we’re skeptical. One reason is that corporate America has been running its payrolls rather lean in recent years compared to previous expansions. Between outsourcing, technology and heavy pressure to run a tight ship, businesses don’t go overboard in swelling its ranks, at least not relative to what passed for average in decades past. As a result, this data series may not surge as much on an absolute basis this time around compared with past cycles.
Meanwhile, weekly jobless claims are a “noisy” bunch, suffering lots of volatility in the short run. Ultimately, the broader trend is the only reliable signal and by that standard it’s clear that jobless filings have been turning up on a relative basis since last fall. Until and if there’s fundamental reasons to think otherwise we continue to expect more of the same.
Based on other economic variables we track, it still looks like the economy’s suffering. Today’s update on new home sales, for instance, reveals the lowest level in 16 years. But recession isn’t our biggest worry, at least not yet. Rather, it’s the outlook for the rebound that makes us anxious. Everyone knows that recessions are painful. Fortunately, salvation comes, eventually. But for a number of reasons that we’ll detail in future posts, the upcycle may not be quite so strong this time. But let’s not get ahead of ourselves. By our reckoning, we’re still grappling with a downturn and on that score there’s still plenty of mystery left, starting with: how long, how deep?

Has the maximum point of stress in the capital markets passed?
There’s no one measure for answering the question. In fact, there’s no convincing answer short of letting time pass. But for those looking for a bit of perspective in real time, among the worthy gauges to watch in search of clues is the spread in junk bond yields over the 10-year Treasury yield. By that standard, a minor milestone recently passed considering that this spread touched a recent peak of 7.93% last month (based on closing yields on March 17, 2008), as our chart below shows. The question: Will the peak will hold?
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Only time will tell, of course. Meantime, what lessons does recent history offer? For starters, an investor who bought junk bonds as an asset class at the peak, i.e., at the close on March 17 is now sitting on a 4.5% return, based on the price change of iShares iBoxx High Yield ETF (HYG) from that date through last night’s close. So far, that’s middling compared with other asset classes. The S&P 500, for instance, has jumped 7.5% over the same period–as per the Spider ETF (SPY)–while U.S. bonds generally have slipped by around 80 basis points over those weeks, as measured by iShares Lehman Aggregate Bond ETF.
Buying when risk premiums are high, or selling when they’re low, is eminently reasonable and in the long run it may be the closest thing to a free lunch for strategic-minded investors. Accordingly, one might wonder if the 793-basis-point risk spread embedded in junk bonds last month was a buy signal for the long haul.
Perhaps. Looking at spreads going back to 1999, as we did last November, reminds that a near-800-basis-point risk premium looks pretty good based on the knowledge that the spread’s high point over the past 9 years is only modestly higher, at roughly 1,000 basis points, reached for a time in 2002.

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Veteran investors–otherwise known as anyone who’s gotten burned at least once in the capital markets–are rightly skeptical when someone comes along and says they’ve got the money game figured out. Someone says that, or its equivalent, about once every three seconds these days.
The reasons for staying skeptical are no less legion. Suffice to say, the proof is in the pudding and so it’s no accident that there’s a huge spread between the number of people who claim to have the secret investing sauce and those who can point to some real-world evidence. With that in mind, you may want to take the following with a grain of salt as well. Your editor too is a card-carrying member of the mere mortals club.
We say that because even a judicious, enlightened approach to investment strategy (which, we humbly believe, is a label that applies to our approach to portfolio design) is laden with risks, both known and unknown. It’s the latter that potentially pose the biggest dangers.
As an example, first consider a known risk, such as shunning diversification. Whether it’s a particular asset class or a broad asset-allocation strategy, everyone knows (or should know) that concentration risk is easily avoided and so anyone who suffers at the hands of this particular demon probably hasn’t been paying attention to the last 50 years of financial research. That’s not to say that one should never, under any circumstances, move away from complete diversification. But at the very least, know what you’re getting into before jumping off the cliff.
Meanwhile, it’s the unknown risks that keep us awake at night. By definition, this class of hazards is mysterious, of course, although we have some clues about how they materialize. Exhibit A is the evolving nature of markets, including the relationships between asset classes. It’s all too easy to look back on history and draw tidy conclusions about how the capital and commodity markets interact with one another. But finance is not physics, and so yesterday’s iron laws can and do turn into something less, something more or something entirely unfamiliar by yesterday’s standards.
Two quick examples: 1) the relationship between the 10-year Treasury yield and commodities; and 2) the extraordinary jump in spreads between the overnight inter-bank lending rate and the Libor rate.

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It’s called the Great Moderation, and it’s roughly 20 years old, give or take. The burning question: will it get any older.
The moderation is a reference to the fall in macroeconomic risk in the U.S. since the mid-1980s. GDP volatility has fallen dramatically since the roller coaster ride of the 1970s and early 1980s. The primary catalyst: shorter, shallower recessions that occur less frequently. In short, economic nirvana. But what’s behind the fading of recession risk?
Among the various theories for why the angels of moderation have graced the U.S. economy: the Federal Reserve has learned a thing or two over the decades in how to dispense monetary policy that’s not too hot, not too cold. The rise of the services economy, which tends to be less cyclical, is a factor too.
But is the Great Moderation now living on borrowed time? It’s a timely question for a number of reasons, starting with the fact that the U.S. economy is probably already in a recession, as we’ve discussed. Will this one be short and shallow too?

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For five months running, the annual pace of consumer price inflation has been running at 4%-plus, the Bureau of Labor Statistics reports in today’s CPI update. That hasn’t happened since 1991. (As of last month, CPI is up 4.0% for the past 12 months.)
Core CPI inflation (which excludes food and energy) has been running at the 2%-plus level on an annual basis consistently since September 2004! (The latest numbers show that core CPI rose by 2.4% for the 12 months through last month.) The Fed is widely said to be concerned whenever core inflation is running above 2% with any consistency.
It would seem that inflation generally has jumped a few notches to a higher plateau. The idea that inflation will soon return to lower levels now looks increasingly unlikely. To be fair, headline inflation at 4% and core inflation in the mid-2% range is hardly the apocalypse. We’re still a long way from the inflationary troubles of the 1970s.
But make no mistake: inflation has moved higher to a level that looks likely to endure short of a more hawkish monetary policy. That’s not to say that the Fed’s going to start hiking rates anytime soon, although we’re inclined to think that the days of cutting are just about over. Even so, leaving Fed funds at 2.25% while headline inflation’s at 4%-plus looks like a state of affairs that’s asking for trouble.
It’s important to recognize that history reminds that higher inflation tends to come gradually, almost imperceptibly over time. No one puts out a press release warning that the new inflationary era began last Tuesday at 3:45pm. Rather, the process of transitioning from contained inflation to something less contained unfolds slowly, in fits and starts. Only with hindsight is it obvious that pricing pressures have increased by more than a little.
In 2008, the crowd’s hoping that the cooling economy will take the wind out of inflation’s sails. That’s possible, although so far the idea of waiting for macroeconomic salvation for managing pricing pressures has a discouraging track record. Perhaps that’s about to change, or not. But given the data so far, one could argue that waiting and hoping seems like an increasingly dangerous strategy when it comes to monetary policy these days. But for the moment, that’s the plan and the Fed is sticking to it. But for how long?

No one will find encouragement in today’s update on wholesale prices, which posted a troubling 1.1% rise last month. So far, however, the Fed funds futures market is still inclined to see another rate cut when the FOMC meets again on April 29 and 30.
Perhaps, although the time has passed for swashbuckling 75-basis-point slashes in the Fed funds. The hour is late when it comes to nipping pricing momentum in the bud. Today’s producer price report is just one more clue that it’s time for the central bank to pay more attention to pricing pressures bubbling. This idea is all the more compelling when you consider that while the Fed can’t do much more at this point to juice the economy via broad changes in interest rates, but it can still act as the defender of last resort when it comes to inflation.

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At long last a bit of good news: retail sales rose last month by 0.2%, reversing February’s stumble and bringing hope to the dwindling number of optimists who think economic growth will remain intact. But while Wall Street may be inclined to jump on the news as a reason to buy, the bigger trend in retail sales can’t be denied.
Indeed, as our chart below reminds, the cycle in consumer spending is still clear, which is to say: down. Over the past year through March 2008, advance estimates of U.S. retail and food services sales rose 2.3%, or near the lowest annual pace since the previous down cycle of 2001-2003.

What’s more, other than the positive sign that precedes the number, last month’s rise in retail sales isn’t all that impressive as increases in this data series go. In fact, March’s gain of 0.2% (0.15% if you carry it out to two decimal points) could hardly be more frugal relative to past monthly reports of recent vintage, as our second chart below shows.

So, yes, monthly data is filled with statistical noise, tempting false impressions for those looking for broader trends. As such, no one should be surprised to see a month or two of relatively large gains in the near future. But that by itself doesn’t change the fact that the economy’s slowing and probably is set to contract for at least a time this year. No, it’s not the end of the world, nor is the contraction doomed to run on for anything longer than what passes for a normal stretch. Of course, no one really knows and so the guessing game rolls on.

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