Insight Line—January 22, 2007

By historical standards, the magnitude of the current decline in total new home sales appears consistent with a maturing business cycle. Yet, some pundits and economists refer to the current deceleration in economic growth as a mid-cycle slowdown. In fact, the vast majority of today’s economic forecasters—the Federal Reserve included—suggest little if any concern about the higher-than-average duration of the current cycle. At 61 months, the present cycle is now longer than the average post WWII cycle of 57 months as defined by the National Bureau of Economic Research. This, of course, begs the question, how does a mid-cycle slowdown occur at the point where, on average, previous U.S. business cycles have ended?

Perhaps Willie Sutton has an answer.

For those of you unfamiliar with “Slick Willie,” his colorful history as one of America’s most infamous bank robbers began back in the 1930s. His illustrious career spanned the next two decades as he eluded law enforcement and the FBI prior to his incarceration. Though revered for his ingenuity in executing robberies, he had insights that went far beyond grand theft, in my opinion. You see, I suggest his most famous quip demonstrates a keen understanding of the foundations of modern banking that speaks directly to our question on the length of the business cycle.

When asked why he robbed banks, Sutton purportedly quipped, “Because that’s where the money is.”

Despite his tongue-in-cheek tone, I offer that Mr. Sutton understood that a fragmented banking industry, while large in size, was small in reality. Simply put, banking in the United States was entirely dependent—as was Willie—on the largesse of the local banker. To be sure, that is where the money was, but that is also where the risk resided. Any misstep and the local economy suffered. Repeat the scenario enough times, like, say, in the 1930s, and you have a full-blown banking crisis on your hands.

Since then, change did not come easily, but come it did. Over the course of the last five decades, legislators, both federal and state, moved to modernize banking laws so that bankers were able to grow beyond state lines, enter new lines of business and, most importantly, securitize lending risk with the help of Wall Street’s investment banks.

The result is that now, more than ever, banks are where the money is but also, I believe, no longer subject to the same risks as their predecessors. In a sense, big is better. (But, not too big. Under current laws no one bank can harbor more than 10 percent of the nation’s total bank deposits.)

And, researchers at the Federal Reserve Bank of San Francisco seem to agree. Writing in the bank’s Economic Letter¹, Philip E. Strahan, aptly details how changes to the national and state banking laws enabled bigger and more efficient banks to access a larger deposit base and in doing so better insulate the bank from local risk factors (even robbers!). Simply put, local banks no longer need shoulder local risk in isolation. In turn, this enables banks to better manage risk exposure thereby freeing them up from an overdependence upon any one industry—say, housing or even auto production.

The implication for investors should not be overlooked.

In years past, rising short-term interest rates took a disproportionate toll on local economies that were tied to local banks. When the Federal Reserve undertook to raise rates, the burden fell first to the banks, then to the clients, and then back to the banks. It does not take much in the way of connective logic to conclude that a fragile banking system was more than likely an important catalyst in defining the average business cycle. I believe it is beyond coincidental that as the banking laws changed so, too, did the longevity of the nation’s business cycle. The last two, November 1982 to July 1990 and March 1991 to March 2001, spanned 92 and 120 months, respectively, versus the 38 month average since 1854. Needless to say, something is different this time.

If indeed the nation’s business cycles are lengthening in part due to a stronger banking system, and of course there is no sure way of knowing, describing the current economic slowdown as a mid-cycle correction is a reasonable statement. Then again, such a statement by its very meaning implies to me that at least half of the business cycle has yet to occur.

The fall off in the nation’s housing activity is noteworthy, if, as I mentioned earlier, for nothing else but its magnitude. Then again, in much the same way that record oil prices failed to have the same impact on economic activity as in years past, that bank robber turned economist—with a little help from the researchers at the Federal Reserve—may have unknowingly identified why a similarly stunning event—years in the future—did little to meaningfully alter the course of the current business cycle.

¹ “Banking Diversification, Economic Diversification?” Philip E. Strahan, Federal Reserve Bank of San Francisco, Economic Letter, May 12, 2006, Number 2006-10.

Factors Driving the Economy

Economic Acceleration

Economic Deceleration

Latest Available Information
(as of 1/19/07)

Employment
^{(Source: Bureau of Labor Statistics)}

Up

Down

Employment gains in December 2006, perhaps due to unseasonably warm weather, were surprisingly stronger than consensus estimate. Continuing the string of record levels, both measures of employment, household and payroll, moved markedly higher. Total employment as measured by the household survey clocked in at 145.9 million as the payroll data recorded 136.2 million workers. The nation’s unemployment rate remained at 4.5 percent.
Overall, the employment tables suggest to me that economic growth, though slowing, remains sufficient to absorb growth in the overall labor force.
(Readers should note that the employment data is scheduled for substantial benchmark revisions concurrent to the February 2, 2007 release.)
Please circle Up on the table.

Personal Income
^{(Source: Bureau of Economic Analysis)}

Up

Down

Personal Income increased 0.3 percent in November 2006. The wage and salary component of personal income, reflecting continued increases in payroll and household employment, as referenced above, registered $6.1 trillion. As I see it, consumers’ cash flow remains sufficiently large to handle rising interest and energy costs.
Please circle Up on the table.

Retail Sales
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

Advance Retail Sales in December 2006, recorded a stronger than forecast 0.9 percent increase. Total sales for the month rose to a seasonally adjusted $370 billion. In spite of this, showing the underlying trends on a year-over-year basis confirms my earlier position that a reasonable argument exists for forecasting a slowing in personal consumption expenditures into the first quarter of 2007. Thus, the appropriate action on the table is to maintain the circle in the deceleration column.
Please circle Down on the table.

Durable Goods
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

According to the most recently available data, the nation’s manufacturing remained sluggish outside the transportation sector in November 2006. As such, manufacturing and production’s contribution to the nation’s fourth quarter gross domestic product (GDP) calculation do not appear robust enough to meaningfully contribute to overall growth. Nevertheless, I am choosing to keep the suggested action in the acceleration column as order backlogs remain meaningful.
Please circle Up on the table.

Inflation
^{(Source: Bureau of Labor Statistics)}

Low

High

Annualized inflationary pressures, using the Federal Reserve’s preferred measure of inflation, the Personal Consumption Expenditure excluding energy and food (PCE), retreated slightly to 2.2 percent in the November 2006 data. This year-over-year measure remains above the Federal Reserve’s stated acceptable levels. As such, recent Federal Reserve Open Market Committee (FOMC) members’ public comments, irrespective of the current policy pause, suggest continued concern over inflationary pressures remains amongst board members.
Please note, though inflation, as measured in a historical context, remains low, the suggested course of action on the table is to circle high, reflecting the publicly stated concerns of the FOMC.

Government Spending
^{(Source: Congressional Budget Office, U.S. Treasury)}

$In

$Out

The fiscal 2007 budget numbers continue to defy some dire forecasts. As of December 2006, due to surging receipts and less than planned expenditures, the fiscal situation of the U.S. Treasury reveals a positive year-over-year swing of $40 billion. That said, the longevity of this pattern will not reveal its true nature until after the April personal income tax date.
Please circle $In on the table.

Monetary Policy
^{(Source: Board of Governors, the Federal Reserve System)}

$In

$Out

The Federal Reserve Board Federal Open Market Committee’s target for the federal funds rate remains unchanged since June 29, 2006 at 5.25 percent. Public comments from members of the FOMC leave little doubt of lingering concerns over the expected course of future inflation. That said, concerns over the shifting course of the economy could very well induce the FOMC to reduce rates at the March meeting. For now:
Please circle $Out on the table.

Yield Curve
^{(Source: Bloomberg, LP)}

Positive

Negative

The difference between the three-month Treasury bill yield and the 10-year Treasury note yield was -24 basis points on January 19, 2007.
Though the shape of the curve remains inverted, it has yet to approach the point where historical analysis suggests heightened concern over the future course of economic activity.
Please circle Negative on the table.

Gross Domestic Product
^{(Source: Bureau of Economic Analysis)}

Above

Below

The final calculation of the third quarter 2006 GDP places the annualized growth rate at 2.0 percent. Available data suggests the rate of annualized growth in the final quarter shifted somewhat higher. Nevertheless, my expectation for below trend economic growth into early 2007 remains, I believe, appropriate.
Please circle Below.