Waiting for a warmer spring

Economic data published in the past weeks came in generally weaker than expected in both the USA and the Euro Zone, increasing uncertainties on the sustainability of the current economic recovery and revitalizing downward pressures on major international equity markets.

In the USA, the Conference Board’s Consumer Confidence Index disappointed investors, as it fell more than 10 points to 46, its lowest readings since April 2009. Economists forecasted that confidence would dip to 55 from a previously reported 55.9 for January (revised to 56.5). The rise in initial jobless claims related to bad weather conditions and eroding opinions on Washington are likely to be the main reasons behind the huge decline in consumer confidence – at least according to the Conference Board’s readings. The decline in the Consumer Confidence Index implies caution on the consumer spending outlook, despite the fact that academic studies published in the past years have yet to come to a clear conclusion on the link between consumer confidence and consumer spending.

The real estate sector is seeing negative indicators coming from new home sales figures, which fell by 11% in January to its lowest level on record, signaling that the extended Government tax credit may be insufficient to rekindle demand in the short term. Investors were also disappointed by the decline in durable goods orders, ex-transportation (-0.6% m/m versus market expectations of 1% m/m) and by the rise in initial jobless claims (+22k to 496k).

In the Euro zone, the IFO Business Climate Index fell in February for the first time since April ‘09 – from 95.8 to 95.2 – versus market expectations of an increase to 96. The index indicated that the German economy, having stalled in Q4 ‘09, may grow at a very subdued pace in early 2010.

Adverse weather conditions are generally considered to be the main reasons behind the negative surprises in the last few weeks. Indeed, the first two months of 2010 have seen temperatures well below seasonal average, and widespread snowstorms in both the USA and the Euro Zone have accompanied slackened economic activity.

Thus we expect fairly weak economic data to be published in the next few weeks with regard to January and especially February.

The first test of strength for our expectations will be the ISM Manufacturing Index and employment data for February in the USA – due to be released on Monday 1 and Friday 5 respectively. No major data on Euro Zone economic activity are set for publication next week. We expect the ISM Manufacturing Index to remain unchanged vis-à-vis January owing to the positive outlook for exports, but we see the labor market further weakening: non-farm payrolls are likely to decline by 30k in February compared to the 20k decline in January.

With data on economic activity in January and February lower than expected, US and Euro Zone economic growth in Q1 ‘10 is likely to be weaker than previously forecasted by economists. The US economy is unlikely to repeat its 5.7% q/q ann. of Q4, while economic growth in the Euro Zone may also prove as anemic as in Q4 ‘09 (+0.1% q/q).

Consequently, corporate earnings in Q1 ‘10 are likely to be lower than projected by analysts. These underperforming earnings are likely to exert further downward pressure on equity markets and bond yields in the short term.

However, should the slowing down in early 2010 turn out to be merely temporary, we may expect economic activity to rebound in the next few months. In fact, Fed economist Martha Starr-McCluer emphasized this in the working paper “The Effects of Weather on Retail Sales”. While monthly data show considerable evidence of weather-related dips, the quarterly data nevertheless attest to fewer effects, and the explanatory power associated with the weather variable is generally quite modest. In this case, a rebound of equity markets and bond yields is a clear possibility.

Nonetheless, the absence of a spring economic rebound would be a clear signal that economic activity in all 2010 will be very disappointing. This scenario would drag down equity markets and bond yields even further, and the Fed would thus maintain Fed Fund Rates unchanged for an extended period.