July 30, 2008

July Economic Update

The selloff in stocks continued into July as concerns over energy prices and the stability of our financial system persist.  Stocks have recovered some of their losses over the past week but are still down over the past month.  Bond yields pulled back a little during the month but have recovered to about the same levels as a month ago.  Short-term rates remain steady as the Fed will likely remain on hold for a while.

The two primary issues affecting economic growth and the markets continue to be the high cost of energy and the health of the financial system.  Both of these areas of concern have improved slightly over the past week or so but further progress is required.  Oil prices have declined over the past week as signs of slowing demand growth and a trend toward facilitating a supply response begin to emerge.  Demand in the developed world is declining as high fuel prices have led to a more efficient use of gas.  Removal of government fuel subsidies in developing economies should create a similar response.  Sentiment favoring increased exploration and drilling in the US is also gaining momentum especially along the outer continental shelf.

Financial companies are still suffering the ill effects of loan defaults and declining house prices.  This problem has grown much larger than almost anyone predicted.  It has even spilled over to affect Fannie Mae and Freddie Mac, the two major Government Sponsored Enterprises that back a huge percentage of home loans.  Unprecedented steps have been taken by the Federal Government to undergird the financial system.  While some of these steps were controversial, they do appear to be restoring confidence in financial companies.  The underlying problem of declining home prices has yet to be resolved, however.

The debate over the direction of inflation rages on.  The very visible but volatile food and energy prices as well as basic materials remain high (but have come under pressure recently).  Consumer goods like clothing, electronics, appliances, automobiles etc. have been stable or declining.  Global growth is having a significant impact on both the rising and declining prices.  While long-term demand for energy and commodities will continue to grow, the trend toward increased free-trade and market-based economies will likely keep inflation from spiraling out of control.

Corporate profits are confirming that the US consumer is slowing down while exports continue to grow at a steady pace.  Financial companies continue to take large losses due to asset write-downs but many are doing better than expected.  Consumer goods companies are still struggling but many exporters are doing well.  While there continue to be many challenges to work through, some bright spots are beginning to emerge.  Lower energy prices and strengthening financial and housing sectors could spark a sustainable rally.

Justin S. Anderson

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