Stocks, hit by subprime turmoil, not getting relief on inflation front

Last week, stock prices plunged on Tuesday when fears over problems in the United States subprime mortgage industry led to worries for the rest of the economy. However, equity investors may have as much to fear from persistent inflation as from a weaker economy.

On 13 March, the Mortgage Bankers Association reported that in the fourth quarter of 2006, the delinquency rate for mortgage loans rose and the proportion of mortgages entering the foreclosure process rose to a record high. Subprime mortgages were especially hard hit, 13.33 percent of subprime loan payments being delinquent in the fourth quarter, the highest level since the third quarter of 2002 and up 77 basis points from the third quarter.

While subprime mortgage lenders like New Century Financial Corporation are understandably reeling from the difficulties in this particular segment of the industry and could face bankruptcy, some analysts fear that the turmoil could spread into a generalised credit crunch, with adverse effects on the overall economy.

As a result, the stock market fell sharply on 13 March, the Standard & Poor's 500 Index falling 2.0 percent. Investors fled to safer assets; the benchmark 10-year US Treasury note was up 17/32, with the yield at 4.495 percent.

The sentiment in markets was exacerbated by a report from the Commerce Department on the same day that retail sales excluding automobiles unexpectedly slipped 0.1 percent in February. Overall retail sales for the month also disappointed economists, rising just 0.1 percent.

Not that everybody would have been surprised by the weakness in retail sales though. Many had actually warned that the weak housing market over the past year or so would eventually lead to declining mortgage equity withdrawal and housing-related employment and thus negatively affect retail sales.

However, compared to the stock market turmoil about two weeks earlier (see "China sends investors scurrying out of risky assets"), this time the damage appears to be limited. After the plunge on 13 March, the stock market recovered some of its losses over the next two days before dipping again on Friday. The total loss for the S&P 500 in the four-day period from 13-16 March was 1.4 percent, much less than the 4.3-percent loss from 27 February to 2 March.

Apparently, that earlier loss had already shaken out many of the more nervous investors from the stock market.

Nevertheless, many investors remain uneasy, with some hoping for an interest rate cut from the Federal Reserve within the next few months to save markets. Is such a cut likely?

Ironically, probably not, for while markets reacted highly negatively to the weak mortgage and retail data last week, other data in the past week or so are indicating that inflation remains higher than what the Federal Reserve would be comfortable with while the economy may still be growing too fast for inflation to decelerate at anything better than a very gradual rate.

On 16 March, the Labor Department reported that the consumer price index rose 0.4 percent in February. Core prices, excluding food and energy, rose 0.2 percent. On a 12-month basis, the respective increases were 2.4 percent and 2.7 percent. In the absence of a full-blown recession, the Federal Reserve is not going to cut interest rates with such numbers.

There was also considerable inflation at the wholesale level. The day before, the Labor Department had reported that producer prices increased 1.3 percent in February, or 0.4 percent excluding food and energy.

Industrial production picked up steam in February. On 16 March, the Federal Reserve reported that industrial production rose 1.0 percent. While cold weather in February and a surge in utility output contributed to the sharp rise in total industrial output, manufacturing production in the month was also good, rising 0.4 percent.

Slack in production capacity has built up somewhat over the past few months, which should help moderate inflation. However the rate of increase has been very gradual. In fact, total industry capacity utilisation rose to 82.0 percent in February, the highest level since September and still close to its cycle peak of 82.4 percent. Manufacturing capacity utilisation, at 80.1 percent in February, was down from a peak of 81.1 percent attained in August last year but is still around the average level in the fourth quarter.

Similarly, the labour market remains tight. On 9 March, the Labor Department reported that nonfarm payrolls increased by 97,000. While that was low compared to previous months, recent history suggests that the number is likely to be revised higher later. Furthermore, average hourly earnings increased 0.4 percent and the unemployment rate fell to 4.5 percent from 4.6 percent. The unemployment rate has stayed stubbornly low between 4.4-4.6 percent for the past six months.

So while inflation may be contained, it does not exactly look like it is about to be subdued just yet. This means that the Federal Reserve is unlikely to cut interest rates for some time to come.

Investors looking for the stock market to recover had better hope that the subprime mortgage turmoil itself is contained.