COMMERCE BANK ECONOMIC REVIEW - March 2007

“Newton was right: What goes up, must come down.”

By Joel L. Naroff, Ph.D.

Gravity and reality hit the markets over the past month and it made for a very wild ride.  There were problems in China, meltdowns at sub-prime lending companies and strange economic data. Basically, we were reminded that the economists’ favorite phrase, “conditions change”, must be kept in the back of our minds at all times. 

Everyone remember dot.coms? I bet you do, but have you really learned the lessons of the late 1990s? A lot of investors and media talking heads have not. From July 2006 to early March 2007 – a period of just seven months – the Dow index rose about 20%. Really now, was it reasonable to expect continued strong gains on top of this huge increase? Wasn’t a correction in the making? 

Well, welcome to the real world. Rarely does anything go up all the time without coming back down, at least for a while. This time, the trigger was a meltdown in the Chinese stock market. That the rest of the world reacted so sharply is a lesson we need to heed.  Investors look across the world: a change in one place impacts thinking and capital movements everywhere. Worries about the Chinese economy reminded everyone that it is economic fundamentals that determine stock prices. And when uncertainty hits, volatility usually is not far behind.

So if it’s the economy, what shape are we in? Neither “too hot nor too cold”, but maybe not “just right” either. Two extremely weak sectors continue to restrain growth. The worst is still the housing market. January housing starts were nearly 30% below the level posted the previous year. New home sales have plummeted, existing home sales are weak and prices are falling. 

Worse, sub-prime lenders are beginning to fail. These are the financial firms that specialized in those imaginative mortgages that let people who could not afford homes buy them. Guess what? They really couldn’t afford those homes. Defaults are rising and as a result, credit has been reduced. It is still available for good borrowers, but less risky lending practices mean less home demand going forward. 

The other weak spot is the domestic vehicle makers. Sales remain soft and firms are struggling to get back to profitability. They are cutting back production, closing plants and laying-off workers. This industry likely will continue to move backward for quite some time as manufacturers work through their problems and suppliers feel their pain as well.

So, is there any reason to be optimistic? Consumers continue to spend money, even if their savings rate remains negative. That is a worry as households are likely to slow their borrowing. However, okay job gains coupled with the fastest wage gains this decade, are adding to incomes and that is creating the basis for future consumption. The low 4.5% unemployment rate should keep the pressure on wages.

As for interest rates, uncertainty reigns. We discovered that fourth quarter growth was not the strong 3.5% initially estimated, but a more tepid 2.2%. That makes three consecutive quarters of sub-par growth. Nevertheless, the Fed continues to worry about inflation. With labor and energy costs jumping, the members have every good reason to have concerns. As long as inflation remains too high for the monetary authorities, don’t expect any rate cut. 

Joel L. Naroff, Ph.D., is Chief Economist for Commerce Bank. Commerce Bank, America’s Most Convenient Bank, is a leading financial services retailer with more than 430 convenient stores in New Jersey, New York, Connecticut, Pennsylvania, Delaware, Washington, DC, Maryland, Virginia and Southeast Florida. Commerce Bancorp (NYSE: CBH) is headquartered in Cherry Hill, NJ and has more than $45 billion in assets. For more information about Commerce, please visit the company’s interactive financial resource center at commerceonline.com.