Wells Fargo Senior Economist

Economic Overview

(1) 9/11, The economic impact: US Economy was already weak prior to the attack. Pre 9/11 consensus: "U shaped" recession followed by extended drawn out recovery. Post 9/11 consensus: "Clearly this shock will push us into an outright recession. We think it will be "V shaped", fairly moderate by historic standards, but clearly a good deal deeper than what we had anticipated earlier. Our feeling is, for the purposes of my forecast, I (see) the recession being fairly moderate… But it will extend through the end of this year and into the first quarter of next year before the economy begins to slow but steady recovery". (2) Immediate disruption: Air transportation shut down for several days, deliveries were disrupted and consumers stayed home watching T.V. (3) Unemployment: Latest survey indicated biggest drop since Feb 1991 recession, this report didn't reflect full impact of 9/11, October decline will be larger; (4) Survey of 60 Industries: International Strategy and Investment conducts survey with 0-100 barometer regarding revenue expectations, considered a "real time business mood" indicator. There was a sharp decline after 9/11 with a slight uptick in the week of 10/5, but still 12% below early September. Major contributor to the uptick: auto sales showed a steady improvement week by week. (6) Previous crises: Looking at 10 crises over 40 years (JFK assassination, Pearl Harbor, OC bond default, etc.). Usually an immediate big drop in markets (shock effect), market begins to come back and then fundamentals take over. "Our sense is that going forward the market will be driven by fundamentals; the economic backdrop, the earnings outlook…that assumes that we have no further terrorist attacks, and that is a big if." (7) Technology: Contributing to underlying weakness in the economy. The 90's saw lots of spending on internet and Y2K preparations. Now we are seeing the downside, overhang of inventories. More innovations to come, technology will be strong again "but getting from here to there will be difficult...we think technology will be a significant drag on the economy well into next year. So it will be at least the middle of next year into the third quarter (until tech recover)"; (8) Consumer sentiment: Consumer spending accounts for 2/3 of our economy. It has dropped more dramatically than it did during Persian Gulf War and accompanying recession in 90-91. Back then sentiment rebounded nicely as the U.S. started the war, but then we had a clearly defined enemy and near certainty of victory. Today, big layoffs and job security deterioration will have a negative effect. (9) Banking system: In much better shape than early 90's. Banks are prepared to step up lending as uncertainties begin to subside and conditions begin to improve. (10) Other mitigating factors: Inflation is much lower than previous downturns, therefore the Fed can ease more aggressively and real wage growth/purchasing power is rising. (11) Interest rates/Housing: Low rates have led to a boom in refi activity, both commercial and residential. Housing has held up well as opposed to previous down cycles. "Affordability index" remains high for the average consumer, job security woes may have an impact. (12) Cushion: Federal budget surplus, low interest rates combined with lower oil costs are providing a "cushion". (13) More on oil prices: Dramatic drop in air travel and increased production by non-OPEC countries (Norway, Russia, Mexico, etc.) easing price pressure. (14) More on terrorism: "Its throwing sand into the gears of our economy". Raising the cost of security and the cost of inventories, slowing import/export dynamics due to increased inspections, etc., raising insurance costs. (15) More on Insurance: Industry is requesting that the US government becomes the insurer of last resort in cases of terrorism. If not, the flow of equity may dry up, having an adverse effect on the efficiency of that market. (16) Stocks: "Investors staying in the market are rotating toward the more "defensive" sectors, healthcare, communication services, a whole array of consumer staples. The problem now is that, that sector which was relatively cheap a while ago, is becoming increasingly expensive and there is some talk about a possible rotation back into cyclical, but probably not until investors get a better sense of where the markets going."

Interest Rates

(1) Yield curve: Was inverted in December 2000, disinverted during Spring 2001 and now is steepening. Why? Fed cuts affect short term rates more than long rates. Long rates are affected by the outlook for growth and inflation. (2) Predictions: "Going forward we think that short rates will continue to decline. We're looking for the Federal Reserve to ease monetary policy a couple of more times, two more occasions before rates bottom out. We think the bottom will be about 2 percent (on the Fed Funds rate), although it could be less than that depending on the extent of the slowdown in the economy. We think that long rates will drop as well, they'll come down as well because of the uncertainty over the economic outlook. However, we still think that long term rates will lag the decline in shorter rates resulting in an even steeper yield curve than what we're seeing now. That's good news to people who are taking out auto loans, variable rate mortgages, anything geared toward money market or shorter term rates. It's also good news for banks. Banks love declining rates because that steeper yield curve opens up that spread between their shorter funding costs and their longer lending costs." (3) Steepening yield curves: Long rates won't decline as quickly as short rates due to budget surplus diminishing, the supply of treasuries will go up and buyers are already anticipating a said increase. Also, some investors are rotating into agency debt (Fannie and Freddie) as corporates also suffer. The recent uptick in yield of the 10 year T is due to an unexpected $6 billion sale of new 10 year notes recently by the government. Look for the 10 year T to possibly drop 25-50 bps before the end of the year. (David R. Pascale, Jr.)

CMBS Update-Looking for a Benchmark: As of today, no standard fixed rate pool has been securitized since 9/11. The good news: Liquidity is returning as activity in secondary market increases and spreads have not widened for the second week in a row. The bid-ask gap has also narrowed to pre-9/11 levels. What's next? The first fixed rate pool to price will be a non-conforming pool of seasoned insurance company loans (average term: 7 years). Of course, this will not be considered a benchmark. Next up are 4 standard pools, which will be very closely watched totaling app $4.4 billion. One of the pools is a "TOP" pool, boasting excellent subordination levels from lenders specializing in low leverage transactions. All are scheduled to go to market by October 31st …Stay tuned…