Recession fears linger

Contrary economic trends were reported last week as analysts looked for signals that a recession was, or was not, brewing. On the one hand, a gauge of service-sector business conditions dropped so severely that it astounded analysts (since consumer spending on services is the largest component of gross domestic product) and was blamed for a stock market plunge when the report was released on Tuesday (the S&P 500 Index fell 3.2%). On the other hand, productivity growth was stronger than expected, unit labor costs were lower than projected, and factory orders continued to accelerate. For the week, the S&P 500 Index fell 4.6% to 1,331 (for a year-to-date total return of
–9.2%), and the yield of the 10-year U.S. Treasury note rose by 5 basis points to 3.65%.

Service sector slumping sharply

A survey by the Institute for Supply Management (ISM) found that a severe contraction in service-sector business conditions took place in January. The unexpected severity of the decline in the ISM's index of nonmanufacturing business activity startled analysts and stoked recessionary fears. An index reading below 50.0 indicates contraction, and, while analysts expected the index to decline from 54.4 in December to 52.5 in January, the index actually fell to 41.9. ISM said this was the first contraction in nonmanufacturing business activity since March 2003 and the lowest index reading since October 2001.

Productivity grew strongly despite a slowing economy

Better-than-expected changes in nonfarm business productivity and unit labor costs, both considered indicators of future inflationary trends, were reported for the fourth quarter of 2007. Following a weak increase in gross domestic product reported last week, analysts expected productivity growth to also slow. It did, but by a far lesser amount than expected (to an annualized 1.8% compared with 6.0% in the previous quarter). Unit labor costs also rose more slowly than expected, by 2.1%, after two consecutive quarterly declines. Rising productivity dampens inflationary pressures, including rising labor costs.

Factory orders rose for the fourth straight month

New orders for manufactured goods rose by 2.3% in December, continuing an acceleration that began four months earlier. Factory orders have increased in six of the past seven months. (They declined by 3.5% in August.) Looking at the mix of December orders, durable goods rose strongly while orders for nondurable goods declined.

The economic week ahead

Analysts will search for further clues in the variety of reports scheduled to be released next week to see if a recession is in the offing. Retail sales and business inventories will be reported on Wednesday, international trade on Thursday, and industrial production on Friday.