Wachovia Corporation

U.S. Review
The Great Malaise
Next week will bring our first look at first quarter real GDP growth. Our latest read has the economy expanding at a 0.7 percent annual rate. While on the surface, such growth flies in the face of many of the recent business headlines, it is only modestly ahead of the consensus estimate of 0.4 percent. Two great unknowns in the GDP data are what happened to business inventories and net exports. We are assuming a modest $7 billion decline in inventories and look for a slight improvement in the nation's trade deficit to add roughly 0.4 percent to first quarter growth. Consumer spending is expected to eke out a slight gain, while business fixed investment is expected to decline. Home construction will likely post its biggest quarterly drop in more than 30 years. So, while we are expecting growth, the economic environment is challenging.

Looking forward, second quarter real GDP growth will be helped out a great deal by the economic stimulus checks, which will begin showing up in tax-payers bank accounts early next week. The rebates have been accelerated and all will be sent out during May.

Rebate Checks May Stave Off A Second Quarter Drop In GDP
Our current forecast has a 0.7 percent drop in real GDP growth during the second quarter. We had been expecting the rebate checks to be sent out over a two-month period, which would push the bulk of the impact of increased spending into the third quarter. The accelerated timetable for getting the stimulus checks to tax payers means that second quarter real GDP will likely come in stronger than we previously thought. Our first pass at the forecast has real GDP essentially unchanged for the period, which is the quarter that we see as greatest risk for seeing a decline.

Of course, if consumer spending is stronger than expected during the second quarter, then some of that increase will likely come out of current inventories. The credit crunch could add fuel to an inventory drawdown, as many retailers have seen their credit lines cut and will need to sell off inventories in order to raise cash. A bigger drawdown in inventories could possibly overwhelm any additional strength in consumer spending, leaving us with a decline in real GDP for the quarter.

While we acknowledge the downside risks to inventories and the economy, it is also important to recognize the upside risk. Over 90 percent of consumers and nearly three-quarters of economists believe the economy is currently in recession. If consumers spend their rebate checks promptly, it is entirely possible we will not have a decline in real GDP in 2008.

We have noted these issues before in our weekly and monthly outlook and even raised the question of whether we can have a recession without a decline in real GDP. We believe we can, particularly if we have a generalized malaise across the economy that results in four or five consecutive quarters of near zero real GDP growth. Such an environment would produce a steady rise in the unemployment rate up to 6 percent or so.

As far as this week's economic indicators go, we had a real mixed bag. First-time claims for unemployment insurance fell a much larger-than-expected 33,000 and continuing claims also posted a convincing drop. Orders for durable goods fell 0.3 percent in March but rose a healthy 1.5 percent after excluding the volatile transportation sector. Data from the housing sector remain weak, particularly sales of new homes. The latest figures show new home sales plunging 8.5 percent in March, following a 5.3 percent drop the previous month. We believe these figures may mark the bottom for new home sales, as credit market concerns likely added to the generalized housing woes in February and March. We expect a slight improvement in sales this spring.

Real GDP • Wednesday
While we only see one decline in real GDP over the coming quarters this year, the economy will feel weaker than that. The weakness in imports combined with the recent strength in exports is producing a sharp turnaround in the trade deficit, which is expected to provide the bulk of real GDP growth during 2008. Business fixed investment and commercial construction are both expected to weaken over the course of the year. In addition, state and local government outlays have been scaled back, reflecting the growing strain from slower growth in property tax receipts.

We expect first quarter real GDP to come in slightly positive, rising at a 0.7 percent pace. We do see real GDP slipping into negative territory during the second quarter, but only modestly, falling at a 0.7 percent rate. The pace of economic growth should pick up in the second half of the year as federal tax rebate checks add to personal consumption growth.
Previous: 0.6%, Consensus: 0.2%, Wachovia: 0.7%

ISM Manufacturing Index• Thursday
Despite a slight rise from February, the Institute for Supply Management's Manufacturing Index signaled factory sector activity contracted again in March, registering at 48.6.

Another weak reading is expected in April. Regional purchasing managers' indices have been mixed as evidenced with the Empire State index rising 23 points while the Philly Fed index registered its fifth consecutive monthly contraction reading. This mixed picture suggests little change in the national headline index. The ISM's new orders index, which is a leading indicator for activity in the factory sector, registered its fourth consecutive month below the key 50 expansion/contraction line. While export growth has blossomed for manufacturers who sell their products outside the U.S., we suspect weak consumer spending, slow motor vehicle sales activity and the continued housing market contraction will pressure the headline index lower in April.
Previous: 48.6, Consensus: 48.0, Wachovia: 47.4

Employment Report • Friday
Nonfarm employment contracted during the first quarter with payrolls declining 80K in March with downward revisions of -76K in both February and January. The unemployment rate jumped to 5.1 percent from February's 4.8 percent reading.

The labor market remains weak as we enter the second quarter. The four-week moving average of initial jobless claims, a leading labor market indicator, remains elevated and is consistent with another monthly contraction. Interestingly, we haven't seen a sharp increase in this series that typically occurs in the early stage of a recession. The April weakness is expected to be broad based with losses in construction, manufacturing, and goods producing sectors more than offsetting gains in leisure & hospitality, government, and education & health. The unemployment rate should remain steady at 5.1 percent.
Previous: -80K, Consensus: -75K, Wachovia: -44K

Euro Surges to All-Time High
The euro surged to yet another all-time high this week, briefly trading above $1.60 on Tuesday before falling back at the end of the week (see chart at left). So what's behind the recent strength of the euro, and will the currency continue to appreciate?

Shifting expectations about the outlook for ECB monetary policy is the proximate cause of the euro's recent appreciation. Earlier this year most investors expected the ECB to cut rates by 50 or 75 basis points by the end of the year. However, the realization that economic activity in the Euro-zone is not completely falling apart along with the sharp increase in the CPI inflation rate (see top chart on page 4) have caused a rethink about the extent of ECB easing this year. Indeed, a member of the ECB Governing Council, the body charged with setting monetary policy, raised the possibility this week that the ECB may actually raise rates rather than reduce them. His comments helped to propel the dollars/euro exchange rate above $1.60.

However, by the end of the week the euro had fallen to a three-week low against the greenback due to weaker-than-expected economic data in the Euro-zone. The "flash" estimate of the manufacturing PMI for April suggested that activity in the industrial sector weakened more than most investors had expected.

The big blow to the euro, however, came with the release of the Ifo index of German business sentiment on Thursday. As shown in the middle chart, the Ifo index, which is highly correlated with growth in German industrial production, fell to a 2-year low in April. Although the index remains at a level that is consistent with continued growth in industrial production, the larger-than-expected drop in the index suggests that growth has weakened. Not only is the German economy the largest in the Euro-zone, but Germany led the "Big 3" (Germany, France, and Italy) in GDP growth last year. If growth in Germany is weakening, it seems reasonable that the outlook for the broader Euro-zone economy is darkening. The news took the wind out of the sails of those market participants looking for a near-term rate hike by the ECB. 4

The euro's decline against the greenback also reflects a bit of generalized dollar strength this week. As shown in the bottom chart, the dollar rallied versus the Japanese yen and most other major currencies as well. As discussed in the "Interest Rate Watch" on page 6, there has also been a bit of rethink regarding the outlook for Fed policy going forward. The recent rise in yields on U.S. Treasury securities, which improves the relative attractiveness of those securities to foreign investors, has generally given the greenback a boost.

The euro suffered one of its worst weeks vis-à-vis the dollar this year. Does this mean that the euro-dollar exchange rate will begin to trend lower? We think it would be premature at this point to look for sustained dollar appreciation against the euro. The U.S. economy is not out of the woods, and further Fed easing remains possible as long as U.S. growth remains sluggish. However, we believe that the greenback will begin to trend higher in the second half of the year as it becomes clear that the Fed's easing cycle has indeed come to an end.

Japanese Industrial Production • Wednesday
The usual end-of-the-month barrage of Japanese economic data will give investors an up-to-date look at the current state of the economy. Recent data suggest that the Japanese economy is slowing, so investors will be especially interested to see how industrial production fared in March. Data on retail spending, housing starts and the labor market are also scheduled for release next week. Data released this week showed that CPI inflation shot up to 1.2 percent in March, its highest rate in ten years.

The Bank of Japan also holds a policy meeting on Wednesday. With inflation rising, will the BoJ hike rates at the meeting? No. The core rate of inflation is much lower (0.1 percent), and slowing economic growth argues against a rate hike in the foreseeable future.
Previous: 1.6% (month-over-month), Consensus: -0.8%

Euro-zone CPI Inflation • Wednesday
CPI inflation in the Euro-zone has shot up significantly this year. Although most of the increase is due to the spike in energy and food prices, the core rate of inflation has edged up recently as well. Consequently, the inflation-phobic ECB has been very reluctant to cut rates. Indeed, a rethinking of ECB policy this year has contributed to the recent strength of the euro (see the main body of the text). A sustained decline in the inflation rate likely would lead to euro depreciation, because it would open up the door for eventual ECB easing.

The docket in Germany, the largest economy in the Euro-zone, is full with data releases as well. Data on retail sales and the labor market will give investors some insights into the current state of German economic activity.
Previous: 3.5% (year-over-year), Consensus: 3.4%

U.K. PMI's • Thursday
Economic growth in the United Kingdom has slowed recently. Indeed, the sequential rate of real GDP growth slowed from 0.6 percent (not annualized) in the fourth quarter to 0.4 percent in the first quarter. Next week will provide some insights into the state of the British economy in the second quarter.

The manufacturing PMI is hovering just above the demarcation line that separates expansion from contraction. Will it slip into negative territory in April? The behavior of the construction PMI indicates that activity in the construction sector is already contracting. Data on house prices, the money supply, consumer credit, and consumer confidence will also shape investor expectations about the outlook for the U.K. economy this year.
Previous Manufacturing: 51.3 Consensus: 50.8
Previous Construction: 47.2 Consensus: 47.0

Interest Rate Watch
Fed: 0 or 25?
The Fed holds a regularly scheduled policy meeting next week. Whereas a few weeks ago most investors expected that the FOMC would contemplate either a 25 bp or 50 bp rate cut, the consensus seems to have shifted to no more than a 25 bp cut. Indeed, a few market participants think the FOMC may keep policy unchanged next week.

An argument in favor of no further easing is the string of recent data, which suggests the economy is not completely falling apart. GDP data, which will be released on the day the FOMC meets, likely will show that growth was positive, albeit very weak, in the first quarter. In addition, CPI inflation, which remained at 4.0 percent in March, is well above the rate that every FOMC member deems consistent with price stability.

There are two principal arguments to cut the target for the fed funds rate by 25 bp. First, the U.S. economy is by no means "out of the woods" and growth likely will remain sluggish for the next few quarters. Further easing, therefore, may very well be appropriate. Second, LIBOR rates, which serve as benchmarks for many other short-term interest rates, remain elevated. Cutting the fed funds rate further may help to bring those other short-term interest rates down.

In our view, the FOMC will cut rates by 25 bp on Wednesday. Most investors look for a 25 bp rate cut, and markets could become dysfunctional again if the FOMC does not deliver a rate cut. That said, we also believe the FOMC will make it clear in its statement that it intends to go to a wait-and-see mode. The tax rebate checks will be mailed next month, and the Fed likely wants to see how much is spent before deciding what to do next.

Rice or Egg roll? (Please Say Egg Roll)
It was almost impossible to miss the coverage of high rice prices in the media this week. The impact of rice shortages and high prices can have a devastating impact on developing nations where rice is a staple food product. In the U.S., warehouse stores are setting limits on rice purchases as business owners stock up - fearing that the run-on-rice will translate into higher input costs for their restaurants or foodservice business.

The price increases were initially attributed to a few countries paring back exports as they feared some crop reports which suggested a lean year for the staple grain. Then India announced an outright ban on rice exports. Soon after, Vietnam a country who competes with India as the world's second largest exporter of rice followed suit. These bans on exports touched off a wave of stockpiling and hoarding the world over, tripling rice prices in a matter of weeks. Thailand, the world's largest exporter of rice drew praise from the World Bank by refusing to impose any sort of export restriction on rice.

While rice shortages are likely overstated and the current hysteria around them is certainly both irrational and destructive, there are some lessons here. Increased global demand for food has developed at the same time that input prices used to grow food are climbing. Gas, oil, and fertilizer are all used to plant, harvest and transport food, and they all cost a lot more than previously. These prices will have to be passed on to a global consumer base with a growing appetite. So is this rice story overstating this increased-demand increased-cost story? In the short term: yes. But food prices will remain an issue in the global economy in the years ahead