Economic Commentary - May 2010

Christopher Bremer
Senior Investment Consultant

Signs of Improvement

Over the past month and year-to-date periods, economic data is showing improvement as many economic sectors are reporting better-than-expected numbers. Recent economic releases have lent further support to the case for continued economic expansion.

The International Monetary Fund (IMF) concurs and recently raised its 2010 world growth forecast from 3.9% to 4.2%. The IMF outlook also confirmed what we discussed in the last commentary, that emerging economic strength is outpacing the developed world, “the global recovery is proceeding better than expected but at varying speeds—tepidly in many advanced economies and solidly in most emerging and developing economies.”

Our objective is to assess what components of the economy are likely to have the greatest say on the strength, sustainability and duration of a recovery.

But still, uncertainty regarding the strength and longevity of the current expansion is ever present. Why is this? In a single word the answer is “leverage.” It is what got us to where we are today. Many imbalances need to be addressed by the developed world before a sense of normalcy can be regained. Most of these imbalances are directly connected to the leverage that was encouraged by low interest rate policies, lax regulation and public policy decisions made during the past several decades.

In September we discussed how economic reports at the time were subject to interpre¬tation and would shed more light on the recovery over time, including, but not limited to corporate profits, retail sales, employment, and credit. Other sectors are demonstrating only mild recovery or outright weakness. Underlying both is a cloud of uncertainty with particular emphasis on budget conditions, Federal Reserve policy and the labor markets. Below we take a closer look at all three segments: strength, weakness, and uncertainties.

Economic Strength

A broad cross section of economic indicators has demonstrated better-than-expected improvement, including inventories, retail sales, and industrial production. Even the drag the housing sector is having on the economy seems to be moderating.

Inventory Restocking: Inventory levels provide insight into the nature of business cycles. Inventory levels can help to forecast short-term economic growth prospects because they reflect tangible and measurable demand. The need to restock inventory directly adds to companies’ top line sales growth.

According to Federal Reserve Chairman Ben Bernanke, a recovery in economic activity appears to have begun in the second half of last year. The ability of firms to work off a glut of inventories built up during the severe recession provided a significant boost to GDP in the fourth quarter of 2009. A bottom in inventory liquidation is consistent with a sharp spike in GDP.

According to the Institute for Supply Management (ISM), manufacturers’ inventories expanded in March following 46 months of contraction, as the Inventories Index registered 55.3 percent. (Fig. 2.) An index reading greater than 42.6 percent, over time, is generally consistent with expansion in the Bureau of Economic Analysis’ (BEA) figures on overall manufacturing inventories.

The problem with the change in the rate of inventory liquidation is that, while a powerful contributor to GDP, it is a usually a temporary occurrence. Inventory stocking may reflect empty shelves and may or may not reflect underlying demand. Because inventories are now more aligned with final sales, they may not provide as clear a forecast as they did when they appeared to bottom out. Continued growth in private final demand, not just fiscal policy stimulus, will be critical.

When inventories were at depressed levels, we noted that getting back to normal could result in a boost to GDP and equity prices. Now that this has occurred, investors are concerned with the next phases of the recovery.

Retail Sales: Retail sales increased 1.6 percent in March according to the Commerce Department, which was more than expected and the biggest gain in four months. On a year over year basis, retail sales rose 7.6 percent. This was the highest growth since January 2006. Importantly, sales gains were broad-based, with 11 of 13 major sales categories showing gains (Fig. 3).

Retail sales going forward could take one of two potential paths. The first path is slower with tight credit, low wages and less than enthusiastic consumer sentiment obstructing the way. The second course to sustainable retail sales growth requires a forceful, even if gradual, recovery in the labor markets leading to higher wages and household wealth.

Manufacturing: The recovery from the Great Recession has resulted in solid gains in the manufacturing sector of the global economy. There was no fooling in the manufacturing data released April 1 that detailed strength in China, Germany, Japan, the UK and US as well as in France, Italy and even Spain (Fig. 4).

ISM Manufacturing, U.S. industrial production, manufacturers’ new orders and U.S. durable goods orders are currently running at above-historical-average rates. Other manufacturing measures such as capacity utilization and construction spending, however, are still not showing the same signs of repair. The manufacturing ISM has rebounded sharply in the last six months and tends to lead payroll employment.

The ISM’s factory index rose to 59.6, the highest level since July 2004, exceeding the most optimistic forecast in a Bloomberg News survey of 77 economists. Readings greater than 50 signal growth.

U.S. manufacturing output is benefiting from stronger export demand as well as the aforementioned inventory adjustment. Significant increases in production may require re-hiring, but the question is whether final demand will continue to support manufacturing expansion.
The Purchasing Managers Index (PMI) also grew, registering 59.6 percent, an increase of 3.1 percentage points when compared to February’s seasonally adjusted reading of 56.5 percent. A PMI reading in excess of 42 percent, over a period of time, generally indicates an expansion of the overall economy. Therefore, the PMI indicates growth for the 11th consecutive month in the overall economy, as well as expansion in the manufacturing sector for the eighth consecutive month. According to the Institute for Supply Management, the publisher of the PMI index, “The past relationship between the PMI and the overall economy indicates that the average PMI for January through March (58.2 percent) corresponds to a 5.4 percent increase in real gross domestic product (GDP). In addition, if the PMI for March is annualized, it corresponds to a 5.9 percent increase in real GDP annually.”

Business spending: According to Bloomberg, chief executive officers in the U.S. turned more optimistic in the first quarter as sales grew, boosting the prospect that employment and spending will climb. And according to The Business Roundtable, 73 percent of executives said they expect sales will grow in the next six months, up from 68 percent in the fourth quarter of 2009. Furthermore, 47 percent plan to invest in capital equipment and 29 percent said they will increase payrolls, a 10-point increase from the previous three months. At the company specific level, Intel is “seeing signs of corporate demand returning.” In an April 13 conference call with analysts, Intel noted that the average fleet of desktops is five years old and information technology executives are generally feeling better about their business which may translate into updating older desktop systems.

Moderate Recovery or Weakness

Employment: Above trend growth in output and a pickup in consumer spending has occurred simultaneously with sluggish growth of payroll employment and moderate improvement in jobless claims, raising concerns about a jobless recovery. For all the talk of improvements in the moderation of job losses, the average number of weekly jobless claims is still signifi¬cantly above historical averages. Furthermore, average hourly earnings and average weekly hours are also significantly below historical averages (Fig. 5). Strip out “pace of job losses” and we are left with awful numbers an on absolute basis.

There are two potential explanations as to why consumer spending is increasing while real labor income is falling. First, transfer payments helped to offset the loss in wages. Second, consumer spending fell more than disposable income.

Personal income is not rising and household debt burdens are still at suffocating levels. While equipment and software spending have ticked up, business spending on commercial building is still weak. Unless jobs and income prospects improve, both consumer demand and sentiment are likely to remain modest at best.

Housing: While housing data is coming in with mixed readings, we put housing in the weakness camp. Recent housing starts and building permits (February reports) were stronger than expected and showed the highest levels since late 2008. Other important housing metrics such as absolute number of home sales and the S&P/Case-Shiller home price composite are still exhibiting significant weakness relative to longer-term run rate averages (Fig. 6).

Government Budget: Though small in relative size, Greece with its misrepresentation of economic facts and profligate ways has cast a long shadow over the sovereign market and, in particular, the weaker members of the European Union. It is emblematic of the problems confronting a number of developed nations. Even the United States is not immune as Moody’s fired a warning shot at the U.S. saying that unless the country gets its public finances into better shape than the Obama administration projects there would be “downward pressure” on its triple A credit rating. The budget deficit has risen to a percentage of GDP not seen since World War II and trillion dollar deficits are driving up the debt to GDP percentage at an alarming rate. As discussed in many different forums, the private sector leverage that was the primary reason behind the Great Recession has been replaced with leverage from the public sector. Normalcy will not return until this leveraging has been reduced.

Focusing on the United States, these imbalances are evident on the state and local level as well as the more publicized federal stage. It is not only the current budget imbalances that are troubling to investors, but also future government liabilities that must contractually be met in the form of health and retirement benefits. A continued lack of acknowledgement of these imbalances can be seen in the recently passed health care legislation which will only exacerbate the federal government’s funding requirements. With the mid-term elections now in clear sight, any actions to improve the budget deficit will likely be postponed until next year.

The rapid growth in federal debt has had a measurable impact on Treasury spreads. In the short end of the yield curve, selected corporate issues have traded through the yield on Treasury issues. Additionally, the seven and 10 year U.S. swap rates turned negative for the first time in March. This implies that it is less risky to lend for seven years to a money market counterparty than to the AAA-rated U.S. government. Along with corporate new issuance considerations, one explanation for this connects back to concerns about the rapid increase in U.S. debt issuance and the related fiscal deficit situation.

Areas of Uncertainty

Employment: Getting back to the here and now, the markets have been buoyed by the strength in corporate profitability as margins have expanded due to the gains in productivity accompanying the upturn in economic activity. Government stimulus programs have injected positive momentum into the economy. The question that now needs to be answered is, “Will this positive momentum translate into jobs and income growth?” The March payroll numbers were somewhat encouraging as employment rose the most in three years. Backing up the strengthening payroll number were increases in temporary employment and lengthening in the average workweek as well as in overtime hours worked. Somewhat offsetting this positive news was the continued rise in job seekers out of work for more than six months and the increase in the underemployment rate. The future path of economic activity will be linked to the trajectory taken by employment for it is the driver of income and, therefore, of consumption.

However, beyond a short-term rebound, the consumer will have to step in to help sustain the recovery. There is widespread debate on whether the consumer can accomplish this and we are too early in the cycle to really know for sure.

Federal Reserve: Another uncertainty in the road to recovery is the Federal Reserve. There are a number of policy changes that the Fed has and will undertake during the period ahead that will influence the level but not necessarily the direction of interest rates. Several of the Fed’s stimulus initiatives dealing with securities buy-in programs have expired. After having purchased $1.25 trillion mortgage securities during the past year, the Fed is no longer “the market” in mortgages. What will happen to mortgage yields and yield spreads is a question that will be answered shortly. One would assume that mortgage rates will increase due to the absence of Fed buying. Since the housing sector is still mired in a severe slump (February new home sales experienced a record low), the removal of the Fed’s support for the mortgage market at a time when the new home tax credit rebate program is set to expire could prove to be quite challenging for this important sector of the economy. The Fed is also in the initial phase of reducing the size of its balance sheet and will be testing reverse repurchase agreements to determine the impact such operations will have on market rates. Targeting a trillion dollar reduction in its balance sheet, the Fed will be draining a like amount of money that was pumped into the economy to help stabilize the markets at the height of the financial crisis. What will be the impact of this action on interest rates and market volatility?

Comments from at least one member of the Federal Open Market Committee (FOMC) leaves little doubt that there is some discomfort with maintaining the current zero interest rate policy indefinitely. For the time being, however, the Fed “continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

What to Watch for

Pay particular attention to the employment data, as employment is typically the last economic indicator to turn positive. A strong reversal in job losses would signal that the economic recovery has some strength (Fig. 7).

The Fed has already taken steps to “normalize” policy by ending liquidity programs, completing asset purchase programs and increasing the discount rate. The impetus behind these actions was the market’s ability to heal, not necessarily sustained economic growth. The when and how of future policy tightening will be wrought with more contention and market volatility. It is not a stretch to say monetary officials in the developed economies (primarily the U.S. and Eurozone) are setting policy with a bias toward avoidance of premature tightening. A key risk at the onset of 2010 was the market’s perceptions of aggressive monetary tightening resulting in a double dip recession. The longer this cautious approach lasts, the more likely the risk becomes falling behind the curve.

Where are we Headed?

The economy has experienced a strong cyclical rebound over the past two quarters driven by factors that do not require long-term consumer participation including inventory restocking, manufacturing production and the continued impact of accommodative government policy. The primary immediate concern with regard to the strengthening of economic data is that activity remains dependent on highly accommodative monetary and fiscal policies.

The longer-term view is ominous. Public debt is on course to exceed 100 percent of GDP in 2014 in advanced economies, according to the IMF and “the outlook for activity remains unusually uncertain, and downside risks stemming from fiscal fragilities have come to the fore. A key concern is that room for policy maneuvers in many advanced economies has either been exhausted or become much more limited. Moreover, sovereign risks in advanced economies could undermine financial stability gains and extend the crisis.” In other words, fragile economies are exposed to global shocks with Greece serving as the first test.

The uncertain road to recovery does not imply a “no” recovery scenario but rather one that most likely will be driven by forces that are different or less powerful than in previous recoveries. Emerging market growth, re-stocking of depleted inventories and the stimulus monies that are being spent have provided forward momentum. Business sentiment indicators are trending higher which translate into higher levels of capital spending and employment growth.

Here is the uncertainty. What will be the rate of growth in employment? With the consumer still leveraged and housing not fully participating in the recovery, the economic trajectory may be much flatter than in past cycles. The nascent recovery must also contend with the uncertainty of when the FOMC will initiate its change from the current zero interest rate policy.

The Fed’s zero interest rate policy, when combined with the outsized budget deficits and their attendant funding requirements, has produced steeply sloped yield curves with the 10 year to 2 year Treasury yield spread reaching a record 291 basis points in February. The United States, and for that matter a good deal of the developed world, is on new, unsettled ground. Growth is being driven not by the U.S. consumer but by the emerging markets of the Far East and Brazil.

Typically, the transitional recovery period out of a recession presents contradictory and often misunderstood market signals. The improvement in the global economy and financial markets has exceeded most expectations. The cautious approach in removing the massive stimulus and monetary accommodation has served to lengthen the horizon leading up to eventual policy tightening. This environment has been and may continue to be conducive to risk assets, but significant underlying uncertainty lurks beneath.