While the range of things that people are worried about is about as wide as the ocean, and as plentiful as grains of sand, everyone can come together united in worrying about two common subjects: 1) is the economy growing anymore, and 2) what will make it grow?
The “bear” case on the economy has been a fairly easy one to make recently, and we’ll lay it out below. We’ll give you the punch line now, instead of making you wait until the end: this economy is suffering from a total lack of confidence. Businesses lack the confidence necessary to make growth investments for the future (in equipment or in labor). Consumers lack the confidence to make big new purchases, other than those to simply replace obsolete assets (think cars, computers). And investors have gone beyond lack of confidence to the point of total disdain for stocks.
The unifying theme here is confidence. Strategas points out that the fuel tank is large, but the spark is far away, meaning that a lot of the ingredients for growth are present (easy monetary policy, low interest rates, heavy cash loads, pent-up demand), but a catalyst is needed for the chemistry to work. What will be the catalyst? No one knows, which is why the mood among Americans is so dour. But we remind you that this is the case in the early innings of every new business cycle, and while we are suffering from unique challenges this time (a semi-impaired banking system, a looming federal budget deficit problem), every cycle has unique challenges. If the challenge were the same now as in 2002 or 1991, no one would worry because we have the playbook on how to get out of it.
The economy, in real-time
From where we sit, we still see the odds of an imminent double-dip recession as low, and much lower than what everyone else seems to believe. Virtually all the indicators that we treasure the most are flashing “modest growth.” The economic recovery had been moving ahead nicely through the 1st quarter, then the growth just seemed to hit what Alan Greenspan has termed “an invisible wall.” A big contributor to this was anxiety around the debt of European countries such as Greece. From May through July, leading indicators fell from sharp growth to standstill. At the same time, production kept growing, making for deep skepticism that not only was demand growth slowing toward zero, but the economy was building inventories, which would reverse to inventory liquidation at some point, and drive GDP growth into the red.
The mistake that seems to be plaguing deep skeptics on the economy is that they have extrapolated the dropoff from growth to standstill, and drawing a line out into the future, the next step must be recession. It’s hard to refute that, except that no trend continues indefinitely, and one must understand the underlying currents of the slowdown to make an educated guess on the future. Our best guess is that growth did, in fact, slow to a “lull” between April and July, but early signs show that growth stabilized in August. GDP growth in 3Q10 is expected by the consensus to be positive, but we wouldn’t be surprised to see something close to 0, and for growth to then resume in 4Q10. Our view is that this type of post-recovery “lull” has happened so many times in past recoveries, notably in late 2002 – early 2003.
That recession ended in December, 2001, and the recovery ensued. The recovery was led by the usual pent-up demand in consumer spending, an incentive-laced boom in spending on new cars (this was the advent of 0% financing), and a mortgage refinancing surge. By 4Q02, however, the recovery looked to be petering out, and fears of a double-dip recession were rampant. The causes: 1) a witch hunt on corporate accounting, thanks to scandals like Enron and Worldcom, and 2) escalating military instability, with a war on Iraq starting to look more likely, and 3) a lack of job growth creating concerns about a “jobless recovery.” Sound familiar? Here’s another fascinating story. A phone survey of 1,099 American investors on September 8, 2002, revealed that an unbelievable 60% said we were still in a recession! Recall that the recession ended in December, 2001. Sound familiar? [Side note: in June, 2001, in the thick of the recession, 72% of them said the economy was “good.”] One more anecdote: 3Q02 was the 2nd quarter of growth in business spending; as you will read, 2Q10 was also the 2nd quarter of business spending growth in this cycle.
So what happened? Growth sank to +0.1% in 4Q02, thanks to the lack of confidence in the recovery, manifested in a drawdown in inventories. Final sales, meanwhile rose at a very healthy +3.5% pace. When businesses finally realized their sales were still growing, they cranked up production to keep pace, and the economy was off and running, +1.6% in 1Q03, followed by +3.2% and +6.7%.
Back to the Present
This time, we’re banking on a few factors which will keep the recovery from petering out:
- Most companies cannot afford to fire anyone, and hiring is actually going on in some industries. There are also reports that some companies are having trouble finding enough skilled labor to hire, and blame it on worker immobility. Because houses aren’t selling, workers are stuck in a place where they aren’t needed.
- Confidence has to improve from here, if only because it’s so bad that it can’t get a whole lot worse (yes, we hear the cackles, “oh, it can get worse”).
- Some of the biggest cyclical businesses can’t see demand drop much lower than now, such as homebuilding and car sales. In 2007, they had a long way to fall, but in both industries, current sales rates are below replacement demand. In other words, household formation exceeds new home construction, and car scrappage rates (when cars stop running) exceed new car sales.
- Many global economies are growing solidly, allowing for export growth to continue.
- Republicans should win back the House in the November midterm election. Strategas believes that, according to regressions they have run on numerous polls and surveys, the House could see as many as 90 seats pass to the Republicans, and the Senate could even be in play. At a minimum, requiring a Republican signoff should reduce the anti-business policy coming out of Washington, and should help to improve business confidence.
We reiterate a big juicy statement we made in our 7/1/10 post (which can be found in the Library on our website): that nowhere on this list is anything to do with government spending. We are not hanging our hat on new fiscal “stimulus,” nor are we hoping for any new monetary stimulus, simply because we don’t believe the economy needs it. If that proves wrong, we still think the Fed has some ammo to fire at the economy, even if it doesn’t involve lowering interest rates.
We also believe that numerous reliable market indicators still contradict a call for recession. We went into great detail on these in our 7/1/10 post, but to rehash, these include: a steep yield curve, the relative performance of small-cap and cyclical stocks, the relative performance of cyclical global markets (i.e. China, Brazil), copper prices, agricultural commodity prices (welcome to the list!), bond risk spreads, and that indefatigable leading indicator, the ISM manufacturing survey. Yesterday, the ISM showed an uptick in August from July, whereas a sharp drop was expected:
The economy is driven by 5 main components: consumer spending, government spending, business spending, inventory investment, and exports (net of imports). We’ll assess the bear case on all 5:
Somewhat surprisingly, consumer spending has bumped along at +1-2% growth for 4 quarters now, continuing into the 2nd quarter, which showed a +1.9% growth rate. This is obviously not robust, but given that unemployment hasn’t improved, wage growth is slow, and the savings rate remains high, it’s not bad. Concerns for the consumer revolve around: 1) unemployment is still high (although it’s the change in unemployment that will determine how consumer spending changes), 2) consumer confidence remains low (although stable in the last couple months despite the economic “lull,” and this is a lagging indicator anyway), 3) housing remains in a depressed state, 4) consumption has been propped up by government incentives which will eventually be gone, and 5) uncertainty on tax rates in 2011. These concerns all have some degree of validity, but we still view employment as the biggest potential upside surprise factor. Why would businesses hire anyone right now? Read on.
Just as companies slashed headcounts in late 2008 and into 2009, they also slashed capital spending on such investments as buildings, equipment, and technology gear. While hiring remains fairly absent, capital spending has accelerated for 2 straight quarters, showing (annualized) growth of 18% in 2Q10, after 8% growth in 1Q10. During the recession, businesses cut too much, and are now restoring basic “necessity” spending. Skeptics on the economy contend that this spending growth can be attributed to “pent-up” demand, like from a company with 8-year old computers which needed to replace them in 2008 but deferred it until now. We contend this is partly true, but we feel a lot of this spending is maintenance-related (as opposed to investing to improve), which should not have been deferred in 2008 – 2009, but was. Pent-up demand is still largely to come, and beyond that, businesses will spend to grow. We have yet to see either of these dynamics play out, given the lack of confidence in the continuation of the economic recovery.
As for employment, hiring always takes place after business spending starts to turn up. This happens because businesses prefer to expand their production capacity through less expensive and less troublesome means. Capital spending is the easy pickings of expanding capacity; hiring has issues, and requires a long-term commitment by the company. If a company had just a short-term need, it could use temp workers (which has been taking place, too) instead of hiring employees. So, hiring is the last resort. But if production keeps growing, businesses will have no choice but to hire. One way to bring home this point: GDP has now recovered to the point that it has surpassed the previous peak in 3Q08, but the number of workers producing it is only 130 million, down from 138 million at the peak. That can only work for so long. And companies have seen margins expand incredibly, and cash build to exorbitant levels, so they can easily afford to hire. The following chart shows the relationship between corporate earnings and capital spending. Since the recession, earnings (“Internal Funds”) have bounced back, but capital spending (“capex”) has only partly recovered. That gap between earnings and spending is historically wide, and the result is corporate cash balances which have ballooned:
Rather than turning this section into a political issue, suffice it to say that government spending has grown thanks to fiscal “stimulus,” but you might be surprised at the growth rate: less than 1% in the last 4 quarters. So while skeptics bemoan the imminent end of fiscal stimulus and how it will hurt the economy, we wonder, “where’s the beef?” One big reason for the meager growth: reductions in spending by tight-fisted state and local governments have offset 10% growth in federal spending. We foresee a flip-flop ahead in 2011-2012, where federal spending growth rolls off, and state and local governments spend more (again, pent-up demand). Don’t easily dismiss this optimistic prediction on state and local. Two straight years of spending cuts (2009 and 2010) totaling roughly 6%, as well as select tax increases, have left budgets now nearly balanced – that’s balanced without federal aid handouts. Until 2009, it had been decades since state and local governments last cut spending. Again, the most likely scenario is for meager, if any, contribution from government spending.
Inventories are always the wild child of GDP growth. Businesses routinely over-cut or over-expand inventories, making GDP growth far more volatile than underlying consumption. After cutting inventories by over $600 billion in 2008 and 2009, businesses have added back $107 billion in 2010. Keep in mind that final sales have risen $66 billion in 2010, so the inventory-to-sales ratio has hardly increased, after falling dramatically in 2008 and 2009. In other words, inventories are still lean, but businesses won’t be adding to inventories until they get more confidence.
Exports have risen solidly in the last 4 quarters, but imports have risen more, which means that “net” exports are a negative contributor to GDP. Higher oil prices are partly responsible for this mismatch. We’d all like to believe America can export our way to growth, thanks to our cutting-edge products and high quality, but this might again prove elusive in this cycle. Nonetheless, net exports serve as a backstop. If the USA grows at a slower rate than other countries in the world, it will show up as a positive for GDP, as our imports decline, and will be a boon for large, multinational companies that can compete overseas. It is in these companies that we’ve been devoting the most investment dollars lately.
It’s hard to see which of these 5 components will drive the economy forward. Business spending is the most logical, but if businesses aren’t confident, and if consumption isn’t growing, they won’t be increasing their capital spending. Still, this is the most likely, and best-case, which would eventually yield employment growth. This will allow consumer spending to keep growing, housing to stabilize, and tax revenues to grow. As the economy recovers, government spending will even have the opportunity to drop, bringing us closer to a balanced federal budget.
So how can confidence be restored? Given the ridiculous amounts of cash sitting on corporate balance sheets, and the ridiculously low interest rates at which they can borrow, the fuel is there. It seems like everyone is looking around to see if anyone else is moving ahead. Companies have tended to act defensively thanks to the recession—only committing to growth if they’re sure they’ll get it, OR if their competitors are committing to it. How can companies use their excess cash flow? Capital spending, share repurchases, higher dividends, and acquisitions. We believe capital spending growth will continue. However, dividend hikes might not ramp up until companies know what dividend tax rates will be in 2011. And companies have notoriously bad timing when they decide to buy back their own shares, seemingly preferring to buy near their stock’s peak, and not buying when their stock is cheap.
The logical choice for using cash is acquisitions, and we have seen a real pickup in activity in 2010, but especially in the last 3 weeks. Just to name a few, Intel is plunking down $9 billion on McAfee and Infineon’s mobile chip business. 3M has announced 2 acquisitions in the span of a week, totaling more than $1 billion. Burger King is going private – again. Sanofi launched a $19 billion hostile takeover for Genzyme. BHP is offering $39 billion in a hostile attempt at fertilizer company Potash Corp. And H-P and Dell have been dueling for control of storage company 3Par, having raised bids 9 times, from a pre-offer trading price of $10 per share to a final offer of $33. We believe there is a possibility of this turning into a gold-rush mentality, especially as it becomes pervasive across industries. The combination of cheap valuations, low borrowing rates, and high cash levels could be explosive for acquisitions.
While the ultimate catalyst could be one we’ve thought of, or it could come from left field, we acknowledge that the rest of the economy needs to “keep working” in order for the economy to move into growth mode. If, for example, legislators enact steep tax increases for 2011, all bets are off. Also, we are counting on a slight thawing of bank credit (could it get any more frozen?). And a massive new round of corporate cost-cutting (read: layoffs) needs to be avoided. Given that companies are under-investing for the future, have tons of liquidity, and have high margins, we don’t see the case for cost-cutting. But if the drought of confidence continues well into 2011, it’s possible. The common thread (and roadblock) of all these components is, again, confidence.
If things work out for the economy, investors are seriously underweight in stocks. After liquidating stock funds and bond funds alike in late 2008 (with proceeds getting “parked” in money market funds), money has only gone back into bond funds, not stock funds. The following chart shows the cumulative amount since the beginning of 2009. The count for bond funds? Over $1 trillion, which explains why interest rates are near record lows. For stock funds? Net withdrawals (more money has come out than has gone into them). This is simple performance-chasing, as the individual investor and 401(k) investor have seen that bonds are safer and can make great returns.
Have you heard this from any of your friends or co-workers: “If I can get 10% from my bond fund, why should I consider stocks?” Well, maybe because if interest rates go up 1% from here, you’ll lose 5% on your bond fund? We view stocks as the less risky of the two asset classes currently.
As for corporate profits:
And as for valuations, when you can get dividend yields in the same ballpark as 10-year treasury bonds, you’re in historic territory. That means the market is not counting on any growth ever happening again…..