Welcome to September! The meteorological calendar suggests that summer is now over, but given the weather this summer, most of us are probably interested in when summer will begin!
More ominously, as many of you have likely heard, September is historically the worst month for the stock market. Crashes usually occur in October, but they get a good running start in September, and those crashes are normally followed by sharp late October rebounds. In years sans crash, fears of a crash seem to weigh on the market in the fall. How bad is September for stocks? An average return of –1.2%. So, at least we got that out of the way on the first 2 days of the month, with a –2.5% decline, and can now look forward to an expected return of +1.3%.
Turning to the Economy
Since we don’t typically base investment decisions on the calendar, we turn our gaze to the economy. If you haven’t talked to us lately, or couldn’t make it to the seminar, what you’ve missed is that we [hesitantly] called the end of the recession in June. Take this with a grain of salt: we won’t know until at least next year whether it was true, and (hopefully) by then it won’t really matter when the recession actually ended.
The simplest piece of data that has emerged since June was the report on GDP, the most comprehensive measure of how much goods and services the U.S. produces, in the 2nd quarter. Originally, the GDP reading was reported as –1.0%, a sharp recovery from the previous 2 quarters. Even better, inventory reduction was responsible for –0.8% of that, meaning that final sales (i.e. consumption) was only –0.2%. Subsequently, the 2nd report on Q2 GDP showed that GDP was still –1.0% in the quarter, but the inventory drawdown was revised to –1.4% …meaning that final sales were actually +0.4%!!! Net-net: consumption increased during the quarter. Logically, during the quarter, both consumption and production progressed from negative to positive.
The more recent data piece, which was released this week, showed that the ISM manufacturing survey shot up to 52.9. Avid readers of Monarch’s reports will know how much stock we put in this survey. On the face of it, it’s just a survey of purchasing managers, asking them to describe how their company’s condition has changed in the last month—their production, new orders they’ve received, their employment, the prices they receive, the prices they pay, etc. A number under 45 symbolizes recessionary conditions. 45-50 is closer to no growth. Above 50 means expansion. So, in August, purchasing managers have disclosed that they’re growing.
We have also posted an Adobe file featuring a hodgepodge of recent charts from our friends at Strategas. You can open it either from the Library page, or HERE. If you have some time to devote to this, you can follow along on that report and this one. The first page shows the “New Orders” component of the ISM manufacturing survey. This tends to be a leading indicator into actual production. But notice the strong correlation between this index and GDP growth. August’s reading of 64.9 puts it in esteemed company from the last 20 years: only in 2003-04 has the reading been so high.
Again, this was the manufacturing survey. The ISM non-manufacturing (i.e. services, which is a bigger sector in the U.S. economy than manufacturing) survey was just reported today. The headline number is 48.4, which continued a steady increase from 37.4 last November, and up from 46.4 in July. And close to 50. Note that the service economy always rebounds after the manufacturing economy. This is because, as we will show in the next section, manufacturing production is highly influenced by inventory buildups and drawdowns, whereas inventories in the service sector aren’t typically relevant.
So, amidst all the gloom and doom facing the U.S. consumer, why is production suddenly bouncing? Plain and simple: production was cut too much. This happens nearly every recession, and plays out in a rather predictable order:
- Companies continue to make stuff, even as sales start to slow, causing inventories to grow
- Companies start to slow production, but sales fall faster than their production, so inventories grow even faster
- Sales stop falling, but companies are still cutting production, vis a vis cutting jobs and cutting capital spending. Inventories stop rising.
- Sales start growing again, but companies have not increased production. Inventories falling rapidly.
- Inventories have fallen to uncomfortably low levels. Companies have no choice but to increase production again.
- As sales continue to grow, companies realize they can’t keep expanding production with no new workers and no new capital spending. So, they start hiring and spending again.
If your eyes have now fully glazed over, perhaps a picture will help. The dark, solid line on the chart below shows hypothetical national consumption, while the red line shows national production. We have placed the first 5 stages listed above onto the chart.
Where are we now? Most industries have made the jump from #4 to #5, and have begun increasing production in the 3rd quarter. Many industries (notably auto-related), however, have moved on to #6. In past recoveries, especially the last 2 “jobless recoveries” (which eventually became “jobful” recoveries, if that phrase exists), the move from #5 to #6 doesn’t usually happen until well after a recession ends. Hence, unemployment normally continues to rise for a full 1 ½ years after the recession ends! 1 quarter into this recovery, and we may already be seeing the peak of unemployment. Please don’t interpret that as a prediction, let alone a definitive statement. We believe the industries still firing will likely outnumber the hiring industries through the end of the year, but it could be sooner. Tomorrow will bring the monthly checkup on the labor markets. Until then, at least 2 leading indicators have already turned to the good: weekly jobless claims and announced job cuts. You can see the latter on the bottom half of page 1 of the Strategas report; in each of the last 2 recessions, this number peaked after the recession ended. Page 3 of the Strategas report shows an interesting connection between the change in initial jobless claims from quarter-to-quarter and the consequent GDP change. Since 1988, whenever a quarter has seen a drop in initial claims of –10%, which is the magnitude of change so far in 3Q from 2Q, GDP has grown in the +4-7% range that quarter. All this to say that the current recovery is looking more like the old “jobful” recoveries of the 1970s and early 1980s than the last 2 “jobless” recoveries.
Obviously, in order for the economy (as a whole) to make the move from #5 to #6, sales must continue to grow, which would stimulate hiring. Who are the ultimate buyers? American consumers, and, to a lesser extent, the government and foreign customers. The conventional wisdom has become that the American consumer has so many headwinds that sustainable spending growth might not resume for years, or until the next cycle. These include: an unemployment rate that will come back down only a little, still-high levels of consumer debt, the possibility that the personal savings rate will shoot back up to above-average, housing prices that will only come back a little (thanks to the departure from the market of the 2nd home buyer, 3rd home buyer, 4th home buyer, and investor classes), availability of credit which will never be as loose as it was in the 2005-07 housing bubble, and the eventual end of government fiscal stimulus. That’s a daunting list, and there’s good reason to believe each of them. There will inevitably be a new growth machine (such as tech in the 1990s or structured finance in the 2000s) that will drive our economy – we don’t know what it will be; we wish we did! But it’s hard to ignore the structural headwinds that will blow much harder this time than in past recoveries.
The stabilization in consumer spending since the end of 2008 has been so much better than feared that it caught corporate America flat-footed. That’s not to say that it’s a bad scenario for corporate America, quite the contrary. As page 2 of the Strategas report shows, when production bounces, that’s good for profits. And when it comes after an unprecedented (since the Depression) round of cost-cutting, it’s really good for profits.
But it should be mentioned that government programs have largely been responsible for the areas of strength so far, such as housing and auto sales. In other words, the spending booms in each wouldn’t have taken place without incentives (skeptics would call them “handouts”) from the government. Page 4 of the Strategas report highlights this. Foreign governments have also responded to the recession with stimuli of their own, and production in foreign lands has similarly responded, as pages 7 shows. LEI (leading economic indicators), shown on page 8, inevitably leads to a rebound in GDP.
These incentives have had the desired effect of stabilizing production and employment in the affected industries, which are both very large U.S. industries. Unfortunately, the other effect is a substantial increase in federal spending, causing a massive increase in the budget deficit. The effects of funding the budget deficit (vis a vis more borrowing) will become more pronounced as the economy recovers. If the economy isn’t allowed to become too hot, interest rates have a better chance of not shooting upwards, and give the U.S. time to roll back the deficit spending sometime a few years down the road. This, of course, assumes there is no expensive health care reform package passed. While this will mean slow growth for a while (the square-root recovery), it’s the closest thing to a Goldilocks scenario. But if the economy does become hot, the combination of budget deficits + higher inflation fears would stoke higher interest rates. This could derail the recovery and throw us back into recession.
Neither are “good” situations, but at least there are 2 silver linings. First, the cyclical effect on interest rates balances the structural effect. This means that in a cool economy, where deficits continue to be large (as the government continues to attempt to stimulate the economy, to avoid the fate of the Depression or Japan in the 1990s), at least inflation fears will subside because the economy isn’t growing. By contrast, in a robust recovery, when inflation fears will be present, at least the government will have cut back on its fiscal stimuli, and probably be a beneficiary of higher tax revenues.
The second silver lining is that, after a budget deficit of 15% of GDP in 2009, and another ugly number in 2010, eventually deficits have to go down. While running a smaller deficit means that we’re still borrowing money, the psychological impact could be a positive, in terms of the value of our currency.
All this to say, Happy Labor Day! Don’t spend too much time worrying about the labor market; it is already showing signs of improvement, and will eventually follow production on the recovery trail. We’re constantly challenging our own assumptions on what the recovery will look like, and what consequences our economy faces when the budget deficit bill “comes due.” Hopefully we can ease into and out of it. While we have some measure of faith in Fed Chairman Bernanke, the depth of the credit crunch and the heavy involvement of Washington in the recovery lead to a belief that the problem is bigger than Big Ben. But until then, let’s all breathe a sigh of relief that Depression was averted, and be thankful for the recovery.