What Happened to the Economy?
In just two weeks, investors have moved on from its concern du jour, a potential U.S. debt default, to the next concern, a potential downgrade to U.S. debt, to a 3rd fear: recession. Two weeks! Mr. Market is known for acting emotionally, but this is a special fickleness. After scolding Washington for not cutting spending enough, Mr. Market is now implicitly sending a message to Congress that they may have cut too much.
At its most basic level, the vast majority of investors are now concerned about an imminent recession. And the case is pretty good: our economy barely grew in the first half of 2011 (+0.8% annual rate), and in the 3rd quarter, the data (namely the July ISM manufacturing survey reading of 50.9) seem to have turned down. Fiscal support (i.e. government spending) and monetary support (from the Fed) have been in place in unprecedented quantities since the recession and continue to be in 2011, yet appear to have gotten us nothing. What happens when government spending is actually a headwind, rather than a tailwind?
This is a good-intentioned and very popular opinion. And we’d be happy to dive into it, except that it involves opening the can of worms titled “could all that government spending have actually reduced business spending?” We’re not going to pry that can open any further today, as it inevitably invokes passionate political opinions, and a lot more theory than hard evidence.
But the one piece of data that jumps out at us is that government spending has actually been a headwind to GDP growth for 3 consecutive quarters, as the chart below shows. Yes, the government has already been a drag on growth!
How? The short answer is that state and local government spending has been falling since 2009 and continues to do so. States and local governments need to balance their budgets, so they have a head start on the federal government on cutting spending. You’d think federal spending growth would more than offset the state and local declines, but actually, federal spending has already started to decline in 2Q11. The good news is that state and local revenues have been sharply rising—more than expected. As the average state budget is now operating at a surplus, modest spending growth should resume.
So, the meager growth in 2nd quarter GDP of +1.3% was largely driven by exports and business capital spending. Consumer spending rose just +0.1%, held back by the surge in gas prices. Business spending is still not as robust as we expected at the beginning of the year, as CEOs continue to manage their businesses ultra-conservatively, with rising cash hoards and a lack of hiring. Now the market is concerned that businesses will become even less confident in the future. Why? We have all been tortured by Congress, having endured the soap opera budget negotiations for the last few months. Also, the sovereign debt standoff in Europe seems to be getting worse, with Italy and Spain now under the gun. And emerging markets, with economies driven by exports to the U.S. and Europe, now appear to be showing slower growth. This all reduces the incentive of corporate America to invest for growth. If this skepticism continues, the pause in spending and hiring will not abate. And if hiring does not pick up, consumer spending won’t grow much either.
If our economy is to move from recovery to expansion, which happens almost every cycle, it needs a catalyst to carry it forward. A good analogy of this is a stool. With 4 strong legs, a stool can stand with no problem. Take away 1 leg, the stool can still stand. But if you take away a 2nd leg, someone needs to hold the thing up or it will fall. It’s tough to avoid the conclusion that, if the business spending leg is kicked away, we’re left with the export and consumer spending legs, and consumer spending depends an awful lot on business spending and government spending.
We’re not willing to throw in the towel yet on business spending. What cannot be easily dismissed are record profits, record lean expense structures, and record high cash levels. At least we can say that if we do slip into a recession, we believe it will be mild, nothing even comparable to the 2008-09 recession, for these reasons:
- Many sectors of the economy had a LOT of room to fall in 2007, namely housing, construction, mortgage finance, and car sales, all of which can go hardly any lower now. New home sales are running way below household formation rates, and new car sales are way below scrappage rates. Buoyant used car prices provide evidence that people still need to replace their cars.
- Households are less indebted now than in 2007, and enjoy lower interest rates (mortgages, car payments), and have increased their savings rate from 2% in 2007 to 5.4% in 2011.
- Businesses were totally unprepared for the 2008-09 recession and thus were forced to slash capital spending and terminate 8 million jobs. Businesses have hired back only 1 million of those 8 million positions (in the U.S.), so they can hardly afford to fire many workers. Similarly, the modest recovery in capital spending in the last 2 years has been driven mainly by maintenance spending that was deferred during the recession as well as a need to replenish depleted inventories. Growth spending hasn’t even started yet. And again, they have far less debt and trillions of cash on hand.
- Banks were on the precipice of a massive wave of home foreclosures in 2007, and eventually higher losses on commercial loans. Their loan loss reserves were low, capital ratios were low, and non-performing loans and chargeoffs had just begun to rise. In 2011 banks have overinflated loan loss reserves, excess capital, and non-performing loans and chargeoffs are falling. Bank surveys also indicate that they are more willing to lend now than they have been in a long time.
- This is the best-advertised recession in history. That line actually came from Dave in our investment team meeting this morning. It’s true, and it’s the opposite of 2007, when almost no one anticipated a recession, even after it followed a housing market bust.
On the other hand, we might not be heading into recession. Looking at current data, it is far from conclusive. The July ISM manufacturing reading of 50.9 is “barely in expansion territory” (of 50 or above), and was a sharp drop from 55.3 in June. The trend is not our friend. But that number reached as low as 46.1 in April, 2003, when double-dip fears were rampant, but resulted in no double-dip recession. Similar story in December, 1998, when it hit 46.8, amidst the Asian Contagion, but no U.S. recession followed. Same in 1995.
We’re also not seeing some of the classic recessionary harbingers. The yield curve is still steep. Granted, it can’t possibly invert with short rates at 0%, but there are no inverted points anywhere on the yield curve. Risky bond prices aren’t tanking. Copper prices, at $4.26/lb., are still near recent record levels of $4.68. For comparison sake, prices fell as low $2.80 last summer in the wake of the first “double-dip” fears.
The outright bull case on the economy is even harder to grasp, and relies on a lot of faith, a bevy of assumptions, and some reversion-to-the-mean arguments. We now list the top prospective catalysts that could not only keep us out of recession, but propel us to the expansion phase. Note that an unfortunately large number of these involve Washington, in which we have little faith. But since no one else does either, that’s where the surprise factor would be the catalyst for good.
- The Congressional deficit committee does something positive. We know, stop laughing, it probably won’t happen. But if there was ever a time when the current members of Congress, as well as President Obama, were deeply worried about job security, now would be the time. What could they do that would positively surprise? They could reincarnate some deep restructuring ideas from the original Deficit Commission report, pairing long-term entitlement cuts with a totally new income tax code, lower corporate tax rates, and the closing of loopholes. Some form of stimulus, like a payroll tax cut for employers, is definitely possible. We expect a temporary reduction of the tax rate on repatriated foreign profits to be back on the table now, as a concession to corporate America to bring cash back to the U.S. and put it to work in hiring people (the logistics of this will be very interesting). Obviously, it all has to be paid for, with a net $1.4 trillion of spending cuts, but that’s where the magic of budget math comes into play! Expect a VAT to get serious consideration, though odds of its passage are low.
- The Fed could announce “QE3” (Quantitative Easing, Round 3). Now that “QE2” ended in June with a whimper, the Fed is no longer buying treasury or mortgage bonds, so it is not pumping money into the economy as quickly as it was during QE2. What form will QE3 take? How much more money can the Fed print? Does Bernanke care that inflation is still somewhat elevated? All good questions, but as the old adage goes, “don’t fight the Fed.”
- The rest of the world has something to say about the global economy too. Just because the Fed might not have as many bullets in its gun doesn’t mean central banks and federal budgets of other countries can’t take on more stimulus. In fact, they can. This would serve to buoy U.S. exports, and stabilize everything else. An interesting anecdote: today, Switzerland sold billions of Swiss francs from its central bank, in order to push down the value of the franc. Japan followed suit in order to reduce the value of the yen.
- The U.S. auto sector is poised to increase production in the 2nd half of 2011, as parts become more widely available. Recall that the auto sector took the brunt of parts shortages that resulted from the Japan earthquake/tsunami. Note that a production ramp up would not be a reflection of a sudden boom in demand for cars, but rather that inventories are low. The rebuilding process should be stimulative, given the industry’s significance to U.S. manufacturing.
- Pro-business proposals from the White House. Again, stop laughing. Just remember that Obama’s re-election campaign to the centrists will come down to one thing and one thing only: jobs. How can he create jobs when his own budget is shrinking? The answer is that he desperately needs the corporate sector to hire people. Anything to get the corporate side more confident about the future could at least stave off layoffs. This could include: passage of long-delayed free-trade agreements (technically Congress needs to pass these, but Obama could push them), opening up new areas for oil drilling, allowing a major Canadian pipeline project (which has been held up by the EPA) to finally pass, or some deregulation out of left field.
- Ultra-low interest rates, in concert with banks’ willingness to increase lending, could lead to a stimulative boom somewhere. It probably won’t be housing, given the “shadow inventory” of foreclosed homes that banks own. But never say never; mortgage rates are falling to very low levels again.
In the meantime, stock prices will move in the direction of economic data and corporate activity. Positive corporate activity would include good earnings growth continuing, more chatter from CEOs along the lines of “the economy does look soft right now, but we’re continuing to see robust demand and orders growth” (Franklin Electric most recently said this on Tuesday), dividend hikes, and takeovers of other companies.
As concerned as the market is about the economy, we all still wonder at least a little what the impact of a downgrade on our debt rating would be. For now, Fitch and Moody’s have retained their AAA rating, with a “negative watch,” while S&P has yet to announce whether it will change its rating from AAA. Despite all the consternation, treasury bond prices have soared, and the U.S. dollar has risen. In just the last 6 trading days, the 10-year treasury bond yield has plummeted from 2.98% to 2.42%. That corresponds with a 5% increase in the bond’s price. If anyone is still concerned about a downgrade, and holders of U.S. debt selling en masse, the bond market seems to be laughing in his face.
Perhaps the most noteworthy trading activity today was that the price of gold actually fell by $7, and silver tanked 7%. Precious metals have been the safe haven of late, so you’d assume that on a day of panic selling in the stock market, all the cash coming out of stocks would be headed to gold. Not so much. This is pure evidence that the market’s worries have shifted away from long-term deficit spending towards recession. In addition, “safety stocks” (health care, consumer staples, utilities) have finally come to the fore by dramatically outperforming the market today, while the deep cyclical sectors like energy and materials got slammed. We would expect that to be the case as long as recessionary fears are pervasive in the market.
Market technicians are looking for support on the S&P 500 around the 1170-1175 level, the lows from last November, which is only down another 2% from today’s closing price of 1200. Below that, good support is in the 1130 range, which gets us back to the levels of last summer’s malaise. It’s certainly instructive to remember how far the market has come up since last summer: since the S&P bottomed on July 1, 2010, at 1010, stocks enjoyed a +34% run into the highs this May.
Obviously, we’ll continue to watch for signals on the economy’s direction and will keep you abreast of the latest developments and our prognostications. Please don’t hesitate to call or email us if you have any questions.