Volume 59 | Number 9
May payroll employment rose a far weaker than expected 54,000, and revisions cut another 39,000 off the past two month’s total. The unemployment rate rose to 9.1% despite a gain of 105,000 jobs in the household report, because the labor force (which has been stagnant) rose 272,000. The consensus expectation going into the report was 160,000 according to Bloomberg, which was revised only slightly lower than the 180,000 expectation before the weak ADP employment report on Wednesday. Several indicators including initial claims for unemployment, ADP, the Conference Board’s Jobs Hard to Get Index, and the various purchasing manager reports have all flashed warning signs that Japanese supply chain issues are weighing on new orders. Some analysts blame the high price of gasoline, which has cut consumers spending power, or weather – but we see these as secondary causes of the current weakness. It should not have been such a surprise that employers would hold back on hiring in May as the economy softened further – especially after hiring so aggressively in February, March and April when first quarter real GDP growth was just 1.8%.
A Bouncy Ride to 2012
Now, the question is how fast are the Japanese supply chain issues resolved? And, secondarily, do energy prices remain a problem for consumption growth. It is clear that auto plants are coming back on line as bottlenecks are worked out of the supply chain. Inventories are quite low and this hit car sales harder than the industry had expected in May. Specifically, plants that would normally be shut down in early July for maintenance are now likely to be running flat out or as close to that as supply chain issues will allow. There will be some incredibly strong seasonally adjusted readings on indicators like initial claims, industrial production, durable goods orders and the purchasing managers’ reports as we reestablish the supply chain. While supply chain issues are likely to depress real GDP growth in the second quarter (now estimated at 2.5%, after 1.8% growth at an annual rate in the first), there should be a strong rebound in the third on autos alone (maybe giving us a solid 4% handle on real GDP growth), then set back again in the fourth to the 2.8% trend. I suspect the jump in the third quarter will lead to over optimism again – with a stock market rebound, but even more likely a sharp back up in interest rates from current very low levels.
We suspect oil prices will be flat to lower over the remainder of 2011, giving some modest relief for consumer confidence. Gasoline prices normally peak seasonally in the week of Memorial Day and crude oil prices peak seasonally just before the Fourth of July. Interestingly the peak in both is about 12.5% above the seasonally adjusted price, and two weeks before Christmas, both hit their trough at about 12.5% below the seasonally adjusted price. Thus, if oil and gasoline stayed at current seasonally adjusted prices we would be looking at $3.00 gas and $75 dollar crude by Christmas. Since CPI and PPI are seasonally adjusted numbers, this would leave them unchanged – but even that is a big change from the recent trend. If energy (and food/corn/ethanol) prices added no oomph to inflation, the headline would slow to less than growth rate in the core – which is currently just 1.3% year on year in April. CPI could be negative in May on falling energy prices.
Our basic view is that we are in a 2007 scenario – with this as the last year before the challenge of a recession next year. The economy is expanding at about 4% nominal (2.8% real and 1%+ inflation as measured by the GDP deflator). However, wages are rising at a 4.5% annual rate – our income proxy (hours worked x average hourly earnings) was up at a 5.7% annual rate in the past three months compared with the previous three, after a low 3.3% reading in the prior three month period. The 4.5% average over the past six months is only fractionally higher than the 4.4% trend in the past year. Bottom line, businesses are in a modest margin squeeze as wages rise slightly faster than revenues, and import costs are rising faster as well. Though margins are narrowing and volume is not great, corporate America has fat margins and high savings to run through before we reach crisis. Small businesses are more vulnerable, especially since they have less of a credit cushion. Bottom line, we expect a rebound early in the third quarter, followed by a “what next?” attitude after Labor Day as businesses begin to worry about the impending loss of stimulus – particularly from the reversal of the payroll tax cut. We worry less about the debt ceiling debate, as austerity from a compromise package is likely to be concentrated in the later years of the ten year horizon, boosting confidence about the future of budget deficits while limiting fiscal drag now.
Fastest Horse in the Glue Factory
We are headed to Helsinki, Finland tomorrow to participate in a Global Interdependence Center conference on the post-crisis financial markets. The discussion will center on what Sweden and Finland did right in getting out of their banking messes. I am sure that some conversation will arise concerning the future of both the euro and the dollar. From our point of view, this is a completion of who has the biggest problem and how quickly and successfully will they reach a solution. As we see it, the US has two basic problems: one is a housing valuation crisis, which undermines our banking system; and, the other is a long term entitlements problem, which threatens our ability to borrow in foreign markets. Europe also has two problems: one is the current losses on Greek, Irish, Portuguese, Spanish, etc. debt caused by German and Nordic overproduction being sold to the rest of Europe with vendor finance that the borrowers now cannot pay back; the second, related, problem is what to do in the future about an economic system that is based on German/Nordic overproduction if they no longer will lend vendor finance to the rest of Europe?
Of the two problems, I see the US as less intractable. We are resolving the housing crisis slowly via: 1) less new production; 2) declining home values still seeking a bottom; 3) destruction of some homes via deterioration. It still may take years to clear the excess; especially as young people are not currently forming households at anywhere near the historic rate. This will keep home building very weak and lead to more units shifting into the rental market. As vacancy rates are far higher for rentals than for owned homes, some excess supply will be absorbed by expanding the rental fleet – and this process may be accelerated in the next recession if a bigger housing crisis pushes prices and interest rates down for potential landlords. By offering accelerated depreciation on rental units, the government could accelerate this process while shoring up values at the low end of the housing ladder. Bottom line, the US has a too big housing stock held in weak hands that it must shrink or at least transfer into stronger hands. It is a long term problem, but the solution is fairly straight forward, though painful.
As to the US entitlements problem, this is a collective fantasy. There is no way the US can pay the benefits it has promised and that lead to the huge projected budget deficits in latter years. In the next political crisis (whether caused by the debt ceiling debate or in a 2012 recession if they don’t address issues before then), we will admit that we can’t pay these future benefits. They will be revised and the US will go back to business with a new long term outlook on incomes. Everyone will adjust – for some painfully – to the new pension/healthcare environment. We already did this in several industries by abandoning pension obligations through bankruptcy in autos, airlines, etc. We are starting at the state and local level. Bottom line, no matter how painful, this will be a market positive as it replaces uncertainty with the reality of doing something that others have done before. Finally, if we do go into recession, the likely narrowing in the trade gap as the dollar falls and US buying power is squeezed again will probably eliminate the foreign funding issue. Countries with high debt levels but no trade gap — like Belgium and Japan — are far better off than countries with debt and trade gaps like Greece etc. (including the US currently.)
Europe’s first problem is what to do about the current losses in their banking system? In the US they go away if home prices rise – which could be accomplished through inflation or manipulation. In Europe, the banking imbalance is due to insufficient income among the borrowers. Imposing austerity is like trying to get blood from a stone. Any money the North gets back on debt is only going to cut into future expenditures from these nations on current goods and services. Ultimately the debt is a Northern problem either through forgiveness or unemployment. Heavy investment in the cheaper labor and land found outside Northern Europe would increase the peripheries ability to repay while still maintaining consumption. Or they could allow mass migration so southern debtors could earn higher wages in the North. Unfortunately, a lack of labor and capital mobility was a major part of how Europe got to this problem. Even if the debtors were kicked out of the Euro zone and their new weaker currencies plunged making debts more burdensome, it is unclear that cheaper land and labor would attract northern business investment. There are too many other opportunities in Eastern Europe and Asia. So far the North has continued lending to the debtors, but that is just kicking the can down the road, as they can’t sustain current import consumption and repay, so the North is still effectively overproducing and sending goods and services for free!
In any case, Northern Europe must either find new customers, or cut back on production, or consume more themselves. Bottom line, Europe has an export driven production system that needs a deficit customer in a world where no one wants to be in deficit — and if they are, you don’t want to lend to them. During this recovery, Europe has benefitted competitively from Japan being killed by the strong yen and now by the earthquake. However, as Japan comes back as a competing export producer, Europe has big problems (not the US as we don’t compete head on with either Germany or Japan). If China does not shift from being an export producer to a deficit consumer, Europe has big problems. Rising Asian and Latin American incomes (and currency values) may provide a new customer base – but this process will also drive up commodity prices and Northern Europe is not a resource exporter (like the US.) Like Japan, Northern Europe’s aging population will soon want to start cashing in the assets they have accumulated, and this may lead to the realization already reached in the US that the cupboard is bare. Bottom line, it seems to me that the European problems are far more structural in nature and will take much longer to resolve than the US housing crisis. We will see. I’ll let you know if I change my mind after my trip to Helsinki.