Volume 59, Number 11 | June 17, 2011
Economics matter less than politics these days with the twin Damocles Swords of the Greek bailout and the US debt ceiling hanging over our heads. Apparently progress was made on both fronts late this week, but as we have learned about the wacky world of politics, no deal is a real deal until it is signed into law – and maybe not even then. If the politicians successfully kick their cans down the road, we expect a rebound in the early third quarter as auto production ramps up during the normal seasonal shutdown in the first two weeks of July. The consensus outlook for the second quarter has faded with forecasts now clumped around 2% real GDP growth – or a rough repeat of the first quarter. The weakness – like in the first quarter – is viewed as temporary, with the Japanese auto problems sapping 0.75%-1% of the growth from the quarter. A rebound to 3.5% is expected in the third quarter – and then the consensus gets mixed with optimists seeing growth continuing north of 3% in the fourth quarter and into 2012 and pessimists seeing a slowdown as stimulus passes and profits fade. You might have guessed we are in the latter group. Autos will give the economy a temporary bump – but it is up to politics to generate the optimistic story, as it would require profound improvements to the structural economic underpinnings of the US, Europe and China. That is a tall, tall order — especially in an election year here, a transition year in China, and with wobbly governments in Europe.
Teach a Man to Fish…
It was Germany that blinked first, backing down from its demands that bondholders share in the pain of the Greek bailout. President Sarkozy, defending the solvency of the French banks, and ECB President Trichet, defending the solvency of the European Central Bank, prevailed. Though the political fallout in Germany is likely to be swift, Chancellor Angela Merkel apparently would rather lose power than be remembered as the women who collapsed the ECB and maybe the whole euro experiment. We have long argued that the crisis in the periphery is really a Northern European problem. The debtors will suffer from a lack of buying power going forward, but the creditors in the North both lose their debt fueled buyers and face a collapse in asset values since the debtors won’t repay old debts either. The North needs a new buyer – but the current decline in asset values will make them more reticent to generate their own debt financed customer. Catch-22, since surplus nations ultimately must fund deficit nations, a reticence to lend reduces global growth.
Northern Europe is learning that it is hard finance your old age by collecting on loans made to foreigners who squandered the money. Had they made equity investments, they might have watched how their money was spent more closely and guided the foreign managers of their funds to the same success that originally made Northern Europe wealthy. It is the intergenerational passing of skills – and the younger generations’ improvement on them – that generates growth. Failure to invest in the education and skills of the younger generation leads to the Dark Ages. When whole nations age, they must depend on technology, or immigration, or foreign investment to preserve their living standards as the old generation becomes less productive. North America has long relied on immigration and the assimilation of those new entrants into the social fabric. Big American businesses are committed to free and open markets, with superior returns on their foreign investments still a major offset to our huge trade deficit. Japan has refused immigration and relied heavily on technology and more recently off-shore investment into China and the rest of Asia. Their debt investments largely have been to the US in the form of Treasuries purchases. Europe has resisted immigration, as reflected in low labor mobility, and new entrants are only slowly assimilated into the core culture. Lending has been largely as vendor finance to nations with previously poor growth track records and foreign investment has been limited to only the largest companies. Major European producers have been slower to invest in their client states – especially within the Eurozone. Now, the biggest new kid on the block, China, is following the US/Japanese model of foreign investment, competing with Europe for new customers.
The Eurozone created an illusion of growth as it allowed the productive North to compete at a weaker than normal currency and the periphery to benefit from debt fueled consumption at lower than normal interest rates. The result is a North which is overly dependent on export sales, which it will not be able to maintain if the euro breaks up and their currency appreciates. The periphery is now overburdened with debt, and between the lack of new lending and rising interest rates they face a profound decline in living standards. The only real solution that allows the North to collect on their debts requires equity investment into the periphery to make them productive enough in the future to repay past debts. That investment can come from the North – or from a new participant, like China, and a new political equation. Alternatively, the North can abandon the periphery and look for new customers elsewhere, but without unwinding the Eurozone with its issues of access and political control, that would seem impossible.
Help on the Home Front?
While Europe is hashing out its problems, Vice President Biden is doubling down on US efforts – promising a potential $4 trillion decade long deficit reduction package in July. Talk is cheap in Washington, but hints are being dropped of a “$3 in spending cuts for $1 in tax hikes” package. Biden elusively stated the reduction would come in ten years “or so”, reminding us of Obama’s $4 trillion proposal back-loaded into years 11 and 12. Nevertheless, any progress is helpful. When Simpson-Bowles was first proposed no one thought it would go anywhere. Now we have members from both parties vying to cut the deficit and a bevy of Governors prepping their runs for the Presidency in 2016 and beyond based on their success in correcting state deficits today. The key is whether the drive to reduce the fiscal imbalance is maintained as the auto bounce develops. We will be watching claims and the equities market as our keys. An improvement in either would relieve pressure on Congress and likely start the stalling tactics again – shifting the pressure to August when the debt ceiling’s threat becomes real (well, more real on a relative Washington basis…)
This week brought disturbing economic data from the Philadelphia Fed, which plunged into negative territory – with new orders having fallen from 40.3 in March to -7.6 in June. The less watched Empire Index also collapsed below breakeven. The question is how much are these statistics in the rear view mirror reflecting Japanese supply chain issues that appear to be abating? Toyota announced this week that eight of its twelve US assembly lines are up and running and that the other four would be on line by September, well before November as indicated earlier. Initial claims for unemployment fell to 414,000 this week as the seasonals begin to look for layoffs that will not occur over the coming month. State level data on claims from last week indicate there were significant declines in all five of the Japanese auto affected states. Meanwhile, industrial production for manufacturing rose 0.4%, failing to reinforce the weaker purchasing manager surveys. Moreover, within the details of the report, fabricated metal products – the category most closely correlated with overall industrial growth – rose 0.6%, sustaining the trend rate of the past five months. The details of both claims and industrial production suggest that the slowdown has been narrowly focused and will soon reverse. However, the details do not point to acceleration elsewhere in the economy. It still looks like 2.75% is trend in the short run.
However, while others believe the economy will accelerate next year – primarily because it always has in the past – we worry that we are headed for slower potential growth due to insufficient capital investment (never mind human capital investment via education.) There is a strong correlation between capital spending growth and productivity – with a roughly a three year lag. The investment boom of the 1990s helped spark a long sustained expansion in productivity, and the jobless expansion of the early millennium.. A less robust investment boom recently is responsible for the still strong productivity growth underway today and another jobless recovery. However, capital spending has collapsed over the past three years as credit has been restrictive. This suggests that productivity will hit a trough of roughly 1% growth in the near future.
In 2010, nonfarm business productivity fell by -1.3%, but that came after a torrid 6.3% gain in the first year of recovery. If productivity slows to 1% over a prolonged period, potential growth will also fall by roughly 1% from the current expectations of near 3%. Potential growth at 2% plus inflation of less than 2% suggests nominal GDP growth of less than 4% — hardly enough to pay down debts at all, never mind aggressively. It also suggests that current 10 year note rates which have been bouncing in a wide trading range between 2.9% and 4% may not be that far out of line – as ten year notes generally track well with long term nominal GDP growth. Big firms indicate they may be ready to spend on plant and equipment again, but small businesses are still very wary of any new capital outlays. Even 100% expensing has failed to stir much interest. We will watch the second half carefully for an expected pulling forward of capital investment – but we see no signs of it yet and given supply chain problems one would have expected buyers to give themselves more lead time.