Volume 60 | Number 3
Apparently Europe has kicked the can down the road and the United States has not – yet. The Euro zone has settled on a package that would broaden the use of the European Financial Stability Facility to allow it to buy securities in the secondary market and to shore up weak banks by lending to their respective parent countries. The debt of the three little PIGs (Portugal, Ireland and Greece) was extended to 15 years from 7.5 and the interest rate was lowered from 7% to 3.5%. Private investors will take a 21% haircut on the value of their bonds, but this will not trigger payouts on credit default swaps according to the ISDA (the body which has final say on credit events.) This agreement still must be ratified by all members of the euro zone, including the Germans and the Finns who have balked in the past. It also leaves open the question of whether the current EFSF is large enough to handle all of the current problems, never mind if Spain and Italy remain under pressure. Still, their can has been kicked.
In the US, Speaker Boehner walked away from his talks with the President on Friday, but negotiations appear to have continued all weekend. The sticking point remains new taxes, which are anathema to the conservative House Republicans. The likely scenarios at this point include the convoluted McConnell plan or a much simpler approach in which the House simply passes a small package of widely agreed to cuts – say $1 billion – and sends it along to the Senate daring them not to pass it and the President not to sign it. This probably would not kick the can past the election, but at this point that may be the point. Both sides appear ready to make taxes hikes versus spending cuts the centerpiece of the election, so move the artificial crisis of the debt ceiling a little closer to the day of reckoning and have at it. The rating agencies are not likely to take kindly to the lack of a big tent solution, so the US crisis may not be kicked too far down the road after all.
Finally, in China economic growth is slowing in reaction to the several rounds of credit tightening and interest rate hikes that have taken place over the past year. Monetary policy acts with a long and variable lag, and China was still raising rates just two weeks ago after further acceleration in their consumer price inflation. This week, HSBC reported that its flash estimate of the Purchasing Managers Index fell below 50 continuing a downtrend that has persisted since the peak in November at 55.3%. The current reading may overstate weakness as the series is relatively new and showed a slump last summer (when the economy was cooling a bit) before rebounding strongly despite no change in policies. Premier Wen Jiabao announced in Europe that inflation is under control now in China, but that was before the last rate hike. Moreover, while the rate of increase in inflation will likely decline as food prices rise at a slower pace – China appears willing to accept a 5% CPI inflation rate, which probably means something closer to 7% or 8% for the GDP deflator. As the recent tax cuts show, China is willing to follow a policy of fiscal ease and monetary restraint to rein in runaway debt fueled spending by the state owned enterprises and provincial governments while still promoting a stronger consumer. We expect that if China’s growth falters below 8% a new round of stimulus targeted toward low income households and small businesses will be forthcoming.
With the efficacy of can kicking unclear and the economic driver of the global economy slowing, it is hard to see why firms would be aggressively expanding. The latest National Association for Business Economics survey showed that only 11% of respondents still see 2011 real GDP growth over 3%, while 24% now see it below 2%. Given slightly less than 2% growth in the first half of the year, that leaves the dwindling optimists expecting over 4% real GDP growth during the second half and pessimists with growth basically the same as in the first half. We note that Caterpillar announced it expected US second half growth to slow to 2.5% from their earlier consensus opinion of 3.5%. Caterpillar is exposed to the fastest growing sectors of the US economy – agriculture and mining – but also its most moribund – construction. We have often said that one of the most important cycles in business is the corporate strategic planning for the coming year that starts after Labor Day. With expectations on growth waning late in the summer, much as they did last year, we doubt hiring and capital spending plans will be robust unless the economic picture clears considerably. Note that even an undesirable permanent outcome on the debt ceiling is probably better for business than continued uncertainty. Failure to reach a long term solution is now one of the greatest risks leading to a slow bleeding out of profits (due to a China imposed commodities price squeeze) and the potential for a catastrophic recession (starting with too high unemployment and too high a budget deficit) within the next two years. The only good news is that the election cycle now provides for a possible coalescing of attitudes with someone claiming a mandate at the end of next year (whether they have one or not.)
The auto bounce appears to have busted. The long awaited decline in initial claims for unemployment as auto plants operated through their normal shutdown period in early July simply did not happen. Initial claims rose 10,000 in the past week to 418,000, with Minnesota government related layoffs accounting for only 1,750 of the new claims. In last week’s 408,000 reading, Minnesota layoffs accounted for roughly 10,000 of the total – so this week’s count rose about 18,000 net of Minnesota back toward the 421,000 four week average. Even the just sub-400,000 reading that would have occurred last week without the Minnesota workers was not due to the auto industry. Claims in the five Japanese-oriented auto states that saw the big run up in claims after the earthquake (Kentucky, Ohio, Indiana, Alabama, and Mississippi) saw initial claims rise 4,000 last week. Meanwhile, claims in Michigan, Illinois, Wisconsin and Tennessee– all states with heavy exposure to auto production and parts and where seasonal expected big increases in claims – they fell only a modest 3,000. Apparently, the auto industry had nothing to do with last week’s drop in claims at all. State data suggest the prime culprit may have been California, where new filers often delay claims until the start of a new quarter to maximize benefits, leading to a sharp drop back to normal numbers in the second week of the quarter.
This week also marked the first time that the four week average of actual benefit receivers has not declined over a 13 week period since the start of the expansion in July 2009. Given the strong correlation between changes in the number of beneficiaries in the first 26 weeks of unemployment (standard benefits) and the payroll employment growth, this does not bode well for the upcoming jobs report. Typically, firms would be most likely to rehire form the pool of most recent layoffs, rather than from those out of work more than a half year. Increasingly, long term unemployment is seen as a signal that bars new employment. If those likely to be hired first are not getting jobs, the situation must be getting appreciably worse for those already long term unemployed approaching the end of their benefits.
Perhaps the auto rebound will come later in the quarter – but the 1.0%+ that an auto rebound was supposed to add to the third quarter is getting a lot more questionable. Like the first quarter whose fade was blamed on the weather, and the second quarter whose fade was blamed on Japan, forecasts for third quarter real GDP are losing their traction as well. Note that there was no apparent rebound in the second quarter from weather, and first quarter weakness now appears to be primarily in the consumer sector after a blowout in the fourth quarter. Weakness in the second quarter was as much rising energy prices as it was Japan. Going into the third quarter, a hoped for energy price decline has been muted, and now hiring is slowing, which limits income growth. We still expect real GDP growth around 2.5% to 3% in the third quarter — but that means either the unemployment rate does not decline or corporate profits are squeezed. It is simply not enough growth to make everyone happy.