Volume 60 | Number 6
It has been our experience that when everyone is lowering their forecasts for growth in the next several quarters and starting to talk about recession, we are already in one. First quarter real GDP grew at just a 0.4% annual rate after the latest annual revisions. Second quarter growth was originally reported at a 1.3% annual rate, but revisions – particularly from a wider trade gap – suggest it will be revised under 1% as well. Now the consensus for the third quarter – once over 3% on an expected auto rebound – is at 2% and falling with a month in the quarter still to go. The stock market has fallen almost 20% and is closing on bear territory. Ten year note rates have collapsed from a peak of 3.73% a month before the Japanese quake to a post war low of 1.99% this week – with rates falling by more than 1% in the past three weeks. The Federal Reserve has effectively eased, calling for zero rates for two years. If it walks like a duck…
It is easy to extrapolate current trends into an exaggeration of the current problem, but the real nature of markets is cyclical, not linear. The reason for lower rates and a weakening stock market is that investors are sending signals to policy makers that conditions for growth are seriously damaged and more weakness will follow if repairs are not made. Policy makers usually heed these calls. The more dramatic the crisis, the faster the resolution – though speed often trumps efficacy. Treasury and Congress responded immediately to Lehman, though several do-overs were needed. Europe has repelled each assault on the PIGS, but so inefficiently that they are still working on a permanent answer. Bottom line, we expect a response to the current slump –especially if it spills over into real economic data – but it probably will be another band-aid, not a cure. President Obama is already out with his calls for more of the same medicine tried last time (payroll tax cuts, extended unemployment benefits, and an infrastructure bank). We are certain to hear more from others as the election cycle heats up this fall heading for Republican primaries in January. Failure to address the end of payroll tax hikes and extended unemployment benefits is a serious roadblock to growth in 2012 that no politician up for election is likely to ignore – and the markets will keep reminding them.
The biggest scare this week came from the plunge in the Philadelphia Federal Reserve Index to -30.7 in August from 3.2 in July, with new orders down to -26.8. This index is directionally important, so we should be nervous about a further slowdown in the previously strong manufacturing sector — but it is a poor indicator of degree and very volatile. Recall that the overall index was at 42 in March, just before the Japanese quake, and the quarter came in at 0.4% real GDP growth. Even using a three month average to dampen volatility, the new orders index was overly pessimistic in 1995 and 2010; it was as weak in 2001 as in 2008; and the series was far too strong in 2004 and 2011.
Indeed, it may have been overreliance on strong manufacturing indexes like Philly Fed that stoked up economic forecasts and the investment markets in early 2011 – helping lift mortgage rates to levels that virtually assured another round of home price depreciation and banking weakness. At the end of the day, the US economy remains hamstrung by a banking system that won’t make new loans as long as it is still uncertain about the risk (and capital losses) in existing loans. The bad news is that a solution to the housing problem is not yet apparent even with 2% ten year notes and 4% thirty year fixed rate mortgages. The good news is that banks can’t cut back much on lending – as they never loosen the credit reins very much — and that limits the depth of any recession. For housing starts to fall as much as in a normal recession would require negative starts (maybe not a bad idea.) Motor vehicle sales are already below replacement. Investment in capital equipment was only growing at a 5.9% annual rate in the second quarter of 2011 – down from 22% in the first half of 2010 – and the sector is 44% imported, so the domestic content accounts for just 4.6% of GDP. The big risk to the economy is that exports – which account for 13% of GDP – slow from their 6% real growth rate. The biggest boost will come if the government sector – which accounts for 19% of real GDP – stops sliding at the -3.3% annual rate averaged over the past three quarters. Government alone has shaved an average -0.7% off real GDP in the first half of 2011. Further cuts are likely, but they are more likely to look like trimming compared to the ax seen in recent quarters.
The Good, the Bad, and the Ugly
The good news is that lower interest rates are allowing businesses and governments to significantly reduce their interest costs. The five year note is now less than 20% of the rate paid by the government five years ago. The 3.7% decline has been partially passed along to businesses as they refinance old bank debt at far more competitive rates – for those who can get it. Bottom line, the strongest firms are gaining further advantage over still over-levered competitors driving more of business into the strongest hands. Successful firms see little risk from new entry, as bank lending remains tight, and have so far avoided price wars in competing for the relatively fixed economic pie. Rather, they are fattening margins where possible by earning monopoly profits (or oligopolistic profits for the economists in the crowd) as they drive weaker competitors from the market. Historically, it is the appearance of temporary monopolies that give businesses the margins and confidence to hire and invest. Usually these come via Schumpeterian creative destruction as new technologies (and their patents) provide innovators with fat margins as the replace old school competitors (can you say Borders.) However, the financial innovation of less debt may be a significant source of creative destruction in this cycle.
The bad news is that while equity prices and interest rates have plunged in recent weeks, many industrial commodities prices are still holding their ground. Brent crude (which is the marker for domestic gasoline prices, rather than WTI) is still hovering around $108, down from $124, but hardly cheap. Copper is at just under $4, down from $4.65 early this year – but still at the peak levels reached pre-Lehman. These trends reinforce the view that this correction is more financial in nature – and more focused on the developed world – than in the real economy. Normally in a recession, falling energy prices act as a tax cut, especially for the 75% of Americans with incomes below $75,000 (AGI) who represent 33% of income and 40% of spending. We have discussed at length how rising commodities (and particularly fuel) prices lead this group to conserve on more expensive domestic labor imbedded in services and rent. Now that the top 2.5% of households, with incomes over $200,000 (AGI), are being hit by the decline in equity wealth, we can expect new pressure on service consumption as this group’s marginal expenditure is service heavy with relatively more spending on finance, insurance, entertainment, travel, education, medical care, etc. Bottom line, the lack of relief from commodity prices means consumers and businesses will continue to conserve on US labor, sustaining the difficulties for retail and construction and limiting any upside from stimulus relative to past cycles.
The ugly is the potential for the gap between the emerging markets and the developed world to close far faster than even we have previously expected. China is in the unique position of being able to raise the value of its currency to defend its export markets, while simultaneously cooling domestic inflation. Like Wal-Mart, China is a low cost provider, so when sales slow due to economic weakness, they can actually raise prices (offer fewer sales) as the downturn will drive more business to the low cost provider anyway. Moreover, if as many think the renminbi is significantly undervalued, a move toward proper pricing would increase efficiency and potential growth – and the biggest beneficiary of stronger world growth is China. Sustained growth in China would sustain growth in the commodities oriented bloc including Brazil, Canada, Russia, Australia, Indonesia and others. Due to their income levels, as these countries grow they demand more commodities and low cost, less sophisticated, industrial exports from each other rather than pricey imports from the developed world. Bottom line, the gap between the cost of their labor and unskilled labor in the developed world may close far faster than currently expected.
The opportunity for the developed world in this environment is in innovating technologies that reduce demand for increasingly expensive commodities and already expensive developed market labor. We expect that emerging market currencies and commodities prices will remain under upward pressure until these new technologies are available – which seems years away. In the mean time, significant movement in relative prices – rather than inflation – will direct more resources to commodities and away from services (especially rent) until a new balance is achieved. This is unlikely to happen smoothly and without contention given the differing political and cultural status of the competing parties. Our primary volition to investors is that they must be nimble and willing to think outside the box to preserve and improve capital. The next few years may be the greatest time ever to be an entrepreneur with creative ideas — and the worst to be a passive investor looking for any positive yield on risk free assets.