While the consensus continues to focus on the resurgent housing market, we are much more concerned with the lack of activity almost everywhere else in the US. Housing now looks like it will see a 25% increase in construction activity in 2013, as single family starts continue to ramp up assisted by low mortgage rates. Car sales also look to improve significantly in 2013. However, the rest of the private sector looks moribund and the 20% of the economy represented by government is still in contraction. The consensussees the surge in housing and believes that we are just breaking out at the beginning of a long awaited recovery. We see declining fiscal stimulus and an inability to increase already wide open monetary accommodation and expect an end to the cycle within two years. We cannot identify the culprit that will bring this cycle to a close. Some end with a whimper rather than a bang – but the lack of investment makes the economy vulnerable to any of a number of global threats from European meltdown, to Chinese banking missteps, to overt or covert economic (and maybe shooting) war.
We are concerned because it looks like most of the good news on the economy is simply distortions caused by the rampant quantitative easing – which is benefitting specific areas of the economy a lot, but the overall economy not so much. The stated purpose of QE is to buy up risk free assets to force investors out the yield curve. This will in turn drive down risk premiums and spur more economic activity. It clearly is resulting in higher asset prices as reflected in the stock market and increasingly in real estate. It is not clear at all that it is increasing the appetite for risky investment as most activity appears to be in mergers and acquisitions and paper trading, not fresh investment in the real economy. Leading indicators came out this week up a stronger than expected 0.5%, after an upwardly revised 0.5% in January and a 0.4% gain in December. This sounds quite good – until one
digs into the details. The strongest components of the leading indicators are lower interest rates, better credit extension and rising stock prices – all direct consequences of QE. The weakest part was consumer confidence – despite improvements in claims and the workweek. The majority of consumers (by population not spending power) are still dealing with the fallout from the fiscal cliff. Add in concern about higher gasoline prices and the still unknown consequences of sequestration, the recently passed continuing resolution and the upcoming budget and they have reason to worry. Meanwhile, business activity remains soft with ISM orders down, and orders for consumer goods and non-defense capital goods ex-aircraft improving slowly.
If we look at the ratio of coincident to lagging indicators, which many analysts see as a better historical cyclical indicator, it has gone nowhere over the past six months. Indeed, it was falling in January and February as leading indicators soared. The coincident to lagging ratio is at a very low level historically – while leading indicators is at an average reading. Both are well past their cyclical high when stimulus was at its maximum. Unless one expects another surge in government stimulus – which we and virtually everyone else sees as highly unlikely – we are not going to get a bounce like in 1996 or 1998. Falling interest rates were a key to the long ten year cycles of the 1980s and 1990s. Now, the only question is how long will this cycle trend sideways to down before it succumbs to some disease of old age.
The dead cat bounce for the Philadelphia Fed Index in March is another signal of the lackluster real economy. With general business activity at 2.0 in March, it was certainly an improvement from -12.5 in February, but hardly robust after to deeply negative readings. New orders limped into positive territory at 0.5, but unfilled orders dropped – as it has for the past six months – as shipments outstripped new demand. Delivery time was also faster (producing a -7.5 reading) signaling slack in
the system. Employment rose very modestly for a second month, but only as the workweek contracted sharply. As we noted last week, employment indicators like initial claims are starting to improve as businesses are adding workers and reducing hours. They have simply reached the limit in working their existing employees and are finally beginning work spreading. This does not promise as much income growth or spending power as the headline jobs numbers would suggest. It is a traditional middle to late cycle process as the pool of available skilled workers is depleted and their mobility leads to both higher wages and better treatment.
Manufacturing output has provided a number of false starts in this cycle jumping early in each of the past four years. As we noted above, leading indicators and the ratio of coincident to lagging indicators both see a monotonic slowing rather than the see-saw pattern depicted by industrial production. The Federal Reserve – which calculates factory output – is uncertain about the sustainability of the early year optimism having been chastened in each of the past three years. Chairman Bernanke noted the upturn in his most recent statement – but indicated no change in policy was on its way any time soon. We believe the Fed is much more worried about the muddle through indicated by the Philadelphia Fed.
We believe in a preponderance of the evidence, and in our view there are still too many headwinds for the wind in the sails of the housing market to overcome. The Fed is certain to continue quantitative easing, and therefore boost both asset markets and the core of the leading indicators. However, until we see banks loosening their lending standards AND (yes, I capitalized it on purpose) consumers snapping up the money, thus lowering their savings rate, we expect the muddle through to continue. We do not see consumers as ready to return to the bad old days before Lehman soon. Meanwhile, businesses also remain cautious because their thousands of consumer analysts and billions spent on consumer surveys do not find an imminent upturn in consumer spending either. The consensus can watch housing, we are focused on bank consumer loans and business investment in plant and equipment, which are still muddling along.