Economic Trends and Risks

Strengthening Sales Despite Reduced Credit

An 0.6% gain in June retail sales was powered by vehicles and higher gas prices but the gain now leaves six month growth back in the black after standing at (an annualized) -4% in May and -14% in March.  We've noted the retail sales improvement in recent posts but a broader measure of sales is also on the mend.

Business sales combine sales from retailers, wholesalers and manufacturing and were released with today's report on inventories.  The modest -0.1% decline in May sales was the smallest in ten months as all three recover from the Q4 plunge.

 

Despite the continued strong declines in payrolls, a turn in trend for industrial production is all that's needed before the recession is considered unofficially over.  Business sales and the tax/refund induced rise in incomes leaves only payrolls and industrial production on the short list to signal a return to growth.  The official word from the National Bureau of Economic Research will arrive well after the recovery has started, as was the official word on the start of the recession. 

Tomorrow's report on industrial production is expected to show a decline of -0.6%, the smallest of the last eight months as the stabilization seen in factory orders (see June 30 post) is passing through to steadier production. 

 

A brief note on consumer credit, which by my records is showing the weakest annual growth since WWII.  Declines in seven of the last eight months leave a -2% decline from a year ago tied to annual declines in both credit cards and non-revolving credit (other non-mortgage household lending).  Banks remain tightfisted as reduced consumer demand has a part in this as well. 

 

Outlook for 2009's Second Half

Last week's post noted the bottoming out of residential and business investment as well as consumer spending.  These components make up private domestic demand and are the key elements to returning positive growth in the second half of 2009.

Not surprisingly my estimates don't vary greatly from the latest from the Fed (provided in the  late April FOMC minutes).  The Fed's revisions in August will include the latest data which suggest a stronger decline in 2009 GDP (gross domestic output) to near 2.8% from the Fed's -2% to -1.3% estimate.  I expect a very moderate rise in the current Q3 quarter and a stronger but  modest gain near 1.5% in the final quarter of the year after the dramatic plunge at the turn of the year.  Any number of factors can alter the outlook.

Last week's reports suggest that the rise in unemployment is slowing.  Continued claims for unemployment benefits may have peaked in late May (or could be due to run off as the long term receivers reach their end dates) as June unemployment rose just 0.1% after the 0.4% average of the prior six months.  I'm holding with a year end rate just below 10% as the Fed will boost its April estimate of 9.2% to 9.6%. 

Inflation will reflect the run off of the late 2008 plunge in energy prices and end the year with an annual growth rate above 1% from the near flat level currently.  I expect core prices (less volatile non food and energy) to continue to soften and end the year in the 1% to 1.5% range the Fed noted in April.  The inflation wary may want to note that the Fed doesn't see core inflation rising above 1.6% over the three year forecast horizon. 

Bottoms, Up?

Last week's reports on home sales and durable goods orders added further confirmation that the recession is nearing an end.  Strong late 2008 declines in home sales, factory orders and personal spending appear to have bottomed out.  The watch now is for the speed of the initial upward trend, expectations are modest despite the massive stimulus.

I touched on the home sales early signs of stability in an April 24 post.  While signs from existing home sales have to be questioned given the inclusion of resold foreclosures, the flat-lining in new home sales suggests that the trough hit early in the year when the level was -76% below the peak in mid 2005.  A revival in housing starts will wait for inventories to be further pared down as demand strengthens.

Durable goods orders (see Apr 24 post) have also flattened out in 2009 after a dramatic drop  over the second half of 2008.  The back to back gains in April and May leave market expectations for a rise in factory orders Thursday.  More importantly, factory orders are a leading read on industrial production (see May 15 post) which have been in a severe nosedive leaving capacity utilization at just 65% for the key manufacturing sector.   The strengthening stability in manufacturing is key for the economy and seen in the ISM manufacturing index as well. 

 

The effects of the fiscal stimulus are evident in consumer spending (see May 27 post) as tax cuts and refunds have provided the recent stability after the plunge in late 2008.  The forces fighting for continued weakness are the lower employment and income growth which limit the ability to spend as well as the return of stronger savings given the massive decline in household wealth (see June 16 post). 

 Real personal spending, in the chart below, adds service spending to the goods spending of retail sales.  The inflation adjustment in real spending has been significant as well.  The 0.1% rise in the personal consumption expenditures (PCE) price index from a year ago contrasts with a 4.5% annual rate in July 2008.  With a large 70% weight of GDP, consumer spending is the key to positive economic growth.

My current expectations are that more troughing indicators will leave a slight rise in the current Q3 GDP and stronger late 2009 growth as the recession marks the longest since the 1930's depression. 

Improving Labor Markets

I'm reviewing the recent trends in the weekly unemployment claims data as a preview of next week's key employment report. 

Remember that May payroll decline came in at a seven month low -- far better than expected given  the lack of a significant decline in initial unemployment claims.  While the data continue to reflect a slow downward trend from the 4-week average peak in early April, they still don't reflect a significant improvement which would drive the payrolls data.  The improvement since the May payroll survey week is only 13,000.   Reason enough to expect market forecasts and the June payroll decline to be larger than the May decline.  That won't help market expectations.

The continued claims data which best approximates the unemployment rate is showing reasons to be enthusiastic about the June employment report.  The lack of a significant rebound after the -126,000 June 6 decline argues for a small rise in June unemployment after the half point rise in May and the 0.4% average monthly rise over the last six months.  A slowing or peaking(?) unemployment rate will strengthen expectations for the recovery.

While initial claims (i.e.  for those just fired) seems to have reached its peak in late March it may be too early to say the same for the record high in continued claims (i.e.  unemployed) in late May.  But peaks are the turning points as the pressures on the labor markets begin to improve and provide further confirmation that the recession is nearing its end.   

Another Drop in Wealth, Lift in Q2?

The first quarter figure on household wealth showed the seventh consecutive quarterly decline since the record high in the second quarter of 2007.  The $1.3 trillion (yeah, Trillion) Q1 decline left a $14 trillion (22%) plunge since the peak in 2007.  A primer on what the measure includes is in a March post as the size of the cumulative dive nearly equals the country's annual production (GDP).

The massive decline in household wealth over the last two years is behind the expectation that this recovery will lack a strong upturn in consumer spending.  The slow rebuilding of wealth will foster the upturn in savings (already seen) at a cost to spending.  However, the outlook includes what seems to be a turn in trend as we're likely to see a stock inspired rise in the current quarter wealth given the sharp equity price gains since the March lows.

Falling home prices have been a smaller negative contributor than financial assets but have been longer lasting for over two years.  Home prices haven't bottomed out yet but their declines are slowing.  New home prices have risen in three of the last six months while existing home prices have shown gains in each of the last three months.  With some good news over the rest of the quarter even real estate holding may provide a small boost to wealth. 

 

 

Rising Treasury Yields

The markets are concerned that 10 year Treasury yields are rising quickly and are now nipping at a measly 4%.  The risk is that these higher rates could choke off gains in the reviving housing market and slow business and consumer borrowing (or what there is of it).  Needless to say a 4% yield on 10 year borrowing is hardly inhibiting as the turn in the downward trend really only reflects the expected factors that direct it.

The vastly expanded supply conditions are the most obvious factor.  The Treasury is funding a tremendous budget deficit of $1.8 trillion this year as the Administration’s outlook is for another $1+ trillion deficit next near and levels above a half trillion for years after that.  Funding a deficit four times the size of last year (11 times the FY07 size) will force higher yields as an investor incentive.

 

(Aside:  Understand the massive size of a trillion.  When was a trillion seconds ago?  Don't calculate, just put out a guess.  The answer is below.)

 

Demand for Treasuries isn’t matching the huge new supply.  The Fed is buying them in an effort to help offset the upward forces.  However, to date little of the Fed purchases have hit the 10 year maturity range.

 

Private investors are edging away from Treasurys as the global recession’s flight to quality cools and equity prices move higher. 

 

The fear is that foreign demand will cool.  Over the last year foreigners have purchased on net over $300 bln of Treasury bonds and notes – a large count during typical times but a small share of the massive $1.8 trillion of new supply this year.

 

Treasury yields also reflect inflation or inflation fears.  The very aggressive Fed easing though a near 0% overnight policy rate and the extremely large quantitative easing has touched off inflation fears now that the economy appears headed toward recovery rather than a more severe downturn and potential deflationary effects.  I expect the Fed to be true to its primary objective of controlled inflation by draining the large supply of excess reserves currently needed.  Moreover, the massive slack in the economy will keep inflation at bay for a few years anyway. 

 

Nonetheless, the market's inflation fears and the approaching (early 2010?) tightening of policy set the tone for higher interest rates.  Rising yields are no more surprising than the turn in Treasury supply relative to demand and inflation expectations that control them.  A 4% 10 year yield shouldn't overly slow the rekindled economy based on massive fiscal and monetary stimulus. 

 

(Aside answer, a trillion seconds ago puts you back to … 30,000 BC!  A trillion – or a million millions -- is a truly tremendous quantity.)  

Smaller Payroll Decline Doesn't Impress Stock Market

The May payrolls decline showed far more improvement than expected but still only warrants the same bottom line seen in many of the economic indicators -- a slower downward trend.  Estimates ranged around a -550,000 decline as May payrolls fell just -345,000.  But add a rise in the unemployment rate to a quarter century high of 9.4% and the shortest workweek on record and the dire labor conditions remain clear.  That may explain why the stock market didn't show any real lift on Friday.

In fact, even the smaller -345K decline is the largest since 1980 if you exclude the plunge during the current recession.  To emphasize the depth of the current employment decline the chart below compares the upward trends from the lowest of the recession payroll declines to the recession ends.  From this basis the May decline finally brings the payroll declines in to the ranges of the past recessions.

 

Nonetheless, the May improvement was encouraging.  Goods-producing jobs showed the smallest decline since October thanks to an unexpected halving in the construction decline.  Manufacturing declines, under the heavy weight of the auto sector, held steady.

The large improvement (over 200K) came from private service-providing jobs.  Improvement of over 40K came from the leading indicator of temporary help as well as leisure/hospitality.  Health care continued on with monthly gains.  The improvement was broad based as retail and financial activities showed the smallest declines in over a half year.  Government payrolls (public service) fell -7K after the 92K lift census hiring left in April.

Digging through the Detail

While the results of the colossal economic downturn are reflected in the headlines, there is some good news in the economic detail. 

The bankruptcy of GM, the related factory closings and employment drop off provide some very ugly news on the economy as does the commentators' opinions of the road ahead for a government funded auto company.  Let your mind wander on that one.

The good news is in the detail of the ISM manufacturing survey where the index of new orders -- the leading indicator for the index -- rose to reflect a positive gain, the first in 18 months. 

 

The improvement in first quarter GDP growth included a rise in corporate profits after six quarters of decline and the massive -17% fourth quarter plunge.  Despite the recent declines the size of profits as a percent of GDP still stands just above the 20 year average of 9.2%.

Tax refunds helped to boost income growth to 0.5% in April -- the largest gain since the rebate-related rise of May 2008.  Given the choice between spending and savings the consumer is now siding with increasing savings given the extreme damage the plunge in equity and home prices left on 2008 household wealth (see March 13 post -- Record Wealth Decline).  The saving rate rose to 6% of disposable (i.e. after tax) income in April -- the highest in 14 years.  Despite the downward effect on spending and growth, the rise in savings is an improvement from the borrow and spend days we're recovering from. 

Confidence and Spending

The jump in May consumer confidence helped spark an impressive equity market gain on Tuesday but be warned that the factors that determine confidence are far more diverse and volatile than those which help determine consumer spending. 

The gain in May confidence left the strongest level in eight months as the forward looking expectations component rose to a 17 month high of 72 from the 27 low of February.  The three months of gain signal the start of an expected recovery though the level still stands -35% below the lowest level of the last recession.

 

Clearly the improvement in the consumer psyche is great news but don't expect it to lead to a quick rebound in consumer spending.  Confidence is rising given the surge in the equity markets and the start of stabilization seen in the economy.  Varied factors such as oil prices, terrorism, unemployment, global tensions and interest rates are also known to swing consumer confidence.

Consumer spending, meanwhile, is largely driven by income growth and to a lesser extent household wealth.  These factors haven't yet shown a turn in direction.  Personal income is up just 0.3% from a year ago given the -1.2% annual decline in salaries (read falling  payrolls). Household net worth (i.e.  wealth) fell -$11 trillion in 2008 given the plunge in equity and home prices.  That massive decline also leaves most economists expecting consumers to continue to boost savings rather than return to the conspicuous spending of a few years ago.

 

Tax refunds and the reduction in payroll taxes which came with the fiscal stimulus have  provided some lift in the monthly data but the uptrend in consumer spending will take longer to develop and be far less dramatic than the turn in consumer attitudes. 

TARP Funds Returning

Its a quiet week for economic releases.  Yesterday's report of a -13% drop in April housing starts to a new record low also carried some encouraging news as single family starts showed a third month of gain as multis/condos provided the direction.   

Underlying the continued downtrend in new home supply is the lack of demand seen in new home sales and the nearly 11 month inventory supply which needs to be worked down before the anxious builders ramp up activity.  Single family starts are stabilizing but an upturn is still a ways off.

 

The news of banks requesting to return the funds provided through TARP (i.e. Troubled Asset Relief Program) shows how quickly the tide has changed (and how desperately they want independence on year end bonuses).   Just two weeks after the bank stress tests a number of  banks are lining up to return their portion of the $700 bln the Fed used to loosen up the frozen mortgage securities market. 

The moveon TARP repayment comes just after a Sunday NYT piece written by former Fed vice-chairman Alan Blinder urging the Fed and Administration not to begin the exit strategy until the economy is back on solid ground.  "To avoid a replay of the policy disasters of 1936-37, both the Fed and our elected officials must stay the course" Blinder warned. 

Industrial Production Also Shows Lessening Declines

Industrial production is following a similar path already outlined in payroll employment (May 8 post) and the ISM manufacturing and non-manufacturing surveys (May 5 post).  After monthly declines averaging -0.8% in the fourth quarter and a doubling to -1.6% in the first quarter, April showed a decline of just -0.5% -- less than half the size of each of the last five months.

Moreover, manufacturing production showed stronger improvement with just an -0.3% April decline after an average monthly drop of -1.6% over the last half year. 

Somewhat surprisingly, auto production is aiding the improvement with a third monthly gain after the stunning forth quarter decline and the gargantuan -26% plunge in January.  Non-auto manufacturing output continues to decline but also at a slower pace than at year end.

The smaller declines are consistent with improvement in the ISM manufacturing index after bottoming in December.  The April production index was far bettered by the forward looking new orders index which reached 47.2 -- still below the 50 mark which marks flat growth (read stability) but nearing it.

 

In past comments (i.e. Telling Economic Indicators) I've reviewed the importance of industrial production as a key indicator of the economy.  The National Bureau of Economic Research uses industrial production and three other indicators (i.e. payrolls, income and sales) to gauge when the economy is in recession.  Income and sales showed gains in March.

Controlling Longer Term Inflation Risk

Despite the disinflationary aspects of the current economy and the long period of tame inflation pressures expected given the large supply of economic 'slack' (well defined by the high level of unemployment and the low capacity utilization rate), worries include the longer term inflationary impacts of the massive Fed easing. 

Not only are Fed policy rates just above 0% (remember, the housing bubble was blamed on the low policy rates in 2003-4) but the Fed has also used a tremendous supply of quantitative easing -- essentially creating money which provides an inflationary lift years later.

Just as the Fed proved able to find ways to help offset financial market pressures with the creation of funds they have begun talking about the exit strategy partly in order to guard against inflationary expectations which can feed inflation.

The solution of excess bank reserves is to either drain them from the system or make them more necessary.

To drain the huge supply of reserves the Fed will use standard forms such as reverse RPs (just the other side of the daily RPs the Fed executes) or more permanent solutions such as sales of Treasury securities.  The funds from the sales are held at the Fed and thereby drained from the banking system.   Some expect that the Fed may go so far as to seek authority from Congress to sell its own bills rather than the outstanding Treasury bills.  And as we've learned the Fed can dream up plenty of other "solutions".

To make the reserves more desired by banks the Fed may boost the interest payment paid on reserves or raise reserve requirements as part of the policy tightening phase -- thereby improving the Fed's control on reserves and responding interest rate movement. 

The Fed will be equally able to drain reserves as add them.   Inflation will continue to be the primary focus of the Fed and believing that it won't guard against an inflationary rebound from the extremely generous policy stance just isn't true to the Fed's ideals or underlying objectives.

 

April Employment -- "Less Bad"

The April employment report echoed the tone of my last few posts.  Yes, the severity of the declines are "less bad" than over the last few months but still reflects a declining economy.

Those receiving April payrolls fell -539,000, the smallest decline since October but at over a half million are still very ugly.  Moreover, hiring for the federal census survey bulked up government payrolls to leave a -611,000 decline in private (non-gov't) payrolls.  Revisions to past months sliced another -66,000 as the recession has left a 5.7 mln drain on employment.  Though it won't get any notice, the separate household survey showed the first rise in employment in a year.  The market (and the press) watch the more reliable establishment employment survey.

Theunemployment rate continued 0.4% higher to a quarter century high of 8.9%.  This lagging economic indicator is expected to reach a peak near 10% before starting a downward trend.

As initial unemployment benefit claims (read layoffs) appears to have peaked the trend ahead should be smaller monthly declines.  However, those currently unemployed (seen in continued benefit claims) continue to rise leaving high unemployment a continued concern for households. 

 

The softening declines are part of the business cycle -- after the accelerating declines and before a return to stabilization and the positive growth that follows.  The slow improvement is agonizing but on the right path as long as added pressures don't bring on a double dip recession (seen in the early 80s) which seems unlikely as the truly massive government aid from the Fed, Treasury and fiscal stimulus provides the forward view.

Slowly Turning Tide

The data continue to reflect a slow turn in the economy from a rapid decline to a slower downward pace.  This period hits before the stabilization expected near mid year and the modest positive growth later in 2009.

Today's survey on non-manufacturing (read services) industries showed a  lift similar to the ISM manufacturing index.  Moreover, the new orders components which lead other key factors  such as production and employment rose to 47 -- close to the 50 mark that differentiates negative from positive growth.  Service new orders reached a low of 35 in November as manufacturing's hit a record low of 23 in December.

Monday's construction spending and pending home resales both showed gains.  The first in a half year for construction spending (thanks to non-residential) as the back to back gains in pending home resales was the first since 2007.  However, the inclusion of foreclosures in existing homes leaves the gains less conclusive.

Also on Monday the Fed released its quarterly report on bank lending.  The key measure which indicates the degree banks are holding off borrowers fell to the lowest in over a year.  While a large 40% of banks tightened commercial lending standards that's down a third since the January survey and off more than a half over the last half year. 

The downturn in initial unemployment claims argues that employment layoffs have peaked.  It also has a tight tie with the end of recessions.  Over the last five recessions dating back to 1975 the average number of weeks from the claims peak to the recession end has been just five.  Unfortunately, like the official statement declaring the start of the recession, the statement declaring the end will come long after we've seen it.

The slightly lower initial claims level in April than March sets up for another smaller decline in the all important employment report.  I expect a payroll decline in the mid -500K range from the -650K+ range of the last four months.   The payroll declines peaked in January and like the claims data suggest that the recession end may be near.

The Week Ahead

I'll be away this week and unable to comment on the incoming economic reports.  The brief previews below lay out the improving news expected. 

Tuesday -- Consumer Confidence.   The index reached a record low in February, edged higher in March and is expected to rise by a larger margin in April.  The expectations component is expected to be the driver as consumers are beginning to see the light at the end of the tunnel.  Improving confidence is needed before household spending/investment begins a sustained lift.

Wednesday -- GDP.  The big daddy of the economic measures will include some positive news with gains in personal spending and global trade.  A very large decline in inventories can be seen as clearing the way for increased production in coming quarters as business investment and housing will show continued declines.  First quarter expectations center around -5% after the -6.3% fourth quarter plunge.  I continue to expect flat/positive growth in the third quarter.

Thursday -- Personal Income and Spending.  The data are embedded in Wednesday's GDP report but revisions leave March growth unclear.  A repeat of the -0.2% decline in February income growth leaves the annual gain near half a percent as the wage and salary component already has fallen in to negative growth from a year ago.  Generally, income drives spending and is directed by the pace of payroll growth.  Tax cuts and federal spending will provide welcome aid to the economy as annual spending growth fell in to decline at year end. 

Weekly Unemployment Claims.  This will provide more excitement with another decline.  The April level for initial claims is already lower than March for the payroll (read employment) survey week.  Initial claims are a forward read on payroll growth and suggest another decline from January's massive -741,000 plunge.  A continued rise in continued claims argue for another lift in the unemployment rate from 8.5% in March. 

 

Friday -- ISM Manufacturing Index.  The survey provides a forward read on manufacturing and has been creeping higher since December's quarter century low.  However, the index remains quite depressed (see chart).   A strong March rise in new orders should translate into stronger levels for production.