Economic Trends and Risks

GDP at Quarter Century Low

Even the largest drop in gross domestic product (GDP) since early 1982 did a poor job in describing the fourth quarter collapse.  GDP fell -3.8%, larger than any of the declines during  the last two recessions.   Final sales -- GDP less inventories -- did a better job explaining the damage with a -5.1% plunge.

The consumer spending (PCE) decline was smaller than last quarter but thank inflation for that.  These are inflation adjusted figures as nominal PCE plunged nearly -9% compared to the -3.5% inflation adjusted decline  The dive in oil prices led inflation lower over the quarter as rising unemployment and falling income, home prices and equity growth drives spending.

The sharp dive in business investment  is the same we watched in capital goods demand through the quarter.  The -33% (annualized) drop in equipment spending added to smaller declines in software and construction.  Businesses are also finding savings in lightening their labor investment as fourth quarter payroll declines were a majority 60% of the recession layoffs.

The decline in residential investment was larger than the prior two quarters.  Its an old story as the sharp three year plunge in housing foretold the recession.  A sustained upturn in new construction may be a year off given the size of unsold inventories which continue to fall in price. 

The trade deficit showed the first negative contribution in seven quarters as exports dove -19% after five years of steady gains.  A -16% fall in imports was impressive as well as the global economy and international trade weakens with the growth of major industrial countries. 

The biggest surprise was the lift from inventories as the monthly figures have shown declines since September.  We haven't seen December yet but we suspect revisions here are likely to push fourth quarter growth even lower. 

Government spending provided an expected gain as the impending fiscal stimulus ($819 bln?) will provide a very significant boost to economic growth over the coming years.

The GDP price index fell a small -0.1%, an unusual occurrence.  As noted, the plunge in energy prices added to the recession's disinflationary factors over the quarter.  Consumer prices (CPI) fell sharply in each month of the quarter to leave annual growth at just 0.1% as the more stable non-fuel or food "core" component stands at 1.8% from a year ago. 

Fed Policy with Rate at 0%

The Fed's policy setting committee, the FOMC, meets today and tomorrow to decide just how to aid the economy with the policy rate already set at a record low range of 0% - 0.25%. 

The 2009 rotating voting members -- four regional Fed presidents -- simply don't have much say as the rate directive doesn't carry any weight with a zero policy rate.  It all surrounds the type of quantitative easing the Fed chairman decides on given the input of the FOMC participants.

 

To date, the Fed's tremendous policy easing and additional moves are starting to show some modest success.  The Libor rate (i.e. Eurodollar rate) is coming more in line with historical standards after widening to over 4.5% above Treasury bill rates early in the fourth quarter.  That reflects increased liquidity as interbank trusts rebuild.  Commercial paper rates are all below 1% though spreads to lower quality paper remain wide.  Mortgage rates have fallen to about 5% and have brought a new wave of refinancing.  Moreover, together with lower home prices, housing affordability has jumped above a decade high.

What to expect from Wednesday's policy statement is unclear.  The last statement noted that the Fed will continue to use its balance sheet to further support credit markets and economic activity.  Fed assets -- the best measure of quantitative easing -- have more than doubled since mid-September, rising $1.12 trillion.  Expect more on the way.

I suspect the possibility of purchasing longer term Treasury securities will be held off unless yields turn sharply higher.  There is also the ugly potential that foreign demand for Treasuries will significantly soften if the Fed announces its intent to force yields lower.  The huge subsidy foreign demand is providing should be carefully examined before risking it. 

An official inflation range has also been alluded to in an effort to cool deflation fears.  There's plenty of added decisions to make here (which measure to use, over what term, severity of response,  ...) as policy is really currently focused on the economy and financial markets.  I don't suspect any reference to inflation targets until the economic crisis fades. 

 

 

Housing Pressure will Continue

As the housing nightmare continues and leaves the worst downturn since World War II expectations are for further weakening in 2009.  But that requires some definition.  Sales are expected to edge higher over the second half as the huge supply of inventory and the weak economy will slow any rebound in new construction possibly until 2010.

There are three key factors driving the downward swirl in housing -- foreclosures tied to the slack mortgage lending of the past, price declines which slow any entry in to the market given the public fear of buying in to a declining market and the weak economy which has reduced household wealth (given lower equity and home prices values), current earnings (i.e. unemployment) and provides less available mortgage lending given tightened bank standards.

Median home prices have fallen over 20% from their peaks as declines are expected to continue given the weak underlying demand for housing (See Nov 25's post titled Self Sustained Downward Spiral).  New home sales have fallen a massive 70% from its peak as December housing starts strut a 76% decline from its peak.

 

As home prices fall, foreclosures rise.  The mortgage to home value ratio provides the rational.  If the value of the home falls below the size of the mortgage the holder has clear reason to mail in the keys and that's whats been happening.  While lower home prices and mortgage rates (presuming you can qualify) provide the usual necessary elements for a rebound in housing, the economic recession adds another key element on the housing drag. 

 

Over the longer term an upturn is inevitable, but don't hold your breath.  The first hints of an improving housing market come with stability in sales.  The market testing time is the Spring sales season, after that the upturn in the economy will provide the best timing.  Increased demand will end the price declines and clear away inventory making way for a delayed rebound in new building possibly off in 2010 I suspect.

Obama's Fiscal Stimulus

President Obama has just been inaugurated.  But now after his moving speech, promise slowly turns toward action and results as the grand expectations are tested. 

Obama steps in to office with a significant piece of the economic stimulus package already cleared by the House Democrats.  Its still a work in progress but the size and composition of the package is now public.  The gargantuan $825 bln package has cleared the first stage of inspection with few calls for less aggressive action as some cushion the response to forward results warning that more may be needed.

The broad outline includes $275 bln of middle class tax cuts that were promised during the presidential campaign.  $500 ($1,000 for couples) for all working Americans who make less than $200,000 a year.

The two thirds majority of the package is broad in scope.  It includes spending on education ($117 b), infrastructure ($90 b), energy ($54 b) and science/technology ($16 b) while providing for the needy ($106 b) and state governments ($119 b).  Its provisions go toward every thing from law inforcement to public schools and highway construction and the expansion of Internet service. 

This tidal wave of spending and tax cuts is largely seen as necessary to put the economy back on track.  But expectations are extremely high for the new president and the daunting economic task ahead of him.

The tax cuts will the fastest to see results through increased consumer spending.  The infrastructure spending will be the slowest (and the longest lasting) and hopefully not the biggest miss on actual spending (think Big Dig in Boston). 

The economic effects are expected to lift GDP by almost 3.5%, reduce unemployment by about 1.7% and raise employment by nearly 3.5 million jobs.  But the costs shouldn't be downplayed as the bipartisan Congressional Budget Office current sees a FY09 budget deficit of $1.2 tln (yeah, that's Trillion) even before accounting for this massive fiscal stimulus.  Borrowing now means paying ahead as the country also encounters the growing fiscal problems of Medicare and Social Security.

Fed's Report on the Current Economy

On Wednesday the Fed released the "Beige Book", a largely anecdotal report on the current economy from each of the 12 Fed districts which is released prior to the policy meeting it is created for.  The picture is no different than what the economic reports suggest but serves as another early indicator on how the Fed will react after the January 28 policy meeting given the near zero policy rate -- 0% to 0.25% range.   I've further summarized the report below, go to this link for the full report.

Overall economic activity continued to weaken across almost all of the Federal Reserve Districts.  Retail sales were generally weak, particularly during the holiday season. Vehicle sales were also weak or down overall. Manufacturing activity decreased in most Districts.  Services sector activity generally declined across the Districts.

Conditions in residential real estate markets continued to worsen in most Districts. Reduced home sales, lower prices, or decreases in construction activity were noted in many Districts. Commercial real estate markets deteriorated in most Districts. 

Overall lending activity declined in several Districts, with tight or tightening lending conditions reported in most Districts. Credit quality remained a concern in several Districts.

Most Districts reported a general weakening of labor market conditions.  Wage pressures remained largely contained, and some Districts reported pay freezes or reductions in compensation.

On the inflation front, lower energy prices were noted in many of the Districts as most noted declining input prices and sizable holiday price cuts. 

Surprises in Retail and the Twin Deficits

The surprise levels in Tuesday's reports on the twin deficits add to the cumulative plunge in retail sales to make them all worthy of comment. 

I'll start with today's report on retail sales which came in well below market expectations to leave nearly a -10% decline from a year ago.  Retail sales include the goods purchases as the addition of service spending provides the fuller read of personal consumption spending released in early February. 

 

After falling for six consecutive months, retail sales are down an astounding -20% over the last half year (annualized).  The biggest drags have been autos (-22% from a year ago) and gas station sales (-36%) as only the food and health care components show annual gains.  The resulting recession fosters the downward economic cycle as higher unemployment and smaller income gains (and equity declines, home price declines, etc) leave reduced consumer spending.

The November trade deficit plunged over $16 bln (almost 30%)  to $40.4 bln -- the lowest in five years.  The smaller deficit is very welcome news for fourth quarter growth and should slice about 1.5% from what forecasters were estimating at about a -6% economic contraction in Q4.

Imports plunged a massive 12% from declines in energy, capital and consumer goods as exports fell almost 6%.  The dive in petrol prices has helped to lightened that significant import component by more than a half since July.  After being stuck in a narrow -$56 bln to -$63 bln range for the year prior to November the smaller deficit reflects the effects from the weaker global economy as well as the energy effects.

The inclusion of the Federal Budget deficit comes as many are just now awakening to the massive borrowing effects from fiscal stimulus.  The Spring 2008 tax rebates and the TARP investments early in the first fiscal quarter add the significant drag from the recession -- reduced tax receipts and increased government spending.

 

The $84 bln deficit in December contrasted to a $48 bln surplus a year ago to leave a $132 bln one-month drag and leaves the first fiscal quarter with a deficit $378 bln larger than a year ago.   Over the last 12 months the deficit has summed to $833 bln as the bi-partisan Congressional Budget Office estimates the FY09 deficit at $1.2 trillion (8.3% of GDP) -- and that's without Obama's massive stimulative package expected soon after he steps in to office. 

Payroll Plunge, 2008 a Post WWII High

The press did a good job covering the December employment report.  The drop in payrolls was shy of November's downward revision and far better than our fears after Wednesday's estimate from ADP -- the payroll check writers (See the Jan 7 post).

2008 payroll  losses were the largest since 1945 as the trends show no evidence of near term improvement.  The -355K average decline over the last six months compare with -464K over the last four months and -554K over the last two.  Over 3/4s of the recession's declines have come in just the last four months.

The breakdown shows declines in all major components outside of health and government.  The chart below compares the payroll movement over the first quarter of 2008 to the final quarter of the year.  The weaker growth seen in all the components shows the sharp contraction in Q4 service employment (e.g. retail, business) as well as the weak goods producing segments (e.g. construction, manufacturing) already falling off soundly in the first quarter.

Even the slowly changing workweek length showed evidence of worsening ahead as it fell to the lowest since the government began tracking the figure in 1964.  Reduced hours is typically foretelling a labor downsizing.  

 

Talk now centers on Obama's fiscal stimulus and just how quickly it will turn the tide in the economy.   Opinions differ.  My 2009 outlook includes some of the details.

Beware Friday's Employment Report

While November's largest payroll decline since 1974 shocked the market, an even larger decline is quite possible in Friday's report as employees were cleared off the books for 2009.  The payroll declines accelerated in September and reached a 533K November decline and have removed nearly 2 million workers since the start of 2008.

The size of the payroll declines and unemployment rise are already larger than during the last two recession as the duration of the current downturn has spanned more than a year compared to the eight month terms of both the last two economic contractions. 

 

The leading employment indicators suggest a larger decline.  Initial and continued claims for unemployment benefits rose from November.   The ISM employment components were mixed however.  Manufacturing showed a decline to the lowest level since 1982 as the non-manufacturing index (largely services) rose slightly but to a very weak level.  

The swing indicator came from the ADP estimate of private (non-gov't) employment.  After undergoing changes to improve the correspondence to the employment report the measure dove to -693K -- more than 200K below the revised November estimate.  The revisions have turned a large 277K average miss over the last three months to a smaller 86K underestimate consistent with a payroll decline near 775K.  A decline over 650K will be devastating to the equity market.

 

The bottom line is that there is no accurate forward read on payroll growth and equity market danger lies with larger declines than expected.   The consensus estimate was for a 495K decline, smaller than November.  A larger decline translates in to weaker income and consumer spending which self perpetuates the overall economic weakness. 

Other key measures in the report include what is expected to be a rise in the unemployment rate to 7%, a modest gain in hourly earnings and flat growth in the workweek after reaching the lowest since my records begin in 1964. 

The Manufacturing Plunge

The December manufacturing survey -- the ISM index -- was released on a shortened trading day Friday.  Its importance wasn't lost despite the equity markets welcome of the new year with a large gain.  The ISM survey provides a slightly forward read on manufacturing as the quarter century low was joined by similar manufacturing indices abroad.  Reduced demand for manufactured goods leaves reduced production (e.g. growth), increased layoffs and the potential to extend the recession which began over a year ago.

None of the 18 industries covered in the report showed positive growth in new orders, production or employment.  Moreover, new orders -- the leading indicator for manufacturing -- fell to a record 60 year low.  The ISM plunge over the last few months has been extremely severe as the July index showed manufacturing still on the rise at a level of 50.

The index is calculated with five equally weighted components -- new orders, production, employment, deliveries and inventory.  The key indices of new orders and production were well below the overall index suggesting more room to the downside in early 2009. 

The prices paid index reached a 60 year low after hitting a 30 year high just six months earlier.

The survey is consistent with the actual figures on factory orders and industrial production as the weakening global manufacturing picture serves as an indicator for the global economy.  Friday's rise in the equity markets were the result of calendar date timing and the growing enthusiasm for a more powerful fiscal stimulus expected to provide at least the U.S. economy the needed punch to help end the downward spiral of the current recessionary economy.