Economic Trends and Risks

Surprise, Surprise. Corporate Profits Nosedive

With Thursday's modest revision to 4th quarter GDP growth (to -6.3% from -6.2%) came the first glimpse of Q4 profits.  Corporate profits fell by the largest amount in 55 years-- $250 bln or -17%.  Over the last year profits have fallen -22% given small declines over the other quarters of 2008.

Also of little surprise, the financial sector showed the strongest profits decline.  Excluding the Federal Reserve, profits fell -$184 bln in the financial sector.  Small by comparison, manufacturing fell -$41 bln as a $17 bln lift from machinery helped to offset the -$24 bln drop in petroleum products. 

The nosedive in profits left corporate America with an even more massive -$346 bln drop in net cash flow.  The "corporate financing gap" which subtracts business investment from cash flow plunged $440 bln, a size not seen in decades (if ever).

Vastly reduced profits, cash flow and the financing gap spell continued trouble for business spending and investment -- a key ingredient in getting the economy back on its feet.  Capital and especially labor investment (hiring) are essential to getting the economy to correct itself.  For the near term it will be government spending rather than exuberant business or consumer spending that provides the economic lift. 

The February Lift in Housing

Today's new home sales figures left February with positive gains in sales, starts, permits and plays well in to the government's hands (and our own) after Monday's announcement detailed the teaming with private investors in an effort to rid banks of their "toxic" mortgage assets.  

After falling 77% from its mid-2005 peak through January, new home sales rose 5% in February.  Its first rise in seven months is more encouraging given the 5% February rise in existing home sales and the unexpected jump in housing starts tied to condominiums.  Permits to build also rose for the first month of the last eight. 

Lower home prices and low mortgage rates improve housing affordability as the economic recession and the severe drop in household wealth (see Record Wealth Decline) fights against a rebound.  Moreover, homebuyer hesitancy given the concern of continued price declines should hold off a significant rebound as inventories remain extremely high and provide the force for further devaluation.  New home prices have fallen -24% and existing are down -28% from their peaks and that's an average with far larger declines in overbought or depressed areas. 

The broad based gains may be a forewarning of more active Spring housing activity or just another weather related lift exciting an anxious market (or writer).  The Spring sales volume will tell us if the February lift was a single spark or the start of a stronger fire.

 

 

Fed Doubles the Quantitative Easing

The Fed's policy setting committee, the FOMC, met Tuesday and Wednesday and given the near 0% level the policy rate is already at (a 0% to 0.25% range) ended the meeting with a more formal declaration of added non-interest rate easing. 

The policy statement noted "to provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion.  Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.  The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets."  The policy statement closed by noting that the Fed will continue to monitor the size and composition of its outright purchases given the evolving financial and economic developments.

In short the Fed has stated its intent to more than double the "quantitative" easing -- or non policy rate easing -- with the $1.15 trillion of added purchases. 

An October 9 post titled Everything but the Kitchen Sink detailed the alphabet soup of credit and capital stimulating plans (e.g.  TAF, TSLF, PDCF, TARP, CPFF) the Fed had added to its traditional interest rate easing.  The Fed now explains all the credit and liquidity programs on its website which include everything from central bank liquidity swap lines, market lending and the programs supporting asset-backed securities, commercial paper and other areas where financial risk and damage has been large.  Its a long and somewhat complicated list for those less aware of the Fed's herculean efforts to address the problems in the financial markets.

Stronger Signs of Stabilization on Horizon

A few hints of improved economic stabilization have helped to push the stock market higher as the down-and-out investors are looking for any sign of an economic bottom.  I expect current quarter GDP to fall in the -4% to -5% range, but hey its better than the -6.2% of Q4. 

Monday's decline in industrial production was largely tied to the large -7.7% dive in utilities as manufacturing's -0.7% decline compared with a three month average decline of -2.6%.  Auto production has been leading the decline having fallen -38% over the last year compared to the 11% drop in overall industrial production.

Tuesday's report of a stunning 22% rise in housing starts was tied to volatile multi-family starts which nearly doubled.  Single family starts rose just 1%  after three months of declines of over -14%.

 

Stronger improvement may only be a few months away.  The expansion of the Fed's Term Asset-backed Securities Lending Facility (TALF) should improve the credit constraints for auto lending and lead to stronger auto sales in the Spring after the plunging pace seen for over a year.  That would help to stabilize the weak manufacturing sector.

 

Home building waits for buying demand (i.e. sales) to pick up.  While lower home prices and mortgage rates haven't turned the direction yet, Obama's Making Home Affordable Plan which allows even lower refinance rates and loan modifications that will lower mortgage payments and further improve home affordability.  The stimulus bill also includes a tax credit for first time home builders -- another effort to lift new home sales from February's record low.

Needless to say the initial effects of the economic stimulus package (tax cuts, one time boosts to Social Security and veteran benefits recipients, government spending) will be seen in the coming months as will the Fed and Treasury efforts to reduce the dire problems in the financial markets.  A slow recovery is expected over 2009 which should leave positive growth in the second half. 

Record Wealth Decline

The front page article on today's WSJ (below the Madoff pictures) provided the bottom line on the massive 18% ($11.2 trillion) decline in 2008 household wealth.  I'll provide some explanation on how that measure is composed and where the declines hit hardest.

The big picture is that the 2008 (and fourth quarter) plunge is the largest loss since the Fed started tracking wealth over a half century ago.  The $11 trillion size is truly astounding as the WSJ compared it to the combined size of the German, Japanese and U.K. economies.  Moreover, the plunge accelerated through later 2008 as the Q4 decline doubled the Q3 decline which tripled the Q2 decline.

 

Net worth ($51.5 trillion in Q4) is simply the difference between household assets ($65.7 trillion in Q4) and liabilities ($14.2 trillion in Q4).

Assets span from home and equity holdings market value, financial deposits and credit holdings to pension reserves.  Liabilities are largely debt owed on mortgages, consumer credit and bank loans.

In the fourth quarter the largest decline was in stock prices which provided a powerful $1.7 trillion drag on assets.  The plunge in the stock market left life insurance and pension funds $1.5 tln lower as lower home prices added another $0.9 tln decline.  Depreciating consumer durable goods (e.g. autos, appliances, etc) provided a small decline to the drop in mutual fund shares.  In sum, the $5.1 tln Q4 decline amounted to 9% of household net worth.

Wealth provides the ability to invest in very big ticket items-- a new house, college tuitions and retirement for example.  Unlike the shorter term spending implications of income growth or the unemployment rate, wealth provides a longer term outlook and a better read on the standard of living -- depending, of course, on how you measure that.  The biggest implication is that reduced wealth will spur demand for savings rather than the other alternative -- spending -- which feeds economic growth.  

No End of the Massive Budget Deficits

The February fiscal budget deficit is released Wednesday as the size swells with the fiscal stimulus.  February's deficit is expected to top $200 bln -- larger than the entire deficit in fiscal year 2007.

To many the longer term deficit outlook is just as disturbing as President Obama redefines the role of government in our society.  A WSJ Opinion column on Friday penned by former Council of Economic Advisors Chairman Michael Boskin noted that the 10 year outlook includes a larger increase to the national debt than seen cumulatively since the country's founding.  Defense spending is reduced to a level unseen since just before WWII as non-defense spending rises to the highest level (relative to GDP) in U.S. history.

The $1.75 trillion deficit expected this year is four times the record size of last year and is larger than our neighbors (i.e.  Canada, Mexico) entire economic growth.  It weighs in at a record 12% of the expected U.S. economy in an attempt to pull the economy back to positive growth.  But there's more to it than a temporary "fix".

 

The deficits over the next two years average over $1 trillion as the 2013 deficit falls to a low point of $533 bln before rising over the following years.  Gone is the underlying (but elusive) goal of a budget surplus that President Clinton was able to engineer with the fall off in Cold War defense spending.  Medicare and Social Security spending aren't the only causes as a new perspective is being tested.

One exceptionally telling detail Boskin's WSJ piece noted is that new and expanded refundable tax credits would raise the fraction of taxpayers paying no income taxes to almost 50% from 38% -- cementing a permanent voting majority with no stake in controlling the costs of general government.  The economic implications of a government expansion are numerous as the author points overseas to the European "social welfare" as a clear example. 

 

Employment Trend Turning?

The as expected  -651,000 drop in the February payroll count seemed to calm the market as downward revisions to the prior two months left larger declines at the turn of the year.  The markets would love to see a turn in direction in the labor market which simply isn't there yet as the unemployment rate jumped half a percent to 8.1% and unemployment benefit claims continue higher.

The recent declines leave a three month average of -662,000 compared to the -300,000 monthly low in the 1990-91 recession and the -330,000 low in 2001.  Those shorter recessions left cumulative payroll declines of less than 2 million compared to the 4.3 mln decline already logged since the start of the current recession in December 2007. 

The composition showed the broad service sector topping the declines in the construction (read housing) and manufacturing which make up almost all of the goods producing side.   See the government release for more detail.

The unemployment rate surged half a percent to 8.1% and now stands above the 1992 peak to a quarter century high. 

Payroll declines and gains in unemployment typically last longer than the recession.  The official arbiter of recession timing -- the NBER -- is even slower to report the return to economic expansion.  The weekly initial unemployment claims data provide a nearly real time read on the economy as reduced layoffs accompany the improvement in growth.  The 1991 intial claims peak came in the same month the recession ended as the forewarning rose to a single month in 2001. 

A Few Gains Don't Turn the Trend

Monday's releases of personal spending, income growth and the ISM manufacturing index showed small gains after the steady declines over the second half of 2008.  But the markets eyes are really on Friday's  employment report given its implications for future spending, income and production trends.

Personal income growth of 0.4% was the strongest gain since May's tax rebates despite the January decline in salaries.  Personal spending also showed the strongest lift since May after six consecutive months of decline.  Manufacturing ISM showed a three month high in February but at 35.8 it remains a very long way from the 50 needed to show positive growth. 

The upward blips are certainly more encouraging than the declines we've growth all too used to but hardly suggest an impending turn in direction.  These aren't independent indicators divorced from the dramatic plunges in housing, finance, employment, production and income.   Call them noise or seasonal effects or volatility but don't expect to see a turn in trends until the underlying conditions are turning.  That isn't here yet.

A good example is the all-important employment report on Friday with an average forecast at a recession low of -650,000 lost on payrolls.  The reason the monthly employment report is so closely watched is its use in driving expectations for other indicators.  The report includes all sectors so comparative analysis shows where the weak or positive areas are.  Payrolls (salaries) are also the key component of income which provides a valuable read on spending.  The payroll direction and size also tells the story of economic production and growth.  And with the weekly unemployment claims data still reaching new highs (at 667K in mid February) its too early to expect a turning in trend direction.