Economic Trends and Risks

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.