Jim Welsh of Welsh Money Management has been publishing his monthly investment letter, “The Financial Commentator”, since 1985. His analysis focuses on Federal Reserve monetary policy, and how policy affects the economy and the financial markets.
Investment letter – May 22, 2009
As noted in the March and April letters, there is a good chance that GDP will post a positive print in the fourth quarter of this year, and maybe in the third quarter. However, the most important issue in the next 12 to 15 months is whether the rebound in the second half of 2009 and first half of 2010 will gain enough traction to launch a self sustaining economic recovery. The short answer is no one knows. What we do know is that the drag to GDP from housing, inventories, and exports will be less in coming quarters. And, with the push coming from the stimulus plan, there will be a positive GDP print in the fourth quarter, if not the third quarter. Although most of the ‘growth’ will be statistical nonsense (less bad confused as actual growth), most economists will be satisfied since they assume that an increase in GDP automatically means a lasting recovery will follow. This view overlooks the many cyclical and secular hurdles that collectively threaten to transform the U.S. economy in coming years.
A dissection of the -6.1% decline in first quarter GDP will underscore why a turnaround in GDP is coming. The decline in residential construction subtracted -1.36% from GDP. However, single family housing starts have held steady for the last 4 months through April. (Apartment construction was very weak in April -42.2%, but that has more to do with commercial real estate than residential.) With housing starts already down 80% from their peak three years ago, there is a good chance starts will continue to stabilize near 350,000, a very depressed level. By the time the fourth quarter arrives, the drag to GDP from residential construction could be near zero, and possibly a slight positive. Businesses slashed inventories a record $103.7 billion in the first quarter, which shaved -2.79% from GDP. Last week, 52 million Social Security recipients began receiving their $250 economic recovery checks. Along with other measures within the $787 billion fiscal stimulus plan, consumers will have more disposable income, which will lift demand in coming months. This will help align sales with production and inventories, so the large drag from inventories will be far less in the second half of 2009.
In the first quarter, exports dived 30%, the largest drop since 1969, while imports plunged 34.1%, the steepest fall since 1975. The decline in exports knocked -4.06% off of GDP. But, in the quirky world of gross domestic product, the larger drop in imports added +6.05% to first quarter GDP, since imports represent production outside the U.S. If the impact of exports and imports were excluded, GDP would have fallen -8.1%, rather than -6.1%. Fiscal stimulus in the U.S. should revive demand for goods and services, including imports. The net result of improving exports and imports could be close to a push.
Business investment on new buildings and equipment plunged 38%, the most since 1947. This accounted for the bulk of the -4.68% non-residential investment subtracted from first quarter GDP. Although commercial real estate will remain weak in coming quarters, business investment has begun to stabilize. In the first quarter, Cisco’s revenue was down 17%, while Intel’s was off 28%. These are staggering declines, but both companies reported that the tech spending environment has stopped getting worse. Even if business investment doesn’t pick up by the fourth quarter, the negative drag on GDP will be less.
The lone bright spot in the first quarter was a 2.2% increase in consumer spending, which added +1.5% to GDP. Although consumer spending will continue to be pressured by job losses and weak income growth, various aspects of the stimulus plan should help maintain consumer spending near first quarter levels.
This breakdown of first quarter GDP shows that most of the improvement by the fourth quarter will result because the extreme weakness in the first quarter will have flat lined, causing most of the GDP components to go from deeply negative toward zero. That may be better than the alternative, but it is no substitute for a healthy pick up in demand. It’s a bit like sitting down for a delicious five-course gourmet dinner, and only being served a plate of Cheetos.
The $787 billion fiscal stimulus plan represents a measure of demand that will certainly provide the economy a lift. However, for the temporary spike in demand afforded from fiscal stimulus to become a self-sustaining recovery, business must be confident enough to increase hiring, since the primary driver of consumer demand is jobs and income growth. Most employers don’t begin to hire until after they discern a pick up in demand. Even then, job growth improvement is usually tentative at the outset of a recovery. That has been the pattern coming out of prior recessions, and I have no doubt that it will hold true this time. This is why most economists correctly consider changes in employment a lagging economic indicator. But is it reasonable or appropriate to consider employment a lagging indicator in the current recession? This contraction has been driven by a full-blown financial crisis, unlike every other post World War II recession, and is already the longest and deepest recession since the depression.
Since the recession began in December 2007, 5.7 million jobs have been lost. At a minimum, another 2.5 million jobs will disappear by early next year. A total of 13.7 million Americans were unemployed in April, as the unemployment rate reached 8.9%. The under employment rate, which includes discouraged workers and those settling for part-time work, rose to 15.8%. The average work week held at a record low of 33.2 hours, while weekly wages gained just 1.3% from last year. The magnitude of job losses since last fall has been a leading contributor to the depth and duration of this recession, since job losses have caused default rates on every type of consumer loan to soar. This has increased loan losses for banks, and intensified the credit crisis. To consider the loss of 5.7 million jobs in six months as benign, since employment is a lagging indicator, suggests that most economists have not thought this through. There is a difference between a punch thrown by the Pillsbury Doughboy or Mike Tyson. As detailed last
month, it could take up to four years to replace all the jobs lost in this recession, even if job growth were to average 325,000 per month. The fact is that consumer demand has taken a substantial punch to the solar plexus, and will not recover until job growth improves materially. Unfortunately, job losses are likely to continue into 2010.
According to the Labor Department, another 539,000 jobs were lost in April. As one
Economist said, “It’s a confirmation that we’re in the early stages of a turn.” That assessment was echoed in a number of newspaper headlines. “539,000 Jobs Lost, Fewest in 6 Months.” “Unemployment Still Rises, But Pace Slows.” By far, my favorite headline was from the Associated Press. “Jobless Report: Economy Getting Back In Shape.” Unfortunately, the April jobs report was a bit misleading. The Labor Department only surveys 5,000 companies each month, so their focus is on large and mid sized companies. Historically, almost 80% of new jobs are created by small growing firms and start ups. To address this inadequacy in their monthly survey, the Labor Department uses the last five years of data to estimate/guesstimate small job creation. Based on the last five years of data for April, the Labor Department concluded that in April 2009, small business created 226,000 new jobs. Does anyone honestly believe that small businesses added 226,000 jobs at a time, when most companies were shedding jobs left and right? Yes! All those economists looking for a V-shaped recovery, who herald any miniscule drop in weekly jobless claims as proof the economy has reached a bottom.
Industrial Production fell .5% in April, the smallest drop in six months. Over the last year, production has plunged 12.5%. Capacity utilization slipped to 69.1%, the lowest since records began in 1967. The manufacturing utilization rate edged down to 65.7%, also the lowest on record. Factory output fell 13.4% in April, versus 13.6% in March. At that rate of improvement, factory output will turn positive in a little over two years. More importantly, the record level of excess capacity will pressure profit margins and postpone the need for business to buy new equipment. This means most companies will be forced to keep costs down, so employment growth will be even weaker than the last jobless recovery. And, when the V-shaped recovery does kick into gear, it will be slower because excess capacity will mute business investment more than in any other post World War II recovery.
A year ago, the International Monetary Fund estimated that total bank losses from the credit crisis would be $950 billion. Last month, they upped the ante to $4.1 trillion. The IMF estimates U.S. banks have another $1 trillion in losses to write off. After the Federal Reserve finished its stress test on the 19 largest banks, it concluded the total loss would be $599 billion. There are two reasons why the IMF’s estimate is likely to be closer to the mark. The IMF has consistently underestimated the losses in this credit crisis, so their current estimate may still be light. We also know that in the two weeks prior to the release of the stress test many banks jawboned the Fed to use a different measurement of bank-capital levels than analysts had expected. Government officials defended their handling of the stress tests, saying they were responsive to industry feedback, while maintaining the tests rigor. Let’s see. The Fed didn’t see this crisis coming, underestimated the scope and magnitude of the crisis, in part, because they relied on bank
executives who assured them their risk managers were on top of the problem. Now, after these 19 mismanaged behemoths have racked up almost $2 trillion in losses, the Federal Reserve felt it necessary to be responsive to industry feedback. Well, that’s a confidence booster! Plus, the stress test allows these institutions to maintain 25 to 1 leverage.
The Wall Street Journal recently put 940 small and midsized banks that have total assets of $2.8 trillion through the same stress test. Collectively, these banks are 20% larger than Bank of America, which means they are too big to fail. Under the Fed’s worst case scenario, total losses would exceed $200 billion through 2010, and would exceed the revenue for 923 of the 940 banks. Tier 1 capital, which regulators consider important, would fall below 4% for 634 banks, with almost 300 banks experiencing a decline in capital to ‘risky’ levels. According to management consulting firm Oliver Wyman, up to 1000 banks will fail over the next five years, unless they receive significant capital injections. The primary driver behind these losses is the decline in commercial real estate. A year ago, I noted that nearly 3,000 banks and thrifts with less than $20 billion in assets had commercial real estate portfolios that exceeded 300% of their risk based capital. I expected commercial real estate to be the next shoe to drop in late 2008 and early 2009.
The Fed’s stress test of the 19 largest banks and the Wall Street Journal’s examination of the 970 banks went through 2010, and show that in aggregate, the banking system in the United States will remain stressed through the end of next year. One of the main determinants in whether a self sustaining recovery takes hold is the availability and cost of credit. Lending standards are likely to remain high through 2010, as some banks are forced to raise capital and others are forced to shrink their balance sheets. In the Fed’s April 2009 loan survey, almost 70% of the banks said they had raised interest rates on credit lines. Higher lending rates widen profit margins, which will help banks increase capital from earnings flow. While helpful for banks, the higher cost of borrowing will not help the economy.
Although banks get most of the headlines, they only provide 35% of the credit for the economy, while the securitization markets furnish 40% of credit. Fifteen months ago, the securitization of auto loans, credit cards, and student loans exceeded $1 trillion. In the last month, the Federal Reserve’s TALF program has securitized a whopping $25 billion. As its peak in July 2007, the commercial paper market was a vibrant $2.2 trillion market. Even with the Fed’s assistance it dropped to $1.3 trillion last week, the lowest in five years. Credit availability is still constrained.
State spending represents about 12% of GDP. In the first quarter, 45 of the 47 states that have reported saw their revenue fall. Sales taxes were down 7.6%, personal income taxes fell 15.8%, and corporate taxes dropped 16.2%. The revenue short fall is forcing many states to institute work furloughs, reduce services, and of course increase fees and taxes. On May 19, the state of California increased the automobile tax from .65% to 1.15%. It will drain $1.6 billion from consumers’ pockets next year and surely give a lift to new car sales. The recession is obviously causing the squeeze on state budgets, but some of this pain is self inflicted. As noted in the February letter, state and local spending
grew 34% between 2003-2007, according to the Bureau of Economic Analysis, while inflation rose 19% and population grew 5%. California grew its budget 40%. Since 1998, state and local budgets have almost doubled to $2 trillion, with state debt increasing from $1.4 trillion to $2.23 trillion in 2008. According to the Census Bureau these figures do not include the nearly $1.5 trillion in unfunded health and pension liabilities. States operate on a July-June fiscal year, and derive as much as 75% of their revenue from sales taxes and real estate taxes. With home values down 20% or more, many homeowners will ask to have their home value reassessed to lower their real estate tax bill. As new and existing homes are sold at lower prices, real estate tax revenues will be less for years to come. As states prepare their 2009-2010 budgets, they will be forced to operate in a world far different than the spending spree year of the past decade. As taxes are raised and services reduced, the public outcry will increase and lead to marches on state capitols.
The other cyclical challenge is the global nature of the current recession and its depth. In the first quarter, the U.S. contracted -6.1%, the 16 countries in the EU shrank by almost -10%, and Japan plunged -15.2%. These countries represent 64% of world GDP. Trade represents almost 25% of global economic activity and is expected to fall 11% in 2009. In the first quarter, exports collapsed 70% in Japan and 30% in the U.S. In April, Chinese exports were off 22.6% from a year ago. In response to tougher times, global protectionism is on the rise, even if overt tariffs are being avoided. According to the World Trade Organization, anti-dumping investigations rose 31% in 2008.
The combination of all the cyclical issues is daunting. The extraordinary weakness in the U.S. labor market will pressure consumer spending well into 2010. The record level of excess capacity will narrow profit margins, delay and limit companies’ need to increase business investment, and restrain hiring. The banking system, from large banks down to community banks, will remain stressed through 2010, which will limit the availability of credit and result in higher lending rates. States will be forced to lower their spending and raises taxes, which will offset a portion of the federal fiscal stimulus plan. And the synchronized nature and depth of the global recession means there is no place to hide. Although China and India are in far better shape, they represent less than 10% of world GDP.
While we’re dealing with these cyclical issues during the next two years, there are a number of secular problems looming. As I have discussed numerous times over the last two years, the biggest problem is the increase in debt from $1.60 for each $1.00 of GDP in 1982, to $3.53 in 2008. Debt has been growing faster than the economy for more than three decades. This is unsustainable. It’s like trying to gain weight by eating your own leg. The other complicating factor is that the cost of money has fallen from 15% to 20% in1982, to today’s generational lows, so the debt burden can’t be lessened through lower interest rates. We’re going to have to fix this the old fashioned way – save more, and spend less.
Consumers have certainly cut their spending since last summer, which is why we’re in a recession. Consumers have also boosted their savings rate from near 0% to 4.5%. Over time, the savings rate is likely to rise to its 1965 – 1994 range of 8% to 10%. As the savings rate climbs, Household debt will gradually shrink from 98% of GDP in 2007, to 85% – 90%. To put this into perspective, the Household debt to GDP ratio was only 44% in 1982. A change of this magnitude is going to take 5 – 7 years to unfold. Once this is accomplished, the foundation for the next major economic expansion will be in place.
But this foundation also needs some major changes in public policy. If we are to succeed in lowering the ratio of debt to GDP, we must adopt economic policies that encourage economic growth, and reduce government spending. As it stands today, almost 85% of the annual federal budget is on auto pilot, mandated by law. This makes it virtually impossible to lower the rate of increase of spending, let alone enacting actual spending reductions. Medicare and Social Security costs equaled 7.6% of GDP in 2008, and will climb to 12.5% by 2030. Long-term unfunded liabilities for Social Security and Medicare top $53 trillion, about 3.7 times today’s GDP of $14 trillion. The Medicare trust fund will run out of money in 2017, Social Security’s fund will be depleted in 2037. Those dates are dependent on the economy growing nicely, which could prove problematic given the many cyclical problems we face.
As our debt problem has progressed over the last 30 years, each party has had control of the White House or Congress, or both. So pointing a finger at one party or the other is juvenile. The average American spends 7-9 hours each day working, 7-8 hours a day sleeping, and more than 6 hours a day watching television. If college professors and high school teachers were asked to explain the law of supply and demand and the impact on prices, I’m guessing less than 10% could answer the question correctly. And in major elections, less than half of eligible Americans even bother to exercise their most valuable right, which is to vote. We the People have been complicit, either from apathy or from ideological self interest.
If we are to rein in government spending, the nobility of the goals must be separated from the ability to pay for them. Providing universal healthcare for every American citizen is the right thing to do, as is providing a dignified retirement for those who worked hard to take care of their family. Raising fuel economy standards and cutting emissions through a cap and trade formula is common sense. Unfortunately, it is already painfully obvious that we can’t even afford Medicare and Social security as they are currently structured, so how then can we afford universal health care? According to the Congressional Budget Office, implementing a cap and trade program to reduce carbon emissions by 15% will cost the average household between $1,600 and $2,200. This burden will weaken economic growth. Increasing fuel economy standards is a great idea, but it will add $1,300 to the cost of a car, lower car sales, and weaken economic growth.
It is going to be difficult to fund the increases in government spending through higher taxes. In 2006, the top 10% of wage earners paid 86.3% of all federal income taxes, while 35% of wage earners paid nothing. Adding $1,600 to $2,200 to the average family’s budget to combat carbon emissions will depress economic growth. And, increasing the cost of a car by $1,300 won’t help Detroit emerge from bankruptcy. It is far easier to believe in the need for universal healthcare, adequately funded retirements, and fighting global warming, than it is to understand why so much depends on lowering the ratio of debt to GDP. In 2008, the federal government spent $253 billion on interest expense or 1.8% of GDP. According to an analysis by the Congressional Budget Office of next year’s budget, in 2018 interest expense will rise to $703 billion or 3.6% of GDP. This is important since the government will spend more money in 2018 on interest than it will on education, job training, housing assistance, veterans’ health, science, workplace safety, transportation, the environment, foreign aid, and homeland security. If the ratio of debt to GDP is not brought under control, interest expense will progressively consume more of the federal budget, like a flesh eating disease.
The cyclical and secular issues confronting our country suggest that economic growth will be below trend for years. As we address significant public policy issues, in an era of political partisanship, the risk is uncomfortably high of not taking decisive steps to bring the debt to GDP ratio down, or worse, adopting policies that increase the debt to GDP ratio.
Most of the time, perception and reality run parallel, especially during periods of economic stability. But when change accelerates, perception and reality often diverge. In late 2007, the perception was that the U.S. economy would avoid recession, since the Fed was handling the sub-prime credit problem, and global growth was expected to remain healthy. When the reality proved far different, the stock market sold off hard in this first quarter of 2008. Since early March, the rally in the stock market has been sustained by the perception that the economy will be in much better shape later this year. This has led investors to dismiss and ignore any negative news, and seize upon any less bad news as proof a recovery is on its way. This theme has led investors to buy commodities like oil, copper, natural gas, silver and gold (the reflation trade). In financials, it has caused treasury bonds to be sold, and corporate and junk bonds to be bought, along with stocks.
Some strategists, who believe markets have paranormal characteristics, point to these trends, as confirmation a recovery is afoot. When investors consider a loss of 539,000 jobs as good news, there is a decent chance that the perception of when the economy will recover is ahead of the reality, especially when the real loss of jobs likely approached 750,000. This suggests the market is vulnerable.
Since I expect GDP to turn positive in the fourth quarter, my expectation has been that the rally from the March low would take an up, down, up form. The down portion likely began after the S&P reached 930 on May 8. I had thought the S&P might have a quick rally to 940 once it closed above 878. A ‘normal’ pull back would bring the S&P down to 830-850. Anything much deeper will depend on a pickup in selling pressure. After this correction, the market should rally as investors refocus on the potential of GDP turning positive later this year. However, the next few weeks could be a bit tricky, since I believe the economy remains in worse shape than the V-shape crowd realizes. In recent weeks there has been virtually no selling pressure. This has been a bit surprising, but underscores how convinced institutions are in the second half recovery story. Although not likely, the market could spike higher, if the S&P closes above its 200 day average near 940. If it does, selling into that strength would be a good idea.
If the rebound in GDP later this year is not strong enough to overcome the cyclical and secular headwinds we face, the perception that a real recovery will take hold in 2010 will confront a stark unpleasant reality. This will lead to another large sell off. Continue to use a trailing 1.5% stop on the high yield bond funds recommended in March (FAG1X +18.0%, NNHIX +6.1%, VAGIV +7.8%).
The pattern in the dollar index suggested it would fall to at least 82.50. With talk of the Dollar being replaced as the world’s reserve currency, sentiment has turned fairly negative. After the early March high the Dollar, it fell 7.00 points, and then rebounded to 86.86, an almost perfect .618% of that decline. An equal drop from 86.87 targets 79.87. It’s possible that the Dollar is completing the correction from the March peak. Traders can buy the dollar below 79.80 on the cash, using a close below 79.10 as a stop.
I have been negative on Treasury bonds for months. The yield on the 10-year Treasury bond has risen from 2.04% last December to 3.38%. Traders can buy when the yield is above 3.44%, using a close above 3.62% as a stop. Lower the stop to 3.44%, if the yield subsequently drops to 3.23%, and sell half if the yield falls below 3.1%.
I still think August Gold has the potential to drop to $820.00-$845.00 in coming months. Last month, investors were advised to short Gold in a number of ways, depending on risk tolerances. The most conservative way would be to short GLD, which is the ETF tied to gold, or by buying DZZ, which is the 2 to 1 short gold ETF, or by shorting Gold futures, which is the most aggressive. Irrespective of the route, use a print of $1002.00 on August Gold as a stop. Short GLD above $94.00, buy DZZ below $20.70, and short Gold above $960.00.
E. James Welsh