Recovery Thesis Holding

It has been a busy week for news on the economy and most of it has been good. The best comes today with news that unemployment in the US has fallen to a three-year low of 8.3%. Payroll jobs grew 243,000 in January following gains of 203,000 December and a 157,000 rise in November. The averages for workweek and hourly earnings improved which will continue to propel consumer income growth which got a bump first of the week.  

Personal income grew 0.5% in November, following a 0.1% rise in October. Wages and salaries also grew strongly. The consumer has been using much of his discretionary income to reduce debt. Debt service relative to income has fallen from 14% to 11%. While this is healthy for households, flat spending holds down the economy, which is largely fueled by the consumer. Spending in December was flat, following only a 0.1% increase in November.

What money the consumer is spending (or more aptly, borrowing) seems aimed squarely at the new car industry. Vehicle sales jumped to a 14.2 million annual rate in January for a 5% gain over December, according to Econoday. Sales were concentrated on cars which jumped 13% to a 7.4 million rate. Truck sales actually fell in January, down 4% to a 6.8 million rate. This is the first time in nine months that the car sales rate exceeded the truck sales rate.

Rising gas prices and continued high unemployment drag on consumers’ assessment of current conditions. The government’s survey of confidence fell in January to 61.1 from December’s 64.8. The present situation component fell more than 8 points to 38.4, nearly erasing December's strong showing. Econoday suggests that weakness in confidence centers on the jobs market where 43.5% of respondents say that jobs are hard to get. Perhaps today’s unemployment number will improve the readings on confidence in the months that follow.

But while falling unemployment may boost consumer confidence, the falling values of their homes will surely keep it muted. Case-Shiller reports that home prices continue to fall with no meaningful signs of turning around soon. For the third straight month, November’s composite-20 index fell a sizable 0.7%. All but 3 of the 20 cities in the index show monthly contraction. The year-on-year rate of contraction for the composite-20 deepened slightly to minus 3.7% from a minus 3.4%. Lower prices drive sales, but existing homeowners are faced with declining net worth or negative net-worth, limiting resale options. 

The manufacturing sector of the economy continues steadily along despite troubles in Europe and Asia. The ISM manufacturing report for January rose to 54.1, safely over 50 to indicate monthly expansion and 1 point over December to indicate a slightly faster rate of expansion according to Econoday. A key highlight was that new orders rose nearly 3 points to 57.6, indicating perhaps a more significant rate of expansion.

Two of the regional Fed reports were also supportive of the national trends in manufacturing. The Texas general business activity index shot up to 15.3 after dipping to minus 0.3 in December. The company outlook index also increased markedly, rising from 5.0 in December to 13.5. Both indexes reached their highest readings in 10 months. Business conditions in the Chicago area also remain quite strong, though they slowed 2 points in January to 60.2 (still quite beyond the 50 to indicate expansion).

 Factory orders were up a strong 1.1% in December following an even stronger November reading of 2.2%. Durable goods led the index with a 3.0% increase compared to a 4.2% rise in November. Buying, not surprisingly is focused on value and longevity.

Productivity bucked the improving trend in the fourth quarter. Even though output was up hours worked increased faster. Nonfarm business productivity eased to an annualized 0.7% in the fourth quarter after gaining 1.9% in the previous quarter, according to Econoday. Compensation rose an annualized 1.9% after a 0.3% dip in the third quarter.

 Construction spending in December jumped another 1.5% after a 0.4% increase the month before. Private nonresidential outlays produced a 3.3% rise in December, following a 0.5% dip in November. Residential spending rebounded 0.8% after a 0.3% decline. Public outlays rose 0.5%, following a 1.7% boost in November.

Finally the week ended with two exclamation points; unemployment dropping to 8.3% and a very strong ISM non-manufacturing report with the headline composite index up 56.8, well beyond economists’ consensus of 53.3 and 3.6 points above December’s upwardly revised 53. New orders jumped nearly 5 points to a 59.4 level that indicates strong monthly growth and points to acceleration in general activity in the months ahead. But Econoday points out that the employment index was the headliner, up 8 points to 57.4 for by far the strongest reading of the recovery so far.

Optimism appears high among stock investors as the broad US stock market is up 3.2% as I write this Brief. The S&P is up 2% and the Dow is up 1.5%. Treasuries on the other hand are down. The Barclay’s 7-10 year Treasury index, which we use in our models, is down .8% and the Barclay’s 20+ Year Treasury Index is down 2.9%. Yields increased today as bondholders fear inflation may be on the rise with an improving economy.  

While it’s been a good week based on the data, it is clearly too early to extrapolate too far into the future. It is quite possible that the recent momentum is fueled by the billions of dollars of stimulus heaped on the economy as well as historically low interest rates. The major problems of debt and deficit spending are not being addressed. Remedies will place huge strains on the economy for years likely extending beyond a presidential cycle.  

Federal Reserve Chairman Ben S. Bernanke spoke this week on Capitol Hill to defend his newly established 2% annual inflation goal. He rejected suggestions by lawmakers that he was prepared to allow higher inflation in order to create jobs. The Fed has a dual mandate to hold inflation down and to promote an economy that creates job growth.

 Bernanke said he sees signs the economy is improving, though it remains vulnerable to shocks. He also called on lawmakers to reduce the long-term US budget deficit. He pleaded “To achieve economic and financial stability, US fiscal policy must be placed on a sustainable path that ensures that debt relative to national income is at least stable or, preferably, declining over time.”  

So we have to wonder whether Republicans or Democrats will have the political will or staying power to see it through. We are heading into a wall built of past excesses at high speed. We will hit that wall precisely when the US dollar is no longer the world’s currency. Until then, we have a grace period unlike that of any other country on earth or in history to get our national house in order. Will we squander it and face collapse like Europe, or will we bridge the ideological gulf that divides us long enough to jettison the weight that will surely swamp us?

Economy Climbing Back

Some air went out of investors’ hopes today as the government reported lower-than-expected growth for the fourth quarter. Economists had projected a 3.0% increase. Still, the 2.8% pace represents the fastest growth for the economy since the second quarter of 2010. The government also said that consumer spending in the US rose 2% in the fourth quarter, improving the 1.7% rate of the third quarter and 0.7% in the second quarter. As the trading session gets started, stocks are mixed. Bonds remain higher.

Today’s slower GDP report is favorable for bond holders because it implies less financial pressure on prices potentially resulting in higher inflation. But the best news bondholders could hope for came on Tuesday when the Federal Reserve, for the first time ever, announced its long-run target for inflation at 2%. They said “the inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2%, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee's ability to promote maximum employment in the face of significant economic disturbances.”

This is the kind of strong language bondholders love to hear. Whether the Fed will be able to sustain interest rates or not in the face of huge US deficits and debt, of course remains to be seen. If bond investors begin to perceive that inflation risk is rising, their demand for higher yields could swamp the Fed’s efforts to restrain rates. When large bondholders, both domestic and foreign sell together as ‘bond vigilantes’ they wield powerful sway over the government’s ability to over-spend and borrow.

The Fed also published for the first time the committees’ views on when interest rates should rise: 3 members indicated it should be in 2012, 3 in 2013, 5 in 2014, 4 in 2015, and 2 in 2016. The Fed also weighed in with its own GDP growth projections for 2012: at 2.2% - 2.7%, 2013: at 2.8% - 3.2%, 2014: at 3.3% - 4.0% and longer run: 2.3% - 2.6%. November projections were about 0.2% higher and more across the board. Projections for unemployment were 8.2% - 8.5%, 7.4% - 8.1%, 6.7% to 7.7% for the next three years. These projections were marginally improved over November’s projections.

 

Pending home sales fell 3.5% in December after a sharp increases or 7.3% and 10.4$ the prior two months. Annual pending home sales are up 5.6%, down 0.3% from November. According to Econoday, the trend looks good for home sales.  

New home sales, unfortunately did not confirm the pending home trend as sales fell 2.2% to a low annual rate of 307,000 vs. the Econoday consensus for 320,000. The most notable decline was in the South, which is by far the largest and most important region in the report says Econoday. Supply of new homes on the market rose to 6.1 months. It was the first time in six months this reading failed to improve. The median price of new homes fell 2.5% to $210,300. On an annual basis, the median price is down 12.8% for the worst reading of the recovery. 

Manufacturing continues to sustain and stimulate the broader economy. December’s Durable Goods Orders increased by 3% following a 4.3% jump in November, surprising economists. After removing the more volatile transportation results from the number, durables still rose a healthy 2.1% following 0.5% in November. Motor vehicles and non-defense aircraft were strong. Primary metals, machinery, computers, and electronics and communications equipment were major contributors.  

In his State of the Union message President Obama challenged manufacturers to “ask yourselves what you can do to bring jobs back to your country.” David Lynch of Bloomberg challenges the notion saying that “factory jobs, which have been shrinking as a share of total US employment since the early 1950s, remain 2 million below their pre-recession level. Obama’s election-year plan ‘to bring manufacturing back,’ as well as a rival House Republican package that would reduce taxes and prune regulations -- fly in the face of structural changes that inexorably lower employment in goods-producing industries.”

He goes on to say “with each year, technology allows factories to produce more goods with the same number of, or fewer, workers. Since the landmark 1994 North American Free Trade Agreement, NAFTA (remember Ross Perot’s ‘giant sucking sound?’) US factory workers also have faced increasingly vigorous competition from low-wage countries. That one-two punch drove manufacturing jobs from their 1979 peak of 19.5 million to today’s 11.8 million even as industrial output almost doubled.

Gene Sperling, head of the White House National Economic Council says “we believe manufacturing punches above its weight economically. The strength of your advanced manufacturing is critical to your innovation as a country.”

In his article, David Lynch quotes Keith Nosbusch, chief executive officer of Rockwell Automation as saying “the government must cut taxes and regulation, curb the increase in health-care costs and deliver relief from frivolous lawsuits. US manufacturers suffer from a ‘‘structural cost disadvantage’’ and highly-automated US factories require fewer workers. Yet even leaner operations have spillover effects on hiring beyond the factory gates.”

‘‘Manufacturing still has the highest leverage factor of any sector. It creates much more value and many more ancillary jobs than any other sector,’’ Nosbusch said. ‘‘That’s why it’s so critical. It’s not about just what is the direct manufacturing population, but do you have a competitive manufacturing environment so that you are able to create those indirect jobs that support automated manufacturing.’’

It looks like we will be hearing more “Made in America” as the presidential campaign begins in earnest. Should be interesting to see from both sides how their plans will incorporate healthcare, regulations, and tax incentives.

Have a nice weekend.

Modest Improvement

Equity investors believe that the domestic and global economies are on the mend judging by their behavior so far. Since the end of September the US Total Market Index, S&P 500, and Dow are up 21%, 19.5%, and 18.5%, respectively. Global stocks as measured by the FTSE All-World ex-US index are up 11.3%. In contrast, investors are shunning the safety of Treasuries as the Barclay’s 7-10 Index is down .25%. But last year the index soared 15% compared to a meager 2% for the S&P 500.

The improvement comes on the strength of improving US economic data and hopes that Europe has stemmed the risks of sovereign and bank credit defaults. Despite the reality of smothering debt and deficits as well as the apparent inability of policymakers to adequately address them, investors seem willing to favor the recovery theme, even though recovery is likely to be weaker than typical. This week the World Bank slashed its global growth forecast for 2012 to 2.5% from 3.6%. But 2.5% is not too bad given that economic recoveries following financial meltdowns tend to be weaker than usual. But it’s not good enough to materially erode unemployment or provide sufficient tax revenues to address deficits and debt.

It is almost certain that Europe will fall into recession given the required austerity and deleveraging measures that must be taken. But Europe is a fairly closed economy, so impact on world exports will be fairly muted. The major threat from Europe remains the potential for another financial crisis/contagion.

The emerging markets, including China are still helping to carry the global economy. As reported by the Wall Street Journal, the JP Morgan Global Purchasing Managers Index ended 2011 at 53, a nine-month high and above the 50 line that divides contraction from expansion. The Chinese economy is growing at 8.9%, but it is slowing. Emerging markets’ growth depends upon China as they feed the giant raw materials and resources. According to the WSJ, China is expected to generate one third of the world’s economic output. The US may or may not take up the slack.

Indications that the US will do its part have been positive the last few weeks, particularly in the area of manufacturing. Industrial production in December posted a healthy gain of 0.4% after dipping 0.3% in November. The manufacturing component made a .9% comeback, following a 0.4% drop in November according to Econoday. Overall capacity utilization rebounded to 78.1% from 77.8% for November.

The NY Fed reported that manufacturing activity in that region rose more than 5 points to 13.48 with the 6-month outlook up nearly 10 points to 54.87. This level takes them back to where they were for the first half of last year, according to Econoday. The Philly Fed confirmed the trend, but less convincingly. That Pennsylvania region inched up five tenths higher to 7.3, well below consensus. It indicates moderate month-to-month growth in general business activity.

Manufacturing has carried the torch for this recovery since its naissance. But it has been and continues only a faint light surrounded by the darkness of a larger confused consumer economy stumbling to find direction. The outlook of most economists is that growth will not be sufficient to spark inflation. Even the prospect that the government might allow inflation to effectively reduce the weight of its debt has not prompted significant worry among the most skittish of investors – bondholders.

So far, price inflation at both at the producer and the consumer level remain tame by historical standards. At the producer level gasoline and food costs fell .1%, but the core which strips out these more volatile measures firmed up 0.3% from November. Econoday says a big part of the acceleration was due to reduced discounting for motor vehicles by dealers. Leading the core up were passenger cars, light trucks, pharmaceuticals, and tobacco. The overall PPI was 4.8% in December compared to 5.9% in November (seasonally adjusted). The core rate in December edged up to 3.0% from 2.9% the month before.

At home, inflation wasn’t noticed at all. Both the headline and core levels were unchanged for both the months of December and November. Lower energy costs played a key role. Within the core, upward pressure was seen in medical care, recreation, and rent. Declines were seen in used cars & trucks, new vehicles, and apparel according to Econoday. Year-on-year, overall CPI inflation posted at 3.0%, compared to 3.4% in November (seasonally adjusted). The core rate held steady at 2.2% on a year-ago basis.

As suggested, bondholders are the most sensitive to inflation fears. Because they commit to longer holding periods their field of view is considerably longer and broader than that of equity investors who tend to focus on quarterly and annual earnings outlooks. When stocks rise on improving earnings (presumably from better economic prospect) some knee-jerk selling typically occurs in the bond markets, but order eventually returns as they resume weighing long-term economic realities against the likelihood that current risks will persist or evaporate.

As mentioned, the Barclay’s 7-10 year Index is down .25% (yesterday’s close) from the end of September as stocks have rallied 20% on average. The longest and hence, most inflation-sensitive index the Barclays Capital 20+ Year Treasury Index is down only 2% for the period. Bondholders seem to be unfazed by inflation at the moment thinking that the recovery will not be sufficiently strong to spark inflation.

If the anemic US recovery persists or improves, and if Europe debt doesn’t blow up, and if China can maintain growth and . . . then maybe the stock and bond markets have it right – growth without inflation. But you’ll note one big missing if. What will the US do with its massive debts and entitlement-driven deficits? To some extent, the elections will answer the ‘if’ the debt problems will be addressed, but the chances for innovative and significant improvement seem to be diminishing as each primary state makes its choice.