A Sense of Unease as the Cycle Begins a Laborious Turn (posted 10/24/09)

October 24, 2009


Most economists now seems fairly confident that an economic recovery of global dimensions is taking place.  Indeed, much of the domestic data we follow has stopped declining and there are many series which have turned up at least slightly. The most notable exceptions are employment, which continues to decline, commercial real estate, and state and local government expenditures. As we are told by the optimists, employment is a lagging indicator, but as it continues to deteriorate it can be a heavy burden for any recovery to carry.

 The effects of cost cutting on operating leverage are showing up in better-then-expected earnings for dozens of major companies, lending credence to expectations of a quick return to past peak earnings when volume growth resumes. The question is when and how does volume growth begin.

 Mind you, there is still plenty of room for recovery just to get back to where we were in real GDP, industrial production, and profits.  At its worst, industrial production registered a 14.7% year-to-year decline, the steepest of the Post-War period.  It has now recovered a very slight 2.5% from its low point.  Capacity utilization, having dropped to the lowest point since the data started to be recorded, has risen only slightly off the bottom.

 States and municipalities (which employ more people than manufacturing) are in agony over declining revenues and increased demands for services. It’s only because of federal stimulus money going to the rescue that major disruptions in services have been avoided.  Higher taxes seem out of the question politically, but look as if they ultimately cannot be postponed.

 As we look for a slow recovery for the U.S. economy we must keep reminding ourselves that it’s a global economy we live in, and generally speaking it’s the developing part of the globe that is the best growth engine at the moment.

 Financial markets have become increasingly sure about a global recovery and its effects on corporate profits. But as I watch the optimism grow, and even as I accept the turn of the cycle, I have an unease, a sense that all is not right.

 I certainly share that view that with consumers deleveraging at a considerable speed, with unemployment still rising, bank credit still contracting, and capacity utilization very low, the recovery will lack vigor. But that’s not the reason for my unease.

The financial world has not been reformed.  Far from it.  The “too big to fail” firms have only become bigger as a result of governments’ moves to save them. Bernanke and the president himself have asked for an end to “too big to fail”. Just how we do that is quite unclear.  I am becoming convinced that any reform legislation should require that these financial giants be broken up into smaller pieces to restore the kind of healthy competition that any industry should have. If that’s not going to happen, then we need very strong oversight and regulation of the survivors. We can’t let them return to playing the same games that finally sent them to the taxpayer trough.

 When I read a Wall Street Journal headline that investment banks expect to pay record bonuses, I get mad.  Has nothing changed?  These firms are remarkably politically insensitive to flaunt their record profits in the faces of taxpayers and the body politic, seemingly thumbing their noses at the rest of us, including the millions who are unemployed because of the excesses created by these very same firms? Goldman Sachs may have paid back all the taxpayer money, but they might not even exist had not the federal government injected sufficient cash into AIG to allow that company to make good on its portfolio of credit default swaps.

 So far I see nothing in the way of seriously proposed reforms that is likely to produce real change in behavior. Naked short selling continues, and bear raids on a company’s stock, which brought many firms to their knees last year, are still possible. The uptick rule, which we lived with for more than 70 years should be reinstated. (This rule required any short sale to be executed only on a price uptick from the previous sale.)

 Global financial markets need a watchdog to oversee systemic risk, to identify it early and then prevent it from developing.  The IMF would seem to be a likely candidate, but we’re a long way from any program with real teeth. The capital structures of financial firms must be firmly regulated. Leverage and asset quality need strong oversight.

As a starter, we need a domestic overseer of systemic risk, but we seem to be mired in a turf battle that is slowing progress on this to a crawl.  The longer we tarry past last winter’s point of maximum stress the less likely we will see an effective agency put in place.

 In an earlier Musing I asked this question: If prolonged periods of stability sow seeds of their own destruction, what kind of seeds do periods of instability create?

 Over the past 60 years the U.S. has experienced 10 recessions.  As we navigated these periods successfully, that is, without ultra severe consequences or systemic collapse, business and financial markets became increasingly confident that depressions were both structurally unlikely and preventable by appropriate fiscal and monetary policy.  We also saw in the early 1980’s that monetary policy could successfully be used to kill inflation.  Each time an economic problem was overcome, confidence rose another notch, culminating in willingness on the part of financial institutions, businesses, investors and consumers to assume greater and greater risks.  Financial leverage at all levels finally exploded upward.

 So the answer to my question is that past periods of instability, as they were overcome, sewed the seeds of higher confidence in stability!

 Now, in this crisis we have seen government actions in dimensions far greater than anything in the past.  I wrote here last December that I thought the Federal Reserve had taken the possibility of a depression off the table. I think that has been proved correct. But what price are we paying? 

 The immense increase in federal debt gets the most attention. To be sure, the fiscal realities facing the OECD economies are daunting.  The future almost assuredly must include some combination of substantially higher taxes, higher interest rates, higher levels of private saving, and curbs on government spending on entitlements. A potent list of growth dampeners, to be sure.

 But additionally, have we created a dangerous faith in our ability to prevent depressions?  Does the fact that we have avoided a depression cause confidence to rise again?  Are we going right back to the same games that got us in this mess?                                                                                                     

 Looking at the remarkable comeback of the stock market one might think so. And given the spineless moves toward re-regulation and prevention of systemic excesses one has a legitimate right to worry.

Low Quality Recovery; Job Losses Continue

October 5, 2009


As I have previously written, the so-called reccovery may be statistically a fact, but it is what I have termed very low quality.  It is the result of an end to the major negative contributors to GDP, but not actual improvement. Headwinds are still strong, and investors should be very cautious after the dramatic improvement in stock prices.

The monthly jobs report, issued last Friday, was disheartening.  Below I have quoted the analysis of the report by Dave Rosenberg, former chief economis t of Merrill Lynch, now with the Toronto-based firm of Gluskin Sheff.

“Nonfarm payrolls in the U.S. slid 263,000 in September, but the details were even more sombre. The Household Survey showed a massive 785,000 plunge in September, and employment on this score has now slid by 1.2 million in the past two months. Sustainability is the key and there can be no durable recovery without net job creation and organic wage growth, which were both lacking in Friday’s report. In fact, the combination of the workweek edging back down to retest the all-time low of 33.0 hours and the near-stagnation in hourly wages dragged the proxy for personal income down 0.2% Month-over-Month (in nominal terms) and the Year-over-Year trend is getting perilously close to deflation terrain, at +0.7% from +0.8% in August and +1.2% in July.

Civilian employment is down 4.3% Year-over-Year and that too is a record in the post-WWII era; remember, the Household survey leads the cycle and typically bottoms and peaks before the Payroll survey does. This survey showed a 785,000 plunge in employment in September, and never before has a recession ended with civilian employment declining this much (on average, it goes down around 70,000 or almost negligible the month the recession ends).

In the last three months, the Household survey shows that civilian employment has plunged 1.33 million. At the time of the end of the 2001 recession, the three-month rally was -3,000 – we hadn’t even entered the jobless recovery at that point. There has never been a time, ever, when a recession ended during a span when the economy lost 1.33 million jobs. So all the calls that the recession is over may have been a tad premature. If the jobs data are correct, and the recession is in fact not over, this entire 60% rally is at risk of unravelling.

There were absolutely no redeeming features in the data. The private nonfarm diffusion index sank to 31.9 in September from 34.9 in August (the manufacturing diffusion index fell to 22.9 from 28.3 in August) which means that for every company adding to their staff loads, more than two are cutting back. The labour force contracted by 571,000 and has plunged now by 1.1 million since May. That again is a sign of the labour market seizing up, which is very disturbing when you consider all the government efforts to stem the tide last quarter – from housing subsidies, to cash-for-clunkers, to mortgage modifications.

The fact that initial jobless claims have peaked and rolled over – modestly by historical standards – tells only half the story which is firings. It is so painfully obvious from the data what is lacking most, is new hiring, especially in the small business sector which accounts for half of the job creation in the United States. The average duration of unemployment rose to 26.2 weeks – a half year! – from 24.9 weeks in August; the median spiked to 17.3 weeks from 15.4. It is so difficult now to find a job that a record 36% of the ranks of those unemployed have been searching with futility now for at least six months. In “normal” recessions since 1950, this ratio peaked at just over 20%. It is nearly double that today. In number terms, we are talking about 5.4 million Americans who have been out of work – but looking – for at least six months. This is troubling.

The U6 measure of the unemployment rate, which is the most inclusive definition of the labour force and takes into account the fact that we have a record 9 million people working part-time because they have been pushed off full-time payrolls, hit a new high of 17.0% in September from 16.8% in August. The gap between this rate and the ‘official’ rate of 9.8% is at a record of seven percentage points. The historical norm is closer to four percentage points and so the concept of mean reversion – Bob Farrell’s first market rule to remember – suggests that the unemployment rate is going to be setting new highs for the post-WWII era before too long (the prior high was 10.8% in November-December of 1982). So the chances that we see a 13% peak unemployment rate this cycle is far from a ludicrous proposition at this point; and just in time for the mid-term elections.

The index of aggregate hours worked, which combines hours worked with the number of bodies at work, seemed to be carving out a bottom in July and August; however, it was a false bottom because this critical ingredient into GDP fell 0.5% in September, to stand at its lowest level in six years. For Q3, aggregate hours worked actually contracted at a 3.0% annual rate, so basically, what is keeping the economy afloat is continued strong productivity gains. But productivity growth alone cannot possibly lead the economy into a sustainable recovery — labour input at some point is going to have to kick in. For Q3, aggregate hours worked actually contracted at a 3% annual rate so basically, what is keeping the economy afloat, is continued strong productivity gains. But productivity growth alone cannot possibly lead the economy into a sustainable recovery; labour input at some point is going to have to kick in.

Take note that the Bureau of Labor Statistics (BLS) also announced a preliminary estimate regarding the benchmark revisions that get published every February and they suggest an additional 824,000 jobs were lost in the year to March 2009, which would put the cumulative decline at over 8.0 million (versus 7.2 million currently, which, even in percent terms – down 5.2%, is the worst in 64 years).

Many of these jobs are never coming back, either. The share of the unemployed who are not on layoff is at record 54.3% as of September. In prior recessions, this ratio would barely pierce the 40% mark. In number terms, we are talking about 8.5 million Americans who have lost their job due to permanent shutdowns, a figure that is double what you typically see at the peak of the recession. “