New Normal, New Mix, Rebalancing….Whatever

April 6, 2010

There are still some naysayers, but it is increasingly clear that the economy is slowly, lethargically, recovering from its worst period since the Great Depression. Many weak spots and vulnerabilities remain, but the direction of movement seems certain.

PIMCO has labeled it the “new normal”, others have called it the “new mix”, and The Economist, in the current issue, calls it a “rebalancing”.  All three labels are, in my opinion, apt descriptions. It seems inescapable that both the private economy and financial markets will be considerably less leveraged than in the decade preceding the recession and financial crisis.  That means that personal consumption will be tied more tightly to changes in disposable income and considerably less dependent on borrowing as an income supplement.

It also means we will have new drivers of growth.  These will be capital spending, particularly spending on infotech and telecom related equipment and software, and net exports.  At some point, not yet visible, growth will also be seen in residential construction, which, even if it rose by 50% would still be at a depressed level.  Even automobiles have some hope for an eventual recovery. Currently, auto sales have been at the annual rate of between 10 and 11 million, below the scrappage rate and far below the 16-17 million range of a few years ago

For those of us trying to make sense of the economy and financial markets there is a huge amount of sheer noise that can confuse the picture.  We are endlessly exposed to talking heads who anxiously await the next important set of statistics on jobs or retail sales or GDP and then call upon three or four experts to analyze the data instantly. Earnings results stream across the TV screen being instantly compared with “the estimates”.  At a time when being correct about the big picture is paramount, most of the stuff we see and hear is providing more obfuscation than clarity.

So, okay, what is the big picture?

Here is the broad economic/political context for the next two years as I see it:

Even though net job creation is likely to begin soon, the economy’s response to the huge monetary and fiscal stimuli has so far has not been adequate, particularly in a political sense. I have called it a “low quality recovery”. Private-domestic-final demand has simply not yet kicked in a substantial and sustainable way. Consumer income has become quite reliant on government transfer payments.  Financial markets are too accustomed to extremely low interest rates. Politicians are restless. But the mood of the electorate seems dead set against any further big fiscal stimulation.

Interest rates are certain to climb.  Even if the Federal Reserve is not vigilant as the economy recovers (I think they will be) and inflationary expectations begin to rise, the bond market will be standing guard and will react quickly.

The most cyclical parts of the economy (consumer durable goods, residential and commercial construction, and capital expenditures) are all extraordinarily depressed.  Together, these components currently have only an 18.5% share of GDP. Their average share for the past 50 years was about 24%, with cyclical peaks soaring to over 26%. An 18.5% share appears to be unsustainably low if the economy is to generate any significant growth.  Eventually, demand backlogs in these sectors will begin to grow, ultimately resulting in a somewhat faster and more sustainable growth pace by 2011-2012.

Conversely, personal consumption is at a record 71% share of GDP, higher than a year ago, and while the personal savings rate has risen from plus or minus zero to  over 3.0% it is still low by historical standards. Further consumer deleveraging would seem to be ahead of us. Spending will be tightly tied to growth of disposable income, largely unsupplemented by borrowing.

One phenomenon of the recession is worth noting. Imports acted like a big shock absorber to domestic economic activity.  That is, as domestic aggregate demand declined, imports fell substantially more than exports.  Both exports and imports peaked in the 3rd quarter of 2008. Net exports at the time were negative by $758 billion. By the 2nd quarter of 2009, net exports were negative by $339 billion, thus contributing a positive difference to GDP of $419 billion.  Over that same period, Gross Private Domestic Investment (construction, capital expenditures and inventory change) plummeted by $582 billion.  That’s where the decline in aggregate demand was centered. But the performance of net exports offset over 70% of that decline. Query: As the economy recovers will imports reverse course and increase faster than exports and thereby be growth limiting? The president, in his State of the Union speech, adopted an objective of doubling exports in 5 years. That’s 15% per year when global demand is likely to grow 5-6%, implying a huge gain in share of market. Can we really do this without devaluing the dollar?  I seriously doubt that we can reach the president’s objective, but I do think that we have a shot at growing exports faster than imports, especially if China becomes more realistic about the value of the yuan.

The question uppermost in the minds of investors concerns how and when the federal government can gain a credible degree of control over the budgetary process. Proceeding along the current path, camouflaging the problem with overly optimistic growth projections for the economy, and coming up with incremental solutions without a credible master plan will not be long tolerated by global financial markets. Longer-term, how will we deal with the unimaginably huge liabilities facing us over the next 20 years from Medicare and Social Security.  Currently, I see nothing that even remotely suggests that the political system has the will to face these problems.

Okay, so sizeable tax increases at the federal and state levels, are both necessary and inevitable. But tax hikes are growth dampeners.  Thus, we have a growth conundrum. How do we simultaneously get higher, sustainable growth along with higher taxes and higher interest rates? By late 2010 or early 2011 the economy, even as fiscal and monetary stimuli wind down, will begin to show some solid, sustainable growth possibilities.  But both higher interest rates and higher taxes will be growth limiting at the very time when higher growth is the best answer to the problems of debt and deficits. (The only other answer is to inflate)  We seem to have painted ourselves into the proverbial corner. It’s what happens when you treat the ills of an over- leveraged economy by increasing debt in excessive amounts.

Another important question has yet to be answered. How do we best put our financial system back in order? Do we have the political guts to overcome the Wall Street interests lobbying for no substantive change in the way the financial system is structured?  It may be true that the “Volcker Rule”, which would prohibit banks from engaging in proprietary trading, private equity, and hedge funds does not address directly what got us into the mess, but such activities are full of potential conflicts of interest and put the financial integrity of an entire enterprise at risk. And how about the badly needed standardization and regulation of derivatives and the way they are traded?  Such changes are absolutely crucial to creating confidence in the markets.

The brightest force in the mix for investors is the performance of corporate earnings.  As volume turns from negative to positive, the cost-cutting efforts of American companies are paying off big time.  Analysts who are better equipped than I to estimate earnings are forecasting S&P 500 earnings for 2010 in the range of $75-80.

In the table below are the operating earnings of the current constituents of the S&P 500, including estimates for 2010 and 2011.

S&P 500 Operating Earnings
(current constituents)
Operating Ex Energy &
Earnings Financials
2005 74.72 47.99
2006 86.71 53.01
2007 86.69 57.01
2008 67.52 54.27
2009 62.84 50.43
Est. 2010 78.93 58.44
Est. 2011 95.37 67.22

Source: BankAmerica Merrill Lynch

What I find quite remarkable is the earnings’ resistance to decline in the worst recession since the 1930’s. This is especially true if the earnings of the financials and energy are removed. Looking at these numbers it is hard to spot the recession.  This relative earnings stability for so much of corporate value is a legitimate reason for longer term confidence in earnings, and is a key reason for the sharp advance in stock valuations since last winter.

So There! Now you have no need to listen to the talking heads in the morning.  Just keep the Big Picture in mind.