Tuesday, March 31, 2009

Economic Deterioration Trumps Talk of Recovery

I've received a number of e-mails from readers wondering how it could be possible to see a 50% rally in the major indices while there hasn't been any improvement in the fundamentals, and in fact, the fundamentals continue deteriorating.

My answer is typically, "never underestimate the foolishness/maliciousness of the media." They have proven over the last few years a fantastic ability to manipulate news into something positive. But regardless, I'm not expecting a move much higher - it merely wouldn't surprise me. The S&P 500 has already rallied 25% from it's lows of 3 weeks ago. That alone is enough to satisfy the requirements for a major bear market rally.

Any move higher would likely be accompanied by reports of improved fundamentals. Most of that would be small bounces in month over month statistics. Surely you heard of the pick-up in new home sales last week? Many analysts were claiming that it could be a "sign" that home prices would bottom and lead the markets to recovery later this year. Well, lets take a look at that improvement in new home sales:



You'll have to click on the chart to actually see the improvement. Still can't see it? That's okay. The reason that it hardly shows up on the chart is because it is such a tiny change in the monthly statistic. You may have also heard about an increase in durable goods orders. Again, the month over month increase pales in comparison to the damage done over the previous 6 months.



To be sure, I'm cherry-picking. There has been meaningful improvements in credit spreads and some other indicators. But in any areas that one would normally see "end of recession" improvement, there is none - or very little. As I've mentioned many times. The eventual recovery, when it comes, will not be marked by an increase in loan activity. It will occur when entrepreneurial people decide to take their savings and use it to invest in a business that will produce value for their customers. Seeing increases in the rate of savings is imperative for this to transpire. And although the gain thus far is a good start, It is likely only a quarter of the way to where it needs to be. I envision this statistic to read +15% by the time we see recovery.



Ironically, the one positive thing I have to say about the economy is what troubles neoclassical economists most. They see a rise in savings as a threat to increasing consumption, rather than a pretext to increasing production. I discussed this in "There Is No Paradox In Saving" a few months ago.

Let us take a look at a few more charts. Once a quarter Brian Pretti reviews the CFO (Chief Financial Officer) survey. He finds that the CFOs, if anyone, know best when it comes to the health of the economy. They see the numbers first. I highly recommend you read the whole article. It is full of interesting charts. Here is one of them:



Pretti also discusses the labour market outlook of the CFOs. Here is the applicable quote:

Very importantly, on the employment front, we suggest the news could not be worse. In aggregate, CFO’s expect to layoff 6% of their workforce this year. If they are even near correct with this comment, this translates to 7.6 million additional jobs to be lost. If that’s the case, we are not even half way through the current payroll contraction cycle. Although these are our comments, the impact on consumption of layoffs of this magnitude? You don’t want to know. 60% of companies will impose a hiring freeze in the next twelve months. 57% of the CFO’s say they plan to reduce or freeze wages. 39% of CFO’s say they plan to reduce hours worked for retained employees. Now you know why we have been screaming so loudly about the decline in wage growth that is sure to come directly ahead. No question about it. Their comments are not good news for the domestic labor market.

If you wanted a picture of the coming and current wage deflation, there you have it. It appears that the increased savings will come at the expense of drastically lower consumption, rather than increased work hours.

Earlier this week, Calculated Risk was talking about his projections for Q1 GDP. His conclusion? Q1 GDP Will Be Ugly. He does a very good job explaining why:

Earlier today the BEA released the February Personal Income and Outlays report. This report suggests Personal Consumption Expenditures (PCE) will probably be slightly positive in Q1 (caveat: this is before the March releases and revisions).

Since PCE is almost 70% of GDP, does this mean GDP will be OK in Q1?

Nope.

I expect Q1 2009 GDP to be very negative, and possibly worse than in Q4 2008. Right now I'm looking at something like a 6% to 8% decline (annualized) in real GDP (there is significant uncertainty, especially with inventory and trade).

The problem is the 30% of non-PCE GDP, especially private fixed investment. There will probably be a significant inventory correction too, and some decline in local and state government spending. But it is private fixed investment that will cliff dive. This includes residential investment, non-residential investment in structures, and investment in equipment and software.

A little story ...

Imagine ACME widget company with a steadily growing sales volume (say 5% per year). In the first half of 2008 their sales were running at 100 widgets per year, but in the 2nd half sales fell to a 95 widget per year rate. Not too bad.

ACME's customers are telling the company that they expect to only buy 95 widgets this year, and 95 in 2010. Not good news, but still not too bad for ACME.

But this is a disaster for companies that manufacturer widget making equipment. ACME was steadily buying new widget making equipment over the years, but now they have all the equipment they need for the next two years or longer.

ACME sales fell 5%. But the widget equipment manufacturer's sales could fall to zero, except for replacements and repairs.

And this is what we will see in Q1 2009. Real investment in equipment and software has declined for four straight quarters, including a 28.1% decline (annualized) in Q4. And I expect another huge decline in Q1.

For non-residential investment in structures, the long awaited slump is here. I expect declining investment over a number of quarters (many of these projects are large and take a number of quarters to complete, so the decline in investment could be spread out over a couple of years). And once again, residential investment has declined sharply in Q1 too.

When you add it up, this looks like a significant investment slump in Q1.

Here is a chart from the St. Louis Fed showing us how the Q4 slump in RPFI looks over the long-haul. Annualize that 28.1% decline from the top and we'll be seeing a drop-off toward 1,300 on the chart.



It's been a while since I discussed the goings on in Asia. Perhaps there's signs of recovery over there? Nope. Things keep getting worse. I'm hearing rumblings about Chinese crude oil demand falling off a cliff. Considering most of their growth has come from industrial production and construction, and both are fueled by, well, fuel, I wonder how on earth they can meet the Asian Development Bank targets for 7% growth. Military investment perhaps?

Japanese Industrial Production numbers have continued to report negatively. Although there is some hope that the recent declines in inventories will stoke the fires of production over the coming months. Regardless, inventories are still at levels far exceeding historical norms. Unless exports pick up, any increase in production should prove temporary.



And how do Japanese exports look? They're only down 50% year on year.



Unemployment is rising in Japan as well, as you might expect. The unemployment rate hit 4.4% last month. Keep in mind that Japan's job market is very different from ours. Their population is aging so rapidly, that there should be ample jobs available to fill as workers retire. The increase in unemployment tells us that the overall job market is collapsing.

And Europe's biggest economy? Still cliff diving. The latest figures we have on German industrial production are for January. It is expected that February's numbers will be similar.



The Wall St Journal reports that the not usually over-pessimistic OECD is predicting a 5.3% drop in German GDP for 2009 and an unemployment rate of 12% for 2010. The German rate of unemployment is currently 8.1% - again, abysmal considering the aging nature of the workforce.

I could go on, but the trend is clear. We are in the midst of a depression. Along the way, there will be decelerations in the pace of decline and there will be month on month improvements. But there will not be any long term recoveries. The reason is simple: much of the previous gains in industrial production were the product of easy credit. They didn't really exist. And not only are those gains being eliminated, but the reparation of corporate and household balance sheets ensures a protracted drop in consumption on top of the decrease in consumption that was due to credit expansion. In other words, consumers are not going to simply revert back to a level of consumption that is commensurate with their incomes. They will under-consume for a period of years until they have enough savings to spend again.

Believe the "second half recovery" mantra at your own peril. But also be aware that the media will likely try to sell any uptick as a sign that the bottom is in. And that false perception should also not be underestimated in its potential ferociousness. I don't think anyone can say with certainty that they know which way the next 20% will be in stocks. If someone tells you they can, my best advice is to run away as fast as you can.

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