U.S. Economy: The Worst is Over?

wrong forum

 

I don't have any real ability to comment on the meat of this article, but I will say that the next time I see a financial/investing writer come out with a downbeat doom and gloom editorial, it will be the first.

They all seem to have embraced the idea that they can effect consumer confidence and make the markets more profitable. I can still remember a Kudlow and Kramer episode right after 9/11, for which the theme was a repetition of the indicators of great state of the economy and the markets despite what all the 'so called experts' were saying. It was so clearly a propaganda event by the pair that I laughed aloud a couple of times.

There are, I guess, some financial columnists who are negative but they seem to be always negative - they have a stake in fear-based prognostication. But unless you are a peak oil proponent or a gold bug, almost all of the columnists seem to want to always put a happy face on the financial situation.

 

should have just stopped there

 

Actually what I probably should have done was bluster, make a total ass out of myself, pretend like I know everything about the subject based on a couple of articles I read in Forbes and then finish it off with a vintage 1980's 'surfer/hipster' word like 'brah' to make it clear that I am not only the only intelligent person on the BBS, but that I'm also the only cool person here. That seems to have worked out well for you.

 

Simple answer: no.

 

Morgan Stanley disagrees
The dramatic improvement in credit and equity markets over the past few weeks echoes our belief that financial turmoil and systemic risk peaked in mid March. Credit default swaps for US leveraged lenders have narrowed by 150-200 bp to 40% of their mid-March peaks. CDS for a basket of 125 investment-grade nonfinancial borrowers, likewise, have narrowed by 63 bp, to 100 bp, and leveraged loan spreads have narrowed by 40%. Global stock prices have rallied by 10-20%. Volatility in both equity and bond markets has tumbled to three-month lows. Those rallies have the potential to turn a vicious circle into a virtuous one; they reflect the belief that the worst is over for the economy, and by reducing the cost of funds, can at a minimum cushion the downturn. Over the past week, better-than-expected economic US economic data and the disbursing of consumer tax rebates have buoyed hopes that the worst is over for the economy and recovery is coming.

We disagree. In our view, the recent run of better data does not signal that recession risks are receding. If anything, there is a renewed disconnect between market pricing and our view of the economy: We think the economic fallout and resulting downturn is only beginning. While our baseline no longer includes two consecutive quarters of declining output, we’d still label this period a recession. Courtesy of the coming one-time bounce to consumer spending from tax rebates, and the subsequent payback, at best we envision a roller-coaster pattern of tepid growth and at worst a double-dip recession. And neither anemic growth nor a mild recession is any longer in the price. Indeed, reflecting higher energy quotes and slipping growth abroad, we see weaker US growth over the next few quarters than we did a month ago. For the four quarters ending in Q1 2009, we now see a tiny 0.1% growth; last month we expected 0.9%. Here’s why.

We Question the Evidence of a Positive Inflection Point

There’s no mistaking the influence on market psychology of better-than-expected US economic data; they have fostered hopes for an inflection point in the economy − in the sense that things are not getting worse, or at least are deteriorating at a slower rate. Notably, first-quarter real economic growth remained at a positive 0.6%, and upward revisions to construction data mean that the first estimate may be revised up to 1%. Nonfarm payrolls declined by only 20,000 in April, one-fourth of the average monthly decline in January-March, and the jobless rate declined by 0.1% to 5%. And corporate profits excluding financial and consumer companies appear to have risen by 11% over the past year.

But as we see it, those data mask a significant underlying deterioration in economic activity, and we expect the growth in Q1 to give way to a 2% contraction in Q2. Domestic final sales declined in the first quarter for the first time in 17 years, reflecting weakness in both housing and business investment and tepid growth in consumer outlays. Only inventory accumulation kept output growth in positive territory, and we suspect the stockbuilding was involuntary. By any metric, real inventory-sales ratios have risen sharply in the past quarter, and some have risen for a year. Nondefense capital goods bookings have turned down in the past 6 months, and while unfilled orders are still rising, they tend to lag turning points. Vehicle sales in April tumbled to 14.3 million units, a 10-year low, and production cuts seem likely. And the better-than-expected payroll data hid a decline in the private and factory workweek, and thus a sharp 0.4% drop in labor inputs. Average hourly earnings rose a scant 0.1% in April, and almost certainly declined in real terms, hinting at weakness in consumer income. And our guess is that some of the earnings gain reflected profits on inventories, and much of it reflected overseas results.

These more ominous signs of weakness in our view reflect important and ongoing headwinds to growth, including tighter financial conditions, falling home prices, rising energy and food quotes, and weakening income support. Tighter financial conditions? That statement seems to ignore the 325 bp of Fed ease since September, aggressive efforts to add liquidity to markets, and the resulting improvement in risky assets and thus in credit spreads noted above. But there are lags between changes in financial conditions and their effect on the economy. As we see it, the wider credit spreads and reduced credit availability of the past few months is just starting to hit the economy. And the April Senior Loan Officer’s Survey reinforces our concerns that the tightening continues. The percentage of domestic banks reporting tighter standards was “close to, or above, historical highs for nearly all loan categories in the survey.” In turn, a weaker economy will extend the deterioration in credit quality to businesses; losses continue to mount at lenders and among investors, eroding their capital base and keeping lenders cautious.

Falling home prices are reinforcing that caution in three ways. First, they increase the probability of borrower default on existing loans, and higher realized loss severity forces lenders to raise new capital, sell other assets, curb lending, or some combination of those three. Second, they are prompting lenders to demand bigger down payments − “haircuts” − on new loans as a cushion for the expected decline in the value of collateral. Going from a 0 to 5% down payment environment to a 10-20% world is certainly safer, but the transition represents another dimension of reduced credit availability. Finally, the erosion in consumer balance sheets has prompted lender curbs on home equity and revolving credit lines, further constraining consumers. The upshot: The credit cycle has begun, and we think the time-honored interplay between a weaker economy and the credit cycle will restrain consumers and businesses for much of this year.

The ongoing rise in global inflation represents a second threat to US and global growth. For the first time since the 1970s, global forces likely will keep US inflation elevated and could push it higher. The ingredients: soaring energy, food and commodity quotes, a weaker dollar, and rising inflation expectations. As a result, we think US headline inflation will remain at or above 4% through September. Over the past several years, the rise in energy and commodity prices was largely the product of booming global growth, especially in Asia and in China in particular. Improving living standards boosted the demand for protein and thus feedgrains, which underpinned a broader increase in food prices. Recently, however, we think that energy, food and commodity price increases are more the product of global supply constraints. That’s obviously hard to prove, but crude prices have jumped $30/bbl while most measures of OECD demand have slowed. The feed-through of energy quotes into fertilizer and agricultural production costs is unmistakable (see “Still Constructive on Fundamentals – Sell-off Presents Buying Opportunity,” by Hussein Allidina et al., March 24, 2008). And the metals boom is taxing the capacity of electric utilities in the metals-producing countries, promoting blackouts and further price hikes.

A weakening US economy will eventually cap US inflation as the housing bust promotes a deceleration in rents and as slack in the economy undermines pricing power. But the relationship between slack and inflation has loosened in the past few years, so barring a significant downturn, underlying inflation will be sticky as sellers pass through some of those cost increases into retail prices (see “Upside Risks to Inflation,” Investment Perspectives, April 24, 2008).

These developments also point to downside risks to discretionary income and growth. Indeed, the resulting loss in discretionary income from the start of the year nearly offsets coming tax rebates. We estimate that the rise in energy quotes between December 2007 and September 2008 will absorb an annualized $70 billion in consumer discretionary income, while price hikes in food − a much bigger share of consumer budgets − will drain about $50 billion from wherewithal. By comparison, the tax rebates that started going out to consumers at the end of April will amount to $117 billion by year-end. The rebates are going out sooner than we expected last month, and we now assume that they will boost spending a bit sooner than we expected. Although we still think that the boost to consumer spending will amount to about 2 percentage points annualized over the next six months, the drain from higher energy and food quotes implies a weaker net trajectory for consumer spending that will hold back overall growth. In that context, we expect that the post-rebate relapse in consumer spending in Q4 2008 and a post-incentive payback in capital spending in Q1 2009 likely will result in near-zero growth in those two quarters.

Finally, overseas growth is beginning to soften. Business surveys, production, and retailing results are starting to turn down in Europe − an outcome our European economics team has long expected. Some economies in Asia, including India, and in Latin America are slowing. And rising inflation means that some overseas central banks cannot or will not respond to these threats to growth. Just as strong growth abroad helped keep the US economy out of recession over the past year (contributing about 40% of US growth), slower growth abroad likely will prolong the mild recession we think is now underway.

Despite those downside risks to growth, we think that the Fed’s 25 bp reduction in the federal funds rate to 2% last week represents the trough in rates for this cycle. As noted, the Fed has eased aggressively and quickly, and it is time to take stock of the impact. Officials have to be gratified by the revival of activity in many parts of the capital markets. But a quick reversal in rates is unlikely, given the risks to the outlook, and we think the Fed will keep policy on hold for the balance of this year. Despite a likely post-rebate relapse in the economy, we don’t expect a “double-dip” recession. Officials probably welcome a period of subpar growth to help reduce inflation. A renormalization of monetary policy (i.e., tightening) is likely to begin around mid-2009.

Reaffirming our Downbeat Calls on the Economy and Markets

The rally in markets and better tone to recent data are challenging our call on the economy and those of our strategists on markets. After all, Mr. Market usually sniffs out changes in the economic landscape before economists and strategists do. Nonetheless, our strategy team and we are sticking to our discipline and our calls. For risky assets, the recent rallies imply that a worsening economy is now no longer in the price. Likewise, the flattening in sovereign yield curves has gone further than position unwinding, and now reflects some expectation that policy will reverse soon. Both may be short lived. In contrast, expectations about the Fed have begun to stabilize the dollar in FX markets, but the important news is that slower growth abroad is changing expectations about overvalued currencies like the euro. Even with a tepid US backdrop, therefore, we think the dollar is bottoming. The biggest risk to our call is that the economy and markets continue to trade in ranges that frustrate bulls and bears alike. But the biggest risk for bullish investors now is that downside surprises in the economy and earnings prove that the recent upswing was a bear-market rally after all.

 

Final sales to domestic purchasers fell for the first time since 1991 this quarter. The increase in GDP (0.6%) is inventory accumulation, and as such is a poor metric.

People much smarter than me forecast the fed lowering rates to 1% by the end of summer.