Macro Factors and their impact on Monetary Policy
the Economy, and Financial Markets
MacroTides.newsletter@gmail.com
Investment letter – October 21, 2011
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Winter is Right Around the Corner
We grew up in the Midwest, where the winters are often measured by wind chill factors below zero and multiple layers of clothing just to prevent frostbite. In most years, there is a day in March when the temperature ‘soars’ to 50 degrees. On those days it was not uncommon to see people walking around in shirt sleeves, relishing the opportunity to savor the first hint of spring. Months later on July 4, thousands of people would gather near Lake Michigan to watch the fireworks display. Too often, the weather failed to cooperate, and by dusk the temperature would have fallen to 60 degrees. Looking around, everyone was bundled up in sweatshirts, sweaters, stocking caps and gloves, even though it was actually a bit warmer than the spring like day in March. The same phenomenon happens with market expectations.
After a series of punk economic reports in August and September, most investors were prepared for the onset of another recession as October began. Instead of a blizzard of more bad news, reports on manufacturing, retail sales, and employment, failed to confirm that a recession had begun. The gloom was replaced by a glimmer of hope. Maybe there would be no recession after all! If this assumption proves true, the recent rally in the stock market is justified, and the market will hold on to its gains. On the other hand, if these reports were simply a phantom spring like day in the middle of winter, the stock market could prove more vulnerable to disappointment in coming months. The recession in 2001-2002 lasted just eight months and was quite shallow, but earnings estimates proved to be 25% too optimistic. In the “Great Exhale” recession of 2008-2009 estimates were off by 40%. We think the U.S. economy will weaken in the first half of 2012, potentially flirting with at least one quarter of negative growth. This scare will cause analysts to cut earnings projections by 15% or more, and should cause the stock market to fall below the lows of October 4.
Manufacturing has been one of the few sectors of legitimate strength since the recession ended in June 2009, and will likely remain resilient through the end of this year due to a tax credit that expires on December 30, 2011. This tax credit allows companies to write off any business investment booked before the end of this year. If a business is planning on making $50 million in business investments in the first half of 2012, they would be crazy not to accelerate a large portion of the investment before year end, since they would be able to write off 30% of the investment on their 2011 taxes. (or whatever their tax bracket) The investment tax credit will pull demand forward into 2011, just like the Cash for Clunkers and first time home buyers tax credit did in 2009 and 2010. In the short run, manufacturing activity will look stronger, but after January 1, business investment will drop sharply.
The Institute for Supply Management (ISM) Index rose to 51.6 in September. Any reading above 50 indicates that manufacturing in the U.S. is expanding. The ISM Index will likely hold above 50 through December as companies take advantage of a tax credit that expires on December 30, 2011 for business equipment investments. Within the September report, there were some cracks. New orders declined for a third month in a row, and order back logs fell to 41.5, the lowest since April 2009. The recent low in the ISM Index was well below the low reached when the economy slowed during the summer of 2010. Although the tax credit should give manufacturing a temporary boost, the overall trend is weakening. In addition, the slowdown in manufacturing is not just happening in the U.S. JP Morgan’s global manufacturing gauge fell .3 in September to 49.9, contracting for the first time since June 2009.
Retail sales gained 1.1% in September, and excluding autos were ahead .6%. This report heartened economists, since it showed resilience in consumer spending, which accounts for 70% of GDP. Retailers tracked by Thomson Reuters reported a 5.1% increase in same store sales in September. This led retail analysts to increase their estimates for holiday sales from the 3%-4% range to 5%-6% level. We believe these targets are overly optimistic. Traditionally, retailers begin taking delivery of holiday merchandise by late October. For this to happen, orders that are placed for goods produced overseas begin to arrive at the five busiest ports in the United Sates during August and September. The rush of holiday merchandise usually causes a spike in container volume at the ports. There was no spike in shipments in August and September at any of the five ports. In fact, each of the five largest ports reported declines from 2010 levels. In Long Beach, the second busiest port, volume in August was 14.2% lower than in 2010, and September was almost 15% lighter. Los Angeles, the nation’s largest port, reported 5.75% fewer containers in August. In Savannah, Georgia, imports were off by 4%, while they were down .9% in Oakland, and flat in New York and New Jersey.
There has been no pick up in railroad volumes associated with the holidays either. According to Burlington Northern Santa Fe, volumes in July, August and September were flat compared to 2010. The Ceridian-UCLA Pulse of Commerce Index, which tracks real time trucking activity, fell for the third month in a row. The index dipped .2% in July, 1.4% in August, and 1% in September. This represents an annual rate of decline of more than 10%, which was only exceeded in the 2008-2009 recession.
In late September, the International Air Transport Association reported freight utilization fell to 45% in July. (latest figures available) Freight utilization measures how full freight planes are, as well as the cargo space in passenger planes. This measure rose from under 40% in 2009 to over 50% in 2010. Given the weakness in all the other modes of shipping in August and September, air freight utilization has likely slipped below 45%. The transportation of goods by land, sea, and air represent the arterial system of economic activity domestically and internationally. These reports provide an unambiguous picture of a slowdown in economic activity in the United States and globally.
Although 103,000 jobs were created in September, the labor market remains incredibly weak, considering we are more than two years into the recovery. Since the recession ended in June 2009, the average length of time an unemployed worker has been out of work has increased from 24.1 weeks to 40.5 weeks in September, the longest in 60 years. Those who did manage to find a job made an average of 17.5% less than they had previously, according to Princeton economics professor, Henry Farber. Between June 2009 and June 2011, inflation adjusted median household income fell 6.7% to $49,909, based on monthly Census Bureau data. This decline is larger than the 3.2% decline in household income that occurred between December 2007 and June 2009, when the recession was in full bloom!
Over the last twelve months, inflation, as measured by the Consumer Price index, has increased by 3.9%. During the same period, average weekly wages rose only 2.1%. Even those with a job are finding it harder to make ends meet, since their cost of living is rising faster than their incomes. It is no surprise that consumer confidence remains at levels only previously seen during recessions. Given the ongoing weakness in job growth and disposable income, it is difficult to see holiday sales increasing 5%-6% this year.
Over the last 60 years, the Federal Reserve’s most powerful monetary tool has been raising and lowering the cost of money to manage the economy. Short term rates have been held just above 0% for three years, and the Fed has indicated they will hold them steady for another two years. With inflation at 3.9%, the effective ‘real’ Federal funds rate is a negative 3.6%. Despite this unprecedented level of monetary accommodation, the current recovery has been anemic, averaging less than half the average GDP growth since World War II. With its most powerful monetary tool neutered, the Federal Reserve has executed two Quantitative Easing programs to spur a pickup in job growth, housing, and overall economic growth. These extraordinary measures have failed. They did, however, contribute to an overall increase in the cost of living, which has only made life for the average family harder. This was surely not their intention. But the unintended consequences of desperate acts are rarely positive.
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