Bounce to Nowhere?
The message from the March/early April macro news continues to be one of the free-fall phase ending, while the economy remains in a severe recession. Retail sales, for example, though disappointing in March, are stabilizing on a year-over-year rate of change, while the six-month rate of change is struggling back from an over-20% pace of contraction. Consumer spending is looking like it will grow 1-1.25% in Q1 real GDP, and a sequential 5-5.25% retrenchment in Q1 real GDP will mark a small improvement from Q4 2008.
To be sure, the larger theme we believe will dominate the consumer sector is the need to reduce leverage, which will require a higher gross saving rate than households previously achieved. In a recent issue, we introduced a base case estimate that $1.2 trillion of household debt would need to be paid down over the next three years to return the household debt-to-income ratio to the pre-housing bubble trend. French banking group Societe Generale, however, estimated that a return to the trend of the past five decades would require nearly twice that level of pay down we expected. The key point here is that the consumer contribution to any future recovery is likely to be muted by these debt head winds, regardless of the degree of fiscal and monetary stimulus applied. Equity investors using the regular playbook and running into consumer discretionary stocks should make sure their long-run earning growth expectations reflect this likelihood.
For example, this is shaping up much more as a U-shaped housing recession than the typical V-shaped one, as the inventory overhang this time around has proven difficult to manage. The National Association of Home Builders reports slightly improved home traffic, reflecting mortgage rates’ drop below 5% again as the Fed has ploughed deeper into Treasuries. Nonresidential construction, however, is just turning into a head wind for U.S. GDP growth, with commercial construction leading the way down. This is typically a late-cycle development, and nonresidential construction tends to remain a head wind well in to the next recovery.
One-third of manufacturing capacity utilization has been idled in this recession – something the U.S. economy has never seen in the post-World War II period. Capital equipment production is particularly hard hit, although the most recent monthly figures show the first sign of a turn in the momentum for both this sector and consumer goods production. Consistent with that is the pickup over the past two months of the percent of production sectors showing gains, as the one-month diffusion index has turned up and the three-month is beginning to make the turn.
Small business is arguably the most entrepreneurial segment of the economy, and there is as yet no sign of any stabilization to be found here. Plans to net hire are the lowest ever recorded, and capital spending plans are as punk as they were in the deep recession of 1973-5. We suspect the credit crunch is hitting this sector especially hard, as banks tend to ration credit to their largest customers during such periods. While we believe the policy emphasis on renewing lending to the private sector is misplaced – private sector debt loads, especially household debt, need to be paid down – if there is a sector where this policy thrust is relevant, it is the small business sector.
“Deflation” remains the watchword for 2009, with headline inflation having dipped into deflation for the first time since the 1950s and the PPI crude material series still deep in deflation, though beginning to stabilize on a six-month rate of change basis, even ex energy. As the Fed trashes cash and drags down mortgage-backed securities and U.S. Treasury yields by expanding its balance sheet, it is at the same time pushing professional investors into riskier asset classes and inflation hedges. The more we think about it, the more we wonder whether the Fed has painted itself into a corner with its quantitative easing initiative.
Despite the current deflation, the ballooning of the central bank’s balance sheet is encouraging many professional investors to increase exposures in tangible assets like precious metals, industrial metals, energy products and agricultural land. That means the cost of inputs to production will rise before the prices of final products rise. In addition, higher energy and food prices are likely to reduce the discretionary income of households already facing wealth destruction, credit constraints and job losses. We are perplexed. How does the Fed expect these impacts of higher prices for inflation hedges on either supply or demand to be supportive of economic growth? Put plainly, quantitative easing may have a built-in contradiction: The inflation expectations it is most likely to generate are in commodities that are either inputs to production or in consumer necessities. How either of these effects increases profit expectations, and hence induces a revival in production in output and employment, still escapes us.
The complexion of the U.S. macro results, while still severely recessionary, is generally better than what is coming out of Asia and Europe. Still, there are a few straws in the wind, like Japanese machine tool orders, which are showing several months of stabilization, along with Japanese consumer sentiment. These are surprising green shoots in what otherwise looks like scorched earth. We’ve proceeded on the assumption that the darker the macro news flow gets, the larger and more dramatic the policy push will be. A fiscal package on the order of 2-3% of GDP is under discussion in Japan, which will contain the damage, but we expect yen depreciation will need to be pursued, along with an escalating quantitative easing program to stabilize the Japanese income.
We’ve expected some retrenchment in equities, given technically overbought conditions and our view that the second derivative trade would give way under the Q1 earnings deluge. That concern is looking premature, although we are not yet in the thick of the earnings releases. Corporate bond spreads have not moved in synch with the equity rally, which is an anomaly we felt confirmed our decision not to chase the rally. So if we are wrong and the equity rally continues or is only briefly interrupted (say, because institutional investors that did not get on the bus early decide they need to get on quick or face career risk), the better way to hedge our view may be through a long position in corporate bonds. Alternatively, there are segments of the financial sector that have large long positions in corporates, like nonlife insurers, that could be played as well.
for The Daily Reckoning