Macro-Finance Outlook: March 2010
(Data supplied by Thomson/Reuters and Charles Schwab Market Research)
The following outlook is a top-down analysis of the US macroeconomy. We will begin by analyzing factors that affect the economy as a whole, and move on to 1.) money, interest rates, and inflation 2.) financial activities and credit, 3.) the outlook for corporations, and finally 4.) the outlook for the consumer.
The year-over-year percentage change in real GDP has been improving. The latest readings are now positive, as Q4 real GDP growth grew at a 5.7%. rate. The chance exists that hopes for a recovery based on robust real GDP growth in 2010 are deceptive, however, because the Q4 number was driven mainly by companies replenishing inventories and increased government stimulus, both temporary factors.
The recent decline in the unemployment rate has sparked speculation that the U.S. economy has stabilized. The rate peaked in October 2009 at 10.1%. It subsequently declined to 9.7% by January 2010. Unfortunately, the decrease isn’t a direct result of increases in employment, but rather a contraction in jobs available and a spike in discouraged workers. The U.S. economy lost 8.5 million jobs in the last two years. Massive job losses didn’t occur overnight, and these jobs will not be gained back in a short period. The unemployment situation magnifies the numerous weaknesses in the recovery process.
As referenced above, the spike in the number of discouraged workers creates a false positive effect on the unemployment rate. Discouraged workers are no longer seeking employment and therefore are not counted in labor force statistics. The inverse relationship between unemployment and discouraged workers has been exacerbated recently due to more people exiting the labor force.
Limited fluctuation in Core CPI signals low inflation in past quarters. Limited fluctuation fuels hope that prices have settled into a zone of little change. Core PPI has also come down off of 4% year-over-year growth, indicating slower price growth in finished goods. With low inflation the Fed will not be pressured to withdraw their easy money policies because there will not be a need to fight inflation, although another severe contraction in economic growth could fuel fears of deflation. The inflation numbers are less encouraging when one considers the most heavily-weighted component of these “baskets of goods” -- real estate, which has been declining precipitously for years. The core numbers are misleadingly low because they fail to account for strong positive inflation rates in energy and food.
The recent rally in the S&P 500, the most heavily weighted leading indicator, forecasts a bull market based on improved corporate earnings and investor confidence. However, corporate earnings may be inflated due to cost cutting, especially labor force reduction. Corporate earnings will be discussed in more detail later in the report. 
The growth in the amount of money in the economy is slowing. M2 growth began an upward trend off of 4.0% growth in Q4 of 2005. Growth in money supply is directly due to an increase in consumer credit extension and activity over the 2006 – 2008 period as consumers heavily leveraged themselves. 
Velocity of money — the average times a dollar spent each year —remains low, further indicating that price levels have settled into a period of small inflationary change.
The Federal Reserve’s Funds Rate remains steadily below 25 basis points, currently at 0.11%, in order to stimulate the economy by stimulating demand for credit (separate from the Fed’s Quantitative Easing program). However, given the recent credit crisis, banks are reluctant to issue loans to consumers, which mitigates the effect of this indicator. The Fed will more than likely hold this rate steady until the economy shows robust signs of recovery. 
The yield curve is relatively steep, which is favorable for banks, although banks remain mysteriously reluctant to issue credit.
The US dollar has seen a long-term downtrend, weakening against other world currencies. This helps multinational companies that generate revenues in foreign currencies. When these foreign profits are converted into weaker dollars, firms’ profits receive a boost. Additionally, the weak dollar boosts exports, which will lead to additional GDP growth. 
Commercial and Industrial loans growth, directly related to capital spending, has experienced a decrease as a percentage of GDP. Loans, growing at nearly 20% in Q1 2008, have tapered off to nearly no growth amidst the weak credit market. Low growth within this indicator negatively affects the overall economic recovery of the US. 
Home prices continue to decrease, albeit at a decreasing rate. At negative 5%, homes continue to depreciate in value, leaving many consumers in a negative equity position. If home values don’t appreciate back closer to their former values, the housing industry could see a further setback as defaults rise. 
The real mortgage rate -- the mortgage loan interest rate plus the house’s price appreciation rate -- has experienced significant inflation. Housing values have decreased in value, making them a less attractive investment. The housing market is still in trouble, and this turbulence is magnified by unemployment and increased consumer loan delinquencies, which will be referred to later.
The decrease in the spread of corporate bond yields to 10-year Treasury yields is a sign that investors are regaining confidence in corporations’ stability.
The decline in corporate profits is slowing, but overall, corporations still have not seen a year-over-year increase in profit. The recent improvement in corporate profits is strongly due to cost reductions and inventory build-ups rather than top line revenue growth. The increase in revenues is long overdue, leading to the question, “how long will investors wait for top line revenue growth before stock valuations decrease?”
Industrial production has increased in the recent past, reflecting the increase in business inventories and the positive GDP growth in Q4 2009.
Capacity utilization has also seen a recent increase, but firms are still operating at lower than normal levels. Low capacity utilization is consistent with low inflation and makes it difficult for business to pass on price increases to the consumer.
Stocks' dividend yield is decreasing, due to companies in the S&P 500 cutting dividends amid the financial downturn, coupled with the increase in stock valuations from March-December 2009. This decreases the return for investors and makes the equity market less attractive.
While disposable income data is volatile, the long-term trend shows a steady decrease over the last decade. This decrease, especially when exacerbated by high levels of unemployment, is a catalyst for negative changes in consumer spending, loan delinquencies, and consumer bankruptcies, which are illustrated in the following graphs.
While consumer spending has increased, it is difficult to decipher whether this change is due to consumers becoming more confident in the market or companies liquidating inventory. The increase can also be partially attributed to government programs directly benefitting consumers (i.e. stimulus payments).
Consumer loan delinquencies are on an upward trend, which hurts both corporations and small businesses trying to collect on their payments.
Consumer bankruptcies are increasing, which hurts the filing consumers and firms’ accounts receivables, as these firms will receive only a fraction of what is owed. 
Higher consumer savings rates, while good for the consumer in the long term, make it difficult for the economy to grow in the short term. 
We are forecasting a U-shaped recovery, including sluggish growth at best through the end of 2011. Some factors show positive signs on the surface, but many metrics are weaker than they appear. The overall economy has at least stabilized, but not due to real economic growth. Rather, the stabilization is the result of two major economic forces: the Federal Reserve’s quantitative easing and expansionary monetary policy, and the Federal Government’s robust stimulus programs. As the government exits the market, the consumer will have to step up and spend if the U.S. is going to experience a long-term economic recovery.
Consumers seem to be taking financial precautions, thanks to uncertainty about the current economic climate, as indicated by the steep increase in personal savings rates. Both spending and purchases of durable goods has increased recently, but this is likely due to corporate inventory liquidation and federal stimulus programs like “cash for clunkers” and the “first-time home buyer tax credit.” Additionally, consumer bankruptcies and loan delinquency rates have increased steadily, negatively affecting confidence in purchasing ability of the consumer. Whether or not the average consumer is confident enough to spend money, take out loans, and save less remains to be seen. Longer-term factors such as the uncertainty of Social Security and Medicare (which has faced persistent cuts for most of the past decade) should also contribute to higher long-term personal savings rate and lower consumer spending going forward.
Due to how heavily GDP growth relies on consumer spending, taking a closer look at the state of the consumer is important to this analysis. Real disposable income, while volatile, has decreased over the last decade, while the savings rate has increased. While these two forces have been working together, essentially leaving consumers with very little money on hand to spend, leading them to live from paycheck to paycheck, consumer spending has increased even though they are deleveraging. Accordingly, with high levels of unemployment, the consumer loan default rate has increased along with consumer bankruptcies. The average consumer seems to be hanging on by a thread that could easily break due to a personal catastrophe such as the loss of a job or contraction of an illness. If this happened, more consumers would default on loans and file for bankruptcies which would lead to greater losses to the firms that own the outstanding consumer debt. The future growth of the economy basically lies on the back of the consumers; however, consumers don’t seem to be financially ready to sustain such pressure.
The effects of the financial crisis still linger. Banks are reluctant to lend despite the steepness of the yield curve. The Fed is currently being forced to work hard just to keep inflation at a low positive rate, approximately 2%. Deflation remains a threat. If politics comes into play and the Fed is forced to exit the markets sooner than is ideal, a deflationary spiral similar to what Japan has experienced is not an impossibility. Growth in many of the metrics reported is misleading because the Fed is “propping up” the economy. GDP growth sparked optimism that the economy is well on the way to recovery, but the growth was inflated by Fed programs and inventory build-ups. The Fed plans to discontinue several of its programs in the upcoming months, which may reveal the true status of the economy.
Unemployment, a lagging indicator, is one of the biggest obstacles to long-term economic recovery. Although the unemployment rate has dipped, major US corporations and small businesses are not ready to restore U.S. employment back to the 4-6% range quickly enough to meet the market’s demand for robust V-shape recovery. As the market’s high expectations for quick recovery are not met, it will have to adjust its expectations to face the reality of higher long-term unemployment in the economy. This could potentially stunt the economy’s growth for years to come.
At the time of publication, there is huge uncertainty within the European Union. The question is whether the financial crisis in Europe is contained to a few small countries, (i.e. Greece, Spain, Portugal) or if the financial instability of more countries in the European Union will be revealed. The severity of this problem could have a major impact in world markets in the future.
Macro-Finance Outlook: October 2009
(Data supplied by Thomson/Reuters and Charles Schwab Market Research)
The percentage change in GDP has been improving -- although the latest readings are still negative -- since the sharp decline in December 2008 of -6.2%. The December drop was the most significant in 22 years.
After-tax corporate profits declined in the 2nd quarter of 2009, although, like GDP, the decline of -17.7% represents an improvement from the 1st quarter’s -24.8% decline. Profits have benefitted from cost reductions, inventory depletion, reduced SG&A expenses and workforce reductions. As these actions only provide a temporary boost to firms’ earnings, investors might consider waiting to see plausible evidence that firms can improve top-line revenues before significantly increasing their exposure to equities.
The ISM Employment Index bottomed out at an historical low in 2008. Since then it has improved dramatically, resembling the highly-touted V-shaped recovery. The last reading of 46.4 is close to the net hiring point (50 and above), suggesting that companies are hiring more workers than they are laying off and firing.
The unemployment rate has not yet confirmed the more positive outlook provided by the ISM employment index. Unemployment continues trending upward after short-lived improvements in June and July. The unemployment rate was 9.7% in August and 9.8% in September (data unavailable to graph at press time). Moreover, the 263,000 net job losses were well above the consensus estimates of 175,000, and past unemployment numbers (most recently July) continue being revised upward. Employment -- which is a lagging economic indicator -- continues to weigh on financial markets and the economic recovery.
The percentage change in Commercial and Industrial Loans continued declining in August, suggesting that business demand for credit remains weak and credit markets are still not supplying credit on a level that would support an economic recovery.
The rate of decline in industrial production slowed in recent months, suggesting stabilization of the freefall that began in January 2008.
The ISM Service Index has turned, which can be interpreted as an encouraging sign, as services drive more job creation in the US than manufactoring.
The Index of Coincident Economic Indicators remains weak overall, but 3 of the 4 components of the index have improved recently (Real Manufacturing and Trade Sales, Industrial Production and Personal Income Less Transfer Payments).
Consumers have been less likely to “roll the dice” in recent years, after 3 decades of increasing expenditures on casino gambling . . .
. . . and, similarly, have been “laying off the bottle” a bit more. The cutbacks in gambling and alcohol expenditures underscore the severity of the most recent recession compared to previous economic downturns.
The Index of Leading Economic Indicators is showing signs of recovery. September marked the fourth consecutive month in which the index improved. It is the first time since August 2007 that the indicators have been in positive territory.
Inversion of the yield curve (measured as the difference between long-term and short-term interest rates) accurately forecasted the recession, and the current wide spread between long and short rates is now forecasting economic recovery. One cautionary note here -- short-term yields are being kept artificially low by an aggressive Federal Reserve interest rate policy. It’s not clear that the yield curve will remain this steep when the Federal Reserve begins raising short-term interest rates later in the economic recovery. The table depicts how a steeper yield curve is favorable for the stock market.
International economies are demonstrating signs of a V-shaped economic recovery. The dramatic improvement in global economies such as China have led this trend. The graph below represents a “diffusion index,” or weighted index of indicators, constructed so that values greater than 0% represent economic expansion.
The US dollar showed slight signs of strength in August, which accounts for some of the market’s “mini-correction” in late September. Somewhat perversely, the long-term weakness in the dollar -- due to the ballooning federal deficit -- has been interpreted as good news for US stocks, as a weak dollar is thought to increase US exports, as US goods become more competitively priced overseas. Notice how increased exports would help firms grow profits by increasing top-line revenues, a statistic the market will be watching very closely in Q3 and Q4 2009.
Growth in the money supply is gradually slowing as the Federal Reserve has been able to pump a bit less liquidity into the financial system. This has allowed markets to reduce their concerns regarding inflation in the longer-term.
The velocity of money -- the average times a dollar is spent each year -- remains weak, which also lessens inflationary concerns.
Accordingly, both the Producer and Consumer price indexes have registered lower inflation in recent months.
Capacity utilization, which measures the percentage of US manufacturing operating at full capacity, has been weak, and has shown signs of bottoming recently. Low capacity utilization also contributes to low inflation.
Low inflation is contributing to the stock market’s recent gains, as stocks’ price-to-earnings (P/E) ratios tend to be higher when inflation is lower. If inflation picks up in 2010, however, the stock market may have to repay this valuation “tailwind” as P/E ratios contract.
Our call on the inflation/dollar question is that the Fed’s loose monetary policy and government stimulus spending will fuel inflation and a weak dollar in the long term. The chart below suggests that, after a brief respite, the US dollar has entered another downtrend. The effects of higher inflation and a weaker dollar will probably net out to a neutral effect on stocks in the long-term. Combined with a steady stream of disappointing economic numbers, as the recovery takes longer to spark than many hope, expect future equity returns to be lackluster compared to their run from March-September 2009.
Durable goods orders have shown a slight improvement. Consumers’ willingness to start buying big-ticket items again will be key for a vigorous economic recovery. This indicator has a long way to go, as the apparent recent “improvement” in the graph indicates consumers’ purchases of these items only declined by -11% year-over-year.
Recent polls, such as those from the Association of Individual Investors, suggests investors’ psychology has turned, and we are indeed in the “hope” period of an early bull market cycle. Progressing to the “relief” stage, where more cash moves off the sidelines and into equities, depends on how the economic news shapes up in Q3 and Q4 2009.
Synthesis and Discussion. Although many of the above indicators reveal continued weakness and volatility in markets and the economy, undeniable improvements are beginning to manifest in several indicators. The stock market’s strong recent performance has had a positive influence on investors’ mood, leading us to conclude that the bear market in stocks has evolved out of the despair phase.
However, we also believe the ongoing government intervention may have clouded the water somewhat. In particular, it will take a long time for the banking system to fully wean itself from government involvement. The various TARP and TALF programs have had positive influences on GDP, industrial production, durable goods orders and capacity utilization. Moreover, one of the strongest influences fueling stocks’ gains is protracted weakness in the US dollar. It’s difficult to extrapolate long-term good news out of an ever-declining US currency.
Many problems linger from the financial crisis. Commercial and industrial lending has yet to improve. De-leveraging in the banking and household sectors has just begun; this process will take years to complete. Until business and household balance sheets can support an expansion of credit, it’s difficult to forecast a completely robust economic expansion. A new wave of adustable rate mortage resets are scheduled to occur in 2010, and a new crisis is brewing in commercial real estate loan defaults.
Based on our preference for long-term, stable investments, the above analysis leads us to conclude that larger-capitalization, more defensive stocks that may have been left behind by the 2009 bull market are the best place to look for new opportunities to invest. Additionally, we favor more recession-resistant stocks with high dividend yields, low betas and strong growth potential in foreign markets. If the dollar continues to weaken, a growing presence in emerging markets will aid growth and firms’ bottom lines, as profits earned in stronger global currencies boost earnings when re-patriated back to weaker US dollars. Emphasizing these themes in an equity portfolio are appropriate for the “new normal” thesis put forth by numerous economists, involving slower growth, de-leveraging, and long-term higher saving and lower spending by the U.S. consumer.
Macro-Finance Outlook: August 2009
(Data supplied by Thomson/Reuters and Charles Schwab Market Research)
The August Economic Outlook is a mixed bag of indicators, some possibly in the early stages of turning positive, others still decidedly negative. This, of course, represents a substantial improvement from our March 2009 outlook, which was entirely negative. The data presented below support the view that the economy is stabilizing, and possibly turning the corner towards recovery. When the NBER employs it rear-view mirror and eventually dates the recession, it is not impossible that they will conclude that the economy bottomed out in the summer of 2009.
Notice that the NBER takes twice as long to date the start of economic expansions than to declare the economy is in recession.
The index of leading economic indicators has turned positive, consistent with its behavior at the midpoint of previous recessions.
The index of coincident indicators continues falling, however.
Notice how consumer spending tends to bounce back first when recessions end -- improvements in employment follow with a lag.
Consumer spending has yet to rebound, however . . . 
. . . and the personal savings rate continues trending upward -- these indicators have not yet flashed positive signals regarding the end of the recession.
Consumers continue pulling back sharply, reducing spending on alcohol . . . 
. . . and gambling -- cutbacks that haven’t been seen in decades.
The graph below shows that unemployment tends to begin turning at the end of recessions . . . 
. . . but initial unemployment claims, which fell by 100,000 last month, turn around just past the midpoint of recessions.
Consumer confidence is stabilizing . . . 
. . . and there are signs that credit conditions are improving. The spread between high-yield debt and treasuries has compressed significantly since the height of the crisis.
Banks have increased their willingness to provide consumer installment loans, which has traditionally been followed by increases in consumer spending.
Business loans have also become more accessible, which tends to be followed by increases in business spending.
The ISM Manufacturing Index turned sharply positive -- but the high volatility of this index makes it dificult to interpret in isolation.
The ISM Service Index has also turned around, however, which is a positive indicator in itself, in addition to providing corroboration for the manufacturing index.
Inventories have declined at a record pace -- this could be a positive indicator, however. Notice how businesses tend to rebuild inventories promptly after similar historical declines. An inventory rebuild would help with unemployment . . . 
. . . and provide a boost to industrial production (shown below).
Global industrial production has rebounded sharply, led by countries like France, Germany, and in particular, China, whose stimulus program has been conspicuously effective. This is consistent with a thesis that was floating around prior to the Great Recession -- leadership in global growth was expected to shift away from the U.S. to other regions. Also notice that the more you move eastward, the less leveraged economies had become, and the faster they are now recovering. The prolonged deleveraging of U.S. businesses and consumers will hamper our ability to rebound as quickly as other nations.
Home prices have improved on a month-to-month basis -- if this improvement spills over to the year-over-year numbers, expect the experts to declare an end to the housing recession. This would be a major turning point for the U.S. economy.
The Housing Affordability index has turned down, further suggesting that the housing recession may be over.
New Housing Starts have also stabilized.
After-tax corporate profits are declining at a slower rate, but you really have to be an optimist to put a positive spin on this one. Corporate earnings have benefitted from massive cost-cutting, but whether or not earnings will get a boost from a rebound in revenue growth in Q3-Q4 2009 and into 2010 remains a big question -- especially in light of the pressures on the U.S. consumer to deleverage and save more.
GDP growth tells a similar story -- output is declining at a less precipitous rate, but it’s going to be a long way back to 3-4% real annual growth (the minimum “feel-good” growth rate).
Durable goods orders continue to contract, reinforcing the view that consumers may be permanently downsizing their profligate ways and shifting to a new era of thrift.
Regarding inflation -- the Federal Reserve’s massive monetary stimulus has resulted in fast money supply growth . . .
. . . but the global slowdown has reduced the velocity of money -- the number of times an average dollar is spent each year.
As long as velocity remains low, inflation is unlikely to be a problem. The way the Federal Reserve is conducting monetary policy strongly suggests that they are deliberately trying to reflate asset values, and that they believe the risk of deflation is worse than overdoing the stimulus and sticking the economy with a few extra points of inflation over the next decade. Notice that a reflation strategy also allows the U.S. government, businesses and consumers to pay back debt (deleverage) with cheaper dollars, making our massive debt problem less serious.
The dramatic dropoff in Capacity Utilization is also helping keep inflation under control.
Let’s wrap up with a peek at market psychology. The graphic below suggests that investors have to endure prolonged despair before the hope of a new bull market sparks, leading to the type of genuine optimism that triggers a resurgence in consumer and business spending.
The latest readings show a strong rebound in investor sentiment. Is it possible that the strong negative sentiment from March 2009 represented the despair phase, and that investors’ improved bullishness is indicative of the start of a new bull market?
W