The data released since the last edition of the Harmonic Notes e-newsletter in mid-November affirmed our assessment of slow and uneven growth in the US economy.  The data tips the proverbial scales slightly to the positive side but many issues remain that could garrote the recovery.

DATA OVERVIEW

• CONSUMER

-        The major negative factor facing consumers remains, of course, stubbornly high unemployment levels. True, the headline unemployment rate fell to 9.4% in December but the decline came mostly because the “participation rate” fell.  Also, while home sales have recently been mixed, with sales of new homes flat but sales of existing homes rebounding, home prices as measured by the Case-Shiller Home Price Index resumed their decline.

+        Despite the still-elevated monthly unemployment rate, weekly unemployment claims have fallen nearly to the critical 400K level, suggesting a downward bias to the rate in coming months.  Probably influenced by this improvement, retail sales and other measures of consumer spending again came in stronger than expected. Also, the Consumer Price Index stayed at about 1.0% year-over-year as the economy shows evidence of disinflation but not the dreaded deflation.

• BUSINESS

-        Participation in the recovery by small businesses continues to be a sore spot; the NFIB Small Business Optimism Index ticked down in December and registered its 36^th month at recessionary levels.

+        The ISM Manufacturing and Service Indices, surveys of large businesses, both jumped unexpectedly and both remain solidly in expansionary territory.  Industrial Production and Capacity Utilization were reported better than expected and CapU rose, although it remains at a very low level.

• INTERNATIONAL TRADE

+        Exports rose more than imports in 2H10, narrowing the trade gap.

• GENERAL

+        The revised report on third quarter GDP growth showed an improvement from 1.6% in 2Q10 to 2.6%. While this rate is better than the initial report, much of the growth in the third quarter appeared to come from inventory restocking, not more sustainable sources.  Meanwhile, our favorite coincident macroeconomic indicator, the Chicago Fed National Economic Activity Index, continues to wobble around the neutral mark. Finally our favorite leading indicator, the ECRI Weekly Leading Indicator, has continued its gradual improvement; after a precipitous decline for about nine months beginning late 2009, it’s risen back into expansionary territory.

GDP growth (white, right scale); Chicago Fed National Activity Index (yellow, left scale); Economic Cycle Research Institute Weekly Leading Indicator (blue, right scale) {CHART: BLOOMBERG}

“ENCOURAGING WORDS”

As mentioned above and in our last newsletter, data continues to tip the scales over-so-slightly to the positive.  Both anecdotal and quantitative evidence offer glimpses of hope*:

• While, as noted above, it’d be a mistake to read too much into the drop in the headline unemployment rate, some of the other data included in the monthly release was encouraging. Average hourly earnings moved higher, but year-over-year growth of below 2% poses no wage inflation risk. The average workweek paused its ascendant trend in December at 34.3 hours. According to Marc Pado, economist and strategist at brokerage Cantor Fitzgerald, each 1/10 hour is worth about 400K jobs.
• The 4-week average of weekly unemployment claims declined from nearly 500K to just over 400K, the level at which economists look for employment growth.

Unemployment rate (white, right scale); Average hourly earnings (orange, left scale); Average workweek (yellow, right scale). {CHART: BLOOMBERG}

• Based in part, perhaps, on this positive trend, the American consumer may have found her footing. Holiday spending appears to have risen by the most since 2005, even while consumers are borrowing less and paying off debt.  This balance sheet repair is a necessary step before growth can resume.
• Manufacturing continues to motor along. The strength in the ISM Manufacturing Index has been one of the US economy’s few bright spots since it rose above the 50 mark in mid-2009 (measures >50 show expansion in the manufacturing economy; >42 show expansion in the overall economy). Strength in this rather small (12%) segment of the US economy is being supported by growing foreign economies; declines in the US$, which aids export prices, may continue to boost this segment.
• The December report on the state of service businesses showed the largest increase since mid-2006.

ISM Manufacturing Index (orange) and ISM Service Index (white), 13 years ending December 2010. {CHART: BLOOMBERG}

• Vehicle production and sales look to be increasing.
• Tech spending is up 12% year-over-year.
• The oil rig count, a good leading economic indicator, surged after the Obama administration said deep water drilling can resume.
• Speaking of the Administration, the rapidity of its move towards the political center has been breathtaking. The respected research firm ISI Group counts 43 business-friendly moves since the November election, including the extension of the Bush-era tax cuts, a payroll tax holiday and other modifications to the tax code.
• The apartment vacancy rate declined and rents rose again in 4Q10.
• January reports by the 12 Federal Reserve districts show strengthening in 9, with none weaker, as 2010 came to a close.
• Food, fertilizer, and agricultural equipment producers are benefitting from the sharp increase in food prices. Ag related products account for about 8% of total US exports; they’re particularly important for Idaho, for which ag exports totaled almost $1.5 billion in 2009.
• Fourth quarter 2010 GDP growth is expected to post a healthy 3.5%.

Real GDP growth, 12/31/05 to 9/30/10. {CHART: BLOOMBERG}

DARK CLOUDS

While the worst storms may be behind, that’s obviously not the same as having clear sailing ahead. There remain plenty of things about which to worry; a partial list**:

• The pace of foreclosures has paused only because of technical concerns about correct paperwork, not because the housing market’s stabilized. There are millions too many houses in the US, the absorption of which almost certainly presents a long-term economic drag.
• The residential real estate market remains moribund, with sales rising slowly if at all and national prices turning downward again. According to economist David Rosenberg of Gluskin Sheff house prices have about 3 times the wealth effect of stocks, so continuing declines put significant pressure on household net worth.

Case-Shiller 20 City Home Price Index (not seasonally adjusted), January 2005 – November 2010. {CHART: BLOOMBERG}

• State and local budgets are under immense pressure, without benefit of the fiscal stimulus that blunted the effects of the downturn in 2009-2010. Not only is spending by state and local governments the second largest contributor to GDP but such spending tends to impact individuals more directly than spending by the Federal government. This shortfall is an enormous problem that will remain front-and-center for some time to come.
• The long-term unemployment rate is historically high. Nearly 60% of unemployed Americans were out of work for 15 weeks or more, with over 44% of them unemployed for 27 weeks or more.
• Labor underutilization is also a huge problem, with the broadest measure of under-employment still at 16.7%.
• Many European countries are tightening their belts and this fiscal drag just began January 1^st.
• “Peripheral” Eurozone countries like Greece, Ireland, Italy and Portugal face very real solvency risks because of indebtedness and other imbalances in their economies.
• Consumer price index statistics for emerging markets are showing signs of inflation, especially in food prices.
• Sharply higher food prices act like a global tax and are especially painful for those at the bottom of the wealth ladder. Riots and other political unrest are often the result.

{CHART: BLOOMBERG}

• Competitive devaluations are a risk as exporting nations try to use their currencies as a tool to maintain global competitiveness (see QE2 below.) The inability of Eurozone members to do this exacerbates their problem substantially.

MONETARY AND FISCAL STIMULUS

Our previously noted lack of enthusiasm for the Fed’s stimulus effort, known as QE2, remains unchanged. Commentators have not yet reached consensus regarding the success of the plan (heck, they can’t even agree on what its goals are) but it seems to us that if quantitative easing was meant to improve the employment situation, lower interest rates so they’re more attractive to borrowers, raise asset prices other than stocks and commodities (like houses, for instance) and drive down the value of the US$, it’s not looking so hot. Below is a chart of major asset classes and the US trade-weighted Dollar beginning on the date Fed Chairman Bernanke first floated the idea of QE2.

US Trade Weighted $ (white solid), Lehman Brothers Aggregate Bond Index (yellow dashed), Case-Shiller monthly 20-city home price index (blue dotted), S&P500 (red dotted), S&P Goldman Sachs Commodity Index (green dashed) –daily 8/24/10 to 1/25/10, normalized as of 8/24/10. {CHART: BLOOMBERG}

Our concerns about the program are straightforward: This medicine probably won’t achieve the desired boost to economic growth but may create some undesired side effects, like asset bubbles (remember stocks in 2000 and 2007, and real estate in 2005-2007?) and ultimately inflation.  A major problem with QE – with monetary policy generally –is that it’s dependent on the financial system to execute. As I stated in the last newsletter, it doesn’t matter how much liquidity comes from the spigot if the hose is knotted. This is why the current (or recently ended, depending on your perspective) recession is quite different than any since in the US the ‘30s.

Further, there’s an important philosophical question to be asked about quantitative easing and other monetary accommodation. Not only are attempts to encourage additional borrowing probably counterproductive in an environment where frugality is in vogue, but we must question whether its logical or even ethical to try to repair an economic malaise caused by an overabundance of debt by encouraging more indebtedness.

We’re fans, however, of the recently passed fiscal stimulus that included a payroll tax holiday, extension of unemployment benefits, maintaining the “Bush tax cuts” for another two years and other tax policy changes. We wished aloud for fiscal solutions in the last newsletter; these aren’t as targeted as we’d suggested, and perhaps it’s a good thing to paint with broad strokes when so much is at stake.

The obvious downside of this monetary and fiscal stimulus, however, is a huge and growing budget deficit. The Treasury is issuing debt to fund that deficit, of course.  Much ink and “hot air” has been expended on the need for deficit reduction, much of it with an explicit political bias. As analysts we won’t join that fracas but will point out there’s a practical limit to the amount of debt a nation can service: PIMCO’s Managing Director Bill Gross reminds us in his January commentary that research by Professors Reinhart and Rogoff (of University of MD and Harvard respectively) demonstrates that when a country’s debt approaches 90% of GDP its GDP growth rate is slowed by the drag of interest payments.  The US debt excluding intragovernmental holdings is currently about 60% of GDP (using total debt outstanding the figure’s around 90%). More pressingly, the bond markets will mutiny long before debt hits that threshold, driving interest rates sharply higher and redoubling the pressure on the government and its citizens.

SOURCE: IMF. {CHART: BLOOMBERG}

The effective conversion of private debt to public debt in such massive quantities, how that’s paid for and by whom, its impact on the quality of life, resulting internal and global political shifts, is the end game. How it plays out over the next several years remains to be seen; according to Reinhart and Rogoff’s book This Time It’s Different, in which they examine 800 years of financial crises, the odds are decidedly not good.

FINAL THOUGHT

At the macro level the solution to the problem’s obvious: We must have job creation that can support the prudent use of credit.  Lower interest rates probably won’t do it – in fact, may well hurt in the long run.  To quote a recent commentary by the aforementioned Bill Gross of PIMCO, in order to turn the tide back towards job creation and global competitiveness we should “Stop making paper and start making things. Replace subprimes, and yes, Treasury bonds with American cars, steel, iPads, airplanes, corn – whatever the world wants that we can make better and/or cheaper. Learn how to compete again.” “It can be done with sacrifice and appropriate public policies that encourage innovation, education and national reconstruction, as opposed to Wall Street finance and Main Street consumption.”

Amen to that.

^* SOURCES: Bureau of Labor Statistics, Cantor Fitzgerald, ISI Group, USDA Foreign Agricultural Service

** SOURCES: Gluskin Sheff, Bureau of Labor Statistics, ISI Group