The data released since the last edition of the Harmonic Notes e-newsletter in mid-September suggests continued slow growth but feels a bit wobbly, like that recovering surgical patient we analogized in the last note.  The data is anything but one-sidedly positive to be sure, and many worry that pressures like the ongoing foreclosure crisis could sideswipe the nascent economic recovery.

DATA OVERVIEW

• CONSUMER

-        The major negative factor facing consumers is, of course, stubbornly (intractably?) high unemployment levels. Also, home sales have recently been mixed, with sales of new homes flat but sales of existing homes rebounding. On an absolute level, however, sales across the board remain at historically low levels.

+        Retail sales again came in stronger than expected, as did other measures of consumer spending. Also, the Consumer Price Index stayed flat at about 1.0% year-over-year and barely positive month-over-month as the economy shows evidence of disinflation but not the dreaded deflation.  Observers got a nice surprise with the release of the October jobs data, which showed a much stronger-than-expected jump of +151K (+159K private payrolls). While Average Hourly Earnings rose only modestly, Average Weekly Hours rose +0.1 hour.

• BUSINESS

-        Industrial Production and Capacity Utilization were reported worse than expected and CapU remains flat at a very low level. 

+        The ISM Manufacturing and Service Indices both jumped unexpectedly and both remain solidly in expansionary territory. Business productivity rebounded in 3Q10 as costs were flat. With such a high unemployment rate it’s clear there’s no wage-based inflation pressure.

• INTERNATIONAL TRADE

-        Exports rose less than imports the August trade gap resumed its widening trend.

• GENERAL

-        The initial report on third quarter GDP growth showed a slight quarter-over-quarter improvement, from 1.6% in 2Q10 to 2.0%. This rate is substandard and at risk for “failure to launch.” Further, much of the growth in the third quarter appeared to come from inventory restocking, not more sustainable sources.  Also, our favorite coincident macroeconomic indicator, the Chicago Fed National Economic Activity Index, fell back into negative territory after rebounding a month earlier.

+        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 slightly since mid-year.

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

HOPEFUL GLIMPSES

It appears as though the economic teeter-totter has risen ever so slightly from being fully pegged down on the negative side, where it remained for an uncomfortably long time.  Both anecdotal and quantitative evidence offer glimpses of hope:

• The upside surprise of above-mentioned payrolls figure suggested that companies might soon see the need to boost staffing. Year-over-year growth in average hourly earnings of about 2% poses no wage inflation risk. The average workweek continues to gradually lengthen; according to Marc Pado, economist and strategist at brokerage Cantor Fitzgerald, each 1/10 hour is worth about 400K jobs.

Unemployment rate (white, right scale); Average hourly earnings (orange, left scale); Average workweek (yellow, right scale)

• Based in part, perhaps, on this positive trend, the American consumer may have found her footing. According to a report by the NY Federal Reserve consumer debt continues to decline as consumers are borrowing less and paying off more debt.  This balance sheet repair is a necessary step before growth can resume. We recently read an article describing the current era as one of “productive”, as opposed to “conspicuous” consumption, a characterization with which we’re inclined to agree.
• CEOs are apparently coming out of the bunker as well, as more earnings forecasts are being raised than lowered.
• 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.

ISM Manufacturing Index, 5 years ending October 2010

BROWN SHOOTS

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:

• After a typical recession we’d have seen plenty of “green shoots” by now. A respected research firm, ISI Group, lists the following concerns:
  • Foreclosures
  • State and local budgets
  • Fiscal drag in Europe (many European countries are tightening their belts)
  • The potential for the Bush tax cuts not to be extended, at least temporarily
  • Low economic growth raises the risk of the economy slipping back into recession (ie, stall speed).

QUANTITATIVE EASING (round II)

The more positive tone of the recently released data buttresses the assertion in our last newsletter that a double-dip recession isn’t in the cards, a situation that’s more certain now that the Fed is on the scene with the cleverly acronym-ed QE2. Shorthand for the Fed’s purchase of bonds in order to drive down interest rates, the recently announced $900 billion quantitative easing program is the 800 pound gorilla in the markets and a giant question mark for the economy.  Its potential effect has been vigorously; it’s an unfortunate truth that even those at the Fed who’ve launched the program in an attempt to stimulate the moribund economy don’t really know what will happen.

Of particular note is the -7.3% drop in the US Dollar since Fed Chairman suggested in late August that QE2 might be forthcoming. While the Dollar’s decline is a boon to US exporters our trading partners appreciate none-too-much that our central bank appears to be manipulating our currency to their detriment, and holders of our debt don’t care much for having their investments eroded to increasing inflation.

Our concerns about the program are pretty 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. The analogy I recently used to an undergrad class with which I was speaking was that of a spigot with a hose attached (the spigot is an analog for the Fed, obviously): If there’s a knot in the hose it doesn’t matter how wide open you turn the tap.  This is why the current (or recently ended, depending on your perspective) recession is quite different than any since in the US the ‘30s.

SOLUTIONS

The problem of subpar economic growth won’t be solved until credit creation begins again, and that requires both lenders and borrowers to participate. While their comfort may be gradually growing, at the moment lenders remain skittish while borrowers either:

• Don’t need or want to borrow (ie, large businesses, which have a ton of cash on their balance sheets, and consumers, who are concerned about future job losses) or
• Are starving for capital but are seen as too great a risk, given the uncertain economic outlook, for banks to lend to (many if not most small businesses).  

To quote the recently released quarterly Fed Senior Loan Officer Survey – “banks eased standards and terms over the previous three months on some categories of loans to households and businesses” but “substantial fractions of banks reported… that standards for many categories of loans would not return to their longer-run averages for the foreseeable future”.

Solid Line = large companies; dotted line = small companies  

Fiscal solutions would seem in order – tax cuts targeted at small business hiring, temporary guarantees or mandates to encourage banks to lend to creditworthy borrowers once “well-capitalized” levels have been reached, etc. – but those seem extraordinarily unlikely. We are concerned that, quite bluntly, almost nobody in DC “gets it”. Further, it’s spectacularly naïve to expect that simply because there’s been a change in the party controlling the House that politicians will begin putting the country before their own self-interests. We’ve all heard the old saw “gridlock is good”; that’s true only when the economy is working properly. Consider how counterproductive it would be for doctors to be arguing over treatment while our archetypal surgical patient is slipping into a coma.

At the macro level the solution to the problem’s obvious: We must have credit creation and job creation.  Lower rates probably won’t do it– in fact, may well hurt in the long run.  As always, the devil’s in the details.