THE ARTIFICIAL RECOVERY?

August 3, 2009

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THE ARTIFICIAL RECOVERY?

Courtesy of The Pragmatic Capitalist

Friday’s GDP report confirmed a trend that has been persistent across the entire economy: there are few signs of sustainable economic growth. There’s no question that the economy has improved substantially since the 3rd quarter of 2008, but the quality of the recovery has grown increasingly questionable. The GDP figure was largely driven by government spending as opposed to improvement in the economy’s primary driver – the U.S. consumer. In addition to the GDP figure we continue to see conflicting signs in the real economy. In particular, revenues continue to lag and the consumer data continues to be weak. In order for a long-term recovery to develop these trends will need to change.

The most recent GDP results were boosted 3% from government spending. Most of this did not come from the stimulus package, however:

most of that increase came from the defense sector, not the nondefense sectors targeted by the American Recovery and Reinvestment Act. Defense spending grew at a 13.3% annual rate, in part a rebound from a 4.3 first quarter contraction. Nondefense spending grew at a 6% annual rate, contributing 0.15 percentage points to overall growth. The economy can use all of the help it can get, but it’s too soon to declare that federal spending is effectively making its way into the system.

Clusterstock had an excellent chart showing the impact of the recent government spending on the GDP:

Government spending is by no means a bad sign, but an organic and sustainable recovery cannot develop without strength in other components of the economy. Unfortunately, there are few signs of strength outside of government spending. The real source of long-term economic growth, the U.S. consumer, continues to show signs of extreme weakness:

On the employment front the U.S. economy is expected to have lost another 300,000 jobs in July – a staggering statistic this deep into a recession.

Many of the same weak underlying fundamentals are apparent in the Chinese stimulus plan as well. Many people have attributed the sharp global economic rebound to China’s stimulus, but the risks in the plan have become increasingly high. Royal Bank of Scotland economist Ben Simpfendorfer said:

“The risk is that the government, in chasing in an 8 per cent growth target, is relying too heavily on public investment and private residential investment to spur growth, rather than pushing ahead with the type of late-1990s structural reforms that will put the economy back on a high-single digit and, more importantly, sustainable growth trajectory.”

In a recent Barrons article Arjun Divecha, portfolio manager at GMO also believes the Chinese stimulus is largely artificial:

“I believe a lot of the money is not going into productive investment. What we are hearing anecdotally is that a lot is being lent by the banks, which remember, are government-owned. Who are they lending to? For the most part, this money is going to state-owned enterprises, which are not particularly efficient companies.

We know they are buying real estate, and they are doing all kinds of things we don’t think in the long run is particularly productive investment.

Two things are likely to happen. First, longer term, if the banks don’t have a problem with bad loans now, they will almost certainly have a lot more bad loans two or three years from now. Second, from a short term point of view, at some point the government is going to get really worried about having too much credit-creation; that leads to a credit bubble, just like you had in this country and everywhere else. As a result, they will start to withdraw liquidity by tightening the gates on the money. I don’t know when that will be. But I worry that it is coming.

A fair amount of the stimulus money has found its way into the real estate and stock markets because China has a closed economy. So there is no way for money to leave the country. The stock market and real estate have had huge spikes. So when that liquidity is withdrawn, it seems inevitable that the stock market will take it badly.”

In May, Stratfor released a detailed report that says the long-term structural changes of the Chinese stimulus will be very beneficial, but also expresses some concerns:

This is not a stimulus program designed to restart the economy in the short run. Good stimulus packages are very front-loaded so that they can shock the system with immediate demand. China’s plan is in actuality a five-year plan designed to help develop the country’s poor interior provinces largely by building infrastructure.

It is not actually $586 billion in cash. Only $146 billion — about one-fourth — of the program will be funded by the national government, and this will take the form of construction bonds. The remaining $440 billion will be up to the regional governments to raise. This will be a neat trick since until very recently — and by this we mean that the idea was only even floated in March — regional governments had no authority (much less experience) in issuing their own bonds.

The Chinese government is not particularly convinced that the package will work. If Beijing were convinced, it would be tapping at least some of its roughly $2 trillion in currency reserves (its own money), rather than going through the more drawn-out process of dozens of bond issuances (getting access to other people’s money).

The Chinese government itself is growing increasingly concerned about the impact of the stimulus package:

But while investors expect the market — up more than 80 percent this year — to keep rising, Chinese leaders are alarmed. They worry that too much of the $1 trillion lending binge by state banks that paid for China’s nascent revival was diverted into stocks and real estate, raising the danger of a boom and bust cycle and higher inflation less than two years after an earlier stock market bubble burst.

Beijing is trying to tighten credit controls without derailing the economic revival or causing a market crash — a risky path at a time when Chinese leaders say a recovery is not firmly established.

“It’s a very serious threat. The Chinese government is walking a tightrope,” said Mark Williams, Asia economist for Capital Economics in London. “There is the question of what happens if they rein in lending, because there is really no strong evidence that private sector demand is picking up.”

Recent economic data and the stimulus driven recovery isn’t the only place where we’ve been seeing artificially driven signs of recovery. This has been nowhere more apparent than in recent earnings reports. We’ve recently detailed the significant cost cutting that has led to the “better than expected” earnings this quarter. Despite the fact that 70% of all companies are beating earnings, revenues are still declining 15% year over year. The underlying driver of real organic corporate growth is still extremely weak. At some point in the next quarter or two we will need to see real underlying revenue growth or investors will likely grow increasingly concerned about the real underlying strength of the economic recovery.

One of the primary sources of optimism has been the housing market. We have been seeing very strong seasonal strength in housing, however and Mark Hanson at Field Check Group is quick to point out that these are more than likely weeds as opposed to green shoots:

But the season ends now. Every year, organic sales fall off of a cliff beginning in August primarily because kids go back to school in Sept. If organic sales follow typical seasonality trends lower again this year and foreclosure-related resales stay the same or rise (no reason they shouldn’t), then the average and median prices will be pulled quickly back towards the distressed market price.

Mark Zandi at Moody’s reports that the stimulus driven economic recovery is not over yet:

The moment of truth is at hand for the U.S. fiscal stimulus plan. The stimulus that became law in February should reach its point of maximum economic benefit this summer. If the plan is working, retailing will improve soon, and businesses should respond by curtailing layoffs measurably. Early results suggest the stimulus is performing close to expectations, but policymakers should be prepared to provide more help to the economy if things don’t work as expected in coming months.

The government has only infused about $50B of the total they plan to spend:

Accounting for these lags, the maximum contribution from the stimulus should occur in the second and third quarters of this year, when it will add more than 3 percentage points to annualized real GDP. This suggests that if policymakers had not been able to pass a stimulus plan, real GDP would have declined nearly 6% in the second quarter and by more than 3% in the third. With the stimulus, GDP is expected to fall close to 3% in the second quarter and rise a bit in the third. The contribution of stimulus to growth fades quickly, adding just over 1 percentage point to annualized growth in the fourth quarter of this year and the first quarter of 2010 and actually detracting from GDP growth by the second half of 2010. The impact on jobs and unemployment is also significant, as the stimulus results in approximately 2.5 million more jobs by the end of 2010 than would have been the case without it, and leaves the unemployment rate almost 2 percentage points lower.

Despite the upcoming stimulus boost, Zandi is still skeptical of continued economic strength in 2010:

Risks to this sanguine script are skewed to the downside. Odds remain uncomfortably high that the economy will enjoy a bounce from the increased stimulus this summer but then fade with the waning stimulus by the summer of 2010. This scenario is more likely if the administration’s foreclosure mitigation efforts don’t quickly begin to reap benefits. Without a measurable increase in mortgage loan modifications, foreclosures will continue to surge, further undermining house prices, housing wealth, the financial system, and the economy’s prospects for a sustainable recovery.

Prepare for the worst

Policymakers should thus be quietly preparing another round of fiscal stimulus for early 2010. Effective additional stimulus might include more help to state and local governments, whose budget problems will probably be even worse next year; an expanded housing tax credit to address the foreclosure crisis; and a payroll tax holiday. Delaying increases in marginal personal tax rates, now legislated to occur at the start of 2011, would likely also make sense. Higher-income households may begin to rein in spending in 2010 as they prepare for the higher tax rates.

It is premature for policymakers to publicly consider all this now; the current stimulus should be given a chance, and the nation’s long-term fiscal challenges are daunting. But if the Great Recession has taught us anything, it is to prepare for the worst.

“Prepare for the worst” is good advice. While the stimulus driven recovery is likely to continue into the end of the year there are mounting signs that the underlying quality of the recovery is poor and the sustainability of the poor fundamentals are unlikely to provide above trend growth any time soon.