Rosenberg and Yellen on the State of the Economy

On the data front, there is not much to report on the positive side of the ledger. The German ZEW index of investor sentiment dropped to 51.1 in November from 56.0 (consensus was looking for 55.0). This sets the stage for a weak Ifo reading ahead as enthusiasm morphs into realism. Meanwhile, global deflation is still the name of the game with the German CPI surprisingly dipping 0.1% MoM in October even in the face of higher oil prices, and this followed on the news of the 0.4% MoM deflation in Germany’s PPI too.

Italy posted a woeful 5.3% slide (-15.7% YoY) in September industrial production. Japan’s forward-looking ‘economy watchers’ index fell to 40.9 in October from 43.1 in September as consumers there are turning more cautious.

In any event, the last leg of the rally in risk assets seems to have come from the comments last week from the Fed and over the weekend from the G20 that government stimulus remains the name of the game. The punchbowl is intact — imagine the desperation involved in expanding a housing tax credit from a first-time buyer to a trade-up buyer at a time when the fiscal deficit is already 10% relative to GDP! It is hard to tell how far this is going to go but it is not sustainable. This symbiotic relationship between the markets having come to rely exclusively on government stimulus measures to bolster economic and earnings expectations on the one hand, and governments offering up repeated rounds of intervention in order to generate asset inflation as an antidote to a jobless recovery on the other hand, is unstable, in our opinion. We can’t see this ending well — this is definitely not a private-sector led secular bull market circa 1982; that much we know.

There is a 70% historical inverse correlation between the direction of government deficits-to-GDP and the price-earnings multiple in the equity market. So we will make no bones about the government’s ability to create growth by either borrowing money or taxing the public in the future, but the major point is that government-led growth deserves a lower-than-average multiple, not an above-normal multiple. And yet, even on a Shiller normalized basis, we have a market that is still overvalued by roughly 20%. While momentum and speculation are keys to the current rally, these are never alluring or enduring features for a fundamental economist and strategist. There remains too much risk in equities for our liking, as impressed as we are with the Dow managing to just reach a 13-month high.

It would seem that investors are optimistic on the future insofar as governments and central banks around the globe are going to damn-the-torpedoes-and-go-full-steam ahead and act as the consumer of first and last resort for their economies. The fact that the U.S. government, at a time when the deficit/GDP ratio is already at record levels of 10%, feels compelled to:

• Extend jobless benefits for up to two years (why not just put these folks on the government payroll? At least the unemployment rate will start to go down).
• Expand the homeowner tax credit.
• Provide tax breaks to homebuilders (the ones who helped get us in to this mess).
• Provide businesses with tax credits for new hires.
• And bump up social security payments once again.

All this really attests to how rotten things are beneath the surface. No doubt that all the government stimulus is going to provide some impetus to corporate profits, but what exactly is the fair-value P/E multiple in a period of state capitalism is a legitimate question.

Deflation Pressures Intact

This may be one reason why government bonds refuse to sell off despite the surge in the equity market. The Wall Street Journal reports that companies like Clorox is keeping prices stable on items like its new and improved trash bags. Campbell’s Soup is cutting prices on select beverages (like V8). Burger King is selling double cheeseburgers for a buck. And, what’s this about RIM starting up a smartphone price war? According to a new holiday season poll taken by Deloitte, 74% of respondents intend to only buy items on sale or with discount coupons. The same survey indicates that holiday shopping will be flat year-over-year this year, which at one point would have been amazingly bullish but at this stage is likely a setback for the stock market. Keep in mind that Wal-Mart is now expecting 1.0%-2.0% sales growth into January 2010 whereas a year ago that expectation was in a 5.0%-7.0% range.

If there is some good news for retailers, it is that they are heading into the shopping season with fairly lean inventories — that won’t prevent but should help limit ultra-steep markdowns this year.

Outlook for the Economy and Real Estate

I frequently differ with San Francisco Fed president Janet Yellen about policy. However she appears to be a straight-shooter when it comes to providing an assessment as to the economy itself. Please consider Yellen’s Outlook for the Economy and Real Estate.

This is the first talk I’ve given since the economy has officially been reported to be growing again. The economy’s return to growth after a year and a half of recession marks a major turn and it looks like more than a flash in the pan.

All the same, I am not going to paint an entirely rosy picture for you. The strength and durability of the expansion is in question. Some of the rebound is due to temporary government programs and a swing in inventory investment that will not provide an ongoing source of growth. Financial conditions have improved markedly in some respects, but many financial institutions are still hobbled with bad loans. The outlook for consumer spending is in doubt because households remain burdened with debt, and they have taken enormous hits to their wealth from declines in house and stock prices in recent years. And it’s particularly sobering that labor markets continue to deteriorate badly, leaving many millions of our fellow Americans unable to find jobs.

As we look at the national economy, it’s important to keep things in perspective. It’s not fun to ponder a subdued recovery. But a year ago, after the near collapse of the global financial system, there was a real possibility of an outright depression. Fortunately, we avoided that. But what we did suffer through was bad enough—the worst downturn since the Great Depression of the 1930s. The recession began at the end of 2007. Economic output has dropped by just over 3½ percent. Over seven million jobs have been lost in the nonfarm sector of the economy. And the unemployment rate has soared by over five percentage points. Few, if any, parts of the economy were unscathed. The labor market was devastated, and housing, consumer spending, business investment, exports, and imports all fell off the table.

Against this backdrop, the nation’s third-quarter return to growth was a great relief. Real gross domestic product—which is the economy’s total output of goods and services—increased at a solid annual rate of 3½ percent. The recession hasn’t officially been declared over, but a wide array of data suggests that the corner has been turned.

In the third quarter, residential investment—which was at the center of the downturn—rose at nearly a 25 percent annual rate, albeit from a very low level. Home sales, prices, and housing starts are once again climbing. Meanwhile, manufacturing is also beginning to show signs of strength. This was helped by a rebound in motor vehicle production, boosted by the government’s temporary cash-for-clunkers program. Our exports surged as growth abroad picked up. And, importantly, consumer spending finally is growing.

To me, the explanation for this turnaround is clear: Massive and concerted responses by governments and central banks around the world rescued the financial system, brought down interest rates, provided emergency support, and broke the economy’s downward spiral.

Federal government policies also have contributed, including the fiscal stimulus program passed by Congress in February. Tax cuts have raised disposable income and government spending is directly adding to payrolls. Much of the stimulus money authorized by Congress remains to be spent and will spur growth in coming quarters. Other government initiatives contributed to the third-quarter expansion as well, including the cash-for-clunkers program and the $8,000 tax credit for first-time homebuyers.

The big issue is how strong the upturn will be. With such enormous reservoirs of slack in the form of high unemployment and idle productive capacity, we need a strong rebound to put unemployed people back to work and get underutilized factories, offices, and stores humming again. Unfortunately, my own forecast envisions a less-than-robust recovery for several reasons. As the impetus from government programs and inventories diminishes in the quarters ahead, private final demand will have to fill the breach. The danger is that demand may grow at too anemic a pace to support vigorous expansion.

It may be that we are witnessing the start of a new era for consumers following the harsh financial blows they have endured. We often hear the word “deleveraging” used to describe the push by financial institutions to scale back debt and build equity. Households too have now begun to pay down debt and rebuild their savings. This phenomenon can be seen not only in the United States, but in most countries that experienced similar housing booms. The United States was hardly the only country where households borrowed heavily just before a severe housing bust set in. And those countries with greater increases in debt relative to income before the crisis experienced greater declines in consumption spending once the crisis began.

In the United States, the personal saving rate, which had fallen to an incredibly low 1 percent in early 2008, has averaged 4 percent so far this year and may well rise higher. In the current environment, such belt-tightening makes great sense from the standpoint of individual households. In fact, some households may have no other option because their access to credit has been crimped. Over the long run, higher saving is surely a good thing for our economy because it provides capital that can be devoted to modern infrastructure, technology, and other productive investments that enhance our standard of living. All the same, the transition to a higher saving plane could be painful if it reduces the growth rate of consumer spending for an extended period.

Now I’d like to take a close look at real estate markets, both residential and commercial. You may be getting weary of my “on-the-one-hand, on-the-other-hand” message, but I’m afraid I have more of that to offer when it comes to housing. To put it bluntly, the outlook for the residential market is uncertain. And uncertain is much better than the prospects for commercial real estate, which clearly are weak.

the bottom line is that the outlook for housing has turned up in response to favorable mortgage rates, lower house prices, and a lower overhang of unsold houses. And growth in this sector should contribute to the overall economic recovery. These developments represent real gains, but it’s important not to get carried away. Some of the advance reflects temporary government support in the form of tax credits for first-time home buyers, and the impact of loan modification programs and foreclosure moratoriums that reduced the pace of distressed sales. Moreover, foreclosure notices surged earlier this year and distressed property sales may rise once again in the months ahead. If so, we could see renewed pressure on house prices. Of course, continuing high unemployment will also fuel additional foreclosures. And the supply of credit for nonconforming mortgages remains extremely tight. Financial institutions are reluctant to place them on their books when they are trying to reduce leverage and we have yet to see any revival of the market for private mortgage-backed securities.

When we turn to commercial real estate, the prospects are worrisome. Commercial property didn’t turn down until well after housing did. The sector’s problems appear to stem in large part from the effects of the recession and the credit crunch, rather than the type of building boom and lax underwriting standards that tripped up housing. Still, there are some parallels between the two sectors. As in the residential market, commercial real estate values posted enormous price gains, with office values roughly doubling from the end of the 2001 recession to the peak. Since then, values have plunged an estimated 35 to 40 percent and vacancy rates are rising for office, retail, warehouse, and other income-producing properties.

Commercial real estate borrowers are increasingly hard-pressed to stay current on their loans. CMBS delinquency rates rose from about half a percent in August 2008 to over 3 percent this July.

Nationwide, the commercial real estate downturn has been a drag on economic growth, subtracting about 1 percent at an annual rate over the first three quarters of this year, compared with a roughly neutral effect in 2008. All indications are that commercial real estate will continue weighing down the recovery going forward.

When the weakness of the commercial property market is combined with the muted outlook for housing and consumer spending, you can see why I believe that the overall economic recovery is likely to be gradual and remain vulnerable to shocks.

It’s popular to pick a letter of the alphabet to describe the likely course of the economy. The letter I would choose doesn’t exist in our alphabet, but if I were to describe it, it would look something like an “L” with a gradual upward tilt of the base.

With such a slow rebound, unemployment could well stay high for several years to come. In other words, our recovery is likely to feel like something well short of good times.

In regards to policy decisions I strong disagree with Yellen’s assessment of the benefits.Cash for-clunkers was a miserable economic failure as are the housing tax credits.

The former destroyed productive capacity while driving demand forward. The latter stimulated housing when there is an oversupply already. Some received tax credits for houses they would buy anyway, the others left rentals to buy into inflated housing prices. As a direct consequence, rental vacancies are rising, rents are falling and there is increased pressure on commercial real estate prices as a direct consequence.

That aside, the economic outlook of something that looks like an upward sloping "L" seems reasonable, at least in comparison to the rosy V and U shaped recoveries everyone else seems to be predicting.

What is not reasonable is giving any credit to the Fed or Congress for preventing a depression. We are still in one as measured by jobs, bank lending, and long-term interest rates. Moreover, as soon as these stimulus measures stop, the entire global economy will stagnate at best. Neither the Fed nor Congress addressed the underlying problems of too much consumer debt, overcapacity, boomer demographics, jobs, or wages.

Interesting, Yellen seem to be backtracking from her previous assessment. Please see Yellen Calls For "U" Shaped Recession and Another Jobless Recovery on September 15.

I am sticking with what I said in the Case for an "L" Shaped Recession written April 8, 2008.

Now that it’s clear we are in a recession, the question has arisen as to what shape it will take: "V", "U", "L", or "W".

The "W" talk seems based on the idea that there may be a brief rebound in the second half based on the Bush economic stimulus plan. That stimulus plan will fail but perhaps it temporarily pulls the US out of recession for one or two quarters.

More likely to me is something like an "L" or a "WW" kind of scenario with the U.S. slipping in and out of recession for a prolonged period of time, perhaps 3-4 years or more.

Mike "Mish" Shedlock