Real and Fake: A Tale of Two Economies

Do you remember the stress tests for the banking system in the US? They were the subject of negotiations by the banks with regards to the outcomes, making them remarkably relaxed stress tests. There was an assumption in the stress tests for an unemployment rate of 8.9% (a curiously precise figure), and 10.3% in 2010. The unemployment rate had already reached 9.8% in September, with expectations of further rises. In other words, the worse case scenario was not indeed the worse case scenario.

Despite this, it appears that business as usual is continuing in the world of banking. When we consider that the stress tests were heavily negotiated and the worse case scenarios are being broken, this is a puzzle.

The real economy is, as you would expect, having an impact upon the banks. Bank of America (BAC), the second largest lender against credit cards is reporting massive losses on their lending, and bank failures continue at a shocking pace (106 so far this year). And then there is the exploding numbers of mortgage foreclosures, including prime loans, such that foreclosure counsellors are being deluged with requests for assistance. Commercial real estate loans in default have now reached about 6% of all loans. Small and medium size businesses are seeing continuing high levels of arrears on loans, with those that are moderately delinquent increasing (but a tiny fall in the numbers that are severely delinquent). PIMCO are warning of ongoing high levels of defaults on corporate bonds, but S&P are offering a more sunny outlook than their previous forecasts, but still at a high level.

Some might point to the positive increases in industrial output, and suggest that there is a genuine improvement on the horizon. However, it is not perhaps as bright news as it first appears:

September's increased output was due largely to a 3.5% increase in durable output, including a 7.4% increase in the production of automotive products. Nondurable output increased 0.5% in September. Within major industry groups, manufacturing output rose 0.9%, mining output rose 0.7%%, while utilities fell 0.7%

The first point of note is the increase in automotive production, which is likely the final residual effects of the 'cash for clunkers' stimulus working through the industry. This from the Wall Street Journal:

Retail sales fell 1.5% in September with the end of the "cash for clunkers" program, but consumer spending rose in many categories, lifting hopes that the economic recovery is gaining momentum at the start of the holiday shopping season.

Excluding sales of autos and parts, total retail and food sales increased 0.5%. It was a welcome sign of consumer activity after the deepest downturn in a generation. August sales were revised downward 0.5 percentage point to a 2.2% increase. The government's monthly retail-sales tally isn't adjusted for inflation.

The same article goes on to say the following:

Indeed, sales at motor-vehicle and parts dealers plunged 10.4% in September, following the expiration of the "cash for clunkers" trade-in program. But consumers spent more on smaller and less pricey items. Sales at clothing and accessories stores grew 0.5%. Restaurants, bars and grocery stores gained 0.2% and furniture sales rose 1.4%, in part because home sales have stabilized with help from the government's $8,000 tax credit for first-time home buyers -- a credit that is due to expire Nov. 30.

While they are heading back to stores, many consumers are doing so with trepidation. After a three-month shopping hiatus, Lauren Madrid, a 26-year-old who works in communications at a San Antonio university, returned to her regular haunts -- the mall and Target Corp. (TGT) -- in August. But Ms. Madrid said she was making fewer shopping trips and going with a mind toward buying specific items. "I didn't buy a stack of T-shirts I'd never wear," she said. "Instead, I bought a cute summer dress that I knew I'd wear and appreciate properly."

The essential problem is that unemployment increases will continue to eat into consumer spending, and for those in employment, there is a shift from credit based expenditure to saving money. With the US economy having been distorted so far into credit based consumption, there can only be expansion in credit defaults across the whole US economy.

What this amounts to is the simple reality that the underlying point of the banking system, loans to individuals and commercial entities, is not a sector in a good state of health. In fact, in aggregate it is looking very ugly. A recent article in Forbes had this to say:

Do banks know something the rest of us don't?

Despite pressure from politicians to take federal bailout money and lend it to companies and consumers to kick the economy out of its doldrums, banks continue to horde cash in dizzying amounts.

Weekly data released Thursday by the Federal Reserve show excess reserves held at the Fed--the equivalent of banks stuffing bills into shoe boxes for storage--topped $1 trillion this week, a record, after climbing steadily since the markets froze up last October.

This is really no surprise. At this moment in time, would you want to be lending into the US economy? For all of the talk about recovery, the banks know that the economic crisis has a long way yet to run. They do know something that 'the rest of don't', and that there is no realistic prospect of a real recovery in the US economy. Despite this, the media, government organisations, and politicians continue to talk up the economy. For example, the Beige Book, the Federal Reserve's review of the economy, has offered a relatively upbeat review, albeit with caveats:

The Federal Reserve's Beige Book released on Oct. 21 reported "stabilization or modest improvements in many sectors," though often from depressed levels. Residential real estate and manufacturing were the more positive sectors of the economy that were helping the recovery. Reports on consumer spending and nonfinancial services were mixed, while commercial real estate was one of the weakest sectors. Transportation activity generally declined. Tourist activity was varied.

The Beige Book indicated that there were more reports of gains in activity than declines, although nearly every reference to improvement was qualified. That's consistent with what we've seen from the data and heard from Fedspeak. Regarding wages and prices, Districts generally reported little or no increases, but there were occasional references to downward pressures.

What we are seeing here is a positive spin upon the most modest of indicators, and disregard for the underlying state of the US economy. Of course, many will point to the stock market as a positive sign, and this article from Bloomberg appears to contradict everything I have said:

Oct. 22 (Bloomberg) -- U.S. stocks advanced for the first time in three days as better-than-estimated earnings at companies from Travelers Cos. (TRV) to McDonald’s Corp. (MCD) boosted speculation that the worst recession since the 1930s is over.

Travelers jumped 7.7 percent and McDonald’s climbed 2 percent to help lead the Dow Jones Industrial Average higher, while New York Times Co. and PNC Financial Services Group Inc. (PNC) also rallied on better-than-estimated results. American Express Co. (AXP) climbed 3.8 percent to a one-year high after Moody’s Investors Service (MCO) said credit-card defaults declined.

Perhaps the most interesting part of the article is the report that credit card defaults declined, which appears to contradict the experience of Bank of America. With unemployment increasing, it is not clear what might actually be driving a decline in credit card defaults, so I view this with some suspicion. One possible explanation is that the decline is due to consumers pulling in their horns, which would mean that the relative numbers of defaults might be increasing whilst the absolute numbers are falling.

Another interesting point is that McDonald's will inevitably do well in a recession, as cash constrained consumers are more likely to trade down in their choice of food. In a recession there will always be winners as well as losers. However, this does not explain some of the positive improvements in earnings data over the estimates, and this needs some consideration. A long while back, a friend who had worked at the highest levels of a multinational FMCG company suggested that, if he were heading a company, he would manipulate the financial data to get the bad news of the economic fall-back over in one go, which would allow for earnings in the following year to appear to be positive. It does occur to me that this is a possibility, but I am unsure. However, the same Bloomberg report says the following:

Profits have topped estimates at 79 percent of the companies in the S&P 500 that have released results, according to Bloomberg data. That would mark the highest proportion in data going back to 1993. Earnings fell for a ninth straight quarter in the July-September period, according to estimates compiled by Bloomberg, and are projected to return to growth in the final three months of the year.

The point here is that there does seem to be some basic disconnects between the real economy, earnings and the stock market. With the economy in very bad shape, excepting the natural winners like McDonald's, the news should be relentlessly negative... but this is positive news due to exceeding estimates, not increases in earnings. This appears to fit with my friends assertion, but it is difficult to see how such a contention might be supported with hard facts.

What I am trying to do is paint a picture of the real economy and the false economy. On the one hand, we have banks that are now under stress greater than that which was the worst case scenario, we have huge numbers of bank failures, money being kept on the sidelines due to the terrible state of credit markets, rising unemployment, increasing numbers of foreclosures, and on the other we have a booming stock market.

Something is wrong in this picture. It looks very much like many people will be losing a considerable amount of money on the US stock market in the near future.

Note: I will probably conduct a similar review of the UK economy for the next post, as the picture looks to be very similar. This from Financial Advice:

Despite the fact that UK GDP (Gross Domestic Product) was a disappointing -0.4% during the last quarter, against an expectation of 0.2% growth, the UK stock market ended on a high today adding 60 points to 5268. But why is the UK stock market racing ahead when the UK economy appears to be going into reverse?

An interesting point - to be continued....

I would also like to return to one of my pet subjects at some stage, which is the $US versus the RMB. The plot continues to thicken, but I would like to review the UK economy first ('events' allowing).

Comments

[yellowhoard:]

We've improved from a rapid collapse to a slow decay.

People that view this economy as improving are seeing the same illusion that you get when one skydiver films another.

The one that pulls the rip cord first seems to be going up relative to the one that is holding the camera.

Oct 25 07:01 AM

[Dave Wrixon:]

Twas ever thus. Why do think the first thing you learn at school is to tell the time? How could they control individuals that cannot tell the time?

Oct 25 07:26 AM

[Leftfield:]

I figured out something about Ebay and will try to extrapolate to this article: Management DOESN'T CARE about the small sellers they are shafting in an economy where Ebay should be a lifeline. They have Paypal, a financial business, and they are setting Ebay on autopilot with the vastly reduced labor force needed to supervise only large merchandisers. They are willing to accept decline in that business as a tradeoff. Paypal is their real focus. Stuffing it to the rabble also keeps them acceptable at the cocktail parties in the "highest" circles.
Our leaders don't much care about the real economy either. It is a nuisance, all these small, complaining constituents. Throw them crumbs, throw them lies, but take care of the best people (crony kleptocrats).
It's working!

Oct 25 08:17 AM

[User 353732:]

The 2 economies merely reflect the fact that we are now two nations: the Occupier and Occupied.

The Occupiers, less than 1% of the population, live in an economy that is built on forced taking from the Occupied(using some of the pillage to bribe and herd the lowest and most servile, ignorant and easily manipulated members of the Occupied) to build political, financial and media palaces and castles. Here, in the tiny and closed society of the Occupiers, there is a boom, not merely a "recovery"; much satisfaction and great self congratulation. All is well in the best of all possible worlds : every day in every way more sybaritic luxury, resource and decision making control, and self worship.

Outside the palaces and castles, the Occupied endure increasing humiliations and privations; coerced into paying escalating tribute even as jobs, net worth, incomes and access to credit at an affordable price compress and the very sources of future wealth and jobs are destroyed.

The Fake rule the Real and the lies of the fake trump the truths of the real. The senses have overpowered the mind and soul of the polity so that economic and financial vices are hailed and historical virtues persecuted. To the Occupiers go the rewards and to the Occupied the risks.

Oct 25 08:58 AM

[The Geoffster:]

I was taught how to tie my shoe laces first so I wouldn't fall on my face when the dinner bell rang.


On Oct 25 07:26 AM Dave Wrixon wrote:

> Twas ever thus. Why do think the first thing you learn at school
> is to tell the time? How could they control individuals that cannot
> tell the time?

Oct 25 09:54 AM

[Roger Knights:]

I think there'd be less of a recovery if benefits to the long-term unemployed hadn't been extended.

Oct 25 10:02 AM

[David Roskoph:]

Cynicus Maximus, the abject bankruptcy we now enjoy is virtually irrelevant as only Goldman Sachs could or would prosecute our failure. We remain Capitalism

Oct 25 10:23 AM

[doubleguns:]

Continuation of long term unemployment means the sheeple are being sheered. When the unemployment ends the slaughter will begin.

I am just not sure yet who will be getting slaughtered. (haves or have nots).

Oct 25 10:34 AM

[David Roskoph:]

Cynicus Maximus, the abject bankruptcy we now enjoy is virtually irrelevant as only Goldman Sachs could or would prosecute our failure. We remain Capitalism's Captain. Whatever the result of this reformation - higher deficits or income caps - we will still be the best living example of Capitalism on Earth.

We have survived the tearing of the veil exposing the lie that 1) we could afford our past lifestyle including retirement for 14 years and 2) that fancy financing equaled growth. Now what, start over? No. We are rebuilding the foundation stronger than it has been in 35 years; this is a recover and the start of a new Bull Market.

Believe it or don't, the desire to expand will hit with almost simultaneous effect and the unemployment ranks will be substantially reduced. It will be a blistering Christmas and the fact that the middle class has rejoined its mojo will drive the market higher. It's a matter of restored confidence.

All the haggling and dire statistics are financial theater, meant to shake the weak hands in or out - just like always.

Oct 25 10:36 AM

[Mudduckk:]

Roskoph, lol. Gimme some of what ever you are smoking. Sounds like you are seeing tracers.


On Oct 25 10:36 AM David Roskoph wrote:

> Cynicus Maximus, the abject bankruptcy we now enjoy is virtually
> irrelevant as only Goldman Sachs could or would prosecute our failure.
> We remain Capitalism's Captain. Whatever the result of this reformation
> - higher deficits or income caps - we will still be the best living
> example of Capitalism on Earth.
>
> We have survived the tearing of the veil exposing the lie that 1)
> we could afford our past lifestyle including retirement for 14 years
> and 2) that fancy financing equaled growth. Now what, start over?
> No. We are rebuilding the foundation stronger than it has been in
> 35 years; this is a recover and the start of a new Bull Market.<br/>
>
> Believe it or don't, the desire to expand will hit with almost simultaneous
> effect and the unemployment ranks will be substantially reduced.
> It will be a blistering Christmas and the fact that the middle class
> has rejoined its mojo will drive the market higher. It's a matter
> of restored confidence.
>
> All the haggling and dire statistics are financial theater, meant
> to shake the weak hands in or out - just like always.

Oct 25 02:43 PM

[The Recusant:]

Funny that McDonald's Corp. is seen as a positive growth factor when it is obvious that if their domestic sales have increased dramatically and the worst is over (for them), that it actually means that nobody can afford anything better. Now, when their sales decrease, then we have two possibilities, either the economy is increasing and people are fine dining, or the extreme opposite, no one can afford to eat out anymore anywhere!

Oct 25 04:41 PM

[David Roskoph:]

As I wrote to very happy clients -
You may think I’m deluded and this market rally is destined to fail. Certainly that is the popular belief. Remember that the market has two functions 1) to provide a mechanism to get money from savers to builders – the investors pledge their capital and the companies use it to expand; 2) to transfer wealth from speculators to professionals. It’s working as good as ever. What changes with time is the medium to shake good shares away from weak hands. As a herding beast, we comfort each other on a sinking ship as long as we all agree it’s sinking. When someone protests that the waterline is falling, they shoot him and settle in for their community swim. If you have a chance to read some of the comments from articles I published a few months ago, you’ll see this in action.

Getting ready for a swim Mudduckk?

Oct 25 09:51 PM