The End of the Expense Cutting Rope

Includes: DIA, QQQ, SPY, TBT, TLT
by: John Lounsbury

Three graphs today at the 5-Min. Forecast go a long way toward telling the story of where we are in this economic recovery.

Productivity has Rolled Over

The first graph shows how productivity growth has been declining for over a year and turned negative in the second quarter.

U.S. corporations have cut expenses to the point where more cuts reduce output. The end of this rope is when it is discovered that cutting expenses can improve the bottom line only up to a point. After that point further cuts will reduce income more than expenses. For any other reality, it would be possible to approach infinite income by cutting expenses close to zero.

Capital Improvement is not Offsetting Lower Employment

The first question that can be raised is that there could be hope for future productivity gains to return based on capital investment in new facilities, tools and technology. The second graph shows that will not happen. The annual change in capital stock has gone negative for the past several quarters.

The decline in U.S. capital stock has not happened since the Great Depression. The folks at say the following:

Capital stock is the total inflation adjusted value of all “business equipment” in the U.S. That’s machines, robots, vehicles, tools, software, computers, pencils, paper… the whole shebang. For the first time since World War II, U.S. capital stock is contracting. Meaning, employers are not reinvesting in their equipment. More machines are left broken or outdated than are being replaced or upgraded.

Employers likely underinvested in capital stock during the darkest days of the credit crisis. But why aren’t they catching up now? Perhaps worker productivity is down -- along with capital stock -- because there’s simply not enough business to warrant investment… either in people or equipment.

The Agora view is that we have a decline in demand which is driving the entire pattern of productivity decline and lowered capital investment. This is demand driven deflation. All the liquidity stimulus in the world fails in the face of contracting demand.

Bond Markets are Confirming the Deflationary Pressure

The third graph from the 5-Min. Forecast shows the surge yesterday in the Treasuries market (falling rates).

With the big sell-off in stocks underway today (Wednesday Aug. 11), the 10-year Treasury yield has dropped further to 2.69%. The bond market is now at levels not seen since March, 2009, as shown in the following graph.

The bond market says we are back at March, 2009 conditions again. The stock market says we are much better off. Both can't be right. This divergence was discussed recently here.

End of the Rope?

Has the end of the rope been reached? Can businesses no longer contract their way to higher profits? Who will win the battle of the markets - stocks or bonds?

Disclosure: Long several S&P 500 stocks. Both long and short positions in several Nasdaq stocks.

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