See if you can guess what economy produced the following year over year changes:
- GDP growth rate +56%
- Personal Income +4.35%
- Savings Rate +23.91%
- Fixed Investment +5.37%
- Steel Output +10.32%
- Business Sales +8.86%
- Durable Goods Sales +12.2%
- Factory Shipments +7.21%
- Retail Store Sales +7.31%
- Factory Orders +17.18%
- Exports +12.58%
You wouldn’t know it from all the doom, gloom and fretting of the last few months, but this fairly impressive list of economic statistics describes - partially - the US economy over the last year. Of course, a year ago, things were pretty darn awful so the comparisons are pretty easy. In addition, there are still some major problems that we will have to address to get our economy growing at anything close to an acceptable rate that will put more Americans back to work. But, too often, I think we minimize how far we have come from the depths of what was a pretty horrific recession. That isn’t to say that we couldn’t have done better; I absolutely think our economic performance would be better than it is if we hadn’t taken a two year detour into wasteful stimulus spending and the regulatory uncertainty of health care reform. But as the statistics above show pretty clearly, things are getting better and we all have much for which to be thankful this year.
The problem with our economy is the same as it has been since the recession started - housing. The housing market continues to be just plain awful and all the government efforts - from loan modification programs to easing of accounting rules for banks to massive intervention by the Fed into the mortgage market - have done nothing more than delay the inevitable. Existing home sales were down 25.9% in October from last year and the rate of decline is accelerating. Fortunately - and I know some people think this sounds crazy - prices are still falling. The only thing that will clear the inventory of homes is lower prices and the sooner the better. At the current rate of sales there is a ten month inventory of houses on the market and probably a lot more in the foreclosure pipeline. There is no government program that will fix that quicker than just allowing prices to fall to their clearing level.
What is important for economic growth is construction and until we get rid of the overhang of inventory in the used home market, new construction and sales of new homes will not improve. New home sales are scraping along at an annual rate of just 283K. Inventories are high based on the sales rate but at an absolute all time low of just 202k houses. The inventory of used homes is having an effect on prices of new homes with the median price falling 13.9% and the average by 8%. Residential investment is only down about 5% over the last year because it just can’t fall much more but builders will not take the risk of constructing more new houses with prices dropping so fast. And prices won’t stop falling and start rising until the inventory is reduced. The cure for falling prices is more sales which will only come from lower prices.
If the government will allow the housing market to just reach its natural level the rest of the economy is performing well enough that the inventory could probably be cleared relatively quickly. Personal income rose 0.5% and more importantly it rose because wages and salaries rose by 0.6%. There was a slight increase in transfer payments but most of the income gains were from private rather than government sources. Spending also rose, by 0.4% from last month and 3.6% over the last year. Furthermore, the gains in income and spending are happening concurrently with a still rising savings rate of 5.7%. Black Friday sales gains weren’t all that impressive according to early reports but with reduced debt and increased savings, individuals have the capacity to spend. One legacy of the recession that doesn’t seem likely to change anytime soon is that consumers are more careful about finding bargains which might explain why online sales were up a lot more than sales at bricks and mortar stores.
Manufacturing has been leading the recovery and we’ll get a clearer picture of the current state of things next week with the ISM report. Durable goods orders, released last week, were down month to month by 3.3% but are still 10% higher than last year. Non defense capital goods orders ex transportation were down 4.5% and that is worrisome as a leading indicator of capital spending. Non residential investment has been rising at an over 8% rate and that has offset the continued drop in the residential component. A lot of that investment has come in the form of inventory building but investment in equipment and software has also been rising. With the apparent bottoming of the inventory to sales ratio it is critically important that either capital spending or residential investment pick up to keep GDP growing. Corporate profits have been robust with a year over year gain of 28.2% so companies have the ability to invest. What they lack are good reasons to invest here in the US when higher returns are available overseas.
What if companies won’t invest? Theoretically - and statistically for GDP purposes - government “investment” could fill the gap but based on what I’ve seen in my neighborhood, this isn’t much of an answer. Or at least not unless stimulus dollars get redirected to projects that will produce some - any - positive rate of return. Last weekend I drove out to the county owned marina near my house (no, I don’t have a yacht there or even a dinghy but the raw bar makes a mean fish sandwich and serves a very cold beer) and got a chance to see what our tax dollars have been buying. Running alongside the road to the marina is a paved bike path. The path has been there for a number of years and I have no real objection to it but local government has been busy “improving” it with stimulus dollars. Someone was actually paid to paint a dashed yellow line down the middle of this bike path, dividing it into lanes as one would find on an actual road. This path runs four miles from beginning to end (I know because I’ve run it) so this was no small job or expenditure. The purpose of these lines - other than to line the pocket of the contractor paid to paint them - is a mystery and I cannot fathom how anyone could possibly believe this type of “investment” is in any way the answer to our economic problems.
That the economy is able to improve even modestly in the face of such idiocy is frankly amazing. Eventually the housing market will hit bottom too and unless our “leaders” do something to screw it up, companies will eventually have to invest in the US again. Further improvement in the economy may positively affect the jobs market soon too. New jobless claims fell again last week to 407k and while holiday weeks are often statistical outliers, I have hope that this decline will extend below the 400k level that we’ve waited so long to see. The idea that government spending has a multiplier effect in the economy is pure hokum but the positive feedback from more employment is real. Faster economic growth means more hiring and more hiring means faster economic growth.
And so having spent the first part of this update discussing how the economy is improving despite what the government is doing to hold it back, I now have to discuss markets, about which I’m not as positive, at least in the short term. I remain quite cautious and that applies to global stocks, commodities, REITs, bonds of all types and gold. If that seems at odds with my more optimistic outlook for the economy, consider what better economic performance would mean to markets. A better economy would mean, first and foremost, an improvement in the performance of the dollar that is about more than just being less bad than the Euro. And believe it or not, despite the negativity associated with the US dollar, the trade weighted dollar index appears to be making a bottom after many years of decline (see the Weekly Chart Review). Capital hasn’t yet moved out of gold and other commodities but an improvement in economic policy could change that quickly. The developing debate concerning how to address the deficit and debt may be the catalyst for just such a change.
A major reform of the tax code and entitlements that includes a reduction in tax rates - particularly corporate tax rates - and reduced spending could be very beneficial to the US economy. But positive changes to economic policy would also mean major changes in how we invest our assets. A more stable or rising dollar means less capital flowing to emerging markets, commodities and gold. Reduced corporate taxes would likely mean more capital investment and less investment in housing and real estate. Higher consumption taxes - another possible reform - could mean higher savings rates, lower trade deficits and lower growth in Asia. Positive changes would also likely mean higher interest rates and lower bond prices.
One of my major concerns is the sentiment regarding markets. Who doesn’t like emerging markets? Who doesn’t like commodities? Or junk bonds? Or even US stocks? Nearly 50% of individual investors call themselves bullish according to the AAII poll last week. Polls of advisors find even higher percentages in the bullish camp. It seems that the majority now is more optimistic about markets but I think they may be underestimating the potential downside. European debt problems have still not been resolved and could obviously affect the performance of the US economy. But even if that is resolved and we get better economic policy here, the transition will not be simple or painless. Most portfolios are positioned for the economic environment that has existed for the last decade. If it changes - for better or worse - the transition could cause a lot more volatility in markets than is currently imagined by complacent investors.
Disclosure: No positions