Has the Economy Really Turned the Corner?

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
December 15, 2009

IN THIS ISSUE:

1.   Has the Economy Really Turned the Corner?

2.   Bloomberg Survey Finds More People Unhappy

3.   Fed “Beige Book” Shows Modest Recovery

4.   Consumer Lending Continues to Shrink

5.   Conclusions – Outlook is Still Very Uncertain

Introduction

The economy clearly rebounded in the 3Q, although many problems such as unemployment have continued to worsen.  This week, we take a look at the latest economic reports to see if the 3Q rebound will continue through the end of the year and on into next year.  Most economists seem to be revising their forecasts upward, but are they doing so prematurely?

While the economy is unquestionably in better shape than a year ago, the credit markets are still a serious problem.  Corporate and consumer lending continue to contract.  The Fed’s latest Consumer Credit Report noted that consumer lending is down 4% from the peak in July 2008.  Fed chairman Ben Bernanke admitted recently that those hardest hit are small businesses and households.  More details to follow.

Adding to the continued lending quagmire, a recent Bloomberg survey found that Americans have grown gloomier about both the economy and the nation’s overall direction over the past three months, even as the US shows signs of moving from recession to recovery. 

The Bloomberg survey found that nearly a year into Obama’s presidency, only 32% of poll respondents believe the country is headed in the right direction, down from 40% in September.  I will discuss the details of the latest Bloomberg survey as we go along.  I will also share with you the highlights of the latest Fed “Beige Book” economic survey.

Has the Economy Really Turned the Corner?

Perhaps the two most important economic reports over the last couple of months were the GDP report on October 29, which estimated that the economy expanded at an annual rate of 3.5% in the 3Q, and the December 6 jobs report which estimated that the US unemployment rate fell from 10.2% in October to 10.0% last month.  The 3Q GDP report was revised downward to 2.8% on November 24 (and still may be overstated), but it does indicate that the economy has recovered at least somewhat since the worst of the recession and credit crisis earlier this year.

Some economists and financial analysts are revising upward their economic forecasts for 2010.  In addition to the better than expected 3Q GDP report, the Index of Leading Economic Indicators (LEI) has risen for the last six consecutive months.  The LEI for October (latest available) rose 0.3%, following a 1.0% gain in September. 

The LEI for November will be released on Thursday, and the pre-report consensus is for a seventh consecutive increase.  Ken Goldstein, an economist at the Conference Board which produces the LEI noted: “The data indicates that economic recovery is finally setting in. We can expect slow growth through the first half of 2010. The pace of growth, however, will depend critically on how much demand [consumer spending] picks up, and how soon.”

With the holiday season upon us, we are hearing a lot about consumer spending, pretty much on a daily basis.  As this is written, traditional holiday spending is reportedly running slightly behind the same time last year.  Even though the retail sales report posted gains in October and November, the International Council of Shopping Centers reported that same store sales fell 0.3% overall in November, despite its earlier forecast of a rise of 3-4%.  That is discouraging because it is compared to November of last year which was also very disappointing.

Bloomberg Survey Finds More People Unhappy

This may be explained in part by a recent Bloomberg survey which found that Americans have grown gloomier about both the economy and the nation’s direction over the past three months, even as the US shows signs of moving from recession to recovery since October.  Almost half the people now feel less financially secure than when President Obama took office in January, noted the national poll results released on December 9.

Those concerns have put many consumers in a gloomy mood as they head to the malls for holiday shopping.  The latest Bloomberg poll found that fully half of respondents are planning to spend less on gifts than last year, and fewer buyers were willing to run up credit card debt for Christmas.

According to the Bloomberg survey, the economy remains the country’s top concern, with persistently high unemployment the greatest threat the public sees.  Eight out of 10 Americans rated joblessness the highest risk to the economy in the next two years, outranking the federal budget deficit, which was cited by 7 of 10.  Tax increases were cited as the next highest concern at 6 out of 10.

The Bloomberg survey found that fewer than 1 in 3 Americans think the economy will improve in the next six months.  They are pessimistic that the government will succeed in reducing unemployment or lowering the budget deficit.  Nearly a year into Obama’s presidency, only 32% of poll respondents believe the country is headed in the right direction, down from 40% in September.

As you can see in the charts below, the Consumer Confidence Index for November paints a less pessimistic picture as it has been basically flat since the peak in May.  This does not bode well for holiday spending.

Consumer Confidence IndexI have a theory that the latest worsening of the mood of the country is correlated with the increasing likelihood that Congress will pass a sweeping healthcare reform bill.  Surveys show that 50-60% of Americans are opposed to the healthcare reform bills in Congress, but leaders like Senate majority leader Harry Reid continue to try and ram through healthcare reform even if it threatens their re-election next year. 

At the very same time, President Obama is once again pushing hard for passage of his onerous Cap & Trade environmental bill, which most Americans also oppose, and last Wednesday he announced a huge second stimulus package.  All of this is causing more concern among the American people.  That’s just my theory, but I could see consumer confidence staying flat or moving lower in the next few months.

Moving on, we will find out in the first few days of January if the November drop in the unemployment was a “one-off” decline, or if a second decline happens in December.  Initial claims for state unemployment benefits actually rose 474,000 in the first week of December.  That number was actually up from 457,000 the prior week.

Keep in mind that even though the official unemployment rate dropped to 10.0% in November, we still lost apprx. 11,000 jobs last month.  Also keep in mind that the real unemployment rate is still around 17% if we count those who have given up looking for a job or are working part-time out of necessity.

Other economic reports over the last few weeks paint a mixed picture.  While retail sales increased in November as noted above, durable goods orders (big ticket items) unexpectedly fell 0.6% in October (latest data available).  Factory orders, on the other hand, rose 0.6% in October, the second monthly increase.  Yet the widely followed ISM manufacturing and services indexes fell in November.

On the housing front, the news is mixed.  While sales of new and existing homes have improved modestly in the last few months, home foreclosures continue to set new records.  Home foreclosures are on track to hit a record high of 3.9 million in 2009 versus the previous record of 3.2 million in 2008.

Most economists agree that the worst of the recession/credit crisis is behind us, and that the economy is rebounding modestly.  Most also agree that the economy will expand at least through the middle of 2010.  But that remains to be seen, especially in light of the latest Bloomberg survey discussed above.

Fed “Beige Book” Shows Modest Recovery

The 12 regional Federal Reserve Banks gather information on current economic conditions in their districts through internal reports and interviews with key business contacts, economists, market experts, and other sources. The so-called “Beige Book” summarizes this information by district and sector. An overall summary of the 12 district reports is prepared by a designated Federal Reserve Bank on a rotating basis and is published eight times per year. 

The latest Beige Book for November was released on December 2.  What follows are highlights from that report.

Reports from the twelve Federal Reserve Districts indicate that economic conditions have generally improved modestly since the last report. Eight Districts indicated some pickup in activity or improvement in conditions, while the remaining four--Philadelphia, Cleveland, Richmond, and Atlanta--reported that conditions were little changed and/or mixed.

Consumer spending was reported to have picked up moderately since the last report, for both general merchandise and vehicles; a number of Districts noted relatively robust sales of used autos. Most Districts indicated that non-auto retailers were holding lean inventories going into the holiday season… Manufacturing conditions were said to be, on balance, steady to moderately improving across most of the country, while conditions in the nonfinancial service sector generally strengthened somewhat…

Residential real estate conditions were somewhat improved from very low levels, on balance, led by the lower end of the market. Most Districts reported some pickup in home sales, though prices were generally said to be flat or declining modestly; residential construction was characterized as weak, but some Districts did note some pickup in activity. Commercial real estate markets and construction activity were depicted as very weak and, in many cases, deteriorating.  [Emphasis added.]

…Multifamily housing markets deteriorated further in the New York and Chicago Districts. More broadly, a number of eastern Districts reported continued declines in home prices--specifically, Boston, New York, Philadelphia, and Richmond. In contrast, prices were said to have firmed somewhat in the Dallas and San Francisco Districts and stabilized in the Chicago and Kansas City Districts.

Financial institutions generally reported steady to weaker loan demand, continued tight credit standards, and steady or deteriorating loan quality… Labor market conditions remained weak since the last report, though there were signs of stabilization and scattered signs of improvement… Activity in the [non-financial] service sector generally picked up since the last report, though results were mixed across Districts and across service industries…

Credit quality showed signs of deteriorating in the New York, Philadelphia, Dallas, and San Francisco Districts but was described as stable or mixed in Cleveland, Chicago, and Kansas City, with Chicago reporting some improvement outside of commercial real estate. Increasingly tight credit standards were reported in the New York, Richmond, Chicago, St. Louis, Dallas, and San Francisco--largely on commercial loans.

Still, some Districts noted scattered signs of encouragement: Cleveland and Chicago referenced public-works projects as a source of increased business, Richmond noted signs of increased leasing activity from the health and education sectors, Atlanta indicated a modest pickup in new development projects, Minneapolis noted some recently started hotel and retail development, and San Francisco cited slight improvement in availability of financing for new development.

This extended analysis is reflective of an economy that is beginning to slowly recover from the deepest recession since the Great Depression and the worst credit crisis in the post WWII era.  The recovery is occurring in part because of massive federal spending of close to $2 trillion.  Yet the credit markets are still extremely tight, as I will discuss below, with few signs of a material improvement expected over the next year.

The Federal Reserve continues to hold short-term interest rates close to zero.  The big question, of course, is when will the Fed begin to raise interest rates back to “normal” levels.  Many analysts believe the Fed should already be tightening, but it does not appear that the Fed will raise rates anytime soon.  Below is a portion of the Federal Reserve Open Market Committee’s (FOMC) latest policy statement on November 4:

“The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

The key words in the FOMC quote above are “an extended period.”  Several of my most trusted sources now believe that the Fed will not raise interest rates until late next year at the earliest, and perhaps not until sometime in 2011.

Consumer Lending Continues to Shrink,
Another Bad Omen for the Economy

The latest Consumer Credit Report released on December 9 revealed that consumer lending shrank 1.7% in October, the ninth consecutive monthly drop, further extending the dramatic decline of financing available to help fuel the economy.  The Consumer Credit Report includes credit-card debt, auto loans and other loans, but excludes mortgages.

The Federal Reserve, which publishes the credit report, calculates that the 1.7% decline means consumer lending fell by $3.5 billion in October alone, representing a 4% drop in consumer lending from its July 2008 peak.  Before July 2008, borrowing by US consumers had been growing annually for more than a half-century.

The obvious problem here is the fact that consumer spending accounts for apprx. 70% of the US economy (GDP).  If lending to consumers and small businesses continues to fall, it will almost certainly stifle the economic recovery.

Fed chairman Ben Bernanke said as much in Congressional testimony last week, predicting that the economy is unlikely to experience a “vigorous” recovery.  Even though unemployment for November was better than expected, he said the picture for US job growth remains unclear.

Bernanke told lawmakers that it’s not just consumers having trouble borrowing. For all the talk of a revival in the financial markets and a perception that the economy is on a path to recovery, many companies lack easy access to borrowing.  Bernanke cautioned: “Despite the general improvement in financial conditions, credit remains tight for many borrowers, particularly bank-dependent borrowers such as households and small businesses.”

In the process of adapting to post-crisis realities, the nation’s lending markets have changed significantly.  In particular, markets where the US government is either a big borrower or a de facto guarantor are ballooning, while most corporate-lending and consumer-finance markets have shriveled.

A recent Wall Street Journal analysis of data from the Federal Reserve and private research firms shows that the corporate and consumer credit markets have shrunk in size by 7%, or $1.5 trillion, in the two years through early November.  That same analysis showed that the financial markets that support credit-card lending, auto loans and home mortgages not backed by the government are between 10% and 40% smaller than they were in the second half of 2007.

On the other hand, Treasury debt outstanding has jumped about 40% as the government races to finance its deficits and investors seek the safety of US-backed debt. The market for securities backed by mortgages that are effectively guaranteed by the government has expanded by 21%.

Credit markets have healed considerably, after having nearly shut down more than a year ago at the height of the global financial crisis. In the process, prices of almost every type of bond have bounced back from their historic crisis-era lows.  Yet the rally in prices doesn’t mean consumers have more money available.  Money flooding into Treasuries does not mean more money in consumers’ pocketbooks (ie – you can’t spend a T-bill at the mall).

Here is a stark example of just how much lending has contracted.  The same WSJ analysis noted above stated that in 2005, over six billion credit-card offers flooded consumers’ mailboxes, whereas this year just 1.4 billion have been sent out, according to Synovate, a market-research firm. The WSJ analysis also stated that Visa reported earlier this year that people were using their debit cards (which draw cash out of a bank account) more than credit cards (which use borrowed money) for the first time.

Credit ChartAccording to the WSJ analysis noted above, the size of the market for securities backed by loans tied to homeowners’ equity has shrunk more than 40% since the second half of 2007.  The market for securities backed by auto loans has shrunk 33%.  For securities backed by riskier mortgages, the decline is about 35% since the end of 2007, according to the Federal Reserve and data provided by FTN Financial.

Some of the decline in lending is also due to lower demand as borrowers focus on paying off the debt they already have.  In the past 25 years, household debt has exploded.  It now stands at 122% of total disposable income, up from just over 60% a quarter-century ago.  At the end of last year’s 3Q, household debt finally started to decline as Americans began belt-tightening.

The WSJ analysis notes that the hardest-hit markets since the crisis were ones at the heart of the financial problem - the “securitization” markets where loans for everything from mortgages to credit-card debt get sliced up and repackaged into complex securities.  These securitization markets provided as much as 50% of consumer lending in the years leading up to the crisis, yet these types of securities have all but dried up since the credit crisis.

Classic short-term credit markets serving businesses have also withered. Commercial paper sold by businesses to finance payroll and other short-term cash needs has slumped by 35%, according to the WSJ analysis.  Likewise, the shrunken markets for short-term debt are also complicating life for investors in money-market funds.

These funds invest in short-term debt and have a reputation as being safe places to park cash. Worried investors (both individuals and corporations) have piled money into these funds. Money-market funds still have nearly $1 trillion more in assets than they did in mid-2007 before the credit crisis kicked off, according to the Federal Reserve.

But the shrinking market for corporate short-term debt has limited money market funds’ investment options and forced them to funnel cash into government-issued Treasury bills that mature in three months or less. This heavy demand helped drive yields on some Treasury bills into negative territory last month.

The bottom line: If lending continues to fall or remains the same, consumers will spend less and businesses will be more reluctant to hire and invest.  Citing similar concerns, Pacific Investment Management Co (PIMCO), the largest bond company in the US, now predicts that the economy will grow only 1.5% to 2% a year going forward, unless the contraction in lending reverses itself.

If lending doesn’t improve, I would say there’s a very good chance that PIMCO’s forecast may be overly optimistic.

Conclusions – Outlook is Still Very Uncertain

The title of this week’s E-letter questions whether the economy has really turned the corner.  Clearly, the stock markets think it has.  No doubt, things improved in the 3Q, and most economists believe the 4Q will be positive as well.  Likewise, most mainstream forecasters believe the first half of 2010 will see positive economic growth, and some believe all of 2010 will be positive.

However, virtually all of my most trusted sources for economic forecasts indicate that the recovery will be slow, and that we won’t return to sustained 3% to 4% GDP growth anytime soon.  With the continued decline in lending to consumers and small business, this recovery may be unlike any other in recent history.  Until lending improves, the economy will be very vulnerable to negative surprises that could send it back into a recession.

Given that the mood of the American people has turned decidedly negative over the last couple of months – only 32% think the country is headed in the right direction – I don’t think it would take much to tip the economy back into recession.  With out-of-control government spending, a massive health care bill being forced down our throats by Congress, double-digit unemployment, an ever-widening commercial real estate problem and wary consumers, there’s no shortage of triggers for a resumption of the recession.

Add to this the falling US dollar (which has rallied a bit of late) and the possibility that foreigners may be less willing to buy record amounts of US debt, and there is the possibility of yet another financial upheaval – with or without some other negative surprise(s).

At the end of the day, the economy has rebounded somewhat from the dire circumstances of a year ago.  Maybe this tepid recovery will continue.  But the risks to that scenario remain high, especially until lending to consumers and small business rebounds.  Until (unless) that happens, I would continue to advise a defensive investment posture, with the ability to move to cash, or hedge long positions, if negative surprises occur.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

Consumer Lending Falls 9th Consecutive Month
http://www.nytimes.com/2009/12/08/business/economy/08econ.html

Consumer Confidence Falls Again in December
http://www.reuters.com/article/idUSTRE5B731P20091208

Iran Lies Again on Nuke Program - Anyone Surprised??
http://www.timesonline.co.uk/tol/comment/article6955250.ece


Read Gary’s blog and join the conversation at garydhalbert.com.


Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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