Current Economic News Needs A Dose Of Reality

Morris Segall      economy, news, recession

Pardon us for interrupting the party but we felt the economy was going to hit a DEMAND bottom at the end of the first quarter as inventories, employment, factory orders and consumer spending plummeted to depths at which they were unlikely to contract further. But a demand bottom did not mean we were at a recession bottom. The current economic condition is comparable to falling to the bottom of a swimming pool. You reach a point where you hit bottom. That doesn’t mean you rise back to the surface. One can lay on the bottom for a while longer. That is where we believe we are in the current cycle. Here’s why:

1. The April unemployment report which showed a reduction in job losses to under 500,000
masked a large component of temporary federal government hires for next year’s census.
Job losses in the private sector were over 600,000 and continued to afflict every industry
sector except government and healthcare, the only sectors that have added jobs in the
last seven months. In addition, prior months job losses have been revised downward. The
average monthly loss in jobs in the first quarter of 2009 is now approximately 700,000
versus a little over 500,000 in the fourth quarter of 2008. More importantly, continuing job
losses have risen to over 6.25 million from approximately 4.5 million at year end 2008. To
come are large job losses from the downsizing and restructuring of GM and Chrysler over
the summer.

2. Reflecting the increased level of job losses and constricted credit availability, consumers
continue to reduce their outstanding debt. In March consumer debt outstanding declined by
a record $11 billion. Since the third quarter of last year consumer credit outstanding has
declined by nearly $32 billion and consumers savings rate has climbed to over 4%. Further,
consumers are using debit cards instead of credit cards paying cash instead of increasing
the use of credit.

3. After holding below 3% since the fourth quarter of 2008 the yield on 10 year U.S.
Treasury Notes rose above 3%, escalating to over 3.25% last week. We have been warning of the upward pressure on interest rates lurking in the skirts of a recession bottom. As optimism of such a bottom increases and stocks continue to rise, money shifts from bonds to stocks. More importantly, the supply of new Treasury financing for the burgeoning federal budget deficits are forcing interest rates up. Speaking of federal deficits, we have projected the current fiscal year deficit of $2 trillion
(See our latest Economic Update, May 1, 2009). Today, the White House increased its
projection of the current fiscal year deficit to $1.8 trillion. We don’t think they are done.

4. Not so quietly, oil prices have escalated 20% to over $55 per barrel since mid April. Likewise, gasoline prices have escalated and are now well over $2.00 per gallon at the pump.

We believe these factors are going to slow down the consumer recovery and prolong the demand bottom we believe we are now experiencing. Yesterday’s April retail sales report was surprisingly weak, further evidence of the consumer’s unwillingness and inability to increase his spending currently. Given the continued high levels of unemployment and consumer spending retrenchment plus the new increases in interest rates and gasoline prices, we do not think the nascent improvement in economic activity is sustainable through the summer when auto job losses hit. We may be seeing a “sawtooth” pattern of episodic improvement followed by retrenchment. We are hopeful the fourth quarter may be the first concrete period of economic recovery but the auto industry job cuts make that forecast less predictable than we believed earlier. This may push recovery into the first half of next year.

So yes it looks like we are reaching a deceleration in the rate of economic contraction but it is too soon to break out the champagne and the stock market needs a correction to stay healthy. We have been bullish on the 1-3 year outlook on U.S. stocks for some time believing the stock market would “smell” out a recession bottom well before the economy recovered as it always has. The rally in stocks since early March is consistent with that trend but it is now vulnerable to disappointing economic data. However, we believe the early March market lows are this cycle’s lows and we expect a correction near term to hold above the early March levels. We would use such a correction to increase investment allocations in equities with a 1-3 time horizon.

Morris R. Segall, CFA, CIC