Third Quarter — Still at the Bottom of the “L”

Morris Segall      2009 economy, business landscape, consumers, economy, government, slowdown

I continue to be surprised at the over-optimism of the mainstream financial press and government spokespeople on the current economic environment which is leading to increased forecasts of economic recovery beginning as early as this year’s third quarter.

Headlines indicating some economic improvement from higher consumer sentiment readings, a guarded optimistic reading on the economy from the Federal Reserve Open Market Committee this past week, a marginal improvement in the rate of economic decline in this year’s first quarter GDP and an impressive growth in the Advance report on Manufacturers Factory Orders for May were used as the basis for this continued optimism and a reversal in the stock market slide of the week before.

So once again I must put the facts on the table:

1. The fractional improvement in first quarter from -5.7% to -5.5% was entirely due to a smaller reduction in business inventories. In fact, consumer spending was actually reduced from a 1.3% gain to .95% thus shading the contribution from consumer improvement.

2. The strong improvement in Manufacturers Factory Orders in May is up only 1.5%, excluding transportation (primarily commercial aircraft), from the severely depressed level of March and is down 23% from May, 2008 levels. More importantly, the book/bill ratio of orders versus shipments in May was 95% versus approximately 96% in March and April. Thus non-transportation factory orders are no better and in some respects worse than they were at the end of depressed first quarter levels.

3. The Federal Reserve statement, while expressing guarded optimism that the worst of the economic contraction was behind us, kept interest rates at essentially 0% because the economy is still functioning at a depressed level.

4. On Friday, the government reported a surge in consumer incomes in May of 1.4% fed largely by government social security stimulus checks. On the other hand, consumer spending in May increased only .3% and the personal savings rate increased to 6.9%, a 15 year high. This low level of spending and the further increase in consumer savings on top of already historically high levels tells us the consumer is still very much concerned about the current economic environment, refuting his statements on consumer surveys, and is not ready to start pulling us out of recession by a surge in spending.

In our blog posting, “Beware Over-Exuberant Reactions to this Week’s Economic News,” (May 28, 2009), we stated “the second and third quarters of this year will be “less worse” than the first quarter but not an end to the recession”. We characterize the current economic environment as the bottom of an “L”. We have been projecting second quarter GDP to contract 2%-3% but with the continued weakness in consumer spending through May, GDP contraction in Q2 could reach 4%. Furthermore, we see little evidence that consumer spending will miraculously turn higher in Q3, particularly with continued high levels of unemployment which we expect will go higher over the summer spurred by layoffs from GM and Chrysler. Thus at this juncture, we expect Q3 GDP to be in a range of 0% to down 2%-3% depending on the level of U.S. government spending in the quarter. This is well below the 1%-3% growth in third quarter GDP many economists are currently projecting. If we are right, stock markets here and around the world are setting themselves up for a material correction from the elevated levels achieved this week.

An economic recovery will occur and we still believe it is largely a 2010 event but the continuation of the current economic torpor is pushing the recovery further into next year. We continue to be vigilant for real indications of a sustainable improvement in consumer spending which is a prerequisite to any recovery from this recession.

Morris R. Segall, CFA, CIC

The President’s Financial System Overhaul: It’s Time

Morris Segall      2009 economy, bailout, banking system, business landscape, economy, The new Fed actions

After a year of speculation and discussion, President Obama released his plan for reform and regulation of the nation’s financial system. There were few surprises. With more oversight and control centered in the Federal Reserve and augmented with newly created boards, the plan brings under new regulation and supervision virtually all major sectors and products of the financial services industry.

Born out of the cataclysmic financial losses of the current recession, the President’s plan seeks to avoid a repetition of the circumstances and events that led to the recent financial system meltdown. It is the quid pro quo for the federal government bailing out the U.S. credit system and nobody should be surprised at the far reaching reform and regulation embodied in the plan.

In the most sweeping regulation of the financial sector in this country since the Great Depression, it creates unprecedented power to seize banking institutions and intercede in the transaction systems in the financial marketplace. This would include the “breakup” of large financial conglomerates that pose a heightened risk to the functioning and integrity of the financial system.

Critics are bemoaning that the increased intrusion of the federal government in the affairs of the financial marketplace may cause restriction and higher costs of credit to borrowers. With all due respect, that has already occurred as a result of the massive debt losses sustained by the nation’s credit intermediaries and its investors and placement firms.

Like it or not the financial marketplace and its players are going to have to deal with more stringent governmental oversight and regulation to protect the country from another financial meltdown from insufficient credit risk underwriting.  The constriction of credit, the inability to conduct market transactions in asset backed securities and consumer and banking failures necessitate the comprehensive overhaul of the nation’s financial system.

The mandating of increased oversight of the nation’s banks including higher capital and liquidity standards and the assumption of prudent risk and the offering of high risk products will force the banking system to adopt a more stable lending and responsible posture. The regulation of credit card companies and mortgage brokers and other financial intermediaries serving consumers is required to also enforce higher standards of professional conduct, better risk underwriting and most of all, consumer protections from fraudulent and abusive practices.

Importantly, the overhaul plan includes regulation of the “paper” created around the asset based lending that leveraged and securitized these transactions and have been a major contributor to investor and lender losses as the value of such paper eroded more than the assets they backed and became illiquid.

Unfortunately, the President’s plan does not use this opportunity to streamline the regulatory system. We believe there are still too many agencies involved in the new regulatory framework and may lead to inefficiencies and inconsistencies in industry oversight. However, no new regulatory plan of this magnitude was going to be perfect and the overall benefits will outweigh the organizational faults. We also believe industry participants will adapt and operate successfully in the new environment and/or exit the more risky sectors of the financial marketplace. This will inure to the benefit of lenders and borrowers in providing a safer and fairer financial system.

The credit industry over the 2004-2007 period lost its way and its mistakes in the extension of credit to poor credit risks and the leveraging of those risks would have plunged us into a massive depression were it not for the Herculean federal rescue. It’s time we got this critical industry and system back under control.

Morris R. Segall, CFA, CIC

Europeans are Mad and Turn Right

Morris Segall     

The recent European Parliament elections held this past weekend confirmed our observations in our blog and website articles, “I am Mad as Hell and I am not Going to Take it Anymore,” March 23, 2009. Voter dissatisfaction with left leaning and socialist governments and their policies handed conservative and right wing nationalist parties a clear majority in the European Parliament and unseated and inflicted major losses on sitting governments in Hungary, Ireland, Great Britain and Spain. This move to the political right is expected to have the following repercussions:

1. A move toward less free trade and globalization and more protectionist
measures to protect local businesses and local workers.

2. A move toward anti-immigration measures to protect local workers.

3. Increased divergence between Europe and the U.S. in regard to massive federal
government stimulus spending to accelerate economic recovery in the Eurozone. In our blog
posting, “Is the U.S. a Party of One, ” we called attention to the divergence of opinion
between the U.S. and Europe on this matter. The conservative electoral victories will make
this divergence even greater which will undermine the strength of the U. S. Dollar and the
attraction of U.S. Treasury debt and stall an increase in U.S. exports to Europe that would
stimulate the U.S. economy.

4. Some increased concern about the future of the European Union as more countries adopt
increased nationalistic policies and viewpoints and re-think subjugating national policy to a
European Parliament and European Union bureaucracy.

I also cannot help but see the parallels between the social and political movements in Europe today and those of Europe in the Depression of the 1930s. In the 1930s the Great Depression saw the rise of fascism as a solution to the terrible deprivation of Europe’s populations. Some of the parliamentary and national government gains over the weekend were achieved by far right wing, nationalist parties preaching anti-immigration and often bigoted platforms. The appeal to a population’s patriotism diverts attention from the real economic problems facing Europe’s governments and for which there are no easy answers and more importantly, no quick fixes.

Morris R. Segall, CFA, CIC

Unemployment And The Cycle

Morris Segall      Chrysler, economy, GM, unemployment

Today’s unemployment report for the month of  May,  showed a stunning decrease in the monthly trend of job losses since the recession intensified in the fourth quarter of last year. The Labor Dept reported non farm payrolls declined by 345,000 in May, the lowest monthly level of job losses since last September, and far below analysts’ expectations of 500,000 lost jobs in May. Combined with the recent downward trend in first time unemployment claims seen in the months of April and May, we believe the current level of monthly losses in the U.S. economy has subsided from 600,000-700,000 to 500,000-600,000 reflecting the already massive cutbacks in payrolls over the last six months. However, we are highly skeptical that monthly job losses have declined below the 400,000 level at this point in the cycle for the following reasons:

1. The May figure of -345,000 is not consistent with the ongoing level of first time unemployment claims of 600,000+ reported through the month of May.

2. The May figure of -345,000 is not consistent with the rising level of long term unemployed workers that reached over 6.7 million during the month of May.

3. The May figure of -345,000 in the Business survey is not corroborated by the less quoted Household Survey which showed an increase in unemployment of 787,000.

4. The May figure of -345,000 does not reflect the continued increase in part time and discouraged workers which now number over 11 million.

We believe the May job losses will be revised downward when the June unemployment report is released next month. The monthly unemployment report from the government is becoming increasingly unreliable in its initial release, and has been subject to consistent and often large revisions in subsequent monthly releases.

Nonetheless, were it not for the forthcoming increases in job cuts coming from the restructuring of GM and Chrysler, we would be comfortable in stating that the rate of new job destruction has peaked for this cycle, which is a prerequisite to a bottoming in this recession. Next must come a peaking in the level of long term or continuing unemployment claims. But a recession bottom is not an economic recovery. The current level of TOTAL unemployed, and part time, discouraged and underemployed workers is approximately 25 million, and there can be no recovery until these people get back to work and start spending again. So while we have hit the nadir of this recession in terms of rate of economic contraction, we fear it will be the fourth quarter of this year before any measurable economic growth will be reported.

Morris R. Segall, CFA, CIC