As Economy Nears Bottom, Keep the Big Picture in Mind

Not to sound like a broken record every week, but I remain convinced that the economy is at or very near its bottom. The green shoots have spread; the purchasing managers' survey, initial unemployment claims, auto sales and production, and even retail sales are showing improvement from relatively dreadful levels.

Some of the earliest of indicators have now been flashing positive for more than half a year. Meanwhile some of the more stubborn indicators such as employment have slowed their decline. However, the production of goods remains weak as does the transportation of those goods. While goods, especially long-lasting capital goods, are typically weak at the end of the cycle, transportation markers are often leading indicators. The market remains concerned that a lot of shipping indicators remain soft, including rail car loadings and the results and outlook reported by  FedEx (FDX) last week. I think the relevance of transportation indicators has been reduced this cycle because of more just-in-time inventory systems and because firms have chosen to sharply draw down their inventories instead of purchasing new goods.

My optimism over the past several months has been based on improved consumer purchasing power (lower energy prices, deflation), wage income that has held up much better than one might guess given the employment numbers, and the consumer's willingness to spend. Just as some of these beneficial factors begin to look a bit tired, consumers will now have funds generated by the stimulus plan and a substantial hike in the minimum wage in July. Weather conditions in the upper Midwest, which have been horrible this spring, probably can't manage to depress demand more than they already have. And while rising gasoline prices will hurt the consumer this summer, natural gas and electric prices will probably be more beneficial for the consumer this fall and winter. Longer term, we believe that both auto and housing production are way below long-term natural demand (driven by unstoppable population growth and natural wear and tear). The question of returning to normal demand remains one of when, not if, in my opinion.

I am spending more time on our backdrop expectations for two reasons. First the Street has now begun to focus on every economic report with a laser-beam focus. Each tick the right or the wrong way generates a large reaction in the stock market. Back in January I couldn't get anybody to look at the national ISM purchasing managers' survey data as it began its upward march. Five months later, the market fell about two hundred points on Monday when the New York state version of the number was disappointing. Then the market rallied on Thursday as the Philadelphia regional report came in better than anticipated. I like the idea of confirming evidence, but I think the Street has taken a good concept and stretched it a bit too far. Furthermore, irregular summer shutdowns in the auto industry could potentially turn this indicator negative in the short run. This wouldn't necessarily spook me, but based on this week's reaction to one regional report, it could hit markets hard.

The second reason I am focusing on my longer-term drivers is that, like the ISM report, many important indicators will be sending mixed messages over the summer that will take a nuanced and proper intermediate-term context to draw appropriate conclusions. Gauging the reaction of Wall Street won't give you the full picture. For example, the second quarter GDP number could be below expectations as some of the industrial production numbers seem to be pointing to a bigger drawdown of inventory than expected, potentially hurting this quarter's GDP. But this drawdown could lead to stronger-than-expected growth for the September quarter. Auto industry volatility will pay havoc with initial unemployment claims and on the ISM data, as noted above.