Recession Moves into the Rearview Mirror

I remain strongly bullish on the economy for the second half and early 2010. This week's economic indicators showed sharply decelerating deterioration (job losses, initial unemployment claims, purchasing managers' survey) and some data showed positive changes (hours worked, real hourly wages, existing home sales, factory orders), not just a slowing of decline rates. The data were almost uniformly in the right direction this week in contrast to prior months when a couple of specialized, early indicators were positive, but many more indicators were still going in the wrong direction.

My 3% second-half growth forecast, which was considered laughable just a month ago, is quickly becoming the consensus. Based on some very positive indicators this week, there is probably a case to be made for an even higher number, but I need to see some more corroborating evidence before I step out on that limb. The biggest real risk to my positive scenario is weakness in the commercial real estate sector and increased interest rates.

Despite a more balanced set of indicators this week, housing- and manufacturing-related statistics were still much stronger than the consumer, who remains in a bit of a funk. This week's most negative trend was that consumers continue to trade down in the items that they do purchase. None other than industry leader  Procter & Gamble (PG) noted the strong trend of customers trading down to lower-priced products. P&G is now developing new, more-basic products, including lower-cost versions of Tide, as the firm sees this as more than a short-term change in consumer behavior. High-end stores like  Saks ,  Tiffany , and  Abercrombie (ANF) continue to show large double-digit declines, while the low end of the market, including various dollar stores,  TJX (TJX) and  Ross Stores (ROST), continue to show real gains. News out of the restaurant industry this week was also pretty bleak, even at the low end of the market.

However, I think recent strong stock market action and headlines about declining unemployment rates could begin to turn the consumer tide in the near future. At some point consumers can no longer sit on their hands knowing a better deal is just around the corner. In the last three months, consumers have seen the best mortgage deals (mid-4% to low-5% rates), the cheapest housing prices, and auto bargains/clunker trade-in programs disappear. This week's declining unemployment number may be just the catalyst needed to get consumers back into shopping mode.

It is still just a bit disconcerting that ground-up information from our analyst team remains relatively negative versus some clearly improving macro trends. However, corporate executives have a lot to lose, including credibility with investors, if they declare an end to the recession too soon. In fact, companies that set expectations low and then surprise to the upside are often richly rewarded in terms of short-term trading results. I guess the good news is that while we are not hearing a lot of strong affirmative news, the doom and gloom out of companies seems to be diminishing.

The one positive trend that I have heard across three of our 10 analytical teams is a strong improvement in China and decent activity in India. For example, incentives for consumer electronics in China have caused a big boost in electronic sales--including a surprising number of flat screen TVs. An industrial gases company also reported nice increases in China's demand for a broad range of industrial products (steel, chemicals, and autos). Furthermore,  Caterpillar (CAT) said at its analysts' day this week that profit may reach $10 a share by 2012 as developing market activity has begun to re-emerge.

This Weeks Economic Indicators
Economic news built into a positive crescendo all week long as very positive ISM manufacturing numbers led off the week, while an extremely positive and broad-based jobs report on Friday left little doubt that the economy was truly on the mend. The jobs report showed that "just" 243,000 jobs were lost in July, down sharply from 430,000 in the prior month and down from January's record high of 740,000. In addition, job losses were reduced by over 20,000 each for the prior two months.

The job losses were below my estimates and Wall Street consensus (320,000) largely because of a sharp improvement in the manufacturing sector. Job losses in the durable goods sector that had been well over 100,000 per month each month of 2009 fell to just 32,000 in July. A number of sectors including health care, education, leisure, government, mining, and miscellaneous services showed sequential job gains in the month. While the other sectors showed job losses, all sectors, with the exception of the one including retail stores, lost jobs at a slower pace than the previous month.

Just as importantly, the jobs report revealed that the average work week showed its first increase since 2006. Work weeks tend to increase prior to more new hiring. Average hourly wages were also up again, probably due to a mix-shift issue between retail (low paying) and auto (high paying), but nevertheless helpful overall for the macro economy. Shockingly, headline unemployment was actually down to 9.4% for July versus 9.5% in the prior month when almost everyone, including me, was looking for an increase in the rate. Fewer people looking for work was an important contributor to the improvement, which may not continue to be true in the months ahead. Still the headline number could make consumers feel better in the short run.

I have spent an awful lot of ink on the ISM purchasing managers' survey since January when it was just about the lone positive economic indicator. Based on this week's plethora of positive economic data, it appears that my confidence in this indicator was well placed. The July number came in at 48.9 above June's level of 44.8 and well above its low in the mid-20s late last year. Many of the individual components of the overall index were over the magic 50% mark. According to past ISM studies, a continuing PMI number at current levels is consistent with GDP growth of approximately 2.5%.

In other news, initial unemployment claims continued their downward trend, slowing to about 550,000 weekly claims. Pending existing home sales also showed improvement at 3.2% which bodes well for existing home sales and inventories due later this month. Factory orders were also up for July while most economists had expected a small downturn. All of this relatively good news came despite low consumer confidence and the fact that only about 10%-20% of the federal stimulus money had been spent.

Next week the key metric I will be watching is the productivity number for the June quarter. With the number of hours worked in the quarter down 8% or so and GDP declining by just 1%, I am expecting a very good number here. While in the short run, productivity is hurting job growth, it also might represent pent-up demand for more employees as overworked employees begin to burn out.

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