Economy Keeps on Trucking

With this week's bank holiday, the flow of economic indicators was at a low ebb. Initially, unemployment claims looked encouraging, as did the more obscure job openings report from the Labor Department.  FedEx (FDX) and  UPS (UPS) both offered favorable comments about the upcoming holiday season, providing one of the first confirmations of improving conditions in the battered transportation sector. Small business optimism managed one of its best monthly improvements during October, but remains mired at depressed levels. While many observers fear commercial real estate issues and mortgage resets, my bigger concerns relate to small businesses and government policies. We will examine both commercial real estate and small business attitudes in greater depth next week since the flow of indicators is so light this week.

Employment Indicators Looking Up
Overall, employment news for the week was encouraging. Initial unemployment claims turned in another very strong performance, declining by an additional 12,000 this week after falling more than 18,000 the previous week. More importantly current initial unemployment claims of 502,000 are finally below the claims level of 509,000 a year ago. This marks the first year-over-year improvement during 2009. Continuing claims (a rough proxy for the number of people unemployed) also lost some altitude during the week. The Labor Department also reported that the number of job openings in September increased for the second month in a row after almost two straight years of declines. Eventually, job openings should lead to better employment levels in the months ahead.

FedEx Gears Up for the Holidays
The transportation sector has been a huge laggard in this recovery. Last year, the economy was in such bad shape, and uncertainty so pervasive, that UPS and Federal Express declined to give their usual holiday forecasts. Therefore, I was pleased to finally see some strong positive comments out of both Federal Express and UPS this week. Surprisingly, UPS termed this recovery "sustainable but fragile." Management went on to say that the consensus seemed to be for down-to-flat overall holiday sales, but UPS thought results would be stronger than that. They echoed the general consensus that online sales were poised to do better than brick and mortar establishments. FedEx was also bullish, noting that they expected peak day shipments for the holiday period would be 8% above year ago levels, and that they would be hiring seasonal employees accordingly. Revenues for the quarter now appear to be on track for flat to up after four consecutive quarters of decline. While our analyst Keith Schoonmaker cautions that DHL is no longer in the market and volumes are absurdly low, I am still comforted by the more positive comments from two companies whose business models are at the flashpoint of any economic recovery.

Commercial Real Estate: Why Should We Care?
In the past, I have cited commercial real estate as being one area that could throw cold water on my relatively optimistic forecast. Some of the most pessimistic prognosticators cite commercial real estate as the lynchpin for their dire predictions. There are many different ways commercial real estate can influence the economy, and economists need to be more explicit about what worries them. Some people are worried about continuing declines in construction employment and how that would exacerbate unemployment rates. Others worry about the companies that are involved in the real estate market, and more explicitly, the publicly traded real estate investment trusts.

However, economists worry most about the viability of the banks that hold most of the real estate loans. In the aggregate, real estate loans don't look quite as menacing as residential mortgage loans, which account for a considerably larger proportion of bank portfolios. While increasing, the amount of loans written off by banks each month is noticeably lower for commercial real estate loans than for residential mortgages. The combination of more limited exposure, lower charge-offs, and improved bank capitalizations should mean commercial real estate has less potential to bring down the whole financial system the way residential mortgages did.

Nevertheless, I continue to worry. Smaller banks have far greater exposure to commercial real estate than larger banks. I would continue to expect more small bank failures going forward.

Small Bank Failures a Potential Issue for Small Businesses
That is not a good thing, as small banks are also prime lenders to small business, and small businesses are usually a driving force for economic recovery. During this recession, improving international sales, better access to capital, and less uncertainty relative to health care, have all tended to favor larger companies over smaller ones. In fact, sluggish small business growth may be one explanation of why employment growth has been more lackluster this recession than during some previous recessions.

Small Business Confidence Begins to Build
Small business optimism this cycle reached its second lowest reading during March, at 81.0. Only the recession of 1980 witnessed a lower level, 80.2. However, the index remained below 90 for only one quarter during that recession. This recession, the index has remained below 90 for six consecutive quarters. Ouch! Luckily, the index did have a nice pop for the most recent quarter, moving from 81.0 to 89.8. The text of the report, issued by the National Federation of Independent Businesses, editorializes that they believe the real issue is lack of customers, not lack of credit. Only 4% of small business owners reported lack of credit as their primary impediment to additional hiring. I don't know if I completely agree, but if true, it would certainly mitigate some of the risk related to small bank failures I expressed earlier.

All Eyes on the Consumer: Influence of Manufacturing and Real Estate to Wane
In contrast to this week's light calendar of events, next week's reports include everything from data on retail sales to manufacturing, to inventories, to housing starts and inflation.

Manufacturing and housing data have thus far been the primary leaders in this recovery. I continue to expect some improvements in these two key sectors next week, but probably not at the improved pace of the past few months. Seasonality will continue to weigh on some numbers.

Also, after some strong growth early in the recovery, improvement becomes more difficult mathematically as the base number continues to grow. At the same time, Wall Street continues to anticipate bigger gains each month, as more firms jump on the recovery bandwagon.

So, I wouldn't panic if industrial production, housing starts, or the regional purchasing manager reports were not as robust as hoped. However, Wall Street might not take such news lightly. Due on Monday is the retail sales report from the Census Bureau, which has proven to be extremely difficult to project. I believe improved chain store sales, higher fuel prices, and improved auto sales should help move the overall retail sales number upwards. I believe that this will be the most important number of the week, as all eyes focus on the consumer. 

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