The Recovery That No One Wants to Believe In
...Except the stock market.
Quarter-End Insights
Consumers Start the Ball Rolling
The skepticism surrounding this recovery is like nothing I have ever seen. Every time the economy vaults another hurdle, a new objection is thrown up in its face. When third-quarter 2009 results proved to be surprisingly strong, the pessimists incorrectly stated that it was purely the Cash for Clunkers program that artificially stimulated demand. In the fourth quarter, growth of 5.6% was higher than any official forecast just one month prior to the data's release. This time the skeptics claimed that the high number was an artifact of inventory-restocking programs (again not entirely true).
Now that the first quarter of 2010 looks set to surprise on the upside, I am sure there will be another round of excuses. Perhaps the housing credits or the Toyota incentives or maybe even the weather will get the blame for the upside surprise this time around.
Looking further ahead, I believe inflation-adjusted economic growth will be 4% or higher when measured from the lowest gross-domestic-product level, recorded in the second quarter of 2009 through the second quarter of 2010. This would be far stronger than the recoveries from the recessions of 1990 and 2001 but still modestly below the 5% average of all the post-war recoveries. By the end of one year of improvements, many of these recoveries had already seen their best days. In contrast, I believe this economy is just beginning to come to life. Growth, thus far, has come primarily from exports and the consumer.
Consumer spending is now approaching its prerecession high despite high unemployment levels. Consumer spending to date has been driven primarily by attractive prices (particularly via discounts and rebates), falling mortgage and other housing costs, and increased funds from strong stock market returns. While still down from record highs, consumer net worth (all assets minus debts) is now $6 trillion above its lows as net worth moved from $48 trillion to $54 trillion at the end of 2009 and is still increasing. That $6 trillion increase compares to the annual GDP level of $14 trillion. That is nothing to sneeze at.
The negative wealth effect that we have faced for more than a couple of years is now beginning to work in reverse. Even without further asset growth, consumer spending still has room to advance as employment and incomes could begin to expand in the very near future. So far, employment has been a drag on consumer spending as it often is at the very beginning of a recovery.
Production and Manufacturing Showing Signs of Life
I mentioned that consumer consumption has already staged a substantial recovery while the production to support that consumption is just beginning to kick in. So while consumption is nearing its old highs, production, as measured by the Federal Reserve, has only recovered about one third of the ground that it lost during the recession. How can this be?
A meaningful portion of consumption was just shipped out of already-existing inventories that piled up during the panic of late 2008. Those inventories can go no lower in my opinion. Low inventories are already costing some businesses sales that they would have otherwise been able to make. The current inventory/sales ratio recorded by the Federal Reserve was 1.25, the lowest level since the Fed began formally measuring the ratio in 1990. On a year-over-year basis, the sales part of the calculation was up while inventories moved down.
My guess is that even if sales remain lethargic, inventory levels are too low. However, if sales begin to increase at a faster pace, it is conceivable that inventories would have to move up in a meaningful way, aiding economic growth in a recovery, just as declining inventories killed the economy in the recession. To build those inventories, factories will have to step up production which should mean more higher-paying factory jobs, too. That should, in turn, help the service economy where the recovery has been slow.
Business Investment Just Beginning to Make Its Move
Although the consumer makes up about 70% of the economy, improvements in business investments will eventually kick in, too. Although the investment portion of GDP is about one fifth the size of the consumer sector, the swings are far wilder. Thus far the business-investment part of the equation has provided little of the economic growth during this recovery. That is beginning to change.
In 2009 and 2010, there were no entirely new semiconductor plants of any consequence built. In 2011, there are a couple of handfuls of very large new plants on the drawing boards. FedEx also announced recently the expansion of its capital-spending program. The only downside to the business-investment category is that real estate spending is likely to continue to decline through this fall.
Productivity Growth Should Drive Exports
Exports is another smaller category in the GDP accounts that has done relatively well and is likely to be an ongoing factor in GDP growth in the years ahead. U.S. productivity growth remains stronger than in most other nations when measured in a period as short as this recovery or as long as this decade. A well-educated workforce, labor flexibility, and a large manufacturing equipment and software industry all have helped make the U.S. economy a productivity machine as of late. When one also includes the fact that U.S. wages have been more restrained than in most other economies and that the dollar has been weak, some U.S. goods are surprisingly competitive in world markets. Therefore, as long as trade remains open, I believe exports will continue to increase as a percentage of GDP over time as they have during the last several decades.
Modest Recovery So Far--Good News or Bad News?
Although many view the rather-slow economic recovery based on a relatively limited number of categories as a really bad thing, I can see some very real silver linings. It is amazing to me that we have crawled this far out of our economic hole without any improvement in employment or investment spending or very much help from the housing sector. Those are things that will come in months and years ahead, sustaining economic growth for longer than anyone thinks possible today.
Wage Growth and Inflation Continue to Do Battle
Even though I have been more bullish than most, I have still managed to underestimate the strength of this economy. Reviewing my last quarterly piece, just 90 days ago, I thought the economy might grow 3.5%-4.0% in the fourth quarter of 2009. Instead we got GDP growth of 5.6%, higher than most of the other forecasts out there. For 2010, I was estimating growth of 3.5%, which I subsequently raised to 4.5% largely because of higher consumer spending.
There are few metrics out there, including the ISM Purchasing Manager Survey, that suggest that growth could be even higher based on past statistical correlations. I am still standing by my relatively aggressive 3% inflation forecast for 2010, though the early months of 2010 may prove to be well below that.
A stronger, more uneven recovery is the primary reason that I am estimating a higher inflation rate than most. A stronger economy probably still makes long-term bonds a dangerous place to invest. But stronger economy should bode well for the tech sector that is in the midst of a PC upgrade cycle. Transportation names have already moved a lot, and the fundamental outlook is finally beginning to look better as the American production machine begins to gear up.
My biggest fear is now the relationship between consumer incomes and inflation. Non-inflation-adjusted hourly wages haven't shown much growth for some time, but inflation has been very tame. In fact, during some months of the recession, average hourly wages were flat while we actually experienced deflation, basically giving employees the raises that their employers refused to grant them. That phenomenon helped move consumer spending along, especially in early 2009.
Now in 2010, real hourly wage growth still looks anemic, but inflation, especially in energy prices, is beginning to pinch a little. In the months ahead, there will be a contest between the removal of salary freezes, merit raises, bonus reinstatements, and so on, and increasing inflation on the other side. I will continue to monitor this real hourly wage metric closely in the months ahead.
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