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Dwight Johnston
Vice President, Economic & Market Research
False Impressions
From Dwight's February Long-Term Commentary
Equity traders entered January with optimism that a solid rebound in stock prices was in store for the month, which would then propel stocks higher for all of 2009. Instead, the S&P delivered the worst January performance on record. The combination of relentlessly negative economic reports and rising concerns on the state of the banking industry led to the dismal January.
February began with an improved sense of optimism as the fiscal stimulus package was nearing completion. The pros and cons of the stimulus package under consideration were many, but the general consensus was that any package of $800 billion or so would have a positive impact. But more than the fiscal stimulus package, the market focused on the expected new banking solution strategy promised by Treasury Secretary Geithner. There were numerous "leaks" ahead of the announcement, and the enthusiasm was generated not that it would work better than previous "solutions," but because it would avoid the nationalization of any of the major banks. That fear had driven the stocks of Bank of America, Wells Fargo, JP Morgan, and the like to extreme new lows.
The combination of the fiscal stimulus package and the bank rescue strategy left the markets with the impression that the gears were finally in motion to turn the economy and the market around. But, to borrow the title from the 1994 movie, "Reality Bites."
Fiscal Stimulus - A Cure or a Sugar High?
Any hopes that the fiscal stimulus package would be innovative or forward-thinking were immediately dashed by the version passed by the House. The Senate version weakened the bill further as the same old tax cuts vs. spending debate forced compromises that watered down some key elements.
At the time of this report, we still don't know what the final bill will look like, but it certainly doesn't look like a cure for long-term job woes. That was an unrealistic expectation to begin with, but this bill seems to fall short of some basic needs. Roughly half of the bill contains funding for unemployment benefits, food stamps, and other social safety net programs that simply must be funded. The rest of the bill contains a hodgepodge of spending and modest tax cuts for taxpayers and businesses, most of which will have no real impact until 2010 at the earliest. Most disturbing is a missed opportunity. The Senate bill slashed $40 billion in aid to states to close budget gaps. This might seem like a victory for states without budget woes, but it will be a victory with a cost for all. The original amount of $79 billion was to bridge budget gaps in a multitude of states (not just California) that will otherwise be forced to cut payrolls and other programs.
"State and local governments" is the largest single sector of employment in the U.S. with twenty million workers. Should that sector's payrolls be cut by 10 percent, it would add a total of two million in job losses this year and next. These cuts will reduce payrolls in various state agencies, teachers, police, etc. States are also going to be forced to close public hospitals and end various successful programs that are directed toward job training, vocational education, and after-school care and youth activities. The impact on health services for the poor and for other program participants is obvious, but these efforts also employ a large number of caregivers and service personnel. This is a real missed opportunity to at least eliminate a major potential source of more job losses. We should eventually demand better fiscal management at the state and local level, but now is not the time to pare back.
The $40 billion cut from the states, which could impact many, showed up as a tax credit for just a few others. The Senate version included a $15,000 tax credit for the purchase of a home. This would not be limited to first-time buyers or new homes. It's great news for potential home buyers who still have jobs, but it is not stimulating. Most of the bargains in the home market are in existing homes. There is nothing stimulative about giving buyers $15,000 to purchase an asset that already exists. The justification is that this will help to stabilize the housing market. The fact is that the housing market is already well down the road to reaching levels of affordability that can be sustained-as long as people have jobs. This tax credit is good news for a few, but it will do nothing to generate jobs.
Now that we've given some of the reasons why the fiscal stimulus bill is bad, we'll give the lone reason it is good. It's a lotta money! No matter how poorly constructed the bill might be, $800 billion will have an impact. That much money will find its way into the economy. We'll likely see at least one quarter of positive GDP growth later this year, but there is little to suggest that we can look for a boost to employment over the longer term. But should the modest rebound later this year coincide with some rebound in business inventory rebuilding, it is possible this could generate some positive momentum. Currently it appears the bill will produce nothing more than one or two quarters of a sugar high and can't alone produce an economic recovery. But should the wall of money crash into the economy at a favorable time, maybe the mix will be surprisingly positive.
Geithner's Gaffe
By permitting a number of leaks ahead of his announcement of the latest version of a bank rescue plan, Geithner allowed market expectations to exceed anything he was ready to deliver. The primary criticism of Paulson was that all of his previous responses to financial problems were reactions to the crisis du jour and were consistently not well thought through in advance. Geithner has been part of the Paulson/Bernanke team for the past two years of dealing with the crisis, and this was his moment to separate himself from the failures of Paulson. He failed on this point.
On the positive side, he did announce that the Fed's TALF program to buy new consumer asset-backed securities would be expanded from the initially proposed $200 billion to $1 trillion. With capital concerns at the top of the list, banks have limited capacity to add loans to balance sheets, and the securitization market has been virtually shut down. This plan would allow them to be more aggressive in making consumer loans and package them in securities for sale. The question is do consumers really have that much demand?
In the latest Fed report on consumer credit, the Fed reported than non-mortgage consumer credit fell by more than $17 billion in November and December of 2008. Compare this to growth of $24 billion in same months in 2006 and almost $18 billion in 2007. Clearly this was due to consumers paying down bills, not banks cutting off credit. This is a trend we believe is firmly in place. The TALF funds will aid consumer lending, but the loan growth might be outpaced by debt paydowns.
Geithner's biggest perceived failure was the lack of any substance to his plan to form a joint public/private fund to buy toxic assets from banks. He vaguely said the fund would start at $500 billion and could be as large as $1 trillion. But he offered no insight as to how the program would operate. He said details must be worked out over time in order to "get it right." After almost two years of failed pilot programs under Paulson, markets are wondering what it will take to "get it right."
From time to time we hear various politicians raise the issue of temporarily suspending the current mark-to-market accounting methodology. In more polite terms, this would be called "regulatory forbearance." A temporary suspension was last used during the S&L crisis. The criticism was that some S&Ls used the relief to swing for the fences in last ditch efforts to save their failing enterprises. This made the crisis even worse. But regulators back then allowed this to happen. Rules could be put in place to prevent that from happening this time. According to The Wall Street Journal, about 40 percent of the almost 1,000 institutions granted forbearance either were eventually acquired by other institutions or emerged healthy on their own. The truly bankrupt institutions did fail. But for some inexplicable reason every time changing accounting rules is brought up, it is just as quickly shot down. We can't find a good explanation for the fact there isn't at least a full, open debate in Congress on this issue. If forbearance can prevent 40 percent of the failures this time around, the dollar value savings would dwarf the savings in the S&L crisis.
In the Meantime, the Slump Deepens
In the January ALCO report, we made the case for a bottoming in job losses sometime in 2009. Clearly, that process has not yet begun. The latest loss of 598,000 jobs brought the five-month total job losses to more than 2.5 million. The string of four months in a row of job losses in excess of 500,000 is the first time this has happened since payroll reporting began. Hours worked remained at all-time lows, and hiring of temporary workers plunged again. These last two items are considered leading indicators of employment. The household survey, separately from the payroll survey, revealed that the Unemployment Rate jumped from 7.2 percent to 7.6 percent. This is a two percent increase in unemployment over a six-month period, the biggest increase over that time frame since the 1930s. The household survey showed employment down 1,000,000 on the month.
The surveys for the January report were taken on the week of January 20. Since that time, Weekly Jobless Claims have accelerated. The most recent survey week showed a jump in claims to 626,000. Should this level of claims be sustained during February, we could be looking at a decline in Nonfarm Payrolls of 700,000 for the month.
There were no bright spots in the most recent report. We'll keep looking for the light at the end of the tunnel.
In previous reports we stated that we thought the worst quarter for GDP might be the fourth quarter of 2008, but that has now been pushed out to the first quarter of 2009. The Commerce Department said that fourth quarter GDP fell by only 3.8 percent. But higher business inventories contributed a positive 1.3 percent to overall GDP. In good economic times this is a positive in that businesses are building inventories due to expectations of increasing sales. In this case, rising inventories were the result of faltering sales. In other words, the gain was unintentional accumulation. This means that in this current quarter, businesses are likely to cut production back further that expected. We believe we are seeing that in the big payroll cuts we have seen. Perhaps inventory liquidation growth this quarter can set the stage for growth in future quarters. Let's hope that declining sales don't again outpace reduced production, or we'll be in the same spot during the second quarter that we're in now.
The Markets - One Clings to Hope, One to Fear
After the encouraging start to the New Year that saw the Dow trade more than 9,000, the market conditions worsened considerably. The S&P decline of 8.6 percent in January was the biggest January decline on record. Since that time, the Dow has been dancing round the 8,000 level. The key remains the financial sector. The overall market improves on any positive news on financials and declines on negative news such as the Geithner announcement. Despite a dismal performance so far this year and the consistently worse-than-expected economic reports, stock traders remain bullish for 2009. We hear the gloom and doom, but stock traders are clinging to hopes of a major rebound. The put/call ratio is back at levels not seen since the big October 2007 rebound. Money manager surveys all remain overwhelmingly bullish. If you are a contrarian, these signs unite to form a big red flag.
Although rates remain very low by historical standards, rates have risen sharply since year-end. The primary concern in the bond market is not related to any fears of an improved economy or a reversal of monetary policy by the Fed, but it is directly related to concerns about the market's ability to withstand the onslaught of supply. Recent large Treasury auctions have gone surprisingly well, but traders are fearful the supply will eventually require higher rates. I suppose it's just in the nature of bond traders to be more fearful than stock traders.