On the Brink Again
July 5, 2010
After several weeks in which the markets were obsessed with the euro, we’ve finally seen that link fall apart. This was not so much that the things are better there economically or financially. It’s more of a case in which the euro had a big rally from a heavily oversold condition. Had the euro-stock link still been in place, we would have seen a big stock market rally over the past month and bond yields would have risen. But, the opposite happened. Economic news, largely ignored for the past two months, took over the spotlight. Since December 2009 I’ve been talking about how an ultra-low rate forecast could be realized. When I first started the discussion, I stated this was how I thought things would play out, but the current data was more supportive of the consensus case of a recovering economy and slowly rising rates. Many of you know that early this month I elevated my lower rate case to the most likely case. The Wall Street consensus remains for growth and ultimately higher rates, but I believe the data is now supporting my lower rate scenario. I’ll explain further this month why I believe the odds have shifted.
We’ve also seen Congress in action, or inaction, as the case may be, and the results of their efforts were maddeningly disappointing. As usual, we’ll start with the all-important jobs number released on July 2.
“Less Bad” is Back
Coming out of the depths of the economic cycle in 2009, the markets cheered each time the economic news, and the jobs report specifically, was “less bad” than expected. The numbers were terrible month after month but each subsequent month was “less bad” than expected. This year, expectations had grown after a couple of good reports that the news would be simply “good.” Heading into the last jobs report, the markets were bracing for a very weak report. The reaction to the news was mostly positive, because the news was “less bad” than expected. But the truth is the numbers were not at all good, nor were the details in the report indicative of anything but a weakening economy. The following are the highlights, or should I say lowlights, of the report.
The headline for Nonfarm Payrolls showed a decline of -125k vs. -130k expected as census workers were kicked to the curb. The more important private payroll number rose by 83k vs. the expected gain of 110k. That is a very weak number as the U.S. needs to grow jobs monthly by 125-150k just to stay even.
The Unemployment Rate fell from 9.7% to 9.5%. That will make a good headline and talking point for politicians campaigning at 4th of July picnics and during the subsequent recess week, but the truth is the decline was a very bad sign. The Bureau of Labor Statistics reported a huge drop in the labor force of 652,000, the biggest single-month decline in fifteen years. This means more people are simply discouraged from even seeking work. This is the sole reason the Unemployment Rate dropped. Without that adjustment, the Unemployment Rate would have jumped to 10%.
If the economy were improving, the Unemployment Rate should actually be increasing by this time as more people seek jobs and enter the labor pool. The U-6 unemployment rate, which includes discouraged workers and marginally attached workers, stands at 16.5%. This is exactly the same level as June 2009. We’re one-year deep into a “statistical” recovery, yet the job market remains in a swamp.
Manufacturing payrolls rose by only 9k, the smallest gain in 2010. Construction lost 22k jobs. State and local jobs were virtually flat, but there is a potential bloodbath ahead in that sector. Temp hiring was still positive but has slowed sharply.
Perhaps the worst news in the report was the reversal of the few bright spots in May’s dismal reports. In May, the BLS reported gains in the workweek and hourly earnings. In June, both of those fell and reversed the modest gains in May. This is vital from the overall income-to-spend perspective. Every .1 hour change in the workweek is equivalent to the income from 250-300k jobs.
Bullish market pundits and politicians will try to characterize this as a good report.
While the news wasn’t horrible, this economy is in need of the kind of kick start or booster shot that can only come from true job growth and income growth. This report fell short on all counts.
The Sugar High Crash
Last month I wrote that some special and non-recurring factors led to what appeared to the strength in the first three months of the year. It appeared to me at the time that the data was beginning to turn downward, and the 1st quarter was merely a sugar high. We got more evidence this past month that the sugar high is over.
Consumer Confidence had been rising slowly but steadily for a few months. May’s confidence reading was 62.7. That is still not a good reading as typical recession readings are 70 and expansion readings are near 100. But it was improvement. In June confidence plunged to 52.9. Consumers cited job and income concerns as worsening. In purchase plans, we saw big declines in plans to buy major items in all categories (including homes) in the next six months.
This attitude showed up in stores and auto dealers in May and June. Retail Sales fell very sharply in May in all categories. We’ll get June’s Retail Sales number on July 14, but major retailers are reporting that sales are “under plan.” Auto sales for May were reported at an 11.6 million annualized rate, but the rate slumped to 11.1 million in June. Remember that 15 million units annualized has been the historical norm. But the rates for May and June were biased higher due to big fleet purchases from rental agencies. Without those sales, the annualized rate would be 10.7 million.
Last month I wrote about why I felt that housing was due for another slide later this year, and the latest data reinforced that. Home sales are clearly in a freefall. While that was expected after the home tax credit expiration, the indications are that the retreat will be far more severe than expected. We’re now in the middle of the season that is supposed to be the best for home sales, but there are no signs that the home tax credit provided anything but a sugar high.
What seems most incongruous about home sales is that the plunge in mortgage rates to historic lows seems to be having no impact in demand at all. Financing a home for thirty years at a rate of 4.5% instead of 5.0% dwarfs the financial impact of the $8,000 tax credit. Yet, buyers remain scarce and scared. I guess mortgage rates don’t matter if you don’t have a job or are worried about losing one. It’s clear that affordability, which is better, and mortgage rates, which are historically low, don’t really matter after all. It’s all about jobs. The home market boomed from 2004 to 2007 when mortgage rates were roughly 6% and prices were at all time levels of un-affordability, but the Unemployment Rate stayed between 4.5% and 5.0% for those years. If there was ever any doubt, I think we now know that the only thing that really matters in housing is jobs.
This retreat from whatever strength the consumer was showing is coming at a very bad time. Businesses were busy rebuilding inventories in the first few months of the year in anticipation of improved economic conditions and sales. That rebuilding of inventories appears to be complete. Businesses will continue to maintain this level of inventories only if they feel the economy is on the right track. Evidence is to the contrary now and threatens to turn into a bout of inventory liquidation. Business confidence was not high to begin with but had improved in 2010. Recent sales results, the jobs reports, and worries about the stock market and the housing market could easily turn business confidence upside down.
Financial Flop
Congress was able to hammer out a financial regulation bill that gives the top five or ten largest banks the one thing they really wanted – to be left alone. At this time, the bill is stalled in the Senate, but ultimately the bulk of the bill will be passed. The delay will probably result in further watering-down. The 2,000 page bill does absolutely nothing to address the “too big to fail issue.” To address that issue, Congress would have had to enact regulations that would force “risky” activities into completely separate entities away from the banking side. This would have cost the banks capital and likely discouraged them from those activities. Instead, the very minor changes will allow the big investment banks to continue on leveraging up riskier activities and wallow in the 0% funding costs the Fed is providing. The much vaunted “Volker Rule” was supposed to address this issue of the separation of “risky” activities. But in the final version, banks are still allowed to have capital devoted to hedge funds and will have up to twelve years to meet the limited restrictions and separations. It’s still called the “Volker Rule,” but Volker would most likely want his name removed. According to a Bloomberg report, sources close to Volker say that he is very disappointed in the watered down version.
For longer-term financing, those top five to ten banks can also continue attracting money at a low cost since investors will now be comforted those banks are clearly too big to fail. The last institutions that investors poured money into under the too-big-to-fail guise were Fannie and Freddie. The investment banks poured millions and millions into the coffers of Congress to limit anything that would hamper this elite private club – and they won. At least that’s the cynical interpretation. Feel free to differ.
There are some losers in the bill. Those losers are institutions deemed not-
too-big-fail. They were never in a position to reap profits from the investment banking activities like the big boys, but those institutions will now be faced with an ever-growing mound of compliance paper work brought on by the other provisions in the bill. There are some modest benefits to consumers, but the overall bill will make consumer business less profitable to financial institutions.
Costs to consumers will rise and loan availability will fall. This will hurt credit unions without a doubt. But, we can also hope for unexpected benefit. This bill will encourage big banks to put their main focus squarely on major corporate accounts and investment banking business. Consumer banking will get only lip service. I believe that credit unions might actually gain from this as banks continue to drive off retail customers. Credit unions will have to work harder and smarter for the business, but the consumer business is all they do, not a just a part of what they do.
The long overdue financial reform bill falls short on all the key components. Republicans and Democrats can share the shame for another colossal failure.
The Biggest Losers
The biggest losers from recent Congressional activity are already in the loser category – the unemployed. While Republicans get most of the blame for this one, the Democrats should have been able to find enough ground for compromise to pass the extension of unemployment benefits. But the unemployed only know they have been suddenly cut off from a vital lifeline. By the end of second week of July 2,000,000 families of workers will have seen their benefits ended, and the numbers will grow exponentially from there. The number will hit 3,000,000. States were also counting on the extension to help fund Medicaid programs. Now states will be in even worse shape. They were counting on $16-24 billion in funds.
Aside from the personal costs, the failure to extend benefits will have an economic impact. Some economists say this will shave .5% off of GDP in the second half of the year. Those receiving benefits tend to spend the entire amount and very quickly.
Some critics say that extended benefits encourage people to not look for jobs. I don’t know where they get that information but they toss that around as irrefutable. This might be true in an era of 4% or 5% unemployment. There are always those small percentages of people trying to game the system. But you cannot argue that 10% of our work force is out to game the system. A recent study by a highly respected university showed that the difference in time to find a new job between for workers without benefits and for those with benefits was 1.4 weeks.
Oh, there were some winners in the defeat of the unemployment extension bill. One proposal to help pay for the bill was to eliminate a big tax break to private equity and hedge funds. Gee, I wonder if that had anything to do with the defeat of benefits.
If the economy was truly in a growth phase relative to jobs, this wouldn’t be such a tragedy. But the true unemployment rate is 16.5% - and that’s according to the Bureau of Labor Statistics. Over the past two years, billions in spending has breezed through Congress to bailout banks, car companies, Fannie and Freddie, and AIG. More billions have been foolishly wasted in programs like cash-for-clunkers, appliance freebies, home tax credits, and mortgage “relief” plans. Let’s also not forget the $780 billion stimulus bill and the hundreds of billions spent on two war fronts. After all of this, Congress decides the $30 billion needed to extend benefits to those most devastated by the economy is the place to draw the line? How can Congress turn such a deaf ear to those people? Oh, that’s right. Those people didn’t have money to rain down on Congress. I’m sure there are many men and women in Congress trying to do the right thing. It just seems that money gets in the way.
The Future Might Come Sooner Than We Think
Stocks closed the first half of 2010 with roughly a 7% loss on the year, and stocks are down roughly 12% from the April high. That’s not a significant loss in this volatile market. But the market people should be paying more attention to is the Treasury bond market. Rates have fallen to lows not seen since April 2009. As many of you know, I have been calling for the 10-year note to hit 2.00% by the end of 2011. The way this market is trading and investors are reacting, I might have to escalate my time frame.
The 10-year note did briefly hit 2.00% at the end of 2008 as uncertainty drove money managers and banks to boost treasury holdings to report on balance sheets at the end of 2008. This was mostly due to window-dressing, and yields rose soon after the turn of the year. But this current move lower in yields has come from all sectors of investors. Buying has been heavy and relentless, despite growing supply of new Treasury issues. Every step lower in yield has been greeted with skepticism from market pundits, but this has not deterred major institutional buying. I believe this is evidence that, despite the still bullish consensus on Wall Street, major money managers around the globe are anticipating the scenario I’ve talked about this year. We’re in for low rates for years to come - a sluggish and vulnerable economy, weak housing, weak income growth, and a deflationary environment. The next time the 10-year note hits 2.00% we’re likely to have to live with it for a long time to come.
Of course I always like to end my happy monthly tome with a note of optimism. No, really I do. As I've said often, I hope I'm wrong about this scenario. The one thing now that does make me think perhaps I will be wrong is that I'm getting a lot of company in my campground. The bullish outlook is still very much the consensus, at least on Wall Street, but, there are clearly more investors leaning my direction and a growing bloc of pundits and economists tiptoeing in on the bearish side. If and when the dark view becomes the consensus view, I'll be looking for the nearest exit.
Dwight Johnston
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