Recovery Revs Up

by Anirban Basu 13. April 2010

Economy Expanding as Predicted, but Will the Run Last?

The nation has strung together two consecutive quarters of growth with 2009:Q4 annualized growth registering 5.6 percent (third estimate).  Employment is now expanding and the unemployment rate has been declining in recent months.  A close inspection of fourth quarter GDP reveals a promising shift away from pure dependence upon government spending to a broadening economic expansion.  Of central importance is the ongoing rebound in retail sales and in consumer confidence.  Year-over-year sales growth is now positive, though the comparison months were of course in the immediate aftermath of the financial crisis that began in September 2008.

Sage does not anticipate a brisk recovery as tight credit, an unsettled and unsettling federal policymaking environment, subdued expansion in various parts of the world including much of Europe, double-digit or near double-digit unemployment rates for months to come and the expectation that policy support for the economy will begin to wane within the next twelve months.

In fact, policy support will begin to wane well before the next twelve months.  As of this writing, Federal Reserve purchases of collateralized mortgage backed securities have been over for two days, which implies that the era of ultra-low mortgages may soon be coming to an end.  Moreover, rumors continue to circle both Freddie and Fannie, and with the federal guarantee of their balance sheets now explicit as opposed to implicit, there will likely be calls for Freddie and Fannie to slow down their purchases of mortgages.

One of the other reasons to believe in the sustainability of the nation’s nascent but weak recovery is the recent performance of financial markets.  On March 9, 2009, the Dow Jones Industrial Average reached a cyclical low 6,547.05 after dipping to an intraday low of 6,469.95.  Since that time, stock prices have enjoyed a roughly 75 percent retracement, replenishing wealth and signaling confidence in corporate earnings.

During the third quarter, roughly 5 in 6 large U.S. companies reported earnings that exceeded expectations.  Moreover, if U.S. stocks were valued at 15 times their expected 2011 earnings by the end of 2010, the S&P Index would be approaching 1,365, about 16 percent higher than the level at the time of this writing (1,178; April 1st, 2010 market close).  This implies even more wealth generation, which could be enough to allow for sustained economic momentum into and through 2011 despite expectations of rising interest rates and taxes at that time.  Fourth quarter GDP report was also consistent with the notion of rising profits and that may be just enough to keep the recovery going into and through 2011.

In many ways the recovery that began during the summer of 2009 is quite ordinary.  As with typical recoveries, financial markets first began to recover followed by GDP growth.    Now comes the final big piece in the puzzle:  job growth.

In January the nation gained 14,000 jobs (revised estimate) and then lost almost precisely that number of jobs one month later.  In March, the nation added 162,000, the first six-digit increase for the U.S. economy since November 2007.  Through March, unemployment has remained steady at 9.7 percent and may fall during the months ahead due to Census hiring.  However, Sage continues to expect that once Census jobs dissipate, unemployment will begin to expand again as more Americans rejoin the labor force.  Despite the recent employment momentum, underemployment issues remain elevated and there has been little sign of progress along that dimension.

Exhibit 1: National Nonfarm Employment Net Change, February 2006 – March2010

Looking Ahead

The last few months have been surprisingly good.  As of this writing, the Dow Jones has rebounded to around 10,900 on the Dow Jones Industrial Average (the Dow began the year at 10,430) and the S&P 500 at around 1,170, up from a 52-week low of 783.  That represents a 52-week retracement approaching 50 percent for the S&P.

Perhaps the most positive indicator of all is the recent expansion in exports, though exports dipped modestly in January.  Most economists seem to agree that massive growth in U.S. exports is required if the nation hopes to maintain current living standards or to improve upon them.  Our concerns revolve largely around the second half of 2010 and 2011.  As stimulus impact ebbs as interest rates rise and as past tax cuts lapse, the economy will become increasingly vulnerable.

Indeed, as we move through 2010, Sage is looking to a number of key economic variables to determine its 2011 forecast.  The first is the performance of financial markets, which have recently done more than a passable job in predicting the trajectory of the economy.  The Dow Jones

Industrial Average peaked at 14,164.53 on October 9th, 2007 before beginning what was then a slow, steady descent.  Two months later, the economy was in recession.  More recently, the market has been trending higher on low volatility.  Perceptions of risk have abated massively in recent weeks and if economic data continue to be strong and largely unidirectional the market liftoff could continue.

The second set of indicators relates to business investment.  Sage is particularly keen to observe increases in business investment that do not appear directly related to government spending.  Industries that appear best positioned to ramp up investment include exporters and energy suppliers, though still tight business credit will serve to limit the pace of investment expansion.

A third indicator will be bank lending.  As corporate profits expand and help repair balance sheets, Sage expects that bank purse strings will loosen.  Higher long-term interest rates, which are anticipated as the economy marches toward 2011, should help induce more rapid velocity of money.

Things are Better, but You’re Still Nervous

by Anirban Basu 14. January 2010

So are we...

Here’s the good news – 2009 is over. Here’s some more good news – 2010 will be better for the economy. Here’s the bad news – 2011 might not be and that implies that 2010 could be a volatile year for stock prices, which appear to lead the economy by six months or so. Bottom line: you should be prepared for a roller coaster ride this year as investors experience mood swings in the face of rapidly shifting economic forecasts and a world replete with geo-political uncertainty.

One might be tempted to dismiss this gloomy chatter. After all, the gloom and doomers have been talking about foreclosures, weak bank balance sheets, high unemployment, etc., for months only to watch the market surge ahead, creating significant wealth for believers in the process. In other words, since March of last year, it hasn’t paid to be a contrarian. After a January/February 2009 market swoon that left markets tapping against lows not felt for a decade, U.S. equities presided over a massive rally that began on March 9th and lasted virtually through the balance of the year with almost no interruption and reduced volatility. The S&P 500 rose nearly 24 percent for the year, while the more heavily cyclical and economically sensitive tech-laden Nasdaq was up a whopping 44 percent.

Investors in certain global markets fared even better. After a miserable 2008, the Shanghai Composite expanded 77 percent last year. Both the Borsa Italiana and Hong Kong’s Hang Seng Index were up more than 50 percent and many other global markets enjoyed returns between 20 and 30 percent.

While some observers may attribute these rallies to the liquidity-enhancing actions of policymakers across the world, the fact of the matter is that one of the primary drivers of equity performance last year was the return of corporate earnings. According to Morgan Stanley, operating earnings per share among S&P 500 companies were down 40 percent in 2008. But last year, they were up approximately 15 percent and are expected to be up 36 percent this year. It is for this reason that there are many who believe that the rally that began in March of last year can only continue.

The Case for Stepped-Up Volatility

As investors know, what makes a market is disagreement. Every exchange of assets, whether stocks, bonds or real estate is a reminder of the differential expectations and valuations between us. In our view, the gap in beliefs is growing as emerging optimism is countered by a growing sense that the good times simply cannot last forever and that reversals of momentum in corporate and economic performance may occur sometime later this year.

For now, economic momentum remains firmly in place. GDP expanded at an annual rate of 2.2 percent during the third quarter of 2009 and as of this writing the consensus forecast for the fourth quarter is north of 3 percent. Job loss has slowed to a crawl, with the Bureau of Labor Statistic’s initial estimate for December standing at -85,000, a far cry from January 2009 when the nation shed more than 700,000 jobs. In November, the nation actually added 4,000 jobs according to the standing estimate.

Reinforcing emerging domestic economic momentum is a synchronized global recovery. Economists from the IMF and other prominent institutions expect big growth years from China, India, South Korea, Brazil, South Africa among others. This creates more global wealth available to pour into equities and other assets as well as an environment conducive to expanding U.S. exports. Morgan Stanley Smith Barney economists expect that the global economy will expand more than 3 percent in 2010. Developing economies are expected to expand 6 percent while developed ones will expand about 2 percent. The U.S. is expected to outperform the collective performance of the balance of the developed world.

Based on this, how can anyone craft a case for enhanced volatility and perhaps even a reversal in market fortunes? The answer is that there are so many gray clouds out there that the likelihood of rain remains elevated. Take the inflation debate as an example – one that promises to intensify in 2010. As has been said before, inflation is everywhere and always a monetary phenomenon. Well, we got money. Both the Federal Reserve and the Federal Open Markets Committee have undertaken a set of unprecedented actions over the past 18 months as they moved the Fed Funds rate to virtually nothing and the balance sheet swelled to more than twice its pre-crisis measurement.

But what can be given can be taken back. The treasury debt purchase program that began during the spring of last year ended in October. The Fed has also announced a tentative cessation of its purchases of mortgage-backed securities at the end of the first quarter of 2010 with an aggregate purchase target of roughly $1.425 trillion. It was the commitment to the purchase of these assets that helped drive down mortgage rates. If the purchases stop, mortgage rates could rise by 1 percent or more in very short order.

Monetary policy will generally become tighter over the course of the year and increasingly the economic impact of the American Recovery and Reinvestment Act of 2009 will begin to wane as we approach 2010. Add it all up and the economy remains at risk of another recession or at a minimum an economic slowdown that batters corporate earnings growth; perhaps in 2011 or 2012 if monetary accommodation is pulled back too quickly. As theories of our collective economic future begin to diverge more forcefully over the months ahead, investors can anticipate a heightening of volatility.

Anirban Basu is Chairman & CEO of Sage Policy Group, Inc., an economic and policy consulting firm in Baltimore, Maryland. Mr. Basu is one of the Mid-Atlantic region’s most recognizable economists, in part because of his consulting work on behalf of numerous clients, including prominent developers, bankers, brokerage houses, energy suppliers and law firms. On behalf of government agencies and non-profit organizations, Mr. Basu has written several high-profile economic development strategies, including co-authoring Baltimore City’s economic growth strategy.

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