The Recession & What To Do About It
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. The Latest Economic Numbers
2. On Inflation & The Fed
3. “The Double Dip Supply Shock”
4. Conclusions – What Next?
5. Investing In Today’s Dicey Environment
The major investment markets seem perplexed this year. Questions abound. Are we in a recession? Not according to the textbook definition of two back-to-back quarters of negative growth in GDP. Nevertheless, US consumer confidence has plunged to a 16-year low as oil and gasoline prices continue to skyrocket. Yet surprisingly, American consumers continue to spend at a growing rate, as I will discuss in more detail below.
With consumer spending accounting for apprx. 70% of GDP, it’s no wonder that we haven’t seen a negative quarter of GDP. In fact, GDP surprised on the upside in the 1Q with a modest gain of 0.9%, following the 0.6% rise in the 4Q of last year. Pre-report estimates suggest that the 1Q GDP number may be revised upward to 1.0% or better on June 26 when the final report is released. But that may be the last of the good GDP news. Most analysts expect GDP to decline in the 2Q as I will discuss below, and perhaps in the 3Q as well.
The Fed seems to be sending signals that the near year long rate cutting cycle has come to an end. With food and energy prices soaring, the Fed risks letting inflation get out of control, and more and more analysts are predicting that the Fed will begin raising rates later this year, perhaps as early as the August 5 FOMC meeting. But can the Fed risk raising rates at a time when the economy is expected to be contracting and the housing/credit crunch is far from over?
For some independent insight and analysis on the economy and the Fed’s dilemma, we turn to a new report by Morgan Stanley economists Richard Berner and David Greenlaw, which I think you’ll find insightful but not very comforting.
Finally, I will reiterate some suggestions for how you should be investing in light of today’s increasing risk environment. Let’s get started.
The Latest Economic Numbers
Of course, the worst news of late was the much larger than expected jump in unemployment in May. The unemployment rate surged from 5.0% in April to 5.5%, the largest monthly jump since 1986. Employers cut 49,000 jobs last month. In addition the Labor Department revised upward its estimates of unemployed workers in April and March.
On balance, the economic reports of late support predictions that 2Q GDP will be in negative territory. How negative remains to be seen, but I would be surprised if the number is much worse than –1%. Unfortunately, we won’t get the first official look at 2Q GDP until late July when the Commerce Department issues its “advance” report.
On Inflation & The Fed
Since April 30, however, oil prices have surged above $135 per barrel and gasoline prices have spiked to over $4 per gallon nationally. Corn prices skyrocketed to over $7 per bushel, an all-time high, and numerous other commodities are at or near record highs as well. Obviously, commodities prices – especially energy – do not appear to be leveling out as the Fed expected.
Thus, over the last few weeks, Fed Chairman Ben Bernanke has sounded more hawkish about interest rates. So have some of the Fed governors who are members of the FOMC. While the general consensus is that the Fed won’t raise rates on June 24-25, the futures markets are now priced for a 25 basis point increase in the Fed Funds rate in August or September and perhaps more before year-end.
The Fed considers keeping inflation under control as one of its primary mandates. So it remains to be seen just how far they will go, what with the housing/credit crunch far from over and the economy appearing to be on track for at least a couple of quarters of negative growth. As recently as a couple of months ago, most analysts felt the Fed would simply hold the Fed Funds rate unchanged at 2% for the rest of the year while the credit crunch plays out. That would be great, but the commodities markets are not cooperating on the inflation front.
If the Fed raises rates too early or too far, what looks to be another mild recession could turn out to be much more severe, and that will be bad news for the equity markets. If the Fed doesn’t act sufficiently, that will be bad news for the bond markets. Sounds like a good time to have a “long and short” strategy in your portfolio. But I’m getting ahead of myself.
Let’s first see what some other well-known analysts are thinking at this point along the road. What follows is the latest analysis from Morgan Stanley economists Richard Berner and David Greenlaw.
A double-dip recession is coming, courtesy of soaring energy prices and the ongoing restraint from the housing downturn, falling home prices and tighter financial conditions. Despite recent economic resilience, we’ve trimmed our growth prognosis by three quarters of a point over the four quarters ending in Q2 2009 to 0.5% from 1.3% last month, with modest declines now likely in both the spring and autumn quarters. Surging energy prices likely will boost headline inflation to 5-5½% over the next few months, and risks are rising that the consequent escalation in inflation expectations will spill over into a more lasting increase in inflation. Our year-over-year inflation forecasts (in terms of the CPI) for both 2008 and 2009 are now 70 bp higher in both years, at 4.6% and 3.5%, respectively. Although we think that the current episode is quite different from the miserable 1970s economy, the result − like that long feared by our colleague Joachim Fels − will feel like a prolonged whiff of stagflation. Indeed the risk is that the 1970s ‘misery index’ − the sum of the inflation and unemployment rates − will rise above 11% at some point in the next year. We have long agreed that investors should pay heed both to downside risks to growth and upside risks to inflation. Here’s why.
This most recent downgrading of our growth prognosis may seem strange at first blush. Despite a prolonged housing downturn, the influence of a credit shock, and the early effects of the recent surge in energy quotes, there’s no mistaking the better-than-expected performance in recent and incoming data for the first half of 2008. First-quarter real growth was revised higher to 0.9%, and we expect a further upgrade to 1.1%. And we now expect a second-quarter decline of just 0.7%, compared with 2% last month. The reasons: Vigor in capital spending and the influence of strong global growth on net exports more than offset the headwinds buffeting housing and consumer outlays.
As evidence, a healthy 4% jump in April nondefense capital goods orders and increases in shipments point to smaller declines in business equipment spending than we thought last month. Strong April results and upward revisions to prior months’ data for nonresidential construction indicate a sizable increase in Q2 spending. And while exports tumbled in March, possibly reflecting the first signs of slower global growth, imports plunged by more, suggesting more support from net exports than anticipated. Finally, expected price hikes may be prompting some firms to buy goods in advance and hold them in inventory, limiting the slide in stockbuilding.
Indeed, there is a risk that the tax rebates for individuals and the business tax incentives in the Economic Recovery Act of 2008 will promote a stronger result than the 0.7% decline we estimate for Q2 real GDP. As of the end of May, consumers had received $50 billion in tax rebates. Although vehicle sales remained depressed last month, May’s better-than-expected retailing results at chain stores could reflect the first signs that consumers will spend a portion of the rebates sooner than we think. Likewise, the ‘use-it-or-lose-it’ nature of the investment incentives may be triggering some capex [capital expenditures] gains, albeit at the expense of 2009.
Four ‘Adverse Feedback Loops’
Nonetheless, the analytics we see unfolding point to more economic weakness ahead. In particular, four ‘adverse feedback loops’ create downside risks to growth, especially to the consensus view that the economy has skirted recession and that a stronger second half is likely.
First, the interplay between the housing downturn, falling home prices, deteriorating credit quality, and lender caution is undermining consumer wealth and ability to borrow. With inventories of unsold new homes still at 10.6 months’ supply, and foreclosures contributing to resale availability, a further 30% decline in 1-family housing starts seems needed to bring supply into balance with demand. Although housing affordability has improved with falling home prices and interest rates, price declines are keeping would-be buyers and lenders cautious. The first-quarter rise in delinquencies on 1-4 family loans reported by the Mortgage Bankers’ Association and chargeoffs on residential mortgages reported by banks − to 6.4% and 0.8%, both new records − has doubtless reinforced that caution. Household net worth in relation to income has declined by 35 percentage points (to 533%) in the 15 months ended in March. Recent surveys from the University of Michigan suggest that cautious consumers ‘are more interested in reducing their debt and increasing their savings,’ and 57% of respondents opined that banks were less willing to lend than before. So while our assumption that only 20% of the tax rebates will be spent may be too low, these factors suggest that their impact will nonetheless be limited.
The second adverse feedback loop stems from the supply-induced surge in energy prices that will undermine discretionary income in the US and abroad, probably depressing consumer spending and challenging the vigor of global growth. If gasoline prices nationwide peak at $4.25/gallon − hardly a bold forecast given the 20-cent surge in wholesale gasoline prices last week and the fact that prices averaged $4.03/gallon the week before − and if food prices rise at a 4.2% annual rate between May and September, the rise in food and energy quotes will have drained nearly $180 billion annualized from consumer budgets between December 2007 and September 2008. By comparison, the rebates will total $117 billion over all of 2008 [emphasis added, GDH.]. Outside the US, countries such as India, Indonesia and Malaysia are reducing the subsidies that have long helped their consumers pay below-market prices for energy. The resulting price increases, combined with those in many other economies around the world, will erode spending power and thus global growth.
A third feedback loop involves slipping profitability, tighter financial conditions and economic uncertainty that will likely slow capital spending and hiring. This feedback loop is especially important for lenders: Weaker economic growth will erode credit quality and make lenders more risk averse, tightening lending standards further. While capital spending seems to be holding up for now, hiring is clearly fading. Nonfarm payrolls have declined by an average 65,000 in each of the last five months, and for all the talk of how little payrolls have declined in this slowdown, the current pace is identical to the pace of decline seen in the first five months of 2001. Combined with sliding real wages, these job declines signal declines in real wage and salary income for the first time since 2001.
Finally, rising inflation and inflation expectations in Europe likely rule out monetary ease and could prompt the ECB to tighten. And in many emerging market economies − including China, where officials just announced a 100 bp hike in the ratio for required reserves, and Poland, Turkey, Israel, South Africa, Brazil, Peru and Columbia − officials likely will tighten monetary policy further to fight rising inflation. ECB officials and those elsewhere will welcome slower growth to bring down inflation pressures, and it seems likely they will eventually get their wish.
For the first time in 35 years, we expect global forces will significantly push up US inflation, and the Fed faces the most serious inflation threat in a decade or more. Surveyed inflation expectations are rising sharply, echoing rising energy, food, and import quotes, and those hikes now threaten to spill over into domestic pricing. Measured by the University of Michigan’s 5-10 year median, inflation expectations rose in May to 3.4%, a 13-year high. The doubling in energy quotes over the past year is affecting pricing in a broad array of industries, including transportation, agriculture, chemicals, construction and construction materials. Thus, core intermediate goods producer prices rose at a 9.4% annual rate in the six months ended in April, and more hikes are coming. Prices for imported consumer goods excluding motor vehicles rose by 2.8% in April, the fastest pace in 15 years.
These developments potentially could create a vicious inflation circle, because the rise in energy, food and import prices is affecting inflation expectations. And we’ve long argued that the dollar and oil prices might become locked in a vicious circle of their own, as oil producers seek to hedge their currency risks with higher prices. The good news is that these inflation pressures do not so far appear to have filtered into the wage setting process. Instead, they are squeezing margins in private industry and budgets for state and local governments. Over time, growing slack in product, housing and labor markets and hearty productivity gains will help mitigate the threat of a wage-price spiral. But that more benign picture is a story for 2009, when operating rates slide more significantly and the jobless rate rises to 6%, not now.
This setting clearly poses a dilemma for the Fed. As we see it, the resolution lies in leaving monetary policy on hold until spring 2009 − far longer than is currently priced in to financial markets. Indeed markets oddly are priced for a first rate hike as soon as the late-October FOMC meeting, just when the stimulus from tax rebates will be fading, and at least some ‘payback’ in growth is highly likely. Despite the coming economic weakness, the rise in inflation and surveyed inflation expectations means that the Fed is unlikely to ease monetary policy again. Those inflation increases have reduced real rates, making policy effectively more stimulative. They also threaten to erode the Fed’s track record and credibility in keeping inflation in check. Chairman Bernanke’s warning that the dollar’s decline has boosted inflation is one aspect of the Fed’s concern. As a result, we think policymakers are on hold and will tolerate and even welcome economic weakness to cap inflation and eventually bring it back down.
For investors, that policy stance will continue to shape risks to the yield curve. With the Fed anchoring short-term rates, rising inflation risks will put a floor under long-term yields and could push them above 4% again. Rising oil prices and inflation uncertainty probably will promote a bearish steepening in the yield curve. Indeed, our colleague Manoj Pradhan provides tests suggesting that core CPI inflation volatility has been a structural driver of breakeven inflation, implying that investors should be compensated with a higher inflation risk premium and breakevens. Our rates strategy colleagues Jim Caron and George Goncalves are concerned that inflation risks might begin to shift the entire yield curve higher. But weakness in the economy likely will cap real yields and limit the sell-off for now, keeping 10-year yields roughly in a 3¾% to 4¼% range through year-end.
Conclusions – What Next?
For most of 2007, there was a general consensus among many economists and market analysts that the US would experience a recession in the first half of 2008, followed by a slow recovery in the second half of this year, and that economic growth would get back to usual (3% or so) in 2009. For better or worse, the US economy has been stronger than expected so far this year, even though GDP is expected to be slightly negative in the 2Q and likely the 3Q as well.
Yet the explosion in energy prices over the last several months has put a dark cloud over forecasts suggesting the economy could get back to normal in 2009. Not only are spiraling energy and food prices draining consumer spending power, they are also raising the odds that inflation will raise its ugly head. In fact, it already has with the Consumer Price Index rising 4.2% over the last 12 months. Inflation is trending well above the Fed’s target range, and this is likely to continue for at least the next several months.
Virtually all of the sources I read now believe that the long Fed rate cutting cycle is over. Now the concern is whether the Fed will feel compelled to hike interest rates, perhaps several times, over the months ahead in an effort to fight inflation. Most of my trusted sources believe such a rate hiking cycle would be extremely dangerous given that the housing slump is far from over, and the credit crisis is still very much with us.
As Morgan Stanley economists Berner and Greenlaw argue above, as well as other trusted sources, the Fed needs to keep rates low at least through the end of this year if not longer. But we also have to remember that Fed chairman Ben Bernanke is still “the new kid on the block,” and he does not want to be the Fed Chairman that sat idle as a powerful inflationary wave developed. He may feel obliged to raise rates.
If I were to advise Bernanke, I would note the following: 1) Food and energy prices make up apprx. 25% of CPI, and raising interest rates will have virtually no short or intermediate-term effect on the prices of energy or food; 2) the economy appears to be going into a recession that could be longer than expected, in no small part because of soaring energy and food prices, and raising rates will only make it worse; and 3) raising rates just ahead will increase the odds that the credit crunch will worsen, rather than improve, and there could well be more large Bear Stearns-type failures in that scenario.
Yet while the above advice seems reasonable, the futures markets are pricing in at least one rate hike before year-end. So it remains to be seen what will happen. It will be most interesting to read the Fed’s policy statement on June 25 next week following the FOMC meeting. Analysts will no doubt be looking for any hints that the Fed is considering raising interest rates.
Investing In Today’s Dicey Environment
Investing in the US stock and bond markets over the last couple of years has been a challenge, especially as the housing/credit crunch unfolded and energy prices exploded. Now we must add in the real possibility of a recession, rising inflation and the chance that the Fed may get it wrong. All of this suggests that market volatility is likely to ratchet up to yet another higher level over the next year or longer.
While the US economy and stock markets have proven to be surprisingly resilient in recent years, we may be in for some rough times just ahead. The stakes get higher with each economic cycle and the ever-rising level of federal debt. The margin for error by our policymakers continues to shrink, while the potential for negative consequences just gets higher.
This is why I believe it is more important than ever to have your investment portfolio diversified in such a way to deal with today’s economic and market uncertainties. In my view, it is critical to have strategies in your portfolio that can move to the safety of cash (money markets) or hedge long positions in case of a bear market.
Likewise, in my opinion, most sophisticated investors would be well served to have strategies that involve “short selling” with the potential to profit from market downturns, provided such strategies are suitable in terms of their goals and risk tolerance.
I also believe it is important to have successful money managers on your team, with proven track records of implementing such “active management” strategies. So far this year, I have written about four successful professional money managers that I recommended in these pages. Each of these four managers has the ability to move to cash and/or hedge positions. Two of the four managers I have written about this year utilize short selling from time to time.
Maybe it’s time to look at them again. They are (click on the link):
These are professional money managers that have delivered impressive actual results, with far less downside risk than a buy-and-hold approach to stocks and/or bonds. While past performance is no guarantee of future results, now may be an ideal time to get these managers on your team.
Over the years, readers of this E-Letter have told me that their biggest reluctance to investing with the money managers I recommend is the fact that my company is in Austin, Texas and they live far away. Let me assure you, that is not a problem. I have over a thousand investment clients all across the US, and I have met relatively few of them in person.
The fact that my company is in Texas and you live elsewhere should not dissuade you from participating in the investment programs I recommend, and where I have the bulk of my own net worth invested. By the way, I have my own money invested in EVERY program I recommend.
If you have any questions or would like to talk to one of our experienced Investment Consultants about whether these programs may be suitable for your portfolio, please give us a call at 1-800-348-3601, or e-mail us at email@example.com.
Wishing you profits,
Gary D. Halbert
Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.