Are We Sure the Recession is Really Over?
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. 3Q GDP Report – Was It Really Better Than Expected?
2. What Else Was Missing in the 3Q GDP Report?
3. Worker Productivity Surges to Six-Year High
4. Latest Unemployment Numbers Not Encouraging
5. Roubini – Too Many People Are “Short” the Dollar
When the government announced on October 29 that 3Q Gross Domestic Product surged 3.5% (annual rate), there was a collective sigh of relief around the world that the US economy had finally emerged from the most serious recession since the Great Depression. After all, the 3.5% number outpaced the pre-report consensus of around 3%.
On closer inspection, however, the latest GDP report was not nearly as rosy as the headline number of 3.5% seems to suggest. For example, if you consider all of the government’s incentives for consumers to spend (think “cash-for-clunkers” which ended in August, the $8,000 first-time homebuyer tax credit, and huge stimulus spending), GDP growth in the 3Q would have been significantly lower.
These and other caveats from the latest GDP report suggest that while we have turned the corner on the recession – barring any big negative surprises – economic growth over at least the next several quarters is likely to be disappointing. For example, most estimates I see for 4Q GDP growth are in the 1-2% range.
Last Thursday, the Labor Department reported that US worker productivity soared to a six-year high in the 3Q, well above expectations. Rising productivity is a good thing, right? Not necessarily, especially when it means that companies are laying off their best and brightest, such as scientists and engineers, that are focused on new product development (R&D).
On Friday, the Labor Department reported that the unemployment rate surged from 9.8% to 10.2% in October, well above the pre-report consensus of 9.9%. 10.2% is the highest unemployment rate since 1983. 15.7 million Americans are officially out of work, and that does not include those who are working part-time by necessity and those who have given up looking for work.
This week, we will examine the latest 3Q GDP report in detail and what that means for the future of the economy. We’ll also take a look at some subsequent economic reports which seem to suggest that 4Q growth will be tepid. Next, we’ll delve into the latest worker productivity report and what that may mean for the economy and the markets. Also, we will dissect the latest unemployment figures.
Finally, I will bring you the latest dire warning from noted forecaster Nouriel Roubini. You may recall that he predicted the housing/credit crisis back in 2005. Now he warns that too many people around the world are “short” the US dollar, and this could spark a second credit crisis.
3Q GDP Report – Was It Really Better Than Expected?As noted above, the Commerce Department reported on October 29 that US GDP grew at an annual rate of 3.5% in the 3Q. Pre-report estimates varied widely with a consensus of 3%, so the actual report was better than expected. Stocks rallied sharply and closed 200 points higher following the report’s release. In the Commerce Department’s report, it stated: “The increase in real GDP in the third quarter primarily reflected positive contributions from personal consumption expenditures (PCE), exports, private inventory investment, federal government spending, and residential fixed investment.” The 3Q boost in the economy followed four consecutive losing quarters, including the 2Q that saw a drop of 0.7%. The 3Q GDP report, the so-called “advance” report, will be revised two more times before it goes “final”, and the next revision will be released on November 24.
While stocks rallied strongly just after the report, it did not take long for analysts to see that the number was artificially pumped up. For example, if you take out surging auto sales (“cash-for-clunkers” which ended in August), GDP rose only apprx. 1.5% in the 3Q. Take away the government’s $8,000 tax credit for first-time homebuyers, which is scheduled to end on December 1, and economic growth was even weaker.
Consider also the fact that GDP was boosted by the federal “stimulus package” spending, which unlike cash-for-clunkers and home tax credits, is not going away anytime soon. But the point is, the GDP number would have been much lower without these artificial incentives. Actually, the White House admitted as much just after the report. Christina Romer, chairwoman of the White House Council of Economic Advisors, acknowledged that without all these government incentives, “real GDP would have risen little, if at all, this past quarter.”
Looked at differently, the 3.5% GDP report noted that the overall economy rose to a seasonally adjusted $13.014 trillion (annual) in the 3Q, up from $12.901 trillion in the 2Q. In other words, the economy added apprx. $112 billion dollars in output quarter-over-quarter. Yet we have spent an estimated $173 billion worth of the $787 billion stimulus plan so far. This shows how heavily dependent the economy is on government spending.
What Else Was Missing in the 3Q GDP Report?
There are a number of factors and trends that the government’s GDP reports do not consider. For example, the official GDP statistics are not designed to pick up cutbacks in “intangible investments” such as business spending on research and development, product design, worker training, etc. There’s plenty of evidence which indicates that companies are slashing this kind of spending, which is essential for innovation, in an effort to cut costs.
Without investment in intangibles, the U.S. can’t compete in a knowledge-based global economy over the long-run. Yet we don’t see that plunge reflected in the GDP numbers which are still too focused on more traditional sectors, such as motor vehicles, construction, housing, etc.
There are more signs that companies are robbing the future to cut costs and improve profits. For example, over the past year, US employment of scientists and engineers has fallen by 6.3% according to BusinessWeek. For the most part, these are the people who create the next generation of products and make the US more competitive over the long-term. Again, this trend is not considered in the GDP reports.
Another clear-cut sign that GDP growth is being overestimated is the sharp drop in venture capital investment, which goes directly to new businesses. Venture capital firms invested about $12 billion in the first three quarters of 2009, barely half the $22 billion invested during the first three quarters of 2008. Some of this shortfall would have been spent on computers and other physical equipment, which would have been picked up in GDP. But most of the drop in VC money would have gone to pay for scientists, engineers, and new product development - all valuable intangible investments that don’t show up in the GDP reports.
Similarly, many companies have slashed their reported R&D spending, which also doesn’t show up in GDP. Just to cite a couple of examples, Alcoa announced recently that it cut its 3Q R&D spending by 36% from the year before. Johnson & Johnson has reduced its R&D by 13% over the past year. Such cuts are going on across industry sectors, with few exceptions. Again, these significant cutbacks are not reflected in the GDP data.
Another big problem not reflected in the GDP statistics is that many companies are retreating from development of new products, especially in stressed industries. In many sectors of the economy, companies have not only cut back on new products, but in many cases are reducing the number of models or options they currently offer.
Likewise, US companies are significantly cutting their spending on worker training. The drop started in 2008, when employers reduced their per-worker “learning expenditures” by 3.8% on average, according to the American Society for Training & Development. No data are available for 2009, but “from anecdotal evidence, obviously there’s a lot of cutback,” says Pat Galagan, executive editor of publications.
Ideally, a big burst of training would occur during a severe recession such as this so that people can acquire the skills needed for the jobs of the future. The problem is how to pay for that training, since unemployed people rarely spend money on long-term training when they’re worried about short-term survival.
Worker Productivity Surges to Six-Year High
Last Thursday, the Labor Department announced that worker productivity surged to the highest level in six years in the 3Q. Productivity nationally rose 9.5% on average, well above the pre-report consensus of 6.5%. Non-farm productivity and costs provide measures of the productivity of workers and the costs associated with producing a unit of output.
The report also noted that overall output rose 4.0% in the 3Q, while hours worked fell 5.0%. Non-farm businesses continued to get lean and mean, finding ways to squeeze more output out of fewer workers (more on this below). Unit labor costs also fell 5.2%, which will help keep inflation contained.
Productivity growth has risen at an 8.2% average annualized pace during the last two quarters, the fastest two-quarter surge off a recession trough since 1961. Unit labor costs, typically the flip side of the productivity numbers, collapsed at nearly a 6% annualized rate during the last two quarters - the largest two-quarter decline off a recession trough on record. Since corporate profits are directly related to productivity growth and inversely related to unit cost growth, this data is good news for earnings.
Normally, it is considered a good thing for productivity to go up but the question is, why so much? With the unemployment rate continuing to go up every month, we know that companies continue to terminate and/or lay off workers. In doing so, they are demanding more productivity from those employees that remain on the job.
Actually, it is not unusual for productivity to rise in the early stages of a recovery as businesses continue to aggressively cut costs even as output begins to rebound. Companies are reluctant to hire near the end of recessions and even in the early stages of a recovery, as they are not sure the economy has really turned the corner, especially with the unemployment rate rising month after month.
On a related note, the Labor Department also published monthly data on the “average work week.” The average work week shrank to a new all-time low of 33 hours in June, and it remained the same in October, as reported in last Friday’s unemployment data (more on that report below). While the manufacturing sectors are averaging well above 33 work hours per week, the much larger service/retail sectors are averaging less than 33 work hours per week.
Many economists believe, however, that the recent productivity gains and the shrinking of the average work week are not sustainable. At some point, hours worked and payrolls will have to rise in order to meet stepped-up production schedules. As this occurs, income growth should recover, allowing households to spend more even if they are setting aside a larger fraction of their income in savings. Of course, the question is, when?
Latest Unemployment Numbers Not Encouraging
On Friday, the Labor Department reported that the US unemployment rate rose from 9.8% to 10.2% in October, the highest level since April 1983. The report noted that in October, the number of unemployed persons increased by 558,000 to 15.7 million, a record high. The largest job losses over the month were in construction, manufacturing, and retail trade.
Since the start of the recession in December 2007, the number of unemployed persons has risen by 8.2 million, and the unemployment rate has grown by 5.3 percentage points. Keep in mind that the official unemployment rate does not include those who are working part-time out of necessity, and does not include those who have given up on looking for a job.
The number of long-term unemployed, jobless for 27 weeks or more, and assumed to have given up on looking for work, was 5.6 million in October according to the latest report. The Labor Department estimates that 35.6% of unemployed persons were jobless for 27 weeks or more. Yet these people are not counted in the official unemployment rate.
The number of persons working part-time for economic reasons (sometimes referred to as “involuntary part-time workers”) was 9.3 million. These individuals were working part-time because their hours had been cut back or because they were unable to find a full-time job. Here too, these people are not counted in the official unemployment rate.
The latest unemployment rate was considerably worse than expected. The pre-report consensus was for a rise from 9.8% in September to 9.9% in October. While many in the media have led us to believe in recent weeks that job losses were falling, the latest report clearly muzzles such optimism.
Most economists believe that the unemployment rate will continue to rise for at least a few more months. A Bloomberg survey of leading economists concludes that the unemployment rate will remain high for at least another year. The average forecast among the dozens of economists surveyed indicates that unemployment will average 9.7% for all of 2010.
If true, this is very bad news for the Obama administration and for Democrats who will be seeking re-election in 2010.
Is the World Too Bearish on the US Dollar?
There is now near-universal agreement that the US dollar will continue to fall for the foreseeable future. While not admitting to it, the Obama administration favors a weaker dollar as it is good for exports, just as the Bush administration did. The Fed is encouraging a weaker dollar by keeping short-term interest rates near zero for “an extended period.”
As the dollar has fallen sharply since March, investors around the world have taken to “shorting” the dollar in various ways. Yet the US dollar is a commodity, after all, and commodities of all stripes have a way of not doing what the crowd expects. There is no way to know when the dollar will reverse higher, but when it does, it could well be explosive at least for a time.
Nouriel Roubini is a well-known professor of economics at the Stern School of Business at New YorkUniversity and is chairman of RGE Monitor, an economic consulting firm. Roubini is best known for his public warnings in 2005 that we were in a housing bubble that was about to burst, and that it would lead to a financial crisis. At the time, he was called “Doctor Doom.”
Last week, Roubini issued a serious warning that too many people around the world are “short” the US dollar, especially via so-called “carry trades” where investors borrow cheap dollars and then invest in other “risk assets” (stocks, etc.) that earn higher returns. Roubini believes that, at some point, the short dollar carry trade is going to blow up.
I have taken the liberty of reprinting his latest warning in the Financial Times (of London).
Mother of all carry trades faces an inevitable bust
By Nouriel Roubini
Since March there has been a massive rally in all sorts of risky assets – equities, oil, energy and commodity prices – a narrowing of high-yield and high-grade credit spreads, and an even bigger rally in emerging market asset classes (their stocks, bonds and currencies). At the same time, the dollar has weakened sharply, while government bond yields have gently increased but stayed low and stable.
The dollar and the sterling have weakened against a host of other currencies since the summer, promoting speculation that they could become the next carry trade currencies and supplant the yen as the ‘funding currency’ of choice.
This recovery in risky assets is in part driven by better economic fundamentals. We avoided a near depression and financial sector meltdown with a massive monetary, fiscal stimulus and bank bail-outs. Whether the recovery is V-shaped, as consensus believes, or U-shaped and anemic as I have argued, asset prices should be moving gradually higher.
But while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally. While asset prices were falling sharply in 2008, when the dollar was rallying, they have recovered sharply since March while the dollar is tanking. Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.
So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.
Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.
People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.
Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage-backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low.
So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.
While this policy feeds the global asset bubble it is also feeding a new US asset bubble. Easy money, quantitative easing, credit easing and massive inflows of capital into the US via an accumulation of forex reserves by foreign central banks makes US fiscal deficits easier to fund and feeds the US equity and credit bubble. Finally, a weak dollar is good for US equities as it may lead to higher growth and makes the foreign currency profits of US corporations abroad greater in dollar terms.
The reckless US policy that is feeding these carry trades is forcing other countries to follow its easy monetary policy. Near-zero policy rates and quantitative easing were already in place in the UK, eurozone, Japan, Sweden and other advanced economies, but the dollar weakness is making this global monetary easing worse. Central banks in Asia and Latin America are worried about dollar weakness and are aggressively intervening to stop excessive currency appreciation. This is keeping short-term rates lower than is desirable. Central banks may also be forced to lower interest rates through domestic open market operations. Some central banks, concerned about the hot money driving up their currencies, as in Brazil, are imposing controls on capital inflows. Either way, the carry trade bubble will get worse: if there is no forex intervention and foreign currencies appreciate, the negative borrowing cost of the carry trade becomes more negative. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies. So the perfectly correlated bubble across all global asset classes gets bigger by the day.
But one day this bubble will burst, leading to the biggest coordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a coordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.
Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.
This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.
I titled this E-Letter “Are We Sure the Recession is Really Over” because I think this concern is still heavy on the minds of most Americans. Certainly, the latest 3Q GDP report is a welcome sign that we have turned a corner, at least for now. But as I have also pointed out above, the reported gain of 3.5% in the 3Q leaves many questions we should be concerned about.
There are still many weak spots in our economy. Most notable, the unemployment rate weakened even more than almost anyone expected in October, reaching the highest level in a quarter century, and is very likely headed even higher for a few more months at least. It will almost certainly remain high throughout 2010.
The worst of the housing and credit crisis appears to be behind us, but bank lending remains substantially below pre-crisis levels, even as short-term interest rates are at historical lows. The Fed continues to buy up toxic assets at unprecedented levels. At some point, this will have to stop and reverse itself, just as interest rates will have to be increased at some point.
The point is, while we may have emerged from the recession, there are many risks that could throw us right back into a further economic contraction in the next year or two. Nouriel Roubini’s analysis just above regarding the US dollar is just one of several scenarios that could result in a “double-dip” recession in the next year or two.
As I discussed at length in my September 29 E-Letter, we are in the early stages of a commercial real estate bust that could very well be the next shoe to drop in the credit crisis. I will have a lot more to say about that next week, unless something more pressing comes about. In any event, we will be hearing a lot more about the commercial real estate problems in the weeks and months ahead.
While we all welcomed the latest GDP report, conflicted as it was, there are few indications that economic growth will continue at that rate going forward. As mentioned earlier, most estimates I am seeing on 4Q GDP growth are in the 1-2% range. Forecasts for 2010 are only marginally better.
Finally, the stock market overshoot since early March has surprised even the most optimistic forecasters. All of my most trusted sources believe that the equity markets are overbought and very susceptible to a downside correction, or worse anytime now. If Roubini’s concerns about the dollar are realized, it could be much worse than a garden variety correction.
Everything I have discussed this week argues for having actively managed strategies in your investment portfolio, strategies that have the ability to move out of the markets, or hedge long positions, in case any one of the negative scenarios arises. If you agree, give us a call at 800-348-3601, or e-mail us at firstname.lastname@example.org.
Finally, our thoughts and prayers go out to all of the families of the innocent soldiers who were killed and injured in the tragedy at FortHood that occurred on November 5.
Very best regards,
Gary D. Halbert
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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.