- change ups
Inching toward economic recovery the Sound of the Economy
INVESTMENTS Julie M. Ridenour, John F. Wisentaner, CFA
Inching toward economic recovery; the Sound of the Economy
The good news on the economic front is that the situation has gone from worse to bad. With the terminology “green shoots” popping up like a farmer’s cornfield in May, the debate lingers as to whether those signs of recovery are a legitimate indicator.
According to the most recent edition of Norris, Perné & French’s newsletter, Sound of the Economy, the bad news isn’t quite as bad as it was three months ago, hence the consensus that we’ve gone from worse to bad. Negative economic news — like an increase in unemployment levels — is a lagging economic indicator. The recent advances of the stock market may indicate that the worst is over for the economy: the S&P 500 has climbed over 35 percent since the March 9 low (as of this writing).
Our firm anticipates an official end to the recession later this year, but also expects a sluggish recovery. It will be difficult to obtain sustained growth in consumer spending until job losses ease. Unemployment will continue to be a drag on the recovery, rising nationally to 9.5 percent by year end, and leveling off around 9.7 percent the following year.
Critical to recovery is a return of confidence and trust, which takes longer to restore than destroy. If the outcome of all this economic turmoil is less gaming of the financial markets and a more skeptical attitude toward corporate management and Wall Street, we’ll have a healthier market. If that skepticism deteriorates into a lack of trust, then expect more of the same.
Piece by piece, below are the various economic segments and their assessment by Norris, Perné & French as of this writing.
Although the recession’s conclusion by end-of-year is widely accepted, so is the anticipation that full recovery will take years. Consumer retrenchment plays a major role in the full recovery, and the recent report that consumer confidence rose to 54.9 in May from 40.8 the previous month is an encouraging sign.
Inflation remains benign, but the massive treasury debt incurred to fund the federal stimulus spending will make inflation a 2010 story. (The stimulus, combined with accommodative actions and quantitative easing from the Fed and Treasury, are beginning to have the desired effect, which is reflected in stock market valuations.)
The economy is expected to shrink again in this, the second quarter, but flatten out in the year’s second half. Job losses will continue at a painful pace into the summer, and even as economic growth returns.
Housing, which has suffered a three-year slide, is beginning to show signs of slowing in the fall of home prices. Phoenix, Detroit, Las Vegas, Los Angeles, Miami, San Francisco and San Diego — major markets and participants in the Case-Shiller home price index — have had declines of more than 40 percent since their peaks.
Housing and job market turmoil have combined to restrain consumer spending and improve household savings rates.
Businesses, meanwhile, have been working to catch up with the consumer retrenchment, working to align their output with consumer demand. Businesses have reduced inventory significantly, creating an anticipation of need increased production, which should put the economy in a better position to stabilize by the fourth quarter.
Bond yields have spent most of this year at near record low levels, but recently started to rise, thanks to the stock market’s upswing and marginal economic signs. Treasuries across the board experienced yield rate increases ranging from 9 to 140 basis points, depending on duration. We believe these yields would be greater if not held back by the Fed’s grip on lower interest rates. Widening corporate bond spreads have resulted in a significant rise in yield. Municipal bond prices have rallied, driving yields lower. In all instances, Norris, Perné & French maintains a preference for high-quality bonds with short and intermediate maturities.
The Fed’s accommodative actions have repressed interest rates, attributable to the interbank lending rate (ranging from zero to 0.25 percent), which has been reaffirmed by the Federal Open Market Committee on four occasions. In January, the Fed turned to quantitative easing, (government purchase of U.S. Treasury and Agency debt and mortgage backed securities to keep longer-term rates low and stimulate the economy).
We believe that these lower rates will work their way higher because of inflationary pressures. Norris, Perné & French continues to be concerned about the national debt. Although capacity is declining and unemployment is rising, creating the potential of near-term deflation, the long-term concern is for inflation. That anxiety is enhanced by the fact that half of U.S. Treasuries are held by foreign investors.
How high can interest rates go? By adding GDP growth and inflation to estimate the fair value of the 10-year U.S. Treasury bond, the indication is 4 to 5 percent for the Treasury benchmark, up from current levels of approximately 3.40 percent.
Although stocks remain well off their December 2007 high, the market’s recent 30 percent-plus rally was greeted as a sign of economic resilience. Even with the rise, volatility remains a concern. As measured by the Volatility Index, fears have abated by more than half since the December 1 high mark. But given the magnitude of the run-up and the decline, it’s not necessarily reasonable to follow the standard script of correction followed by recovery.
Recovery will come in dribs and drabs rather than leaps and bounds. That situation was anticipated more than 150 years ago by Charles Mackay in his book “Extraordinary Popular Delusions and the Madness of Crowds.” Wrote Mackay, “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly and one by one.”
Julie M. Ridenour is director of business development and John F. Wisentaner, CFA, is portfolio manager for Norris, Perné & French.