Economic stability is evident, but strong recovery distant

September 14, 2009
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Norris, Perné & French’s most recent edition of the firm’s quarterly economic overview, Sound of the Economy, recognizes signs of economic stability, but no apparent evidence of a strong recovery on the horizon. Those who have declared an end to this country’s recession may be providing heartening — if a little premature — news.

What signs of stability are visible? A firm gross domestic product estimate of a decline of 1 percent bested consensus estimates by half a percent and provided the strongest signal to date that the longest recession since World War II is finally winding down.

Much of the improvement can be attributed to government spending, which increased by 10.9 percent in the second quarter. State and local governments also contributed to the improvement by increasing their spending. In the private sector, less drastic spending cuts and improved trade contributed to the better-than-expected GDP results. Let’s continue to emphasize, however, that GDP still reflects a contraction, not growth.

The counterparts to the above good news for the quarter were rising unemployment as well as lower investment and home values, all of which dampened consumer spending. Since our report, however, consumer confidence has had a bit of a rebound, exceeding a 47.9 consensus estimate for August by 6.7 points. Unemployment has continued to rise to 9.7 percent nationally (15.0 percent in Michigan and 17.7 percent for the Detroit metropolitan area) and even exceeded estimates.

During the second quarter, the federal government acknowledged through the Commerce Department that the recession had made a deeper impact than originally reported. Commerce officials reported that the economy grew just 0.4 percent in 2008, much weaker than the 1.1 percent reported earlier. The implications of this change are significant: The economy shrank more than twice as much as previously estimated and reflected bigger declines in consumer spending and housing. Our conclusion: The recession may officially end later this year, but the recovery will be sluggish.

Despite this revision, there are other signs that the economy has bottomed out and is in the earliest stage of a turn-around. The Institute for Supply Management’s manufacturing index rose in June, July and August, reaching 52.9 in August. Readings below 50 on this index indicate contraction, and the August number was the first time the mark was above 50 since January 2008.

Housing data also is looking less bleak. Home prices continued to fall through July, and in August, the S&P/Case-Shiller Home Price index reported two consecutive months of positive signs. The upswing in July was the first monthly gain of home prices in nearly three years. While home prices are continuing to fall, that drop has slowed — an encouraging sign. New home sales also rose 11 percent month over month, providing an additional positive signal that the bottoming process is underway.

Inflation continues to be perceived as a benign condition. Declining capacity use, high unemployment, a weak housing market and low money velocity all contribute to this understanding. Headlines continue to imply that inflation is a possibility because of the government’s massive stimulus actions. But most of the money injected into the economy so far has been used by the banks to bolster their balance sheets. The funds haven’t made their way into the economy on a large scale — yet. We expect headline inflation through the end of this calendar year to be down 0.5 percent, with core inflation of 1.5 to 1.7 percent.

The current quarter holds some economic promise because of the prospective need of companies to replenish their inventories. That need, coupled with the likelihood of stimulus dollars reaching the general economy, may result in economic growth through the end of this year and to an even greater extent in 2010.

Job market prospects, however, remain weak. Businesses will continue to cut payrolls through the end of 2009 and unemployment will continue to rise, potentially topping 10 percent by year’s end. Additional hiring will be deterred until businesses regain confidence in the staying power of a recovery.

While U.S. Treasury yields had a modest rise to 4 percent in June before declining in July, expectations are for essentially flat interest rates based on comments by Fed Chairman Ben Bernanke. The chairman repeated the Fed’s stance that the federal funds rate is likely to remain at its current low levels given the continuing fragility of the economy. Shorter maturity, high-quality corporate bonds continue to provide attractive yields. Those who jump into the bond market should place a high value on credit quality, whether for taxable or tax-exempt bonds.

The appetite for equities on Wall Street continues to be reserved. The government’s measures to bail out financial and manufacturing companies have improved Wall Street’s confidence and liquidity, but both businesses and consumers are wrestling with continued credit concerns, large debt burdens and uncertain income streams. While the S&P 500 gained 15.9 percent in the second quarter, June was flat (0.2 percent) and July was a better-than-expected 7.4 percent.

The financial meltdown of 2008 has brought with it a massive increase of risk aversion from pre-crisis levels. But we’re also seeing a recent increase in the market’s appetite for risk. With financial markets beginning to stabilize and an inventory-based recovery expected for the year’s remainder, optimism is increasing that the growth of past decades will return.

However, we expect slower growth, narrower profit margins and smaller asset returns as the result of de-leveraging and re-regulating of the American economy. The U.S. consumer has swung from living beyond their means to saving more and paying down the debts incurred during the bubble years. This, too, will contribute to below average economic growth.

At last we’re seeing light at the end of this long tunnel — and fortunately, the source is daylight, not an oncoming train. But we’re not seeing full daylight yet. Emergence from economic contraction has been and will be slow, with recovery for the economy and stocks during the second half of this year and next year.

Julie M. Ridenour is director of business development and John F. Wisentaner, CFA, is portfolio manager for Norris, Perné & French.

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