Corporate Cash & Capital Spending

Second quarter GDP data for corporate profits present a level of cash flow that has usually been prologue to. . . .

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October Stock Market -- Most Volatile of All

The calendar turns to October -- historically the most volatile month in the year (see chart). It is also telling that the average price change for the month is close to zero (see chart). In other words, there is no bias to the direction of price in the first month of the fourth quarter -- only that prices get there with a lot of noise. The biggest down October

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There's no V in Durables

It is important to remember that durable goods data are notoriously volatile from month to month so patterns and trends inform more than point estimates. Looking at nondefense capital goods less aircraft the pattern of sales, shipments, unfilled orders and inventories suggests that the worst of the recession is over but we are far from recovery of any shape let alone a V.

Inventories and sales are still in deep negative territory on a year-over-year basis. For those looking to shorter measures of momentum -- new orders are down for the second consecutive month. To the extent that inventory restocking is supposed to help lift the economy past the current quarter, the ratio of inventories to new orders has peaked but the ratio is only down to the peak levels of the 2001 recession (see chart).

All told this isn't great news for the hawks squawking about V-shaped recoveries and inflation. The economy is better in that the economy has moved into a mild recession from a near economic collapse. There is still a long way to go.

Recovering Is Not Recovery And The Fed Is Still A Long Way From Tightening

The Fed has moved from agnostic to true believer when it comes to economic recovery. More specifically, they see a "V" shaped return to positive growth as a better bet than a slow upturn. They signaled their upgrade of the economy's prospects by stating that economic activity has "picked up" rather than "is leveling out" (August statement) and that the FOMC now believes their policies will "support a strengthening of economic growth" rather than "contribute to a gradual resumption of sustainable economic growth".

The Fed is going to test its belief first by reducing their support of the credit market. They signal that the financial crisis is over when they state that the Fed will now only "continue to employ all available tools" rather than "employ a wide range of tools". The narrower need for policy options is underscored by the FOMC pushing out the finish line of its plan to purchase $1.25 trillion in agency mortgage-backed securities from year-end to March 2010. Buying less per week means less market support and you can be sure that should conditions warrant they will end up owning less than the targeted amount. The proof-in-the-pudding will be how credit spreads react as the Fed begins tip-toeing away from the market.

Belief, however, is not certainty and the Fed made sure to let everyone know that it sees only a "gradual return to higher levels of resource utilization" -- meaning high unemployment and low factory usage is going to be with us for quite a while longer. Capacity utilization is the Fed's real time indicator of when the punch bowl needs to leave the party and utilization rates are still below the lows of the previous recessions (see earlier blogs). "V" shaped or not, it will take a long time before we see levels that made the Fed tighten in the past. Therefore the FOMC "expects that inflation will remain subdued for some time". To underscore the greater impact of resource utilization on overall inflationary pressures, the FOMC removed any reference to energy and commodity prices.

In other words first steps first -- remove the market's liquidity underpinnings before even considering a higher Federal funds rate. And if past is prologue we will be well into 2011 at best before the funds rate is above 0.25%.

V is for Victory, Not Recoveries

As we wait for the Fed to hint to us their plan for scaling back their security holdings (they are already talking with broker/dealers regarding reverse repos) there has been a rising chorus of economists, analysts, and pundits singing that not only is the recession declared to be over but that the shape of the recovery will be a V -- a sharp upturn with inflation risk is on the rise. The Treasury market doesn't appear as worried.

Considering the track record of this chorus during the past several years why would anyone would believe they've got it right now. Bernanke's assertion that the recession is over must be taken in context with his proclamations that the sub-prime housing collapse was not going to effect the broader economy. Better that the Fed Chairman is a cheerleader than a doomsayer but that is beside the point. There is no question that the current quarter will be positive, probably to the tune of a real 2.0% SAAR. This is just the math that comes off of increased auto spending and a decreased pace of inventory de-stocking. The fourth quarter is likely to be negative.

The recovery will come but only grow slowly. The economy is still sitting with capacity utilization below the lows of the past two recessions, job losses are continuing, and remember that the recovery of the past decade, one of the more anemic ones on record, was built around getting overleveraged to buy a house. Where exactly is this V coming from?


As to the fourth quarter, this is the headline in today's WSJ -- "Holiday Jobs Look Scarce as Pessimism Grips Retail"

Nearly half the nation's 25 biggest retail chains expect to hire fewer holiday workers this season than they did last year, another sign that retailers aren't counting on recession-strained shoppers to relax the tight grip on their pocketbooks this year.

About 40% of stores surveyed across a broad swath of retailing, including consumer-electronic chain Best Buy Inc., teen-retailer American Eagle Outfitters Inc., and luxury-goods seller Saks Inc., told the Hay Group, a human resources consulting firm, that they expect to hire between 5% and 25% fewer temporary workers this year than last, when the recession forced many retailers to trim staff in response to falling sales.

That's a grimmer outlook than the Hay survey found a year ago, when 29% of retailers said they would be slashing their holiday workforce. . . .

. . . . A third of retailers in the survey said they expect sales during Christmas to decline 5% to 25% this year. Another third expect sales to remain the same as last year. Researcher Retail Forward estimates last year was the worst selling season in 42 years with sales declining 4.5% in the fourth quarter. It also issued a forecast predicting sales will be flat with last year's weak numbers.

"Retailers are not planning inventory or staffing for any sales growth this holiday," said Craig Rowley, vice president of the global retail sector for Hay Group.

Fewer holiday jobs will only make retail sales worse, said Mr. Katz, the Harvard labor economist. "It is what we call the multiplier effect -- consumers are pessimistic about the jobs market, so they are not shopping as robustly, and as firms continue to not hire or lay off workers, consumers get more pessimistic," he said.

Bit since this is a banking day, the accompanying chart points up why the banks aren't going to be opening their pocketbooks to lend. In every cycle banks repair by boosting securities holdings relative to loans and leases. The current one is no different and it has only really begun. Further, so much of the loan growth has been centered in real estate, commercial and residential. Who are they going to lend to next to rebuild their books?

Housing Starts/Completions Signals Bottom Not Growth

The single-family home implosion kicked-off the "Great Recession" and it appears that the collapse is over based on the ratio of starts to completions (see chart). This will be another factor helping GDP turn in a positive growth number in the current quarter. Unfortunately the boost is unlikely to carry through into the final three months of the year.

Behind the implosion was an extraordinary excess of building driven by demand levels pulled from the future and pushed by too-cheap credit. It couldn't last forever and it didn't and builders went over the cliff. Housing cycles by nature are inventory driven. Down cycles consequently see starts below completions and the end is signaled when starts and completions move back to balance. As the chart below indicates, this is where we are and it also has generally coincided with a recession's end.

But this housing cycle is different. In the past, housing demand fell off because of weak income and falling employment. The recession consequently built pent-up demand for homes that was unleashed when the economy turned. This time around future demand was satisfied before its time and those that lost their homes because they bought too early in their life-cycle are unlikely to be getting a mortgage in the near future. The consequence is that the current downturn isn't building unsatisfied demand for new homes -- it is only getting the demographic supply/demand equation back into some normal cyclical balance. Starts will, of course, stay low enough long enough for pent-up demand to build and eventually push the housing cycle forward. The key is knowing when pent-up demand is exceeding available inventory by enough to kick-off a new cycle in building.

Given that the housing industry appears to have finally gotten starts in line with demand, it will still be a while before pent-up demand builds. At least the first part of the housing correction is now completed. For real GDP growth this means an add to the 3rd quarter but the boost from housing is unlikely to carry forward and help 4th quarter GDP turn in a positive number.

Capacity Utilization, Fed Funds, & The Hi-Tech Economy

Production and capacity data released this morning and Bernanke's comments yesterday have market participants stirring that the recession is over and figuring out how to best price-in the possibility it is true. Capacity utilization data are important because they are, by the Fed's own research, the best real time indicators of when to begin taking away the punch bowl. While the market is premature in pricing in a tightening given the historic relationship with factory utilization, the coming cycle may see the Fed stay on hold for an even longer period. Data are proving out that hi-tech is an increasingly pro-cyclical industry and so the Fed now has a new industry to consider before raising the cost of borrowing.

In response to this morning's data the Jan 2011 Fed funds contract is down near 10bp in price -- an implied yield of 1.5%, an expectation of a more than 130bp increase in the funds rate between now and then. While this is more realistic than last August when the Jan 2011 contract was priced to a 2.25% Fed funds rate, 1.5% is still out of line with historic experience. The Fed waits for utilization rates to recover quite a bit before acting, as illustrated below and as I wrote a few weeks back ("Before the Minutes -- Capacity Utilization Says At Least 35 Months Before First Rate Hike". Those 35 months are still there at a minimum considering that utilization rates today are still far below the lows of the past three recessions. You can still bet against Fed tightenings.



Further supporting the case that it is going to be a while before the Fed begins to take away stimulus is to compare factory utilization rates for hi-tech with the auto industry. Automobile manufacturing may be the industry of what was but it is still big enough to impact the overall stats for manufacturing activity. So before dismissing the poor state of factory activity in the U.S. as an automobile-induced event, it is worth seeing how some other industries are faring. Oil and gas extraction, for example, remain at full capacity. Hi-tech is a key industry to watch because it offers, with its virtual highway, the road map for U.S. industrial growth. The chart below illustrates that since the 2000-02 dot com bust the sector appears to be much more pro-cyclical. In fact, utilization rates in this decade never topped the late 90s levels let alone the Y2K-induced peak in 2000-01. There is a reason why Bernanke noted the fragility of the upturn. He is going to wait a long time before making industry pay more for the credit off of which the economy expands.

Discretionary Retail Sales Turn Positive ... But

This morning's release of August retail sales signaled good things for the economy most specifically because discretionary buying was positive. The overall number was not too much of a surprise given auto sales and the run-up in gasoline prices. But general merchandise store sales were up 1.6%, clothing store sales were +2.4% and sporting goods, hobby, book & music stores saw sales increase 2.3%. As the chart below indicates, this is the first solid monthly gain for all three categories since the recession began. There are always some quirky seasonals and weather issues that can front load, at this time of year, back-to-school sales. Because incomes continue to be squeezed and jobs are still being lost, one should be cautious about putting too much optimism into one number. Nevertheless, a plus is better than a minus and underscores that, at the very least, the world isn't still coming to an end. The greater economic challenge, if all this is going to work out in a sustainable manner, is for domestic production to feed domestic demand. To this end, the tire tariff is only the opening shot to protracted negotiations to create more balanced trade.

U.S. Dollar Depreciation Reflects Portfolio Shifts Not Shifting Terms of Trade

The hand-wringing over the depreciating dollar has begun anew and again it is focused on the wrong metrics. Currencies are supposed to change in value in order to re-balance the terms of trade. Take a look at the chart below of the 90-day percent change in the Fed's Trade-Weighted Dollar Index against the Major Currencies (Euro, Sterling, Yen, etc) where the U.S. trade deficit isn't and against the OITP (Other Important Trading Partners -- Brazil, Russia, India, China) where the U.S. trade deficit is. In the last 90-days, the dollar has depreciated near 8% against the major trading currencies and only -1.5% against the OITP.



Incredibly, but not surprisingly, the negative rate of change for the OITP shows improvement -- this is the group of currencies, notably the Yuan, where the dollar mispricing is most grievous (see chart below) considering the trade gap that was and is growing again. What the currency movements most likely reflect is a global portfolio shift out of dollar assets into UK, Euro, Japanese, Aussie and Canadian assets. But the price movement that can begin to help address trade gap with the Pacific Rim has yet to occur in earnest.

Treasury Yield Curve -- The Ratio To Recovery

Negative yield curves presage every recession and steeply positive ones are necessary to pull the economy out of a downturn. Positive curves work because they rebuild bank balance sheets and punish investors for holding cash. An interesting facet of post-industrial America (the U.S. economy since the 1980-82 recession) is that each recession has needed successively steeper yield curves to move the economy forward. Rather than look at the spread of 10-year Treasury yields to 2-year or 1-year yields I charted the ratio. I did it this way because the sharp decline in the yield environment means that a basis point of spread is worth more today. The steepening necessary for this recession, to the surprise of no one, is staggering.

There any number of reasons why steeper and steeper yield curves have been needed but my favorite is that the financial sector has effectively become the economy's core and the positive curve is a government bailout -- so why not take bigger risk the next time around. It would be nice to say that the current episode is the end of a trend but with re-regulation fading and too-big-to-fail banks getting bigger and a huge Federal deficit requiring the real yields to attract foreign capital, my guess is the end isn't here.

U.S. Trade Deficit -- Pacific Rim, Yet Again

If the U.S. economy is going to recover with the balanced growth that policy makers are touting the trade relationship with the Pacific Rim (meaning China and Japan) has to change and it has to change first with currency revaluation. The trade data released today are a mixed bag that indicate a stabilizing economy but also the same trade patterns now deeply entrenched. The deficit grew most where it is centered -- in the Pacific Rim. Policy seems to be tilted for the most expedient route out of recession and waiting to address the balanced growth issue at a later date.

But the issues can not be treated sequentially, growth requires addressing the trade balance now. During the previous expansion it took some time before growth in spending on capital equipment took hold. It was generally viewed that to meet domestic demand the incentive was for domestic firms to invest overseas in plant and equipment and labor. There is no reason for firms to act differently this time, especially given the excess in global productive capacity. There is also plenty of excess capacity here and prices for labor and capital and structures could fully adjust downward accordingly but the order of the day is to avoid deflation and that is an order worth following.

Consumer Credit -- More Contraction To Come

Yesterday's report that consumer credit contracted $21.6 billion in July marks about one year of diminished household borrowing and the outstanding amount is now firmly in negative territory when it comes to year-over-year comparisons. There was a bit of hand-wringing yesterday about what to do given that no borrowing means no consumer spending and without spending. . . There really isn't much that can be done as a quick fix given falling wages and depressed asset values.

The accompanying chart illustrates the ratio of consumer credit to wage and salary disbursements. As you would expect, the ratio has been rising steadily but without asset values growing there is a natural ceiling to how much current income is going to support debt. Home and equity prices are steadying but job losses continue and wages disbursements are below year-ago levels, so there is every reason to believe debt/income ratios are still well above desired levels and that outstanding debt levels have only begun to fall.

The Poor Market for Labor Confirmed by Manpower Employment Outlook Survey

Last Friday I wrote that the August Employment data were better but not good and that there is still a long way to go before hiring turns positive and the Fed thinks about heading for the exits. Today's Employment Outlook Survey by Manpower only underscores my view and suggests that the shorter end of the Treasury curve should be flatter still.

The survey reveals that the employers expect a net decrease in the rate of hiring, quite weaker than the survey results from last quarter and compared with one year ago. In fact, the -3% reported is the lowest level since the survey began in 1962. Every region of the country will be hiring less, the worst being the Northeast and the South, registering 0%, is the best. The table below shows the breakdown by industry -- all are dropping save for education and health services.

Employment -- Better But A Long Way To Go

Losing jobs at a slower pace only says that the “deep recession” is over and a milder downturn is underway. Talk of data turning positive and central bank exit strategies is putting several carts in front of the horse. It is true that the pace of layoffs is tailing off, but the average duration of unemployment remains at 25 weeks, a third of the unemployed have been so for 15 weeks or longer and the broad underemployment rate jumped up to a cyclical high of 16.8%.

The BLS birth/death adjustment also continues its upward trend, making the payroll numbers somewhat suspect. On a 12-month basis the b/d adjustment added 864,000 workers to the payroll compared with 838,000 for the 12-months ending in July. If not for the adjustment, the total number of jobs lost in the year ending in August would be 15% larger. When the revisions to the data are made much of the b/d adjustment will be wiped out and, perhaps, even turn negative.

Employment is a lagging indicator but to the optimism that an end is near I compare the diffusion index of employment change (the percentage of firms surveyed that are adding workers plus half of those holding jobs steady) to the change in payrolls (see chart below). The diffusion index of employment change has been rising the past several months and it increased in August to 35.2% from 29.9% in July. Jobs aren't added in earnest until the diffusion index is over 50 and the index is still well below the lows of the past three recessions.

The poor prospect for employment growth lies in the continuing accumulation of loss in wealth and income resulting from lower employment levels, the extended period of unemployment, and the increased number of marginal and part-time jobs taken when work can be found. There is a cyclical component to these figures but also a structural one. In other words, the prospect of consumers driving the economy is a long ways off.

An interesting side note to the August data is the loss in government jobs. While the Federal government is trying to do its part it is being more than offset by job losses in the Post Office and in state & local governments.

After The Minutes -- Reaffirmation of a Troubled Economy

The minutes of the August FOMC meeting have been released and it reveals policymakers still very much concerned about the economy's health. Earlier today I wrote that it would be 2012 before the Fed starts tightening. In today's minutes (italics mine):

". . . given their forecasts for only a gradual upturn in economic activity and subdued inflation, members thought it most likely that the federal funds rate would need to be maintained at an exceptionally low level for an extended period."

As for the tenuous underpinnings of recovery, the Committee cites (italics mine):

"Conditions in the labor market remained poor, and business contacts generally indicated that firms would be quite cautious in hiring when demand for their products picks up. Moreover, declines in employment and weakness in growth of labor compensation meant that income growth was sluggish. Also, households likely would continue to face unusually tight credit conditions. These factors, along with past declines in wealth that had been only partly offset by recent increases in equity prices, would weigh on consumer spending. . . . very substantial excess capacity in many sectors; this excess capacity, along with the tight credit conditions facing many firms, likely would mean further weakness in business fixed investment for a time."

As for the upside, the FOMC offers (italics mine):

". . . less-aggressive inventory cutting and continuing monetary and fiscal policy stimulus could be expected to support growth in production during the second half of 2009 and into 2010. In addition, the outlook for foreign economies had improved somewhat, auguring well for U.S. exports. Participants expected the pace of recovery to pick up in 2010, but they expressed a range of views, and considerable uncertainty, about the likely strength of the upturn--particularly about the pace of projected gains in consumer spending and the extent to which credit conditions would normalize."

I noted in previous posts how inventories are a weak reed on which to rest a growth forecast. We also know that export growth is a key to the recovery (watch for continued pressure to weaken the dollar against Asia), as to the impact of policy stimulus the FOMC offers this assessment --

"The improvement in financial markets was due, in part, to support from various government programs, and market functioning might deteriorate as those programs wind down. . . . All categories of bank lending had continued to decline. . . .

. . . fiscal policy helped support the stabilization in economic activity, in part by buoying household incomes and by preventing even larger cuts in state and local government spending. Participants generally anticipated that fiscal stimulus already in train would contribute to growth in economic activity during the second half of 2009 and into 2010 . ."

There are also a few throw-aways in the Minutes regarding inflation risk -- after all the Fed needs to keep that group from steepening the curve too much. Disinflation is, as was noted in the Minutes, the greater risk.

In all, a sober assessment of what lies ahead. Thus far policy has only succeeded in slowing the decline. Without foreign growth and a weaker dollar there is no obvious demand driver to sustain economic expansion. It is going to be a long haul before the economy is up and growing, and that is what the Fed has let us know.

Before The Minutes -- Capacity Utilization Says At Least 35 Months Before First Rate Hike

If the slight uptick in capacity utilization in July (68.5 vs 68.1) marks the recession's end then we can figure at least 35 months before the Fed's tightening cycle begins. We know now the Fed uses capacity utilization as the real time indicator of economic activity (see "When Will Fed Tighten?. . .") that gauges when to begin taking away monetary stimulus. As the chart below indicates, capacity utilization bottoms with recession's end and the Fed's policy response has always lagged. Back when inflation was more of a problem the lag was shorter (see table below). After the past two recessions the Fed waited for capacity utilization to be near 6% above its low before tightening -- and that took 35 months on average.

Current events conspire to give us a much longer period before the Fed acts for many reasons, among them are the severity of the downturn and the damage to consumer balance sheets. Waiting for a 6% increase in utilization rates means taking away monetary stimulus when usage is still below the lows of the previous recessions. With inflation far from a problem and export growth a priority, the Fed is going to want more than a 6% increase in usage before the tightening cycle begins anew.

The January 2011 Fed funds contract is trading at 98.56 implying an average effective funds rate of 1.44% or about 120 basis points above current levels. You can look at the forward rates implied in the Treasury yield curve and find similar expectations of Fed tightening. Seems to me the market is way off base. It will be 2012 before the tightening cycle begins.

Capacity Utilization & When The Tightening Cycle Begins
			Recession's End Month
			Nov-70	Mar-75	Nov-82	Mar-91	Nov-01	Jul-09
Capacity Utilization			77.85	74.46	71.47	78.73	73.63	68.07
Fed funds Rate			5.6%	5.5%	9.2%	6.1%	2.1%	0.2%
Months To First Rate Hike			16	24	7	38	32	??
Capacity Utilization			83.69	83.77	74.06	83.39	77.74	72.15
Capital Utilization %Ch			7.5%	12.5%	3.6%	5.9%	5.6%	6.0%

September Stock Swoon -- Some Details

It is absolutely true that September is the unkindest month as far as stock prices are concerned. While August and October are the most volatile months (see "Stocks in August -- A Volatile Month"), September is the only month with a negative average return -- based on the S&P 500 from 1896 to 2009 (see chart). Lest one think that the September average is skewed by a few big down months -- t'ain't true. Of the 113 Septembers from 1896 to 2008 only 49 registered positive returns and in the past ten years Septembers have been much more negative than not. Why this should be true is not clear to me but judging from the above average positive returns in July and August perhaps it's because the adults have returned from summer vacation.

No Inventory Growth In Goods Or Labor

This morning's ISM reported that we are finally seeing outright expansion in manufacturing rather than contraction at a slower rate. Welcome news but be careful in broadening out the impact of this data too far. The sharp upturn in ISM New Orders does not mean positive growth in inventories and labor anytime soon. Overall labor and inventory rebuilding are much less impacted by new orders than they used to be. True, the cycle upturn in employment and inventory restocking duly follow new orders but the turn will be to less negative numbers not positive ones. This is the stuff of a milder recession not economic recovery.

The chart below plots inventories and new orders and clearly illustrates how inventory swings relative to new orders are much smaller than they used to be. The histograms plotted on the axis show that the average inventory number shows continual contraction while the new orders index average of just less than 60 is strongly expansionary. Firms on the whole have continued to shed inventory as part of the "just-in-time" process. The sharp drop in demand in this cycle proved out that manufacturers and retailers still had too much stock on their shelves. Looking forward, manufacturers are going to be extremely cautious in rebuilding inventories and the ISM Inventory Index is unlikely to move over 50 for a long to come. In the 1990s, in fact, it never did. I reiterate what was written in my past several blogs -- economic models basing 2nd half growth on inventory restocking will be overestimating the upturn.



I also have a chart comparing new orders to employment. Here we see that the upturn in manufacturing orders has meant less new jobs with each cycle. The smaller number of manufacturing employees has a lot to with the lessened impact of new orders on the overall jobs total. But there is also the point that, as with inventories, the sudden drop in demand left firms much more surplus labor than they thought -- and they will be cautious before adding back employees. Look for the pace of job shedding to abate and it will be several months more before the employment data indicate economic expansion.