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Things look so bad they can only get better



To judge by the level of Treasury yields, the outlook for the U.S. economy has never been so bad. At 0.2% and 0.9%, respectively, 2- and 5-yr Treasury yields are lower today than they have been at any time during my lifetime. Far lower. Lower even than they were at the end of 2008, when the market was priced to years of deflation, a global depression, the default of as many as half the companies in the country within the next 5 years, and a global financial collapse. Wow.

The only thing that makes sense of these extremely gloom-and-doom yields that we are witnessing today is that the market is pricing in a massive default of European sovereign debt that in turn would result in the collapse of the Eurozone banking industry, and such an implosion might bring down the entire global economy. In other words, we have a market that is essentially priced to an end-of-the-world-as-we-know-it scenario.

In order to reach this grimmest of all possible scenarios, the market is making the dangerous assumption that all the bad things going on are going to get much worse: that Obama and the Democrats are never going to triangulate to a real pro-jobs program, that the Fed is going to print us into oblivion, that the economy is headed straight down, that the PIIGS are never going to veer from their big-spending, big-borrowing path, and that Europe is going to eventually implode.

Can things really be this bad and get even worse? Is there no hope for a turn to the better? Yesterday I read an amazing policy piece put out by the progressive think tank Third Way. In it they propose sweeping tax reforms, most of which make perfect sense, and if implemented would very likely usher in a new wave of economic growth and renewal. Art Laffer might have ghost-written most of the piece for all I know. It's a stunning contribution to good public policy, especially coming from the Left. Today Obama bowed to the reality of a weak economy and asked the EPA to withdraw its new stringent air-quality standards. Ireland has already opted to slash spending; maybe the Greeks will figure out that they have no other choice.

With his popularity plunging, and the economy on the ropes, Obama is being forced to change. I can't imagine that he will not adapt further, eventually supporting pro-growth, pro-business policies. The electorate doesn't like what's been happening. Keynesian stimulus policies have been proven not to work, and next week he simply can't reiterate his calls for more stimulus spending and more unemployment benefits. I've never seen so much political, economic and financial tension in the markets. This is not a long-run equilibrium situation; something has to change for the better, and it can't wait until next year's elections.

August jobs data do not point to a recession


The U.S. economy is not entering a recession just because there were no new jobs created in August. The number reported today that is making headlines is the result of applying seasonal adjustment factors that are often wrong to data that are almost sure to be revised significantly a year or so from now. (Before seasonal adjustment, I note that 118K nonfarm payroll jobs actually were created in August, according to the establishment survey.) You can't jump to huge conclusions based on one or even two months' worth of jobs data—they are just too volatile and always subject to later revision.

Yes, jobs growth appears to have slowed down a bit in recent months. The six-month annualized growth rate of private jobs, according to the establishment survey, has slipped from 2.1% in April to 1.5% in August. But as the chart above shows, the bigger picture is that the economy has managed to create between 2.1 and 2.4 million private sector jobs since the end of 2009, depending on which survey you look at, and to my eye, the trend in both is still upwards. It's not a robust upward trend, since the economy is still struggling and fighting headwinds, but taking into account a range of key indicators (e.g., flat weekly claims, strong factor orders, strong commodity prices, rising C&I Loans, strong corporate profits, a steep yield curve, low swap spreads, rising capital goods orders, consumers' improved financial health, rising industrial production, rising retail sales—all documented in my posts of the past month), I believe that on balance the economy is still making forward progress and is not in danger of sinking into another recession.

I am not saying that the economy is in great shape; I'm just trying to make the point that things are not nearly as bad as the headlines would have you believe. From an investor's point of view, it is not enough to know that the economy is weak—you have to know whether the economy is weaker than the market believes it is. I think there is room for optimism because the market has an exceedingly bearish outlook for the economy (best found in the extremely low level of Treasury yields) that in the fullness of time is likely to be proven wrong.

Manufacturing slows, but still grows


The August ISM manufacturing index slipped a little, but was nevertheless somewhat stronger than expectations (50.6 vs. 48.5). As the chart above shows, at this level the index is consistent with overall GDP growth of about 2%. For most of the recovery to date, the manufacturing sector has been the star performer, but now it too has slowed down, along with the rest of the economy.

But this does not mean we are on the cusp of another recession. The economy has been fighting numerous headwinds this year (e.g., the Japanese tsunami, bad weather, increased regulatory burdens, and the threat of a Eurozone banking system collapse), so forward progress has been slow. However, it's my belief that growth and expansion are the natural state of affairs when it comes to the U.S. economy. It takes an awful lot to stop it or to drag it down to recessionary levels. Left to its own devices, the economy will expand by roughly 3% a year. Given the proper incentives, and given the unusually large amount of idle resources present these days, the economy could easily enjoy 5-6% growth for several years. That the economy is not doing a lot better is the problem, not that it risks slipping into a recession. The notion that slow economic growth is like "stall speed" for an airplane—below which you abruptly lose altitude—is terribly misleading; analogies are not always helpful aids to understanding.


The rather abrupt slowdown in growth this year is reflected in an equally abrupt decline in productivity. After rising at an almost 4% annual rate in the two years ending last December, productivity plunged to -0.7% in the first half of this year. This in turn has meant a sharp increase in unit labor costs, as shown in the chart above. A highly productive labor force contributed to low inflation through the end of last year, but now, weak productivity is contributing to higher inflation via higher unit labor costs. But as the chart also suggests, all of this is fairly typical in the early years of a business cycle expansion, so it is not deeply troubling. Recessions oblige business to drive down costs and increase worker productivity, and most of those gains have now been realized. Going forward, growth will be more a function of new hiring, rather than getting more out of the existing workforce.

The jobs picture hasn't changed--modest/moderate growth still likely



A quick update on two releases today. The August Challenger tally of announced corporate layoffs reversed some of its gains in July, while still remaining firmly in territory consistent with ongoing growth and, at the very least, no double-dip recession. The ADP estimate of new private sector jobs was a bit below expectations, but still points to gains in private sector payrolls to be announced this Friday on the order of 100K or so, as is currently expected.

I would note, however, that since the beginning of the current recovery, the ADP estimate of private sector jobs has lagged the BLS estimate by some 500K jobs. So if I had to bet on whether the BLS number will be more or less than expected, I would take the over. In any event, given the pessimism that seems to be rampant these days, we are probably overdue for some positive surprises.

Factory orders continue very strong


I'm not trying to be a cheerleader for the economy, since I'm very much aware of all the headwinds out there. But I can't help posting this chart and commenting on the strength of factory orders, especially now that the world has adopted a very gloomy view of the outlook for the U.S. economy (as embodied in record-low 0.9% 5-yr Treasury yields). New orders received by U.S. manufacturers rose 2.4% in July, more than the consensus expected. Orders are up 13.9% over the past year, and they are up at a very strong 15.5% annualized rate year to date. To be sure, orders are still below their pre-recession highs, but at this rate we'll see new highs before the year is out. There is no denying the manufacturing sector has experienced a V-shaped recovery, even though there is still plenty of idle capacity remaining to be utilized. It's been a slow recovery overall, but it remains a recovery nonetheless.


And for good measure, I'll add this chart of commodity prices (a diversified basket of 27 commodities including energy, industrial metals, precious metals, agriculture and livestock), which shows a pretty decent 8% rebound from the recent (August 9th) lows, and prices which are only 5% off their all-time highs. Together, these charts strongly suggest that the pessimism has been overdone, and the talk of a double-dip recession is misplaced.

Housing price update--still consolidating


This chart compares the Case Shiller index of housing prices in 20 metropolitan markets to the RadarLogic index of prices in 25 metropolitan markets (measured on a price per square foot basis). Both are doing a remarkable job of tracking each other, so it's unlikely that they are missing something important. And according to both, prices have been essentially flat for the past two years, after falling by about one-third from their 2006-2007 highs.


This next chart shows the Case Shiller index of 10 major markets, with data going back to 1987 and adjusted for inflation. Here we see that prices have fallen some 38% from their 2006 highs, and have lost a bit of ground in the past two years.

Considering that mortgage rates are now at all-time lows (down by about one-third from the levels that prevailed in 2006-2007), the effective cost of buying a house in the nation's large cities has plunged by almost 60% in the past five years. Taking into consideration that real median family incomes have been generally rising, while mortgage rates and housing prices have fallen significantly, houses have never been more affordable than they are today, as reflected in the chart below. (The most recent datapoint signifies that a family earning the median income has 176% of the amount needed to purchase a median-price resale home using conventional financing.)


The housing market has undergone the most painful and wrenching adjustment imaginable. Prices fell by an order of magnitude early in the crisis, but have managed to hold relatively steady for two years. The excess inventory of housing is declining daily, since new home construction today is only a fraction of the levels that have prevailed for many decades, and less than what would be needed to keep pace with new household formations. Perhaps the rebound in housing will take longer than many, including myself, have expected, but surely by now we can rule out another collapse, can't we? The next surprise in the housing market is likely to be a growth and rising price story, rather than another tragedy.

A reassuring message from commodities


This chart compares Bloomberg's Constant Maturity Commodity Index (white line) to the S&P 500 Index (orange line). From last November through April, these two indices were almost perfectly correlated, suggesting that both were reacting to the same economic growth fundamentals. The correlation broke down over the past month or two, however, as equities were overcome by fears that a collapse of the Eurozone banking system could have serious repercussions for the global economy. Commodities initially shared in the onset of panic, but have since bounced back, and today are trading a little above their average for the year to date.

The action in the commodity markets suggests that the economic growth fundamentals have deteriorated much less than the behavior of the equity markets would suggest, and that the fundamentals have actually improved in recent weeks. This is an important development, of course, since growth can trump lots of problems. The Eurozone is far from conquering its sovereign debt problems, but commodity markets suggest that there is at least some concrete hope for a solution.

Durable goods once again contribute to inflation


On a six-month annualized basis, using the Fed's preferred measure of inflation (the Personal Consumption Expenditures Deflator), both headline and core inflation are above the Fed's target range of 1-2%. As recently as late last year—about the time that QE2 got underway—both measures were below the Fed's target range. We're now back to a 2-3% inflation environment, much as we were in the years leading up to 2008.


What has changed so much since late last year? This second chart gives us a clue: durable goods prices are no longer deflating. In fact, durable goods prices have risen at a 1.2% annualized rate since the end of last year, and that's the first sustained rise in durable goods prices since 1994. The seemingly relentless decline in durable goods prices was a major factor holding down overall inflation for the past 16 years, but that's no longer the case.




The above chart shows the three major components of the PCE deflator: services, nondurable goods, and durable goods. Note the dramatic differential between the rise in service and non-durable goods prices, and the decline in durable goods prices. Since the end of 1994, service sector prices have risen 57%, nondurables have risen 47%, and durables have fallen by 27%. Since 1994, service sector prices have more than doubled relative to durable goods prices. Since service sector prices are dominated by labor costs, that's roughly equivalent to saying that an hour's worth of work today buys more than twice as much in the way of things (e.g., autos, TVs, appliances, computers) as it did 16 years ago. That's a unique, and for most folks, a very fortuitous development, since prior to 1994, durable goods prices never declined on a sustained basis. Unfortunately, those good times look like they have come to an end.