The second quarter was nothing less than spectacular for the stock markets. The S&P 500 Index lost 24.64% from January 1 through March 9 and gained 36.88% from March 10 through the end of the second quarter. This market rebound continues and for the month of July through the 25th, the index advanced another 10.02%. For the year, the S&P 500 Index is a positive 8%. The US financial system was about to walk off a cliff in the first quarter. The US Treasury and the Federal Reserve came to the rescue by taking immediate and unprecedented efforts and means. Although many of the problems that contributed to the implosion remain, the market gains confidence daily that the risk of a further pandemic destruction in financial and banking systems recedes. The focus since then has been the general economic recovery.
Is it “green shoots” or “yellow weeds” out there? This is the most asked question since March. The simple answer is “it depends”. The term “green shoots” was first introduced by the UK Business Minister in January, and it implies that the seeds of a recovery have taken root. By this definition, the US economy has shown signs of stabilization and the rate of decline has slowed and in some areas flattened. If the term “green shoots” means that the economy has recovered and that we will harvest the “fruits” soon, there is very little evidence of that. The “green shoots”, if any, remain fragile.
The challenge for everyone is to interpret news and data and draw the right conclusions. Increasingly, data is suggesting that the rate of economic decline, shrinkage or change is slowing. Many observers are calling this the “second derivative” argument for the presence of green shoots. To put it another way, the economy is showing signs of hitting bottom and all the economic and financial data are no longer in free fall. The rate of change has slowed, suggesting that the worst is, or will soon be, behind us. The U.S. is getting out of the longest and deepest recession since the Great Depression. Many economist and market observers expect the Great Recession to have ended during this third quarter. The focus is to move from a period of economic contraction to economic expansion. There is increasing data to support the view that economic contraction is coming to an end soon, but there is little evidence to support any economic expansion or growth thereafter. The lexicon for the recovery has expanded recently. The general consensus is that we are not in a V shape recovery where the economy immediately bounces back from a severe recession. This is also not a U shape recovery where the recovery is not quite as instantaneous as a V recovery but a little more gradual towards an economic expansion. Many economists are expecting an L shape recovery where the end of the recession is followed by a very long period of anemic growth. The new theory is a W shape recovery where we come out of an economic contraction for a short period before diving back into a recession then gaining a more solid footing for recovery. One thing seems clear: there are lots of opinions. For the record, U.S. is in the L shape recovery camp. Statistically, the US will be out of the current economic contraction by the end of this month or next and thereafter experience a long recovery period. Federal Reserve Chairman Ben Bernanke, in his semiannual testimony to Congress on the economic outlook, projects the economy will be growing again by year end and will expand at a modest pace between 2.1% and 3.3% in 2010.
From the 2008 peak, industrial production has declined more than 15% and capacity utilization has hit a new low since 1947. Factory output has fallen in 17 of the past 18 months but is poised to rebound this quarter. The decline in industrial production has moderated to around 9% at an annual rate over the past three months, less than half the pace of decline in the prior three months. The first regional manufacturing survey for July indicates that both new orders and shipments are now firmly in expansionary territory. Factory output is expected to rise close to 5% at an annual rate this quarter.
Housing starts increased from 562,000 to 582,000 annualized units from May to June. In the second quarter, housing starts increased by an annualized 10% for the first quarter-over-quarter gain since mid-2005. According to the S&P/Case-Shiller Home Price Index, the rate of decline in existing house prices slowed in April, suggesting that stability in house prices may be in sight. The seasonally adjusted 20-city composite index, which offers the broadest geographic coverage, fell 0.9% in April, the slowest monthly decline since August 2007.
The National Association of Realtors reported that existing-home sales rose again in June from the previous month, even though the prices are still down sharply compared with last year. Home resales rose by 3.6%, to a 4.89 million annual rate from a revised 4.72 million in May. Foreclosures and short sales reflect 31% of sale activity in June. These distressed property sales have pushed prices lower. The median price for an existing home last month was $181,800, a 15.4% decrease from June 2008. Although many believe that the real estate market is getting close to the bottom, the wild card remains the unemployment rate. If unemployment continues to rise for the next 12 to 18 months, more foreclosures are expected. This combined with a healthy volume of bank-owned properties, will keep the downward pressure of real estate prices for many months to come.
The stimulus that became law in February should reach its point of maximum economic benefit this summer. The existing stimulus includes temporary tax cuts and increased government spending worth just over $700 billion (about 5% of GDP), with the bulk of the money to be distributed this year and next. The maximum contributions from the stimulus should occur in the second and third quarters of this year. This is expected to add to the GDP this quarter and next in a positive way, which further augments the likelihood of ending the recession.
Since the beginning of the earnings report season, we have heard many upside earnings surprises which further fuel the speculation that the worst is not only behind us, but we are on our merry way to a robust economic expansion. However, if we examine the factors that contributed to the earnings surprises, we would conclude that many are due to non-repeatable factors.
The U.S. Financial Accounting Standards Board (FASB) agreed to give banks more flexibility in applying mark-to-market accounting to their toxic assets. This led to massive capital writedowns in banks which triggered more writedowns elsewhere and created a chain reacton that almost destroyed the entire banking system. After significant Congressional pressure the new flexibility allows companies to use “significant judgment” in valuing assets in order to significantly reduce the amount of writedowns they must take on “impaired investments”, including toxic assets. By letting banks use internal models instead of market prices and allowing them to take into account the cash flow of securities, FASB’s change could boost bank industry earnings by 20% or more and take the pressure off of raising tier one capital.
For the second quarter, Bank of America reported earnings of $3.2 billion and Citigroup reported earnings of $4.3 billion. They are the two largest recipients of bank-bailout money from the Treasury, with $90 billion between them. Citigroup’s $6.7 billion sale of its Smith Barney brokerage unit into a joint venture with Morgan Stanley reversed an otherwise net loss of $2.4 billion. Bank of America received a one-time gain of $5.3 billion from the sale of shares in China Construction Bank Corp. and another $3.6 billion from the formation of a joint venture.
Rival banks have paid back the government and have much more freedom to take advantage of the rebound in markets and decreased competition. The huge earnings were derived from trading in a rebounding stock market and cannibalizing the businesses of weakened competitors. J.P. Morgan Chase announced a strong $2.7 billion quarterly earnings. Goldman Sachs Group’s $3.44 billion earnings — more than Goldman earned in all of 2008 – was strictly derived from expanded trading activities since it has little commercial banking activities and virtually no consumer or retail loan issues.
The toolmaker and home-improvement products company Black & Decker Corp.’s second-quarter profit plunged 60% amid a continuing sales slump, though core earnings beat analysts’ expectations. Black & Decker has slashed its dividend and has taken other cost-cutting steps in an attempt to maintain its earnings. The company’s second-quarter profits were $371 million, down from $1.106 billion a year earlier, but it squeezed operating costs by $4.5 billion from a year earlier. Layoffs and early retirements have reduced 15% of its work force this year, and it is instituting “rolling layoffs” in which it has been furloughing workers a few weeks at a time. Kellogg’s first quarter earnings rose 1.3% as cost-cutting offset falling revenue. International Business Machines’ second-quarter profit rose 12% despite falling revenue by cutting $3.5 billion costs this year. Ford reported a profit of $2.3 billion. The profit was derived mainly from gains it recorded as part of efforts to restructure its debt during the quarter. Excluding those gains, Ford would have reported a loss of $424 million, even though it is narrower than a comparable loss of $1.03 billion a year earlier. Drug makers Bristol-Myers Squibb Co. and Wyeth reported higher second-quarter earnings, helped by cost cuts and rising sales of top products. These onetime benefits from restructuring or layoffs will not be repeatable in the foreseeable future and in many ways distort the true and serious nature of the economy.
Earlier this month, the International Monetary Fund upwardly revised its growth projection for the world economies from 2% to 2.5% in 2010. The reason for this improved outlook is primarily due to the massive government intervention around the globe. Continuing upward revision for world economic recovery is attributable to China, India and a handful of emerging economies and almost none from the developed world. China’s $1 trillion bank-lending spree keeps finding its way into the markets. China’s government has turned around its economy faster than most thought possible. Annualized domestic growth is at a rate of 7.9% in the second quarter. China will have little problem meeting its target of an 8% expansion for all of 2009. In the first quarter, gross domestic product grew 6.1% from a year earlier.
The Shanghai stock market’s benchmark index has gained almost 85% (in local currency) as of July 25 and is expected to go even higher as the rest of world looks to cash in on one of the few growth stories around. The question is, can the current reversion be transitioned seamlessly from a government driven recovery to a sustainable private sector driven expansion? In fact, this question regarding state-driven growth spurts is a critical issue for the global economy. A lot depends on China’s ability to substitute growth from exports to growth from its domestic economy while avoiding stirring new bubbles in the economy. Banks have issued twice as much in new loans so far this year as in the first half of 2008, and China’s money supply is now expanding at nearly triple the rate in the U.S. Along with China’s stimulus plan of $585 billion, the credit boost has helped to restore confidence, but the flood of easy money into the economy coupled with foreign investments could be spilling over into markets for stocks and real estate and generating new bubbles.
The US has significant headwind as we emerge from the current recession. The recent statistics about unemployment, savings rate, and consumer confidence continue to suggest that the engine that propelled us and the rest of world is not returning. Consumer spending represents almost 70% of the US GDP, and this huge slice of our economic activities took many years of reckless spending and borrowing coupled with a false sense of confidence about ever increasing real estate value to create. With almost $14 trillion lost in real wealth and the economic malaise that remains, consumers and corporate America are more interested in repairing their balance sheets than shopping. Without the consumer recovering, the US economy can only expand so far and by so much. Forget about exports as well. Other trading partners from the developed economies are in worse shape than us and are not likely to increase spending either.
Since the recession began in December 2007, the economy has lost 6.5 million jobs. The unemployment rate has jumped five percentage points, while the economy has contracted by roughly 2.5%. Our unemployment rate has reached 9.5%. We have been predicting a 10% unemployment rate for a number of quarters, and it is likely that we have underestimated. It is likely that the rate will reach 11% to 12% before it is all over in 2011. This coupled with furloughs and other creative methods of belt tightening by businesses, is instilling insecurity among all consumers. Not surprisingly, the University of Michigan Consumer Sentiment Index fell in July to its lowest level since April.
The financial crisis remains alive, albeit less critical than when Lehman Brothers collapsed. The recent news about the inability for CIT to raise cash, even though a handful of its bondholders were willing to extend a $3 billion loan, is a sign that our shadow banking system remains in a state of disarray. The old model of raising money through securitization in order for these institutions to lend to borrowers is dead. The liquidity (loan) contraction continues and is impeding economic recovery in an all encompassing way – small business loans, auto loans, retail credit cards, equipment leasing, aircraft leasing, etc.
The commercial real-estate market, valued at about $6.7 trillion, represents 13% of the U.S.’s GDP. The recession and lack of credit are forcing more commercial developers and investors into default. At the same time, property values continue to decline, and banks are required to record a loss on any troubled real-estate loans where the appraised value falls below the amount owed. U.S. banks have been charging off non-performing commercial mortgages at the fastest pace in nearly 20 years. At that rate, losses on loans used to finance offices, shopping malls, hotels, apartments and other commercial properties could reach about $30 billion by the end of 2009. Many of the most troubled banks have heavy exposure to commercial real estate. So far, 57 banks have failed this year. This may spell trouble for insurance companies as well since they are also lenders in the commercial real estate market.
States’ tax revenue fell 11.7% in the first three months of 2009, the steepest decline on record, and collections have gotten even weaker since. The 45 states that have reported taxes for April and May have seen revenue declines of about 20%, compared with the same period a year ago. The recession has cut into just about every revenue source. States’ collections of corporate income taxes were down 18.8% in the first quarter, compared with a year ago; personal income taxes dropped 17.5%; and sales taxes declined 8.3%. With sharp declines in both income and sales taxes, state tax revenues were at 2005 levels in the first quarter, erasing about three years of gains that paid for new programs and salary increases.
Trying to predict the future is a futile exercise. What we have learned is to expect the unexpected and to check our own emotion regarding greed and fear when making investment decisions. The economic data for the second quarter and even the third quarter may continue to surprise us on the upside. Instead of blaming the analyst for getting the earnings estimates wrong, we cheer and fool ourselves into believing that the party is here again. As businesses wind down on inventory of every kind, there will come a time that the factories of America will have to be turned on again to replenish our supplies. We will likely misread that event for a sustainable economic renaissance. We are entering a tough phase of jobless recovery. In the intermediate term we should be more concerned about deflation than inflation since the suppressed demand will keep inflation in check. With our national savings rate increasing, we are also concerned with the negative effect from the paradox of thrift. The euphoria in the stock market will be short-lived, and this is not the beginning of a bull market, in our opinion. If anything, we believe this is a cyclical bull market in a secular bear market. The headwind of high un- and under-employment, the continuation of deleveraging and balance sheet repair, and the increased regulation and taxation are too great to ignore. Although we cannot tell the future, we must take these obvious trends into consideration in managing our portfolio risk and return expectations. Finally, if China, India and the developing economies recover in a robust and sustainable way, commodity prices will rise due to increased demand. If this is coupled with a loss in confidence in the US dollar, the US will once again import inflation while the economy remains stagnant. We may return to a period of stagflation where domestic monetary and fiscal policies will have little positive effect.
In summary, the good news is that the economy is recovering even though housing prices and unemployment remain the biggest challenge to economic renewal and expansion. In the short-term the stock market may continue to behave irrationally, but in the longer term, the emotional excitement will give way to economic reality.