Four factors signaling a U.S recovery and two reasons why we shouldn’t brag yet

An Update of the U.S. Economy by Dan North, Chief U.S economist at Euler Hermes (Baltimore, ML, USA)

18.08.2009


The U.S. economy has reached bottom and is now on the road to recovery. Economic data strongly suggest that the economy will start to expand soon, and the forces to make it happen are well-entrenched. Data on factory orders, industry surveys, corporate earnings announcements and other measures show improving conditions. And an examination of the all-important consumer and employment situations is particularly revealing.

The U.S. consumer is not dead; overall retail sales have risen two of the past three months. Real retail sales ex gasoline and autos have actually grown 0.3% for the past 12 months over the prior period. Real disposable personal income is also growing, rising at an annualized pace of 3.2% in the second quarter. And while consumer confidence has fallen from the recent high in May, it is still at 46.6 compared to January’s 25.3. There is some concern that Americans’ new-found desire to save will deter consumption in the future. But during a recession, consumers almost always dramatically slow their spending, and then when the recession is over, pent-up demand sends personal spending soaring again, just as it is likely to do this time.

Perhaps the most crucial measure of any economy is its employment situation, and that is improving sharply. In July the unemployment rate actually came down 0.1%, and while the economy lost 247,000 jobs, it was only one-third of the 741,000 jobs lost in January.

So the data is strong, and it is driven by the same forces which helped start the recession; oil, housing, monetary policy, and fear.


Indicators for the recovery

First, spikes in crude oil prices are almost always followed by recessions several quarters later. Prices spiked in the middle of 2007 by about 40%, followed by a further 60% spike into the middle of 2008, leading to the current recession. However, since then crude oil prices have fallen by more than 50% despite the recent run-up, and this price collapse offers strong support to the economy.

Second, the burst housing market bubble drove prices down dramatically, but now several measures are showing a reversal in the downward slide. Other housing market data has also been quite positive, including sales, inventories, housing starts and permits. The Federal government is helping stimulate demand by offering a 10% tax credit (up to $8,000) for some first-time buyers.

The CEOs of major home-builders are also signaling optimism. Lennar CEO Stuart Miller: "…abject pessimism… seems to have given way... pent up demand is beginning to reveal itself.” K Hovnanian CEO Ara Hovnanian: “In some markets, you could almost make the case that. …there is actually a shortage of homes…" In April, homebuilder Pulte bought another homebuilder, Centex. The acquisition and the comments from Pulte CEO suggested that they see a bottom: “… we’re cautiously optimistic… opportunities … are now becoming visible on the horizon." And finally, Toll Brothers reported that sales contracts signed, on a year over year basis, increased for the first time in four years. Certainly the housing market is on the mend, contributing to the recovery.

The third force boosting the recovery is Monetary Policy. The Fed over-tightened from 2004 – 2006, bursting the housing bubble, and leading to an inverted yield curve, which almost always forecasts a recession. But in September 2007, the Fed started very aggressively cutting the Fed Funds rate, lowering it 225 basis points (bps) in five months, and eventually lowering it to between 0 and 25 bps by December 2008. In addition, the Fed invented numerous schemes to pump money into the financial system to ease credit, in the process more than doubling the size of its balance sheet. As a result, the yield curve steepened significantly, an almost certain indicator of a coming recovery. In addition, the Fed has also engaged in quantitative easing as well. The Fed’s aggressive, creative actions helped save the economy and it will give it a huge thrust going forward.

The fourth force boosting the recovery is the retreat of the fear which had devastated the financial markets and the economy from the fall of 2008 to the spring of 2009. From August to October of 2008, the S&P 500 fell 30% in 38 trading days, and in February through March of 2009 it fell another 22% in 17 trading days. The dizzying plunges suggest that fear was ruling the markets, not fundamentals. But since then fear has left the equity markets which have recovered almost 50% since March. An upturn in the stock market often presages an upturn in the economy.

Similarly, when Lehman Brothers went bankrupt on September 15th, fear of the next bank failure paralyzed the credit markets and the economy. The overnight London Interbank Offered Rate (LIBOR), which had been around 2-2.5% since May, skyrocketed to 6.4% in two days. These loans made overnight between banks which largely knew each other tripled in price, indicating tremendous risk aversion, or fear. Other spreads also gapped up, such as the TED spread which is the difference between the rates at which banks lend and borrow, and it went from about 1% to 4.5%. But since that time, overnight LIBOR has fallen back to a very low 0.25%, and the TED spread has dropped down to 0.3%. The fear which crippled the credit markets in the fall of 2008 has now receded, aiding the recovery.


Corporate failures and employment situation will lag behind...

However the recovery doesn’t fix everything right away. Corporate bankruptcies, like unemployment, continue after the recession ends. Standard and Poor’s forecasts a record high 14% default rate for non-investment grade corporate bonds in 2009. And just as the narrowed interest rate spreads indicate recovery, the spread between corporate bonds and Treasuries by contrast has remained very high, indicating an increased probability of default even as the recovery continues.

Similarly, unemployment continues to rise after the end of the recession. Unemployment lags simply because employers are reluctant to hire until they are really sure that the economy has recovered. This situation is likely to create a “jobless recovery,” which all recoveries are. Every recovery has failed to lower the unemployment rate for a significant number of months after the end of the recession. To try to mitigate this problem, Congress and the President took drastic action, signing a $787 billion stimulus package in March. Unfortunately, fiscal policy actions can take several quarters to have full effect, so unemployment will still not shrink as fast as we would like.


...and be prepared for a steep bill

Creating a stimulus program is a classic idea which has had some success in the past. But the government has to borrow the $787 billion which drastically increases the budget deficit and the debt. In addition, the design of this stimulus package is seriously flawed. Only 23% of the $787 billion is scheduled to be spent in 2009, yet the recession will be over by the end of 2009. That means that 77% of the spending designed to stimulate the economy will be spent well after the need for stimulus is over. This is wasteful spending which will significantly increase the deficit, the debt, and inflation. In fact, the current administration’s plans are to run up debt equivalent to virtually 100% of GDP by 2011, when the average has been in the mid 60%’s for most of the past 20 years. This debt will be an enormous burden which is likely to ignite inflation in the U.S. in the next few years.


Daniel C. North
Chief Economist
Euler Hermes ACI