The Economy
With fourth quarter growth of 2.5%, the economy remained on its glide path to what appears to be a soft landing. For 2006 as a whole the economy grew a robust 3.3%, but as a general proposition the force of economic gravity has taken hold in this sixth year of a recovery and expansion, as one would naturally expect as a cyclical matter. Most economists expect that growth this year will stay below 3%, but few are using the R-word—recession—at this point. The last expansion lasted a decade, and this one may as well.
The economy’s deceleration has been confined to manufacturing, in general because of inventory adjustment and in particular because of woes in autos and housing (more on the latter below). The much larger service sector continues to hum. Consumer spending remains remarkably strong (especially given housing’s weakness) as it is supported by both a vigorous labor market and the consumer’s what-me-worry appetite for debt. As to the former, the unemployment rate actually downticked a tenth of a percentage point last month to a very low 4.4%; as to the latter, the personal saving rate was negative in 2006 for the second year in a row, the first time that has happened since the Great Depression.
The above-quoted aphorism (from the famed Salomon Brothers economist of decades ago) gives a hint as to why. In a recent speech, Kaufman said that Americans no longer count as liquidity what they have in the their wallets, so to speak, but what they can squeeze out of a credit card advance from an ATM, a home equity line or the like. In other words, what once was seen as a liability is now viewed as an asset. This state of affairs no doubt has its moral dimension but certainly its economic consequences, including inducing consumers to spend more than their income. This behavior would likely come as a mystery to anyone who survived the Great Depression.
All of this good news does not conceal some worrisome trends. One is a serious slowing in productivity growth, which fell to a poor 1.6% (annualized) in the fourth quarter. It is worth discussing this topic at somewhat greater length because productivity growth is key to increases in living standards. To put it in vulgar terms, how many clunkers do you see on the road these days? Very few—largely because of the great record in productivity growth achieved in the decade from 1995 to 2005.
The vagaries of productivity growth, at least on a long-term or secular basis, are little understood bymacroeconomists. Here is the last half-century’s record: for the 25 years after WWII it averaged a healthy 2.6% a year, but then, for unknown reasons (stagflation?), fell to 1.5% from the early 1970s to 1995. For the next five years it reaccelerated to an average of 2.6%, presumably (but only presumably) because of the vast amount of capital expenditure, especially in information technology and telecommunications, that took place during those years. Despite the bursting of the stock market bubble in 2000 and the brief and shallow recession in 2001, this trend continued at least until last year. Now it has receded from an annual peak of over 4% a few years ago. Yet that extra percentage point of annual productivity growth from 1995 to 2005 added a total of $6.4 trillion in production, more than half one year’s GDP. One reason for the retreat is that capital expenditure by business has remained surprisingly anemic
since 2001’s recession. Paradoxically, another cyclical reason is that hiring has remained strong, suggesting that companies are more prepared to hire the marginal worker than to build a new plant or buy a new machine. Certainly, businesses suffer from no financial constraint, given strong and liquid balance sheets, record-high earnings growth (and, therefore, outstanding cash flow) and accommodative external financial conditions.They are willing to commit copious amounts of cash to share buy-backs and to corporate acquisitions but not to capital expenditure. The upshot of the combination of slowing productivity growth and weak capital expenditure is that the economy’s “potential” growth rate (i.e., that above which inflation becomes a serious threat) has probably fallen from the 2.9% rate seen in the boom years (of 1995 to 2000) to perhaps 2.5%. That may
not seem like much, but compounded through time that means much less production and wealth accumulation than otherwise would have been the case. It also means that the Federal Reserve must exercise more vigilance in the exercise of monetary policy. With measured inflation (2.4% for core PCE) still above the ceiling of the Fed’s professed comfort zone (2%), it should come as no surprise that the market (as measured by fed funds futures) now foresees the likelihood of only one fed funds rate cut by the end of the year as opposed to the several such cuts that earlier had been implied in that futures market. II. The Capital Markets
Last quarter’s essay emphasized the fearful future consequences of the markets’ lack of fear. Well, barely had the essay left our doors than the markets woke up in a cold sweat. The first disturbance was the revelation early in February that the “subprime” portion of the home mortgage market was in distress. That last essay had noted, “It is no longer your father’s . . . mortgage market.” One aspect of its structural change is that borrowers who earlier would not have qualified for a bank mortgage now can get one from a non-bank originator that in turn will sell the loan to a Wall Street or other firm for “securitization.” To go into further detail would take us beyond the proper scope (and length) of this essay, but suffice it to say that this corner of the market, known as “subprime,” suddenly developed deep dyspepsia. Then in late February, the red-hot Chinese stock market (is it not amazing that there could be such a thing?) suddenly nose-dived 9%. That sent a frisson of fear through the rest of the world’s stock markets, causing a one-day trading loss of 3% on the Dow Jones Industrial average (less than half last May’s more prolonged slump). Suddenly, everyone was awake. From the vantage point of six weeks’ time, it appears that they can all now stand down. Both episodes produced little more than a hiccup in the stock and bond markets. Stocks generally have recovered. Measured volatility spiked (though not much) but then receded to the prior low levels.
Nonetheless, it would be most unwise for us all to go back to sleep. One reason is that we have
enjoyed a five-year bull market (though not enough for all major indices to resume their peaks) without a correction (10% or greater decline), very long by historical standards. Second, and more substantive, the housing market in general and the mortgage market in particular are still showing signs of on-going stress, and there remains the possibility that it will not be contained. Even before the subprime fiasco, many observers were concerned that the housing bubble would burst like the dot-coms in 2000 and 2001, rather than gradually lose air. In our previous essay, we saw little evidence of that outcome, but the debacle in the subprime segment, which is by no means a small portion of the mortgage market, lengthens the odds of “infection.” We see no reason to embrace a doomsday scenario, but let it just be said that an already overleveraged consumer, who now on the margin faces materially higher risk of default and foreclosure, could remove the sole remaining
prop under the economy and thereby sink the stock market. In that case, interest rates—already held hostage to the current account deficit—might surge. Right now stock prices are vulnerable to decelerating corporate earnings, whose growth, as we have emphasized for many quarters, has been spectacular. For 14 straight quarters, corporate earnings (as measured by the S&P 500 group of companies) grew by more than 10%. In virtually every case, that represented a surprise on the upside when compared to Wall Street consensus expectations, a rare occurrence among that congenitally optimistic band. Now, consensus estimates for the first quarter are in single digits and in fact have been rapidly declining over the course of the last several months (from 8.7% to 3.8%). In the long run, as stated many times in these pages, corporate earnings growth and nominal GDP growth must be in line so with the
economy growing around 2.5% a year and inflation running at, say, 2.5%, corporate earnings growth should be falling toward mid-single digits. Yet in a period of rapid earnings growth deceleration, valuations that previously looked quite supportable (as they have) suddenly become suspect, and price-earnings multiples may shrink via the “P” in PE (price-earnings multiple). In this environment, stock prices may come under pressure.
Still, the market retains strong forms of support. The most important perhaps is that financial conditions remain favorable. Second, usually at this point in a market cycle, one would expect the factories of Wall Street to be producing lots of new paper in the form of stock issuance. The higher prices get, in other words, the more they want to sell more corporate stock through new issues. In this cycle, however, there have been several strong countervailing forces to shrink the supply of corporate stock. One is corporate America’s big appetite for share buy-backs. Another is the private-equity phenomenon, by which a significant number of companies have been taken private in recent years, as a result of all the availabile liquidity as discussed in the previous essay. Some have called it the private-equity put (to echo the term used in the late 1990s, the Greenspan put, that characterized the Fed’s willingness to cut interest rates in order to support stock prices). In other words, if stock prices decline, then private-equity firms will come out of the woodwork with their tremendous buying buyer and, indirectly, support the market as a whole. A third source of shrinkage in publicly-traded equity is mergers and acquisitions. Altogether, these three forces extracted a half-trillion dollars from the market last year. On balance we think that a period of relative equilibrium lies before us. Given moderate valuations,
stock prices may rise modestly through the balance of the year. Any expansion of price-earnings multiples, however, strikes us as unlikely.
Jerome W. Anderson
April 10, 2007 |
