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Bad News is Seeping In…

  • Written by Syndicated Publisher 3 Comments3 Comments Comments
    May 25, 2012

    The Market Is Starting To Recognize Reality is a recent market commentary by Comstock Partners Inc. The piece recognises that, once again, not unlike the situation last summer, optimistic forecast made at the beginning of the year are gradually fading and slowly giving ways to pessimism. I think that this pessimism is warranted.

    Europe could take a turn for the worse with an increasing number of pundits calling for Greece to quit the Euro zone, emerging economies are slowing down and the U.S. consumer still seems reluctant to clean it’s balance sheet once and for all. The latter, while helping to avoid a recession, is dragging the U.S. economy into an endless slowdown.

    I guess that in the opinion of many, it is better to be “dragging along” than having to suffer from a profound recession. The policies of low interest rates and aggressive fiscal stimulus are supporting this spending behavior on the part of U.S. consumers but are also responsible for the U.S. economy dragging its feet for more than three years. Potentially, as amunitions are being drawn down and the world economies are slowing down, the slowdown could extent beyond 2012.

    Are there some reasons to remain optimistic? Some will answer this question positiviely. For instance, yesterday (May 23rd), news of better than forecast new-home sales came out. However, by looking more closely at the data, one is forced to conclude that this piece of good news is most likely insignificant. The media were excited by the announcement but the markets knew better and were not impressed!

    One has to remember that when it is claimed that new-home sales grow by 3.3% to 343,000 homes in the month of April, the 343,000 is given on an annual basis. This means that in reality only about 28,600 new homes were built last month. An increase of 3.3% of 28,600 new homes translates into an increase of less than 950 new homes … in the entire country!

    Using rough back-of-the-envelop calculations, the construction of 343,000 homes in the U.S. on an annual basis also only represents approximately an increase of 0.5% in the entire stock of American homes. If household formation is growing at a rate of above 1% per year for the foreseeable future, we would need an increase of 100% on a sustained basis (i.e. for several years) to keep pace with demand in a healthy economy.

    Obviously, the glut of vacant existing homes is responsible for this snail’s pace of new home construction. The inventory of empty and foreclosed homes has to be liquidated before construction gets its groove back. There are signs that this will happen … in a few years!

    But, for now, there is no escaping the fact that a single-month 3% increase in the pace of new homes building is like a drop into an empty bucket and thus cannot be considered as valid evidence of an emerging recovery.

    In other words, a single rainy day did not put an end to the dust bowl! The recovery will have to wait …

    Here is the commentary:

    As we have long expected, the economy is tracing out a trajectory typical of the weak recoveries that follow balance-sheet induced recessions and credit crises caused by highly excessive debt. This is significantly different from the garden-variety recessions after World War II that were primarily caused by Fed tightening of monetary policy in response to rising inflation and full resource utilization. In those instances, once the Fed achieved its desired response it eased monetary policy once again, and the economy resumed its normal growth path.

    In a balance sheet recession, as is happening now, the dire effects of debt deleveraging overwhelm the efforts of the government to stimulate the economy. Periods of credit crises are almost always followed by many years of below average growth, high unemployment, anemic expansions and frequent recessions. Recent examples include Japan’s two-decade period of sluggish growth and the current tepid recovery in the U.S. In our view, working our way out of the mountain of debt, both private and public, that was incurred during the boom will take many years and will keep a solid lid on overall gains in the stock market.

    The current economic recovery remains in sharp contrast to any other expansion of the post-war period, and is now showing definitive signs of petering out once more. The recently reported first quarter GDP is a mere 1.3% above the amount reached at the peak of the last cycle in the fourth quarter of 2007. In eight previous post-war expansions, GDP had increased by an average of 13.3% in the 17th quarter following a peak, with the lowest being 10.5%.

    Now, even this tepid recovery is slowing down once more. In the last two months the overwhelming weight of the evidence supports this view, as the following indicators have either come in below expectations or suffered an actual downturn: core durable goods orders, the Chicago Fed National Activities Index, new home sales, existing home sales, payroll employment, the NFIB Small Business Index, construction spending, the ISM Non-Manufacturing Index, the Kansas City Fed Index, the Philadelphia Fed Survey, industrial production, the Empire State Manufacturing Index, the NAHB Housing Index, the ADP payrolls, auto sales, real disposable income and the GDP.

    At best, we think the economy will be disappointing in the period ahead. Consumers, who account for about 70% of GDP, are hamstrung by debt. In addition they have kept up their spending only by running their savings rate back down to 3.8% of disposable income, only the fifth month below 4% since 2007. Other limiting factors are low wage growth, high unemployment, the large numbers of workers who have dropped out of the labor force, declining home prices, higher tax payments and a flattening out of transfer payments. Therefore it no wonder that consumer confidence still remains at recessionary levels.

    Still ahead is the so-called “fiscal cliff”, another conflict as we approach the debt ceiling again, a contentious election, and the continued inability of a dysfunctional congress to get anything done. All in all this is not a political outlook that is likely to give investors any confidence in the period ahead.

    Adding to the headwinds is the worrying state of the global economy. Europe is plunging into recession with the fragile consensus unraveling with the fall of the Dutch government, the election of a left-of-center government in France and the indecisive results pending the new election in Greece. For more than two years the goal of European leaders has been to prevent the Greek crisis from spreading to other southern-tier nations. After innumerable meetings, agreements and bailouts, that attempt has seemingly failed with the increased vulnerability of the Spanish financial system. Most of Europe has now plunged into recession, an event with global implications, as Europe is the largest source of Chinese exports.

    China is dealing with a speculative housing boom and a major political scandal prior to a change in leadership to a new generation. Even the suspect official economic statistics have been indicating a slowdown in the economy, while other evidence indicates that the situation may be worse than the official numbers show. China’s economy is heavily based on exports and is extremely vulnerable to slowdowns or recessions in other major economies. India is experiencing a similar deceleration of growth. In the last few years China and India have accounted for the lion’s share of global growth, and any slowdown has major implications for the overall global economy.

    We believe that the numerous headwinds to economic growth are creating substantial downside risks to the economy and corporate earnings that, until recently, were not being appropiately discounted by an increasingly euphoric stock market. We believe that the correction is only the beginning of a major downturn. At current levels the downside risks are still far greater than the potential upside rewards.

    Images: Flickr (licence attribution)

    About The Author – Luc Vallée

    Currently President of The Independent Market Observer. Chief Economist and Vice-President at the Caisse de dépôt from 2001 to 2008. Chief Financial Officer and Vice-President, Corporate Strategy for Mediagrif Interactive Technologies from 1999 to 2001 – MDF.TO. Deputy Treasurer at Canadian National Railways, 1997-1999. Associate Professor of Applied Economics at l’École des Hautes Études Commerciales (HEC) in Montréal, 1989-96. Consultant for the World Bank, the Canadian government, the Quebec government and the City of Montreal. Deputy director of the Center for International Studies, 1993-1996. Adviser to the investment banking division of Société Générale in Canada, 1996. President of ASDEQ in 2005-06. Member of the National Statistics Council of Statistics Canada, 2008-now. Ph.D. (1989) in economics from the Massachusetts Institute of Technology.
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