The Truth Behind a "Recovery" in GDP

As discussed since March, GDP will likely be positive in the fourth quarter and maybe in the third quarter, if inventory restocking kicks into gear. If both the third and fourth quarters are positive, the National Bureau of Economic Research could determine sometime in the first half of 2010 that the recession ended in July or August 2009. Before anyone breaks out the champagne in celebration, it must be noted that in declaring an end to a recession, NBER is only identifying the trough in business activity. In determining the beginning and end of a recession, NBER looks at employment, real personal income minus government transfers, industrial production, retail sales, in addition to GDP. In the last two recessions, NBER decided the trough in activity coincided with an increase in industrial production in April 1991 and December 2001. As a result, NBER determined the 1991 recession ended in March, and in November 2001. If the past is any guide, NBER could determine that the current recession ended, in the month preceding a turn around in industrial production. The next few months could prove interesting in this regard. In June, industrial production fell -.4%, after posting a deep drop of -1.2% in May. For the second quarter as a whole, industrial production fell at an annual rate of -11.6%, after plunging -19.1% in the first quarter.

In my December 2007 letter, I stated that the Federal Reserve was going to have a more difficult time containing the coming credit crisis, since so much credit creation was taking place outside the banking system. Twenty-five years ago, banks provided almost 75% of the credit to the economy. In recent years, it had fallen to 35%, while the securitization of mortgages, home equity loans, auto loans, credit card debt, student debt and company receivables provided more than 40% of the credit.

"Since the market place is supplying a greater proportion of credit creation to finance economic growth, the Federal Reserve's capability to manage the credit creation engine has diminished. This is why this crisis is quite different than the other crisis faced by the Fed in the last 20 years. Most investors really don't understand the credit creation process, and as a result, don't comprehend the scope of this crisis, or the Fed's limited ability to deal with it. It really is different this time."

As much as the phrase "It really is different this time" applied to the credit crisis we were facing in December 2007, it also is appropriate in assessing the sustainability of the coming recovery. As noted last month, the decline from a growth rate of 2.8% in the second quarter of 2008 to a negative -6.1% in the fourth quarter, and rebound into a positive GDP print by the fourth quarter of 2009 is going to look every bit like a V-shaped recovery.

In tracking the end of a recession, NBER is merely identifying when the economy in aggregate reached its lowest point. It tells us virtually nothing about the quality and strength of the recovery that follows the trough. In the three worst recessions since World War II (1957-1958, 1973-1975, 1981-1982), real GDP (nominal GDP less inflation) averaged 5.6% in the first full calendar year after the recession ended. If measured from the trough of those recessions, real GDP growth averaged 7.8%. The coming recovery will be far weaker than prior recoveries. Those recessions were precipitated by the Federal Reserve increasing rates enough to significantly slow economic growth, causing a buildup of inventories, a reduction in production to pare inventory levels, and an increase in unemployment. Since the higher cost of money negatively impacted demand for homes and cars, pent up demand was unleashed as soon as the Federal Reserve lowered interest rates, which launched a strong self sustaining recovery.

The current recession was precipitated by the largest global financial crisis in history, not by a large increase in interest rates. The collapse in credit creation has resulted in the deepest synchronized contraction in global trade and economic growth since the 1930's. The depth of this recession, and commensurate increase in unemployment, and declines in business investment and trade, has made this financial crisis worse and more protracted. The magic elixir of lower rates, which spurred the strong recoveries after the 1957-1958, 1973-1975, and 1981-1982 recessions, has proven a placebo. Lower rates have helped, but the demand for housing and cars has collapsed, so there is no pent up demand for the recovery to draw upon. The banking system remains crippled. Lending standards are very high for most forms of credit, credit availability remains restrained, and the volume of securitized credit is still off by more than 80%. When the Fed lowered interest rates in 2001 and 2002, it sparked a pick up in demand for cars and trucks. But the main reason the assembly lines kept humming was that every car and truck loan could be securitized. Between 2002 and 2006, more than 90% of the Detroit automaker's profit came from financing, not from manufacturing cars and trucks. On the surface, the car business looked healthy, but under the hood the decay was plain to see, and exposed once the securitization market vaporized. And despite all the Fed's efforts, the securitization markets remain moribund.

Before the housing bubble became a bubble, lower rates in 2001 and 2002 made it possible for millions of home owners to refinance their mortgage. This increased their disposable income and spending, helping to offset the decline in business investment in 2002. Household debt as a percent of disposable income actually rose 6% during the 2001 recession, which had never happened before during a recession. Lower mortgage rates are helping rejuvenate refinancing activity again. But for the 20% to 25% of homeowners whose mortgage exceeds the value of their home, refinancing is often off the table. And for the 16.5% who are unemployed or underemployed, refinancing is almost out of the question.

As the economy emerged from the 1973-1975, 1981-1982, and 1991 recessions, the savings rate had been 8% to 10% for decades. This provided consumers the wherewithal to increase their spending after the Fed lowered interest rates. Between 1993 and early 2008, the savings rate plunged to less than 1%. According to Christianson Capital Advisors, Americans saved $57.4 billion in 2007, and spent $92.3 billion on legalized gambling. One of the secular changes I forecast in the April 2008 letter was an increase in the savings rate, as consumers confronted the reality of lower home values and stock prices. As I noted then, an increase in the savings rate of just 1% would shave .7% off annual GDP growth since consumer spending is 70% of GDP. This suggested that GDP growth would be lower in coming years, as consumers gradually increased their savings back toward 8% to 10%. According to the Bureau of Economic Analysis, the savings rate soared to 6.9% in May. However, that grossly overstates the reality. Of the $167.1 billion increase in personal income in May, $157.6 billion came from The American Recovery and Reinvestment Act of 2009, in the form of a $250 one-time check to social security recipients. Wage and salary income actually fell $12.4 billion. If the impact of the one-time income transfer is excluded, personal income grew just .2%, rather than the headline grabbing 1.4%. In coming months, the savings rate will fall back under 3%, since real income growth is likely to remain weak well into next year.

State spending represents 12% of GDP, and has averaged an annual increase of 6% over the last 30 years, adding almost .7% to annual GDP. Unlike the Federal government, states by law cannot run fiscal deficits, but that certainly hasn't inhibited spending! However, the worst recession since the 1930's is forcing state governments to change. According to the Rockefeller Institute of Government, 47 of the 50 states experienced a decline in tax revenue in the first quarter. Overall, state tax collections dropped 11.7% versus March 31, 2008. The decline in tax revenue was the steepest in the 46 years quarterly data has been available. Importantly, the decline in tax revenue appeared to worsen in the second quarter with tax revenues down 20% from last year. In the first quarter, personal income tax collections fell 17.5%, weak retail sales sent sales tax collections down 8.3%, while corporate taxes fell 18.8%. In aggregate, states face a budget short fall that could approach $350 billion over the next 2 years. According to the Rockefeller Institute, it could take five years before state tax collections recover to their pre-recession levels.

In the first quarter state tax revenues were down to 2005 levels, erasing 3 years of gains that paid for new programs and salary increases. Although some states are actually cutting jobs, many states are enacting furloughs for employees that amount to pay cuts of 5% to 14%, as in Hawaii. Across the country, 15,000 school districts have reduced or eliminated summer school programs. But many states are also raising taxes and fees to close their budget gaps. These tax increases will reduce consumer's take home pay, weaken spending, and offset some of the Federal stimulus. Since states are on the frontline in delivering services to the American people, higher taxes and fees, along with a reduction in services are going to make millions of citizens unhappy. There will be marches on state capitals before the end of 2010.

Exports represent about 12% of GDP, very similar to the contribution made by state spending. Over the last year, exports have fallen 21%, while imports have plunged 32%. As a result, the trade deficit is the lowest since 1999. In May, exports grew 1.6%, driven in part by an order for 20 Boeing airplanes. As I discussed in the May letter, in the quirky world of GDP accounting, a decline in imports adds to GDP, since imports represent production outside the U.S. This methodology is used even if the decline in imports is the result of economic weakness, as it surely was in the first quarter. A 34.1% decline in imports added +6.05% to first quarter GDP, while the 30% decline in exports subtracted -4.06%. As a result, GDP was boosted by 2% in the first quarter. Since imports declined and exports grew in the second quarter, this methodology will add more than 2% to the second quarter GDP report, and suggest the economy is in better shape than it really is.

Since the credit crisis first broke in August 2007, the European Central Bank has been behind the curve by 6 to 9 months. In June 2008, the ECB raised rates to fight inflation, which even at the time seemed terribly misguided. On June 25, the ECB pumped a record $622 billion into Euro-zone money markets at 1%. These funds will replace prior short term loans, extending maturities out a full year, and increase the total amount of ECB support. Lending in the Euro-zone has collapsed from 10% in mid-2008 to just 1.8% in May, the lowest since records began in 1992. European banks have been slower than their U.S. counterparts to write down the value of impaired assets, and they were leveraged 40 to 1, versus the leverage of 30 to 1 used by U.S. banks. Standard & Poor's estimates that bad loan write-offs at Europe's 50 largest banks will double next year. This could curb lending even more and weaken growth in the E.U., which represents 28% of world GDP. The IMF estimates that the EU will only grow .6% in 2010. Weak growth in Europe and Great Britain will not help the U.S. materially increase its exports in 2010.

As I discussed in the January letter, the sharp decline in sales and production has created a global economy awash in excess capacity. "When sales are falling, every dollar of revenue becomes more important, so many companies will increasingly compete on price to boost revenue. Companies will also move to lower costs, and millions of workers around the world will lose their job." Over the last 30 years, capacity utilization in the U.S. has averaged 81. In June, the overall operating rate fell to 68, a record low dating to 1967. The operating rate for manufacturing fell to 64.6, the lowest ever since 1948. There is more excess capacity now than in the deep recessions in 1957-1958, 1973- 1975, and 1981-1982. This means most companies can delay any increase in business investment, since they have so much unused capacity. The July survey by the National Association of Business Economics confirms this, as 62% of the respondents are not increasing capital spending. This is not likely to significantly change until companies experience a meaningful increase in demand. Even then, it will take time to use up the massive overhang of excess capacity.

In June, another 467,000 jobs were lost, and that was after the Labor Department added 185,000 jobs based on its birth/death model. A total of 6.5 million jobs have been lost since December 2007. Average hourly earnings rose just three cents between April and June, the smallest quarterly increase since at least 1964. The average work week fell to 33.0 hours, the lowest level ever recorded, and from 33.8 hours in December 2007. The 48 minute decline in the work week since December 2007 represents 3.3 million jobs that may have been lost had employers not reduced the hours worked so aggressively. The unemployment rate climbed to 9.5%, almost double the 4.8% rate in December 2007, and the under employment rate reached 16.5%. The average length of official unemployment increased to 24.5 weeks, the longest since 1948. In May, there were 5.7 unemployed workers for every job opening. According to Manpower Inc., hiring plans for the third quarter were the lowest since their data began in 1989. As Federal Reserve Chairman Bernanke stated in his "Semiannual Monetary Policy Report to the Congress "Job insecurity, together with declines in home values and tight credit, is likely to limit gains in consumer spending. The possibility that the recent stabilization in household spending will prove transient is an important downside risk to the outlook."

Most economists consider unemployment a lagging indicator. But in a recession precipitated by a credit crisis, the usual rules don't apply. The magnitude of 6.5 million lost jobs has been a leading contributor to the depth and duration of this recession, since job losses and underemployment have caused default rates on every type of consumer loan to soar. According to the American Bankers Association, late payments on 8 loan types rose to a record 3.23% as of March 31. Since another 1.2 million jobs have been lost in the second quarter, more record loan losses are coming.

Over the last two years, I've often cited the following statistic, since consumer spending is integral to changes in demand in our economy. Household debt as a percent of GDP rose from 44% in 1982 to 98% in 2007. As all this debt was accumulating, consumer demand was goosing GDP growth. Consumers could carry more debt without a huge increase in their monthly payments, since interest rates fell from 15% to 20% in 1982 to generational lows in recent years. With short term rates near zero, this mountainous debt burden cannot be eased with lower rates. It will have to be paid off the old fashioned way - hard work over time. It's not going to be easy. Since 1982, household debt as a percent of disposable income (income after taxes) has risen from 60%, to 133% at the end of 2007. It has since eased to 128%. In May, the San Francisco Fed determined it would take 10 years to get the ratio down to 100%, and shave .75% off consumption growth every year. If consumers increase savings .7% a year, and pay down household debt, GDP growth will be 1% less annually for a decade.

Over the last week, a number of prominent companies have reported earnings, which have exceeded depressed expectations. Analysts have dismissed the conspicuous weakness in revenue from year ago levels. Here's a short list: IBM -13.3%, Intel -15.3%, Cisco -16.6%, CSX -24.8%, GE -9.0%, Caterpillar -21.8%, Dupont -19.1%. Most of the companies were able to exceed earnings estimates by aggressively cutting costs, and in most cases, laying off thousands of employees. That's like getting fat by eating your own leg. Most analysts are excited, since earnings are expected to soar in coming quarters, as revenue growth returns, with most of it dropping to the bottom line. If this was a normal recession, it would be reasonable to expect a normal recovery in demand. Although government stimulus spending will give the economy a lift into the first half of 2010, consumer spending will remain weak, as the unemployment rate breaches 10%, and the underemployment rate flirts with 20%. Business investment will be retarded by excess capacity, and a cost control mindset by executives. Spending by states is going to be weak certainly by historical standards. And the global nature of this recession is going to restrain export growth. Where's the beef?

We're going to get what looks like a V-shaped recovery in GDP, and it will pack the nutritional value of a Twinkee.