As we review macroeconomic data from the second quarter, it appears that the growth trajectory of our economy has changed. Approximately 5-6 weeks ago we began to hear some reports of a ‘soft patch’ in the economy, and since that time the data has generally continued to grow softer, raising the specter of a possible double-dip recession. The June reading of the Philadelphia Fed Business Outlook Survey, which has historically been a reasonably good indicator of our economy’s health, fell back to its lowest level in 10 months. It is still in positive territory and suggestive of growth, but the survey result, similar to the June ISM surveys, is another confirmation that the pace of our economy’s recovery has slowed. Last week past Fed chair Alan Greenspan characterized this weakness as a “typical pause” in the recovery. Through this period, our base case view has not changed. We continue to believe that this is indeed a pause rather than something more ominous, and that the chances of a double-dip remain low.
What changed over the past month? The biggest headwind by far remains the employment situation, a stubborn problem with no readily apparent solution. Although the Labor Department’s monthly payrolls data shows a V-shaped recovery from the dramatic 2008-09 decline, it is quite clear that recent levels of hiring will not be enough to make much of a dent in the unemployment rate. Temporary hiring has been strong for many months now and is normally a harbinger of future permanent hiring trends, but a meaningful boost in permanent hiring remains elusive. On the other hand, the Business Roundtable, an association of CEOs at large U.S. companies, indicated in a recent survey that 39% expect to increase hiring in the next six months. This is the highest reading since the second quarter of 2007. And if we compare this payroll cycle to all other cycle troughs since 1950, we are within normal recovery ranges from the trough level.
The greatest risk to our continued recovery at this stage is confidence. Consumer confidence peaked in May but fell significantly at the June reading. Stock market declines are one of many factors responsible for the deterioration, as consumers see the stock market as a sign of the health of our economy. Confidence levels of large company executives remains high as of the most recent survey, but if those levels were to slip the economy would be at risk of falling into a negative feedback loop. Investor George Soros refers to this as reflexivity: when the price of an asset (or in this case the entire stock market) can influence the fundamentals, rather than the more typically understood situation where the fundamentals of an asset influence its price. Thus, a drop in the stock market might lead an executive to decide to delay the purchase of equipment to expand his manufacturing facility, or a board of directors to defer expansion given the economic uncertainties implied by the stock market’s decline. As this scenario plays out across the economy with consumers as well as businesses, one can envision how the sum of these decisions to delay purchase of goods could have a negative impact upon the economy as a whole, and the price (of the market) effects a very real impact upon the fundamentals (of the economy).
For this reason, an important role of our elected leaders is to help inspire confidence, through economic policy on trade, regulation, and in general by promoting a pro-business agenda.
In addition to the uncertainty relating to pending changes in laws and regulation, there is also a growing austerity drive among politicians to cut the federal budget deficit by reducing spending, raising taxes, or a combination of both. Although these austerity efforts may be well-intentioned, they also have the effect of being an economic drag at a time when the need for additional stimulus seems to be growing. Similar pressures are being exerted at state and local government levels, where budget pressures are leading to dramatic spending cuts.
On the international front, the sovereign debt crisis continues to unfold. Austerity budgets have been signed into law in many countries in the EU, and these measures will provide a headwind to global growth as imports slow with cuts in spending. Mitigating these cuts is the weaker Euro, which has fallen against the dollar and yen and will to at least some degree give exporters in Europe a relative advantage. While the Euro has strengthened versus the dollar over recent weeks as fears of slower growth in the U.S. have emerged, the situation remains fluid and persistent questions around the funding of European sovereigns and financial institutions are likely to be a weight on the currency in the months ahead. The sovereign debt issue remains at the forefront of concerns because the banking system in Europe is the largest in the world, with assets of nearly $25 trillion at the end of 2009. That is 3 ½ times larger than the U.S. banking system. European banks have taken less than half of the bad loan write-downs of their U.S counterparts, and aggressive actions on this front were at least partly responsible for the U.S. banking system’s emergence from the crisis in reasonably good condition. European banks face dual threats of the quality of sovereign debt they hold as well as the potential deterioration in the quality of loans to companies in countries experiencing austerity-related economic slowdowns. The upcoming stress tests could alleviate some of these concerns, though questions remain around the rigor of the tests themselves as well as how banks would address any capital shortfalls that are identified.
The upshot of all this has been a flight to safety that has pushed US government bond prices up and yields to record lows, and a valuation-crushing exodus from equities as the macroeconomic backdrop overwhelmingly has come to dominate the micro in the minds of investors. This sentiment is reflected in the extremely high correlation of stocks at present. It is also reflected in the very low market multiple (11x current year estimates), 1.6 standard deviations below the mean of the prior 10 years. In such an environment, investors are essentially signaling that they perceive risks in the stock market to be fairly uniform, and therefore it makes sense to be positioned quite differently from the benchmark index. In the current environment, there are a few trends we think it makes sense to explore and develop as investment themes: the emergence of a middle class in developing economies, “steady eddie” companies that exhibit low but stable unit growth, and companies with true pricing power, often in industries that are in the process of consolidating or have already consolidated, leaving only a few strong dominant players. These companies should have the wherewithal to best withstand the current environment.
Despite the long list of uncertainties and uneven macroeconomic data, there are many positives which are discordant with the double-dip scenario. Despite a narrowing towards the long end, the yield curve remains steep and indicative of growth. Short rates are near zero and likely to remain there for the intermediate term, which equates to attractive mortgage rates for consumers, and benign terms for corporate borrowers. Inflation is quite low. Inventory levels remain quite lean, and corporate balance sheets overall are in good shape, perhaps already having adjusted to a new normal. Railcar loadings continue at levels normally indicative of healthy economic activity, and durable goods orders remain in an uptrend. Product cycles abound across many industries including technology, alternative energy, and biotechnology, to name a few. These positive factors have perhaps been reflected in S&P 500 earnings estimates, which have generally been increasing even as stock prices have declined. Second quarter earnings, which will be reported by most companies over the coming 5-6 weeks, will provide an excellent barometer of how companies have been handling the soft patch as well as their all-important outlook for the second half.
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