market commentary

WEEKLY ECONOMIC COMMENTARY -- WEEK OF FEBRUARY 12, 2010

Just what we needed - another snowstorm to muddy the economy's performance. As it is, economists are scratching their heads over incoming data, which portray a highly confusing picture of the unfolding recovery. Output, as measured by GDP - the broadest gauge of the economy's performance - staged a respectable gain in the closing months of last year and appears to be holding up reasonably well early this year. Some other measures are also showing promise, including investment spending, exports and, to a lesser extent, consumer spending. But companies are still not hiring, the commercial real estate depression is deepening, budgetary cuts by cash-strapped state and local governments are intensifying and global debt woes are sending shivers through the financial markets.

At the root of confusion is the strength of the fundamental underpinnings driving the recovery. Fiscal and monetary stimulus has played an outsized role in the first stage, and inventory restocking is sustaining the thrust. But unless other elements that define a self-sustaining upturn kick in, these positive influences will fade quickly. Discerning the staying power of consumer spending is particularly important as it accounts for 70% of total activity and is vitally necessary to sustain the recovery. Needless to say, analysts closely monitor each and every data point that might influence household behavior, and that task is complicated when harsh weather conditions distort the findings.

Nothing, for example, is more influential than the growth, or lack thereof, in jobs, which generates the income needed to support spending. But the latest snowstorm that blanketed the northeast this week could not come at a more inopportune time, as it spanned the very week that the Labor Department conducts its survey of companies and households that make up the headline-grabbing monthly employment report. Odds are, the work stoppages, construction delays and other impediments to job creation associated with the wintry blast will distort the report to some extent. Even Washington was forced to shut down on Thursday (which may be a good thing in a broader sense) forcing a one-day delay in the release of some key economic indicators. We suspect that many of the February releases will come with the caveat "weather may have influenced the numbers," keeping the mixed perceptions about the economy's performance squarely in the forefront.

That said, it is hard not to be encouraged by the steady improvement in some key indicators. This morning's delayed retail sales report is a good example. Consumers are obviously not going on a spending binge, given the multitude of headwinds that battered their purchasing power during the Great Recession. But a slow and measured recovery from the deep spending retrenchment of 2008 and early 2009 is clearly underway. In the second half of last year, real personal consumption increased at a 2.4% pace, a marked contrast to the 3.3% spending collapse that transpired in the second half of 2008. To be sure, the recovery was fueled by sizeable government incentives, including the cash for clunkers program and tax credits for home purchases, but consumers returned to the malls, department stores, restaurants and other retail establishments as well.

What's more, the latest retail sales report suggests that household spending in the fourth quarter may have been stronger than originally estimated in the latest GDP report, as sales for November and December were revised modestly higher. More important is that the forward momentum was sustained in January. Retailers reported a half % gain for the month, which was slightly above expectations and solidifies the year-over-year increases that have now extended to three consecutive months. Nor are the numbers being unduly influenced by volatile auto and gasoline-station sales. Excluding auto dealers and service stations, sales posted a solid 0.6% gain for the month, more than reversing a 0.3% drop in December. The "good news" is that this measure, which strips away much of the noise from the data, has exhibited a steady, albeit moderate, upward trend since last summer. Indeed, the source data from the retail sales report that enter into the broader calculation for personal consumption stood an impressive 3.6% above the fourth quarter average. If this holds up in February and March, consumer spending is on track to at least equal the modest 2% gain posted in the fourth quarter of last year.

Again, no one should get carried away by this trend. After all, the comparison with last year is easy in light of the spending collapse during the second half of 2008 that depressed the base level of spending in early 2009. For another, the spending increases so far have lagged well behind the typical gains that occur early in a recovery when households, buoyed by improving job and income prospects, strive to satisfy pent-up demands from the recession. Those spending propellants are hardly present so far in this recovery. While households undoubtedly postponed some big-ticket expenditures during the recession, it's unlikely that the sacrifice was great. Thanks to the debt-fueled spending binge prior to the onset of the recession, personal consumption accounted for a significantly larger share of GDP than it had during most of the postwar period. Hence, whatever purchases were delayed during the recession was more than offset by the over-consumption in the years leading up to it.

Nor are households eager to step up spending in response to improving job and income prospects. Companies are still trimming payrolls, albeit at a much-reduced rate in recent months, and the huge slack in the labor force militates against hefty pay raises that would accelerate the growth in incomes. Even if wages and salaries revive to some extent, as expected, much of the increase will be used to restore depleted savings and pay down debt, which remains a crushing burden for millions of Americans. It will take at least a year or two before households repair damaged balance sheets, and spending propensities will be curtailed until that and the job market returns to normal. In all likelihood, therefore, consumers will not provide the typical spark that ignites economic growth during the early recovery phase.

But the more subdued influence of consumers may be a welcome development, allowing the economy to rebalance its growth drivers from consumption towards exports and investment. This rebalancing act is precisely what the current administration would like to see, as discussed in the latest annual Economic Report of the president released this week. Before getting into that, it is also important to note that the economy should continue to draw strength from inventory restocking as long as the modest gains in consumer spending are not stymied. While the inventory boost will not measure up to the eye-opening 3.4% contribution it made to the fourth-quarter's 5.7% GDP increase, its impact should be significant in the current quarter.

That's the almost inescapable conclusion that the latest inventory figures suggest. Despite the formidable production increases over the final six months of last year, business stocks continued to shrink, both in absolute terms and relative to sales. In December, total inventories declined by 0.2 %, halting a modest string of two monthly increases that followed 13 consecutive months of liquidations. The inventory shrinkage in December was expected, given the strong gains in business sales during the month. But it means that business stocks entered the New Year in an even leaner state relative to sales than thought. At the end of December, the inventory/sales ratio slid to 1.26, matching the lowest ratio since November 2007. For retailers, stocks are virtually at bare-bones levels. At 1.37, the ratio of retail inventories to sales is the lowest on record, dating back to 1992.

As a result, companies are expected to start the inventory restocking effort in earnest, giving the economy's growth rate another sizable boost, albeit not as strong as was the case in the fourth quarter. How long this continues is open to question. The primary motive behind the restocking process reflects a desire to keep pace with demand, lest companies lose sales for lack of merchandise. As long as this balance is maintained, the inventory thrust to growth will diminish with each passing quarter. Remember it is the change in the rate of inventory accumulations that matters, not just changes in inventory levels. However, if businesses turn more optimistic about future demand conditions, expecting the growth in consumer spending to accelerate, they will voluntary build up inventory levels at a faster rate than is justified by current demand. Such a voluntary buildup would kick the economy's growth engine into higher gear. But that inflection point - which tends to show up at some point during a cyclical upturn - is not imminent, nor is it likely to happen as long as consumer spending stays on a modest growth track.

What the administration would like to see happen is a recovery that is powered less by consumption-related forces, and more by business investment and exports. By all accounts, the early signs are promising. As noted in our discussion of the GDP figures in an earlier commentary, capital spending shot up at a solid 13.3% annual rate in the fourth quarter, the strongest since the first quarter of 2006. Unlike the overconsumption binge that prevailed during the years leading up to the recession, there was no capital-capital spending boom reminiscent of the 1990s that left a legacy of unused productive machinery, other equipment or software that needs to be worked off. Indeed, strong gains in capital goods orders late last year point to an ongoing demand from companies for productivity-enhancing production tools that spur greater efficiencies and lower production costs.

More than anything, the productivity enhancements derived from capital spending enable companies to compete more effectively in the global market place, which is paying off in spades. This week's trade report provides further evidence that the muscular export gains revealed in the fourth-quarter GDP report is no fluke. In December, exports increased by $4.6 billion and are now up by 17% since hitting a low last April. In the fourth quarter, exports contributed 1.9% to the GDP growth rate, the strongest in more than 30 years, thanks to the rapid recoveries in emerging-market economies. The latest outlook published by the IMF indicates that these nations, particularly China and India, will be leading the global recovery, usurping that time-honored role from the U.S. While that may seem like an ego-deflating experience to us, it would go a long way towards a more balanced and sustainable global expansion than those fueled by American consumers in the past. Equally important, the strength in exports provides the U.S. recovery with a much-welcomed assist while households are getting their financial house in order.