market commentary

WEEKLY ECONOMIC COMMENTARY – WEEK OF FEBRUARY 26, 2010

There were more downs than ups in the mix of economic data this week, which only added to the widespread uncertainty regarding the strength of the nascent recovery. Indeed, the growing anxiety about the recovery's progress is in stark contrast to the perception prevailing only a few weeks ago. In late January, optimistic expectations were fueled by an array of upbeat data. These included government releases showing the economy picking up momentum heading into the new year, a labor market that was poised to finally generate net job increases and a housing industry set to crawl out of the most severely depressed state in generations. Investors, too, had higher hopes of bigger returns, coming off an astonishing nine month stock market rally that was supported by growing corporate profits and a solid increase in the economy's growth rate in the year's final quarter.

But that was then. In the space of a few short weeks, a series of disappointing data has served as a rude awakening to economists and investors alike that this recovery may not follow a smooth upward growth track. The first inkling of the cloudy future came from the setback in the labor market, where job growth remained more of a hope than a reality in January, as companies defied expectations and continued to trim payrolls. True, the pace of job losses has subsided considerably, and the jobless rate slipped last month. But the latter is considered to be more of a statistical anomaly than any fundamental easing of the plight of job seekers, which continues to be dire by any measure. Worse, conditions in February do not seem to be improving, as the number of applicants filing for jobless benefits increased, even as households reported that jobs were harder to find in the latest consumer surveys.

No doubt, inclement weather conditions are playing more than a trivial role in the economy's wayward path. Several snow storms in February, including this week's blast, derailed spending, travel, shipping, construction as well as a host of other activities, and will likely distort the job figures scheduled to be released this coming Friday. The seasonal factors are supposed to compensate for the wintry weather, but climactic conditions over the last month have been much harsher than usual. The question is, will the return to more normal seasonal climate bring a quick recovery of the weather related losses, or is the economy less resilient than generally believed a few weeks ago? We are agnostic on this point, but do believe that the setback in some key economic indicators in recent weeks exaggerates the actual weakness in the economy.

That's particularly the case with the recent batch of home sales figures, which, if taken at face value, portray an industry that is back in a depression mode. Make no mistake; housing is still teetering on a shaky foundation. Mortgage conditions remain tight, homes are still overvalued relative to incomes and rents, and prospective buyers are hardly ready to make what is arguably the biggest financial commitment of their lives in the face of widespread unemployment and heightened job insecurity. But the shocking decline in home sales, both for existing and new homes, reported for January this week is less reflective of a buyer's strike than aberrations related to the tax credit and, perhaps, a looming shortage of new homes for sale.

Recall that the first time homebuyer's tax credit was originally scheduled to expire at the end of November, but was extended and expanded to include repeat buyers and higher income households through the end of April. As the chart shows, home sales have undergone some wide gyrations during the time span covered by the on again, off again and then on again tax incentive. Smoothing out this gyration, what you are left with is a modest recovery from the lows reached last year, at least for the larger market for existing homes. Sales of the latter fell 7.2% in January on the heels of a record 16.2% plunge in December, but that two month slide was primarily a payback from the tax credit induced surge over the previous six months. Keep in mind that to qualify for the federal subsidy before it was extended, a transaction had to be closed by November 30, and existing home sales are recorded at the time of closing. Not surprisingly, there was a bunching up of sales in November, which pushed forward transactions that would otherwise have taken place in December and January.

But even after the two month slide, the sales pace for existing homes stood 11.9% higher than a year earlier. By this yardstick, housing has indeed risen from the ashes; with the renewal of the tax credit, some further increase in sales should be expected in coming months, although it will probably be more subdued than the response to the original version of the federal subsidy. Meanwhile, a large fraction of existing home sales, around one-third, continues to be distressed sales, reflecting the ongoing heavy volume of foreclosures. With millions of homeowners carrying larger mortgages than their properties are worth, the pipeline of potential distressed sales is huge, something that weighs heavily on home prices and inflates the so-called "shadow inventory" of homes that may yet flood the market. Until some resolution of the foreclosure crisis is arrived at, the housing industry will be battling a powerful headwind.

Similar factors are impacting the much smaller market for new homes, where sales tumbled to an all time low in January. While the tax credit played havoc with this sector as well, other forces also contributed to the sales slide. Topping the list is the competition from the existing home market, where sellers have much more leeway to slash prices than do homebuilders. But we suspect that supply constraints may also be dampening sales. Thanks to the dearth of residential construction over the past several years, the inventory of unsold homes dwindled to only 234,000 in January, which is far below the 325,000 average level of unsold units that prevailed from 1990 through the summer of 2005, when the subprime debacle ignited the bust in home sales. Even more startling is the puny 97,000 of completed homes for sale in January. For sure, supply constraints play a secondary role to other sales dampening influences, including restrictive credit conditions, a weak labor market and competition from sellers of used homes. But even a modest rebound in new home sales, which should occur in coming months, will spur more construction from homebuilders because of low inventories than would otherwise be the case. That will be a positive influence on the broader economy, as it will generate more construction jobs and spending on building materials.

Still, it is unlikely that housing will play a key role leading the economy up the recovery track. Two more probable growth catalysts will be business investment spending and exports. Both showed unexpected vigor in the fourth quarter, and they should remain a positive force in the current quarter. Interestingly, tax incentives also appear to have influenced capital spending last year, as the year end expiration of the accelerated depreciation bonus may have pushed some outlays forward into the final quarter. Indeed, this week's revised GDP report showed that the capital spending increase in the fourth quarter was even stronger than the robust 13.3% pace originally estimated a month ago. The new figures put the capex growth rate at an even sturdier 18.2%. In light of the huge amount of excess capacity and uncertain demand prospects, which surge in business spending on equipment and software does seem to be excessive.

We agree that some payback following the expiration of the bonus depreciation is in order, and this week's report on new orders for capital goods confirmed that suspicion. In January, bookings for non-defense capital goods less the volatile aircraft orders slipped by 2.9%, the largest decline in a year. But that should not be viewed with alarm, or the start of a trend, as about half of the robust increases over the previous two months remain in place. According to some recent surveys, a large contingent of businesses claim they postponed capital spending during the recession and plan to satisfy some of that pent up demand this year. And, as we have discussed in previous commentaries, the incentive to remain competitive in the global market place is expected to boost the demand for productivity enhancing equipment and software.

No doubt, capital spending will not provide as much of a boost to growth in the current quarter as it did in the final months of last year. Still, we expect a respectable increase that should help sustain the recovery, although contributing to a much slower increase in GDP than the upwardly revised 5.9% gain reported this week for the fourth quarter. That upward revision, from an original estimate of a 5.7% growth rate, reflected a larger amount of inventory restocking than originally thought. With inventories brought more in line with final demand, the boost from the source should recede considerably in coming quarters, resulting in a slower headline growth rate in GDP of about 2-3%.

But in addition to capital spending, exports should continue to be a positive force in the quarters ahead. Like capex, exports were also revised up in the fourth quarter, from an 18.1% increase to a gain of 22.4% over the third quarter. Trouble is, imports were revised up even more, so the trade deficit showed less shrinkage than first estimated and, hence, made less of a contribution to growth. Many economists believe that with the U.S. recovering earlier and stronger than other developed nations, the trade deficit will widen and subtract from growth in coming quarters. But it's quite possible that much of the spurt in imports last quarter was a mirror image of the upward inventory revision, as companies import more of the goods that go into stocks than in past years. If that's the case, the smaller increase in inventories expected in coming quarters will lead to slower growth in imports. Since exports continue to benefit from strong growth in emerging market nations, such as China and India, it's quite possible that the trade deficit may actually shrink and make a positive contribution to GDP for a while longer.

Simply put, the lowered expectations derived from some downbeat data in recent weeks are probably justified. The economy still faces some powerful headwinds, and the outsized growth rate registered in the fourth quarter of last year was mainly inventory driven and not sustainable. We suspect that growth will slow to a tad under a 3% pace in the next quarter or two, and remain on a subpar growth trajectory throughout most of the year. Not until employment conditions improve materially will households start spending with enough vigor to bring the recovery up to normal speed. While we expect positive growth in jobs to emerge sometime in the spring, it will take a while to recover from the steep erosion in asset values in recent years and to defuse the anxiety associated with near double digit unemployment rates.