market commentary

WEEKLY ECONOMIC COMMENTARY -- AUGUST 20, 2010

At first blush, a look at this week's economic data would belie the headline-grabbing fears of a double dip recession, much less the scourge of deflation. Yes, first time claims for unemployment benefits rose more than expected in the latest week; but a one week spike that may have been bloated by Census workers going back on the unemployment rolls does not make a trend, nor should it undercut other data that portray an improving job market, albeit one that is painfully slow to unfold. Likewise, the latest housing data paint an ongoing grim picture of the residential market, as single-family home construction in July fell by 4.2% to the lowest level in more than a year. Only a jump in multi-family starts, the noisy component of the housing mix, gave a slight lift to the overall number.

But the frail housing market is nothing new and some of the recent weakness can be viewed as a payback from earlier strength spurred by the homebuyer's tax credit. What's more, homebuilders are responding to the poor sales market with understandable restraint that will strengthen their hand going forward. If nothing else, by holding down the pace of new construction they are preventing inventories of unsold homes from piling up. Indeed, inventories in the new home market are at historical lows. It is in the existing home market where about 2 million foreclosed homes are flooding the market annually that a severe oversupply condition exists.

The initial claims and housing data provided the worst news on the economic front this week, which was enough to send stock prices into a tailspin. That is not surprising; given the negative psychology that has taken root in the markets over the past several weeks. With economic growth downshifting abruptly in the second quarter and the job market still not showing any vigor, there are few compelling reasons to feel encouraged over the near term outlook. When perceptions are exceptionally grim it is easy to overlook, or at least downplay, the positive events that may surface. From our lens, there are at least two developments this week worthy of note. This supports our long-standing view that the struggling recovery is not poised to morph into another recession.

The first is the Federal Reserve's release of its latest survey of senior bank lending officers. It is no secret that one of the biggest headwinds facing the U.S. economy is the inability of creditworthy borrowers to obtain loans. Of course, this credit restriction does not apply to large corporations that have access to the capital markets. Yield-hungry investors have been gobbling up record amounts of new bond issues in recent months, including those from companies with less than investment grade ratings. More than anything, the reopened floodgates in the capital markets confirm that the financial crisis, which ignited and intensified the Great Recession, is now a chapter for the history books.

While the restoration of a functioning capital market has played a pivotal role in jump starting the recovery, its contribution to growth has not been as powerful as it should be. Much of the issuing activity has been for refinancing purposes or to generally repair ailing balance sheets that were damaged during the recession and financial crisis. Indeed, large companies have built up a cash hoard that, as a percent of total assets, is the highest since the mid 1960s. It's not entirely clear what's behind this huge appetite for liquidity. To some extent, it may simply reflect a lack of investment opportunities, as the uncertain economic climate and slackening demand for goods and service have undercut the potential rewards that such investments might provide. Another influence, cited by a number of corporate treasurers, is the fear that a financial crisis may erupt again; hence a larger cushion of liquidity is a rational defensive measure to guard against such a contingency.

However, smaller companies that rely on banks for financing do not have the luxury of deciding what to do with excess cash raised in the public markets. They need these funds to sustain operations, acquire working capital and to meet payroll. More to the point, small firms are a major source of job creation and their inability to obtain funds has been one of the powerful headwinds keeping the job market in the doldrums. The Fed's latest survey of banks, taken over the last two weeks of July, may be a sign that the tide is turning for the better. For the first time since late 2006, the Fed reported that banks were easing the lending standards for small businesses. The survey did not specify why banks turned more hospitable to small and medium sized companies, but there are several possible reasons.

Topping the list may simply be that the year-old recovery itself has made lending officers more confident in the ability of these borrowers to repay their loans. True, the recovery has lost momentum in recent months, which would seem to make lenders rethink that more optimistic attitude. However, proprietor's income has posted solid increases in twelve of the past thirteen months and stand 4.6% above the level of a year ago. That may not rival the outsized profit gains experienced by their larger corporate brethren but those companies are not coming to banks for funds, turning instead to the capital markets. What's more, banks are sitting on a huge amount of excess reserves which are earning little or no interest at the Federal Reserve. While risk aversion has not faded entirely, the improving income and revenue stream at small companies does shift the risk/reward equation, making small-business loans a more attractive alternative for banks.

In addition to the encouraging bank lending survey, the markets seemed to overlook another positive report this week. While economic growth has hit the skids in recent months, the downdraft has not yet engulfed industrial companies which continue to ramp up activity. Industrial production in July rose by a sharp 1%, more than reversing a slight 0.1% drop in June. Over the past three months output at factories, mines and utilities has increased by a sturdy 8.4% annual rate. Like most other yardsticks, industrial production has its volatile component that can obscure a trend, most notably wide gyrations in automobile output. In July, auto production did spike higher thanks to the decision of GM to keep 9 of 11 plants open during the usual retooling month. Even so, industrial output, excluding autos, registered a strong 0.6% increase in July. In other words, the gains were broadly based with the majority of major industry groups ramping up production.

To be sure, the economy may turn in a bipolar performance for a while, but sustained hefty increases in the industrial sector are not likely to persist if the rest of the economy is weakening. For the most part, the strength in manufacturing benefited from impressive increases in exports and the restocking of inventories that were greatly depleted during the last recession. We are not too concerned that export demand will wither, as are some, as global economic activity should hold up better than seemed likely a few months ago when the European debt crisis hit.

For one, the euro zone just turned in a solid performance in the second quarter, growing at about twice the pace as the U.S. with Germany doing most of the heavy lifting. That surprising strength will probably fade as the fiscal austerity imposed on several deficit-ridden countries in southern Europe drags down the region's growth rate. The slowdown however, may be less severe than thought a while ago. Also, while the Chinese authorities are leaning against the wind to dampen speculative excesses, that nation's huge economy is still cruising at a remarkable growth rate of around 9 %, only slightly below last year's 11% pace. Meanwhile, other emerging market nations in Latin America and Asia remain on a fast growth track, accounting for ever larger shares of global output. Demand for American made goods, especially heavy machinery and other equipment used to build infrastructure in developing countries should remain strong, underpinning exports.

While most of the inventory restocking has been completed among domestic firms, the lift from this source may not have run out entirely. At last look, inventory levels were barely keeping up with demand; the ratio of stocks to sales stood at 1.26 in June, up from a historic low of 1.23 in April, but well below the 1.48 cyclical peak reached early last year. What's more, the increase over the past two months stems primarily from the fall off in retail sales. Unless the economy slips into the dreaded double dip recession, that relapse should be reversed in coming months. Given the slim volume of merchandise sitting on shelves, it will not take much of a sales rebound to ignite more restocking of inventories by companies

Simply put, there was little in this week’s batch of economic data to suggest the economy’s "soft patch" is getting softer. With the scaled down expectations of growth still the dominant theme, it will take a string of upbeat news to alter market psychology, and that's not likely to happen anytime soon. Next up will be the second reading of last quarter's GDP, which is widely expected to be revised down sharply from the original estimate of a 2.4% growth rate. The consensus is that Washington's revised numbers will bring the growth rate down to about 1.5%. That is still a positive pace, but close enough to the zero threshold to leave the economy highly vulnerable to an external shock. Of course, the most important yardstick of the economy's health is the headline grabbing employment report, which is due September 3. It may not be as ugly as recent reports, but with another 140,000 Census workers falling off of payrolls during the month, it will not be a particularly encouraging omen. Stay tuned.