Thinking Things Over              February 5, 2012

Volume II, Number 5:   On the Markets and the Economy, Who Is Right, the Bulls or the Bears? 

By John L. Chapman, Ph.D.                                                                                                                     Washington, D.C.

Last week this column noted a disconnect between the words of President Obama in his State of the Union Address and those of Chairman Bernanke and the Federal Reserve the very next day (January 25).  Mr. Obama, on the one hand, sees a “strong” recovery underway and asserts it can be cemented in “an economy built to last” if the Congress will follow his plans for industrial policy, progressive taxation, and (implicit) dollar devaluation.  Meanwhile, the Federal Reserve updated its multi-year economic projections, and the outlook was dour enough to cause the Fed to extend its “zero-bound” interest rate policy for another 18 months, to the end of 2014.  The Fed also sees the unemployment rate barely below 8% two years from now, and down to perhaps 6.7% in three years, while long term GDP growth is expected to be in a range of 2.3-2.6% per annum, way below the 20th century (and post-war) average of nearly 3.4%.

Various high-frequency data on the economy came in positive this past week (see below), highlighted by Friday’s jobs report: the headline number was the establishment survey’s 243,000 new jobs in January.   This further fueled what has been a nice 2012 rally in U.S. equities, which in the case of the Dow Jones Industrial Average (at 12,862.23) are now at their highest level since May of 2008 (and now just 10% off the all-time high set on October 9, 2007); the tech-heavy NASDAQ market ended Friday at 2905.66, its highest close in more than 11 years.  With stocks up 7% so far this year and markets giddy over 3.2 million new U.S. jobs in the last 23 months, are bullish calls for U.S. growth now correct?  Or do the pessimists, who worry about a dysfunctional Eurozone, potential war in the Middle East involving Iran, a China asset-bubble bursting and downturn, and various other assorted macro-economic ills, have the more correct view of the current situation.  And indeed, how might these threats manifest themselves?  We briefly review the macroeconomic situation in order to answer these questions.

The Wisdom of Keynes

The answer to any and all queries about the future can be summed up in the recognition that investor expectations are all-determinative.   There is no better summary of this truth than what Keynes wrote in 1936:

The state of long-term expectations, upon which our decisions are based ….depends on the confidence with which we make [decisions].  The state of confidence, as they term it, is a matter to which preactical men always pay the closest and most anxious attention…..its relevance to economic problems comes in through its important influence on the schedule of the marginal efficiency of capital….. The state of confidence is important because it is one of the major factors determining the ….investment demand-schedule.

Chapter 12 of The General Theory, from which these words are taken, is on long-term expectations, and is perhaps Keynes’ most lucid writing in his entire career.  He is quite correct about the importance of confidence to investor (and indeed, consumer) expectations and demand (or as well, willingness to supply — that is to say, to bear risk heading into an unknown future).   And this in turn really is the crux of the matter at the moment.   A look at recent data and some competing outlooks allows us to gauge the present reality. (We cannot fail to add here that with respect to confidence-driven expectations that form investment demand, the current Administration bears some responsibility for a very lethargic recovery.  From the attack on Chrysler bond-holders, to the 100% partisan (that is to say, zero votes from the opposition party) cram-down of a massive new health care entitlement that added to unfunded liabilities, to out-of-control spending that seemed to have no underlying strategy or coherence, to Dodd-Frank, Boeing, Solyndra, Keystone XL, suing the State of Arizona, new EPA regulations, disregard for the dollar, corporate cronyism, and many other examples, the Obama team have not shown themselves to be allied with job-creating business concerns — or to say it more precisely, to possess a capital investment-friendly zeal, that would speed the end of a deep recession by instilling confidence in risk-taking job-creators.)

The Labor Department’s Jobs Report for January

The Bureau of Labor Statistics’ report for January job creation was impressive.  The business establishment survey showed gains of 243,000 (the broader household survey, which picks up self-employment and new business formation, showed a net job gain of 631,000) which, with revisions, brings total non-farm employment up to 132.4 million, or a growth of three million jobs since the February 2010 cyclical employment low; the unemployment rate fell to 8.3%.  Further, private sector payrolls increased 257,000 in January, and combined with revisions to the prior two months added 66,000 more jobs, bringing the net gain to 323,000.  December gains were led by professional & business services (+70,000), manufacturing (+50,000), leisure & hospitality (+44,000), health care (+31,000), and even construction (+21,000).  This is all very positive and explains the market move on Friday.

While this was the best report in nine months, beat expectations, and came with a $0.04 gain in hourly earnings to $23.29 (a 1.9% year-on-year increase), it is well to place it in long term context as we analyze the state-of-play in the U.S. economy.   Chart I depicts total non-farm employment in the U.S. since 1939, seasonally-adjusted:

Chart I. Total Nonfarm Employment in the U.S., 1939-Present (Log Scale, Seasonally Adjusted) 

This graph is shown in logarithmic scale in order to highlight equiproportional changes in job growth over time, and also, by essentially “linearizing” the data, to show to long term trends.  And what we clearly see is that the 40-year boom in jobs after 1960 ended in 2000, and that nonfarm employment is now essentially where it was 12 years ago.  While labor force entrant growth was expected to slow after the end of the Baby-Boom coming of age in the 1990s and before the Gen-X and Gen-Y wave, there is no justification for such a flattening in U.S. labor force growth, especially considering immigration, and the correlation of economic strength and labor force participation rates.

In other words, a long term challenge on employment and GDP growth is the reality for the U.S. economy.  The labor force participation rate is now at 63.7%, down nearly four percentage points from its all-time high of eleven years ago — and nearly two percentage points during Mr. Obama’s tenure.  Combined with the uncounted non-labor force participants who have not looked for a job within the last four weeks but have within the last year, there should be no resting-on-laurels among the political class over recent job growth.  While part of the decrease is no doubt permanent due to aging of the U.S. workforce (the oldest boomers turn 66 this year, and labor force participation begins to decline by age-group after age 55), a long-term challenge is clearly in play in terms of getting the graph above back up toward its long term quasi-linear trend.  Depending on how this is modelled, the U.S. is at least 12 million jobs below trend and perhaps double that now.  That is to say, while the age 55 and above percentage in the labor force has increased dramatically since 2000 — after being flat at 27% of the labor force between 1980-2000 it has shot up to 33% in 12 years — there are nonetheless several millions who are now on the sidelines who, while not unemployed in the official sense, want work in a growing economy.

Still, in the short-run, the news continues to be generally positive for U.S. economic data.  Jobless claims, which hit 352,000 two weeks ago, were at 378,000 the week ending January 28, trending down to the recent history range (around 350,000) that are commensurate with a sustainable expansion.  Combined with data on U.S. auto sales — themselves up sharply now to over 14 million units annually — these are the best short-run trend indicators in the U.S. economy due to their immediacy and low-correction rate in subsequent reports.  And so indeed, since the summer correction they have reinforced the reality of a mild but solid U.S. expansion.

Other Recent News Confirms the U.S. Expansion

Much of the other economic news this week was positive in terms of evincing sustained growth.  Personal incomes increased 0.5% in December; consumption was also up slightly, and year-on-year, personal incomes are up 3.8%, while spending is up 3.9%.  Disposable personal income (i.e., after taxes) was up 0.4% in December and is up 2.3%, year-on-year.  Along with a 2.7% increase in hours worked, the average worker kept ahead of the 2.4% year-on-year gain in the Consumer Price Index.

Meanwhile the ISM manufacturing index increased to 54.1 in January from 53.1 in December (levels higher than 50 signal expansion, while anything below 50 signals contraction.).  The forward-looking new ordersindex gained to 57.6 from 54.8, and the supplier deliveries index rose to 53.6 from 51.5.  And the service sector is growing as well: the ISM non-manufacturing composite index increased to 56.8 in January, up sharply from December’s 52.  Here, new orders index rose to 59.4 from 54.6, while the business activity index — which shows high correlation to real GDP growth — increased to 59.5 in January from 55.9.  The employment index went up to 57.4 from 49.8, showing the highest reading in nearly six years for services.  And January same-store chain store sales were up 4.8% from a year ago, according to the International Council of Shopping Centers.

Given the Foregoing, What Can Go Wrong?

In spite of the (short term) positive data described above, and a Federal Reserve committed to an easy money policy now indefinitely, there are those who fear the worst.  Respected analyst John Hussman, for example, who has made many correct calls on the market and the economy in the last 20 years, has issued a warning for a global recession in 2012 and a drop in U.S. equities by up to 25%, this year.  Nouriel Roubini echoes this sentiment and claims that a multi-trillion dollar coordinated central bank liquidity program will be needed.  Their thinking is centered on the Eurozone, and on imbalances in the Chinese economy (a massive property bubble and commercial malinvestment, undervalued currency, and major labor force underutilization), with a third risk being a war over Iran that would disrupt the flow of oil.

Of these three, by far the biggest near-term risk is the Eurozone, which is currently in de facto recession and expected to show GDP growth of only 0.6% this year.  What would throw the U.S. into recession this year here?  Quite simply, a “blow-up” in Greece, Portugal, and possibly Italy which, while not large in terms of scale, would have a major effect on Keynes’ focus: investor confidence.  Specifically, say, continued Greek recalcitrance and resistance to a reform-based deal with international creditors will end both their access to global capital markets and the “gifts” from the IMF and ECB in lending support. How could this play out, in the absence of what needs to happen, which is an immediate thirty percent reduction in Greek living standards?

(1)  Default on currently-serviced Greek debt becomes official, and commercial ties to the country would at least temporarily cease.   In Latin America in the 1980s and ’90s, and in Russia in the ’90s, for example, there were international lending consortia led by the United States who stood ready to renegotiate and seek work-outs, often involving currency reform and change of governments.  But the times are different now, with the entire world more highly-“leveraged” or indebted.  While there are multiple possible scenarios, what seems most likely is Greece issuing a New Drachma to its citizens not unlike the German currency reform at the end of 1923.  But capital controls would be slapped on the country immediately as Euro-holders would seek to convert holdings into hard assets.  Absent a bona fide work-out plan backed by international creditors (which would happen eventually), months of chaos would ensue.

(2)  This would lead to major gyrations in the European banking system, and government support for banks holding all periphery country debt would become axiomatic.   A temporary inter-bank freeze would ensue (although this has already been anticipated and stanched by recent ECB backstop actions), and share prices would fall dramatically in Europe.  There may well be riots in more countries than just Greece.

(3)  In theory, U.S. investors seeing this, and listening to Eurozone calls for a Fed/U.S. Treasury-led bailout, would become nervous, causing a sharp drop in U.S. asset prices and flight to Treasuries, gold, oil, and other traditional hedges.  Any quantitative easing by the Fed might well have a countervailing effect on U.S. share prices, but would cause sharply higher commodity prices around the globe.  U.S. retrenchment in turn would have repercussions on an already-imbalanced China.

The result of all this is, Messrs. Roubini and Hussman fear, a potential for a mini-depression.  Paul Krugman agrees with this and wants another $2 trillion in stimulus spending in the U.S. to fight a liquidity trap, now.  But how possible is this dark scenario?

We remain sanguine about 2012: the ECB has taken significant action in recent weeks to assure liquidity of the banking system and freely flowing access to bank credit.  Behind the scenes, there are contingencies being looked at in the event of an untoward Greek exit from the Eurozone, and the Greeks themselves, harsh though their reality is, have seemed more amenable to at least an orderly default.   We thus see the likelihood of “decent” growth in the U.S. for 2012 still quite strong.

But we do agree with the bears that the future is fraught with trouble: either U.S. fiscal and monetary policies will be revamped pro-actively, by a Beltway political class that comes to its senses on economic growth (in terms of a stronger dollar, spending restraint, roll-back of onerous new costs on job creation, and tax reform to encourage capital investment), or the U.S. faces a future no different than our Greek brethren do now.  That is to say, there are storm clouds gathering over the U.S. economy that years of anti-capitalistic malfeasance have foisted upon us.  2012 is a year of stark choices, and we can only wonder if Messrs. Romney and Obama, say, understand this in depth.  We can only add: we hope so.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@4kb.d43.myftpupload.com.  The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.  

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