Cost Cutting Our Way Back to Prosperity
- Earnings continue to come in at or above expectations, with cost cutting producing more than enough savings to offset declining revenues. The better than expected earning news helped send the Dow above 9,000 on Thursday.
- More folks are also buying into the notion that the recession is ending. The Leading Economic Index rose 0.7 percent in June, marking the third consecutive increase.
- Existing home sales rose 3.6 percent in June, marking the third consecutive increase. Prices rose slightly and the months' supply of home on the market declined for the second straight month.
Slow But Steady Progress Is a Good Thing
Second quarter earnings announcements overshadowed this past week's relatively light schedule of economic reports. Earnings have generally beaten expectations, with cost cutting more than offsetting disappointing news on revenues. The emphasis on cost cutting is evident in the economic data but may be easing a bit. Layoffs have clearly slowed, as evidenced by the declines in both weekly first-time unemployment claims and continuing claims for unemployment insurance. In addition, mass layoff announcements tracked by the Bureau of Labor Statistics also show some tentative signs of topping out. While layoffs may have peaked, hiring shows no sign of picking up. We do not expect businesses to boost hiring until they see some evidence sales are growing again and order backlogs are rising.
One unambiguously positive bit of economic news this week was the 0.7 percent rise in the Leading Economic Index. The increase marks the third consecutive significant gain for LEI, which in the past has tended to signal a turn in the business cycle. The ratio of the coincident to lagging indicators, which is an alternative measure of business cycle turning points, also rose solidly in June, climbing 0.4 percent. The coincident to lagging index has risen 1.3 percentage points since bottoming in March. The breadth of the increase in the LEI adds credence to the notion that we are at a turning point in the business cycle. Seven of the ten leading economic indicators improved during each of the past three months.
Another clear, positive sign the economy is on the mend is the continued flow of better news on the housing sector. Sales of existing homes rose 3.6 percent in June to a 4.89 million unit pace, marking the third consecutive monthly increase. The National Association of Realtors reported that the foreclosures and short sales accounted for only 31 percent of sales in June, which may explain the improvement in average and median home prices. The supply of homes on the market declined slightly, falling to 9.4 months. While good news on the housing market is clearly welcome, there are concerns that a considerable backlog of foreclosed properties and homes likely headed for foreclosure will hit the market later this year and in 2010.
The federal minimum wage rose to $7.25 per hour today, marking the third installment of a 70 cents per hour increase enacted back in 2007. The increase in the minimum wage comes at a difficult time for many businesses, which have seen sales slump and orders decline. Businesses are much more focused on cost cutting right now rather than expanding operations or adding staff. This is particularly true of restaurants and retailers, where the vast majority of minimum wage workers are employed. The Bureau of Labor Statistics notes that roughly 2.5 percent of workers paid hourly earn the minimum wage or less. Among those earning the minimum wage, most tend to be young, with about half the workers below age 25 and about one-quarter being teenagers. Coincidently, the teenage unemployment rate has skyrocketed since the first phase of the most recent hike in the minimum wage took effect two years ago.
U.S. Outlook
Consumer Confidence • Tuesday
The Consumer Confidence Index fell 5.5 points to 49.3 in June after jumping nearly 14 points in both April and May. April and May's gains were due in large part to the expectations series which rose around 40 points in the two month period and was likely bolstered by "green shoot" sightings. Consumers likely removed their rose-colored glasses in June, with the labor market still under considerable stress and the unemployment rate reaching 9.5 percent. We expect the consumer confidence index fell for the second consecutive month in July to 47.8. The labor market has shed roughly 6.4 million jobs since the recession began and while layoffs have subsided, hiring has not picked up. We expect the unemployment rate will likely rise upwards of 10 percent in early to mid 2010.
Previous: 49.3 Wells Fargo: 47.8 Consensus: 48.7
Durable Goods • Wednesday
New orders for durable goods posted two consecutive increases of 1.8 percent in April and May with transportation and defense responsible for most of the gain. Recent declines in industrial production, the new orders component of the ISM manufacturing survey and manufacturing capacity utilization suggest the gains will be reversed in June. Driven by slowing business and consumer demand, orders for durable goods will likely fall 1.3 percent in June. Domestic demand in particular is being restrained by continued job losses, sluggish wage and salary growth and a massive loss of wealth. Nondefense capital goods shipments did not fall anywhere near as much as they did during the first quarter, which means business fixed investment fell at a less dramatic pace during the second quarter. It still dropped, however, and probably at a hefty double-digit pace.
Previous: 1.8% Wells Fargo: -1.3% Consensus: 0.5%
GDP • Friday
Real GDP in the second quarter likely posted its fourth consecutive decline, but the pace of the decline is slowing. We expect real GDP likely fell at a 1.6 percent annual rate in the second quarter with the bulk of declines due to a continued drawdown in real inventories. Our forecast for the second quarter calls for inventories to drop by around $100 billion, which would subtract around 0.4 percentage points from second quarter real GDP. While personal consumption, business fixed investment and residential construction will likely also post declines, the pace of declines has slowed significantly suggesting the worst of the recession is behind us. With inventories at historic lows, production is now set to ramp up in the third quarter which should help to push GDP into positive territory. The economy may expand during the third quarter, but consumer demand is not improving.
Previous: -5.5% Wells Fargo: -1.6% Consensus: -1.5%
Global Review
The Great Melt-Up?
- Stronger data came out of Asia and North America this week. Large and frontloaded fiscal packages are a major factor here, as is the fact that the severe production cuts we saw in Q4 of last year are just not sustainable longer term. The inevitable bounce eventually ensues.
- European data also surprised on the upside. Eurozone manufacturing and service PMIs for July both came in well above expectations, bolstering the case that the global recession is easing. Adding to the euphoria, U.K. retail sales surged in June and French business confidence strengthened again in July.
The Great Melt-Up?
The firmer tone in economic activity continued to build across the globe. We saw notably stronger economic data in Asia, North America and Europe this week. South Korea reported GDP in the second quarter jumped 2.3 percent. At a seasonally-adjusted annual rate, as GDP is often reported in the U.S., the increase becomes 9.7 percent, in line with the Bank of Korea's estimate at the beginning of the month. The GDP increase was broadbased, with private consumption clearly responding to stimulus measures, rising 3.3 percent quarter-over-quarter. Gross fixed investment jumped 2.9 percent and exports of goods and services expanded at an 11.2 percent pace.
In North America, Canadian retail sales for May surged 1.2 percent on the month, twice the consensus estimate prior to the release. This followed an upwardly revised decline in April of 0.6 percent. Auto sales paved the way with a healthy 2.4 percent gain, but seven of eight retail categories also registered sales increases on the month. Building and outdoor home supply store sales rose 1.0 percent on the month and have risen now for two consecutive months.
Even the United Kingdom reported stronger retail sales. June retail sales jumped 1.2 percent month-over-month compared to consensus expectations of a modest 0.4 percent gain. Retail sales in the United Kingdom have hardly lost a step in this recession so far. Year-on-year retail sales are up 2.9 percent. Analysts attributed the gain to a bout of warm weather and the impact of the temporary 2.5 percent cut in the VAT from 17.5 percent to 15.0 percent for stoking consumers' animal spirits and getting them to part with their cash. The VAT tax reduction has been in effect since December of last year and will remain in place until December of this year. The drop in energy prices is helping to boost real incomes and consumer discretionary spending power.
U.K. vehicle sales were strong, with a government car- scrapping scheme effectively propping up new car sales. Prime Minister Brown recently credited the car-scrapping scheme for boosting car sales by over 120K vehicles. However, the market has its doubts about the reliability of these data. U.K. consumer spending and retail sales data have been moving in opposite directions since Q4 2008. There have been changes to the methodology that are supposed to reduce the growth rate of the retail sales data. So far, this does not appear evident in the releases.
Eurozone PMIs for July confirmed the improving global economic outlook. The July manufacturing PMI jumped to 46.0 from 43.6. Consensus was looking for 44.1. This is the fifth increase in a row with gains seen in Germany and France. The service PMI increased to 45.6 from 44.7. Both indexes are still below the 50 level that would signal outright expansion, but at this point, we will take what we can get. In addition, Germany's Ifo index for July jumped to 87.3 in July from 85.9.
Global Outlook
Japan Total Retail Sales • Tuesday
The Japanese consumer appears to be slowly returning to the stores. Consumer confidence rose to an 18 month high in June to 37.6 from a record low 26.2 in December. Encouragingly, new vehicle sales are undergoing a broad-based recovery. Newly registered vehicle sales (ex-minis) improved to -13.5 percent year-over-year in June, boosted by government incentives. May total retail sales were roughly flat at -2.5 percent year-over-year. We expect further improvement in total retail sales in June.
Japan's real PCE in May jumped 2.2 percent on the month. Real Japanese PCE growth is now a positive 0.3 percent year-over-year. For working households, real PCE growth is even stronger, up 1.8 percent year-over-year.
Previous: -2.7% (Year-over-Year) Consensus: -2.5%
German Unemployment • Thursday
Germany has begun to see some stabilization of employment losses from the steep declines seen in the first quarter of this year. The May data looked much better than expected partly due to changes to the official statistics, though the government's decision to extend the possibility for companies to shorten working hours has had a large positive effect as well. The risk is that when these policies expire, if demand has not materially improved, German job losses and unemployment could spike far higher. German June jobless numbers rose 31K with the unemployment rate rising one-tenth of one percent to 8.3 percent. We expect job losses to continue at a moderate pace in July, with the unemployment rate ticking higher.
Germany also reports July CPI and consumer confidence earlier in the week. CPI will be volatile month-over-month due to changing energy prices, but the risk of prolonged deflation is ebbing.
Previous: 8.3% Consensus: 8.4%
S. Korean Industrial Production• Friday
South Korea, along with China, Japan and Taiwan are experiencing a healthy bounce off the January lows in exports and manufacturing production. We expect to get more encouraging news on this front on Friday when South Korea reports June industrial production. South Korea's industrial production rose 1.6 percent in May. It was the fifth straight monthly increase and the highest reading on industrial production since October. Industrial production was down 7.7 percent year over year in May, a marked improvement from the -25.5 percent record low in January.
June export orders for South Korea foreshadow another respectable gain in industrial production in June. June exports jumped 17.4 percent for the month. Export and manufacturing gains are now clearly visible in key South Korean sectors such as electronics and vehicle production.
Previous: 1.6% (Month-over-Month)
Point of View
Interest Rate Watch
Fed's Exit Strategy and Its Implications for Spreads
With his opinion piece in the Wall Street Journal prior to Tuesday's testimony Chairman Bernanke outlined an approach to the Fed's exit strategy from the "highly accommodative monetary policy" of the Fed that began two years ago. For some time we have spoken about this exit strategy with the explicit focus on the change in relative spreads such a strategy implies. In an earlier speech (June 15, 2009) Governor Duke presented some interesting views on the mortgage market and its "average" spread over Treasuries. There are three essential points about this exit strategy for fixed income markets.
First, Chairman Bernanke mentions several times that "these policies would help to raise short-term interest rates." This is the traditional approach to a monetary policy aimed at limiting liquidity. This policy aim clearly means a higher average level for all interest rates and a flatter yield curve. The spread between long and short rates will narrow and thereby impact bank profitability and the profitability of lending along the curve. Markets anticipate change and as the economy recovers the markets will anticipate a flatter yield curve.
Second, the Fed's attempts to reduce liquidity will impact the relative returns for all instruments it attempts to sell. Over the last several months Fed holdings of Treasury and especially Agency MBS have risen sharply. When the Fed attempts to sell these assets, relative asset prices will change sharply.
The final issue is not if there is a plan, but if it will be implemented in a timely manner. During the American Civil War General McClellan had the Army, yet refused to wield it, to Lincoln's consternation. Moreover, even when McClellan won at Antietam he failed to follow through and pursue Lee. We now know the Fed has a plan - but that's not the issue. Will they implement and follow-through?
Consumer Credit Insights
The Fundamentals
Consumer credit, in all its forms, reflects the fundamentals of both supply and demand. On the demand side we have witnessed changes in consumer incomes, their confidence level and their expectations of prices for goods/services that are often financed by credit. The decline in the use of credit is not an irrational reaction generated by panic but rather the rational response of consumers who see changing fundamentals.
Expectations drive behavior and household expectations for future income gains have downshifted to reflect the reality of a weakened labor market and future tax burdens. In our July outlook we estimated that real disposable income growth in 2009-2010 will average 1.7 percent compared to the pre-recession average of 3.2 percent in 2006-2007. This is accompanied by slower wage growth as well as significant downshifts in expected lifetime earnings in the manufacturing and finance sectors. Further, our expectations are for persistently high unemployment rates. Therefore, consumer optimism is down and household saving rates will be higher at any given income level. A more cautious, higher-saving consumer will give rise to more limited demand for credit over time. Finally, the expected future appreciation of assets that are frequently financed by credit has also diminished. This is certainly true of housing. Therefore, for any given interest rate, less financing of such assets is likely to occur.
Wachovia Corporation http://www.wachovia.com
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