The Economy and Profits

The plummet is now more of a sharp fall.

That’s the best way to describe the way the economy is now behaving. This morning’s release of the revised first quarter 2009 GDP data has it declining at ‘only’ an annual rate of 5.7%. The original estimate, made last month without some of the final data, had the drop at 6.1%. So it seems that the economy is falling less rapidly than either we first thought or the previous quarter which saw a fall of 6.3%.

So have things begun to turn around?

Maybe.

The revision to the first quarter is (a) not very large; (b) less than many people were hoping for; and (c) due mainly to an unexpectedly high level of inventory. This latter point is particularly ambiguous. Inventories can be high because businesses are gearing up for rapid sales. Or they can be high because sales were bad. I think it is the second of these two explanations that underlies the first quarter result and so gives us little to cheer about. Consumption remains mired in the doldrums despite the 1.5% increase in the first quarter, and since that is, ultimately, what will drive us out of recession placing too much hope on the slight upward revision is foolhardy.

Other components of the economy are equally bad: business non-residential investment is awful and much worse that the end of last year; so too is residential investment. Trade has diminished on both the export and import sides and is unlikely to recover any time soon – at least while the entire world struggles to recover from the recession that is now global in nature.

We should also note that the last six months of decline have been the worst for fifty-one years. We only averted a total collapse by the skin of our teeth, in large measure due to the extraordinary efforts of the Federal Reserve Board and the administration. Nonetheless we are hardly off life support yet: the banking system remains weak, and rising unemployment casts a long shadow over the near term outlook for consumption. These are the short term dangers. Longer term we have to be concerned about the negative impact of debt reduction. This so-called ‘de-leveraging’ will cramp demand for a long time, possibly several years, so even when the economy is recovering, growth is likely to be slow by historic standards.

Plus all the anecdotal evidence piling up tells us that efforts by businesses to cut costs will come back to haunt them. In particular is the pernicious effect of salary reductions. By eliminating part of income from pay packets around the economy businesses are making harder for consumers to return to old spending habits. This will aggravate the effects of de-leveraging and slow us down even more.

Conversely cost cutting appears to have boosted profits. They rose quite strongly in the first quarter, by 3.4%, after having fallen a whopping 16.5% in the fourth quarter of last year. Only closer inspection much of this recovery in profits seems to be in the banking system where the very steep yield curve – the difference between short and long term rates – is bulking up bank incomes. Don’t forget that banks make most of their money by borrowing short and lending long, so a steep yield curve means they can borrow cheaply and yet lend at much higher rates. This steepness is intentional: part of the administration’s recovery strategy is to engineer a profitable yield curve for the banks so that they can ‘earn their way’ back from insolvency to capital sufficiency. On the face of it this strategy is working so far.

Apart from de-leveraging and cuts in wages there are still very significant dangers lurking out in the weeds. In particular the commercial property market looks very weak. Spreads in the secondary market for commercial real estate based securitized loans are very wide. This is a sign of the growing concern in the market that many developers will not be able to find sufficient funding to roll over their debts and thus will default. The administration is currently trying to extend its TALF loan support program into commercial real estate to help restore confidence, but its efforts have been hampered by Standard and Poor’s announcement that it is reviewing the commercial real estate sector with a view towards reducing most of its ratings from AAA to something a lot less. This could have a profound impact since many secondary investors only invest in AAA rated securities. If the downgrade goes through then the prospect of default by many developers gets much greater. Such defaulting, coupled with the continued uptick in credit card losses could undo all the work to restore bank profits.

So the situation remains delicately poised.

While there are some signs that things are leveling off somewhat all the real variability still lies on the down side. In other words the risks are biased towards worsening that improvement. We need to avoid any of these risks materializing over the next few months in order to emerge from recession.

Will we?

I think the outlook is the same as it was last month: the economy should just about climb out of recession later this year. Possible growth in the fourth quarter of between 0% and 0.5% – that’s a considerable upturn form the first quarter’s decline of 5.7%. Next year looks very weak: growth of between 0.5% and 1.5%.

But this improvement depends on our avoiding the rocks, especially a second round of losses at the big banks. It is not cast in stone.

Keep your fingers crossed.