Yet More Mixed News

The recent pattern of mixed news about the economy continues this morning with the latest data on consumer spending, construction spending, and manufacturing all being released at once. Together these reports simply add to the overall difficulty we have in identifying a clear or firm trend.

Let’s take them one a t a time:

• Starting with the good news. The monthly survey of manufacturing conditions published by the Institute of Supply Management tells us that activity at American factories continues to accelerate. The summary index the ISM reports rose to 58.4% in January, up from 54.9% in December. This is the highest level this index has reached since August 2004 so we have reason to be very optimistic about the near term outlook for manufacturing. Gains were widespread – 13 of the 18 industries surveyed had solid gains in activity, whereas only 9 had reported gains in December. That things are looking up was confirmed by that fact that 70% of those surveyed said they were having to pay higher prices for supplies. Such rising prices are a good sign of tightening conditions along the manufacturing supply chain, and are usually caused by demand rising ahead of capacity being added to meet that higher demand. If this keeps up we should see both rising prices at the consumer end – subject to consumer demand which I will talk about in a minute – and, at long last, an uptick in hiring as factories finally have to add extra shifts to meet demand. So, the manufacturing news today is very good.
• Much less good is the report today about consumer spending. As you know consumption makes up about 70% of our economy on an annual basis, so any movement up or down in consumption has an exaggerated impact on GDP. Indeed was the implosion of demand that created the hole in GDP and sent us into recession, so we watch consumer spending very closely for signs of growth. In this context today’s report is not encouraging: consumers reduced spending in December from the rate of previous three months. Spending still rose – by 0.2% – but that was the lowest rate for any of the months leading up to year end and was well below forecasts. If we adjust that number for inflation spending barely rose at all, eking out a 0.1% gain. Suffice to say that this level of activity is not going to provide the power necessary to keep the economy moving.
• In the same report as spending the government also reports of incomes, which rose 0.4% in December. This figure is a composite and includes personal income from a variety of sources. Most of the sub-categories grew quite well: income from rental property grew 0.7%; incomes from investments grew 0.6%; and small business incomes grew 0.8%. The clunker was in ordinary wage income, which grew a miserly 0.1% after having grown 0.4% in November. It looks as if this latter figure is the reason spending seems so weak at the moment: people are not getting any additional wage income, so they are being very cautious in spending.
• Finally in today’s line up of reports is construction spending, which dropped an alarming 1.2% in December, much more than most experts predicted and a figure that we should certainly be concerned about. The drop in construction during 2009 makes for grim reading: residential construction was off 28% from 2008; private non-residential investment fell 11.2%; and, perhaps just as worrying given the economic outlook, spending on public works projects is also falling – state spending was off 6% in just the first half last year. While the loss of activity in residential construction is easily explained by the glut created during the boom, the slow down in other investment sectors is more of a problem: it will hamper the recovery and suggests that business has a decidedly less rosy view of the medium term.

What do we make of all this data?

Clearly the economy is still going through an adjustment period with no strong direction. The improvement in manufacturing is welcome as long as it can be sustained. The problem looks to be medium term: with consumers as cautious as today’s spending numbers indicate there is little room for price increases to bolster profits, and little margin for error in production cycles. With the boost to production created by the end of year inventory replenishment now coming to an end, businesses will have to look to sales growth for future profit opportunities. That will mean convincing consumers to spend. Given the high level of uncertainty surrounding the employment outlook, and the ongoing need most households have to rebuild wealth and pay off debts, such persuasion is going to be very difficult. A less risky strategy seems to be to modify sales expectations to a more reasonable and possibly lower level.

Unfortunately that all implies slow growth.

The economy’s trajectory appears positive – we will see GDP growth over the next few quarters – but there appears no motivation for an acceleration. Certainly the first quarter will see a sharp drop from the fourth quarter of last year.

Overall: hang tight. This is going to remain a tough economy. It will test the mettle of our businesses and strain the patience of our consumers. All the real risks remain on the downside, which means that any deviation from the current course is more likely to be negative than positive.

What can we do to fix this?

• More stimulus to overcome the jobs problem. It doesn’t matter too much what the cost is as long as it’s enough to put a stop to the reduced activity at the state level. Our local governments are now acting as a very negative factor by cutting jobs in order to balance their budgets. This needs to be more than offset at the federal level. Otherwise we will be back in recession later this year. The private sector will follow the government’s lead, as yet there is no sign of a hiring surge, so the government has to do more.
• Keep the pressure on bank reform. The banks are mending, not lending. I cannot blame them for that: the economy is still uncertain and sensible banking dictates that credit extension is limited until the economy perks up more. Of course this is a little of a chicken and egg situation: until credit eases the economy will not pick up; and as long as the economy doesn’t pick up banks will not lend easily. The break normally comes as business expectations become more optimistic and demand for credit expands in support of capacity increases – e.g. new factories, equipment etc. With the huge capacity overhang we still have – upwards of 6% according to the Congressional Budget Office – it is very unlikely that we will see large credit increases until later this year, if then. In this context bank reform needs to focus, inter alia, on creating more competition. For that we will need to see smaller, or more focused banks.
• Stop fixating on the federal deficit. It is huge. Get over it. The problems are both cyclical and structural. We won’t fix the structural issues any time soon, and certainly not without tax increases. The cyclical problems will go away once the economy is growing again.

A wise friend once told me that when solving our problems we should always ‘shoot the wolf closest to the sled’. With that in mind our order of activity should be:

1. More stimulus, aka ‘jobs programs’
2. Stop the rot at the state level.
3. Reform the banks.
4. Fix the deficit.