inventories

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Up and Down We Go

As if right on cue today’s news encapsulates everything we’ve been talking about all week: despite all the brouhaha about recovery our progress is precarious.

First: durable goods orders.

Today’s report is bad news. Durable goods orders fell at a 2.4% rate in August. That’s the second drop in the last three months, but follows what we all thought was a turn around in July when they rose a strong 4.8%.

As usual I caution everyone about taking one month’s data and making it the whole story. Durable goods orders are notoriously ‘chunky’. The numbers include a whole mix of things and run the gamut from refrigerators to airplanes. One order for a few airplanes and the index can leap, only to plummet next month. So we should look at the numbers in both more detail and over time.

The problem with this is that the story doesn’t improve too much.

Durable goods orders are typically seen a harbinger of future activity since they include machinery needed to re-tool factories. They are also, obviously, a factory based set of products so they give us insight into the state of play in manufacturing.

There are two major possible distortions that could cause the data to mislead us: the aircraft orders I mentioned already, and defense spending. Both tend to come in batches of large orders and thus can skew the data off of a ‘normal’ trajectory. Since it is that trajectory we are interested in it is sensible to look at the data without them.

Unfortunately that doesn’t help us. Take out aircraft and defense and orders still declined. Clearly businesses are being very reticent about investment. They are sitting and waiting for more insight into the nature of the economy as it grows over the next few months. This report suggests a continuing lack of optimism throughout the business world.

Worse: the drop in orders has now caused the backlog of unfilled orders to decline. That means our factories are looking at a few months of flat or slightly lower activity. If this data means anything it tells us that the hope for an acceleration in manufacturing is more hope than reality.

One consequence of this is that factories are not about to begin a burst of re-hiring. So our job market will remain weak, at least in the manufacturing sector. A flat order book provides no incentive to re-hire or to expand capacity, and with so much idle capacity already out there we are probably looking at a few more months of moving sideways rather than making solid gains.

On a different front today’s report of weaker than expected new home sales is also bad news. They rose only a meager 0.7%, which is a poor record given that home prices have dropped so significantly over the past year or so. The mean price of a new home dropped 9.5% between July and August – the largest one month decline on record – and the median price has declined by 11.7% over the past year. Couple these price drops with the recent tax credit for first time buyers, and I think many people expected a stronger performance in August. In this context that 0.7% gain looks anemic to say the least.

As I wrote yesterday the housing market is all muddle at the moment. Builders are completing fewer new homes as they try to avoid sitting on inventories of unsold homes: completions dropped 5.8% last month, and that helped reduce the inventory of unsold homes to about a 7 month supply – the lowest since early 2007. But builders are facing very stiff competition for buyers because of the flood of cheap foreclosed homes: many first time buyers who normally would have bought a new home were able to purchase a cheaper foreclosed home. The bad news within the data is that a new home, once completed is now taking as much as a year to sell. We are used to thinking of a 6 month unsold home inventory as ‘normal’, so, given the ‘stickiness’ of sales it looks as if it will be a few months more before we reach that level – perhaps by the first quarter next year. After that I think the market will stabilize around a lower volume, at which point housing will once again be a net positive for the economy as a whole.

Rather than leave you on such a low note I should also mention today’s release of the University of Michigan’s regular Consumer Sentiment survey. The index of confidence jumped from 70.2 to 73.5 in the the first couple of weeks of September and compares really strongly with August’s overall reading of 65.7. Consumer confidence is a very difficult statistic to get our arms around simply because it is intangible. The big question is whether rising confidence will lead to more sales. If it does then the steady improvement we are now seeing in consumer outlooks should translate into the kind of consumption that would cause those reticent businesses I mentioned earlier to start investing and blowing the cobwebs off their factories.

Setting this all in the big picture:

Our economy is suffering from a massive reduction in demand. We have production capacity sitting idle waiting for signs of a revival in spending. While that revival looks suspect or way off in the future businesses will not invest – this is why durable goods orders are weak at the moment and is also why we will continue to keep an eye on them. Every month we go without getting back on track costs us hugely in lost wealth we will never recoup: at our current rate we are losing, for ever, around $200 billion of national wealth. So that uptick in consumer confidence cannot come at a better time – let’s hope it translates into sales in the stores.

Meanwhile: keep in mind that $200 billion a month figure.

Nest time someone you know argues about the cost of bail-outs or stimulus plans think about their cost in the context of the wealth leaking away. The contraction has cost us almost $2 trillion. So the spending of about $trillion to get things going again was a good deal. Remember that without that spending we would have fallen deeper and longer into the abyss. At that point the $2 trillion loss could easily have doubled.

Yes, it is expensive to have the government bail out the private economy, but the private sector collapsed and we had no option. Deficit spending is not something I advocate as a permanent policy, far from it, but there is a time and place for it.

Like now.

It works. Now let’s move on.

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Upbeat News – Maybe

This morning’s release of the Conference Board’s Index of Leading Indicators brings us more good news: last month was the fifth straight month that the index gained. Yes the August increase of 0.6% was weaker than either July (0.9%) or June (0.8%), but it keeps the upbeat rhythm going and helps to confirm the growing sentiment that the recession finally ended in the third quarter.

By now there is, of course, no surprise in this. For several weeks now it has been clear that the economy reached its nadir sometime this summer and is now slowly edging away from the abyss.

The Conference Board also publishes two other indices that are supposed to track the economy one coincidentally and one with a lag. Both those are showing the same trend. The Coincident Index has now stopped declining and is essentially flat, while the lagging index is still falling, but now at a much slower rate.

Things are evidently looking up.

Up to what?

Here the difficulty arises.

I have written before about the variety of interpretations concerning the direction and strength of the economy from here on out. Depending upon your degree of inherent optimism we are now rebounding nicely, or we are teetering on the brink of falling backwards. Neither position will be exactly correct and the most likely course for growth seems to be ‘patchily and slowly upward’.

The current phase of growth depends heavily on a combination of inventory adjustment – businesses re-stocking depleted shelves – and the administration’s stimulus plan. Take those two elements away and we are still mired in recession. In other words the economy has not yet entered a self-sustaining growth cycle where consumption is sufficient to drive job, incomes and hence spending growth.

The degree of optimism built into anyone’s forecast at the moment depends entirely upon their view as to what happens when the ‘training wheels’ of inventory adjustment and stimulus plan are taken away.

My own view is that once those effects fade, as they will towards the middle of next year, the risk of a second contraction – renewed recession – remains high.

I say this for two major reasons that are inter-linked:

  1. Unemployment hangs very heavily over us and will continue to exert a negative drag on spending.
  2. Related to this: the economy has accumulated enormous excess capacity, which has to be used up before we can return to a more normal cycle of expansion.

As long as that capacity overhang exists business can expand and meet growing sales without either investing in new factories and other forms of capital, or, and this is crucial, investing in an expanded labor force. So the outlook for job growth is spotty to say the least. In fact I think it likely that unemployment will continue to edge up throughout this year even though we are out of recession. Last week’s unemployment data – new claims for unemployment insurance – concerns me. That fact that we seem stuck and are still losing half a million jobs every week or so gives me great pause. There is no sign whatever of the private sector re-hiring. On the contrary belt tightening still seems to be the order of the day.

Setting aside the obvious attendant human misery that this unemployment trend is creating, we need to focus on the drag this places on the recovery. It appears as though businesses are still in a defensive mode. If this is the case throughout the next few months then there is no way that a recovery can become self sustaining: as each business seeks to preserve its own profit it acts to diminish the sum total of all profits – a cut cost for you is lost income for me. This is what caused us to sink so low, and it could be sufficient to sink us again.

In other words the private sector still is fearful enough that it could self destruct and derail the recovery next year some time.

Think of it this way: businesses have to make guesses about their future sales – let’s dignify this and call them ‘forecasts’ – they then make decisions about buying raw materials and hiring workers based upon those forecasts. So the economy of late 2010 depends heavily upon business expectations today. To a very large degree those expectations become self fulfilling: if the forecasts were for higher sales then the act of tooling up to meet those expectations creates much of the growth – the new jobs and raw material purchases generate incomes which, in turn, create the sales that the businesses were forecasting.

Economists have a fancy name for this: ‘Say’s Law’, which roughly translates into the supply side mantra that ‘production will create its own demand’. This idea lies at the heart of classical economics. The problem comes when expectations are for insufficient sales: then it seems that Say’s Law breaks down and, instead we enter a Keynesian world that he called ‘the paradox of thrift’ – cuts lead to more cuts and so on downwards. This is the exact opposite of what the classical textbook predicts.

So business expectations are vital to the recovery, and a key variable informing those expectations is the availability of disposable income which, in turn, depends highly upon job growth.

Advocates of a more robust recovery are clearly predicting a much stronger uptick in employment. I just don’t see anything to support that view – remember that the last two recoveries have also seen very weak job growth, and it was one of our major criticisms of the Bush era that it simply failed to generate enough jobs. Clearly the US economy has a different tenor than it did a few decades ago and those job growth surges so characteristic of earlier recoveries are no longer ‘normal’.

So, while there are many anecdotal signs of jobs ‘out there’, the aggregate story remains both dull and challenging.

We will get more information on Thursday when the weekly claims for unemployment insurance numbers are published. Most people are forecasting another drop, but the relevant question is whether that drop is large enough to undermine my more cautious outlook.

Stay tuned.

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Job Outlook and Is GDP The Right Gauge of Growth?

Today’s weekly data for new claims for unemployment insurance can be read in a number of ways. New claims dropped by 12,000, so if your are optimistically inclined you could argue that this is more evidence that the economy is now recovering – there is plenty of anecdotal support for this contention and yesterday’s report from the Philadelphia Fed district that manufacturing is perking up certainly bolsters that view. This is the mode we have entered as inventories continue to decline and put pressure on suppliers to re-stock shelves.

The pessimists, however, can point to the continuing size of the new claims: 545,000 last week. This brings us back down to where we were in mid-July when a few folks were making the case for a rapid recovery. Since then things became stuck, and progress has been minimal. The good news is that we are now seeing rates of new claims 125,000 below the peak we reached in the early part of the year. The bad news is that we don’t seem able to get the figures to dwindle to a level indicative of a healthy economy. Obviously something continues to be very wrong.

For my part, as you know, I look at unemployment as an indicator not just of the economy’s immediate vitality, but also of the sustainability of the recovery.

Which means that I am inclined more towards pessimism than optimism based upon this data.

It looks very much as if businesses are highly skeptical about the recovery and the chances of it lasting. That drives them to avoid making a commitment to rebuilding their workforces. The private sector is a long way short of being able to maintain healthy growth, if for no other reason than it is locked up in fear. This, of course becomes self-justifying: the longer businesses hold off hiring, the longer consumers fear unemployment and save rather than consume. This lowers sales and thus validates the decision of businesses not to hire.

There is nothing unusual about this syndrome: it is normal during a recession. What is odd this time is the depth of the cuts that were made and the much larger number of unemployed now waiting new jobs. The longer this situation lingers the more risk we run of falling back into recession. So numbers like these are not a cause for much joy, even though they represent a move in the right direction. Were manufacturing cranking up more aggressively we should be seeing the new claims data dropping quickly down into the 150,000 range. Instead we have continuing claims, i.e. longer term unemployment, rising steadily.

We are nowhere near out of the woods, despite the recession having ended in the textbook sense.

Which bring me to a different topic:

Many commentators are now suggesting that GDP is a very inaccurate measure of what is going on in the economy. The reason for this is that GDP measures the production and consumption activity of an economy, but completely ignores a whole slew of ‘softer’ and more difficult to measure notions like well-being, quality, sustainability, and so on. A good example of this problem is our current situation: the recession is most likely ended because a classic inventory cycle appears to be unfolding. Stocks are depleted below acceptable levels and producers are being forced to increase activity, even though sales are still weak. The problem with touting this turn of events as a solid achievement is that we still have huge imbalances and a vast sea of distress: not just unemployment, but record foreclosures and bankruptcies as well. Any concrete measure of well-being would surely indicate we are still mired in trouble. This casts a shadow across the credibility of the claim that things have turned around. Studies of public opinion reveal that an increasing number of people regard figures like GDP as wrong, rigged, or simply irrelevant. This undermines support for public policy actions when they are needed to boost the economy and things like GDP are used as factors in the discussion.

We could put this public skepticism down to it being simply part of the general cynicism that has settled onto public discourse, but even so we need to think hard about why it that the public looks at GDP and other statistics as being nonsense.

One reason is that the wide distribution of incomes and its increasing concentration in a very small number of households has made the average person feel disconnected from the average growth in wealth. Obviously if the growth tends to go disproportionately to one group, others, who receive a smaller share, will view the overall change with a healthy disbelief. The American economy has undergone a rapid and historic shift in its distribution of wealth: the top tier garnering almost all the increase for years. This makes public statements by politicians about how well we are all doing ring hollow for more and more people.

Likewise when politicians sing the praises of the recovery they are talking to a population still reeling from the loss of wealth in their home values, and in ongoing fear of losing their job. Not just this but large numbers of people face poverty despite being fully employed.

The disconnect will inevitably grow as long as wealth is distributed the way it is here.

And the political process will become more extreme as various sections of the population steadily lose their ability to keep up with what they hear is a healthy overall economy. Populism and extremism are almost always associated with wide disparities in income because the middle class finds itself falling into ‘working class’ conditions. This tendency is exaggerated by an economic downturn. And is even more exaggerated by a downturn where a primary cause of the crisis was a bunch of vastly overpaid bankers whose jobs were saved by the very people losing their own jobs as part of the crisis.

Getting back to GDP: the French government commissioned an international study of ways to make GDP more responsive to actual outcomes in life and the way in which average people perceive their lifestyles being affected by economic changes. The study has recently been released and the French have announced that they will adopt the new measures. The effect will be to raise French GDP quite a bit. The driver of the increase is largely the way the new measures take into account some of the ‘soft’ issues. The average French person gets a much longer vacation: this obviously has value to them but this value is not measured in GDP. Similarly work at home and do-it-yourself activities are not counted in GDP – if you mow your own lawn that activity has no value in GDP; but if you pay to have in done, it will count because it is a ‘productive’ activity. This is clearly nonsense, but that’s the way GDP works.

Perhaps an even odder example of the way GDP distorts things is the example of a traffic jam: all those idling cars are consuming gasoline which adds to GDP via sales of gas. But nothing is being created that we can look at and say, credibly, that society is better off. Quite the contrary. Likewise Hurricane Katrina wipes out New Orleans, which is surely a social disaster, yet the re-building adds enormously to GDP. Where is the sustainable social benefit from reconstruction of devastated cities?

The French study was undertaken by a group of very well known and respected economists including Joe Stiglitz and Cass Sunstein form the US. It remains to be seen whether other countries adopt the new measures – I think it likely most of Europe will because of the new environmental components being proposed.

How would the US do with these new measures?

Our GDP would fall. I wonder if this has anything to do with the French haste in adopting the new standards? No it couldn’t be!

On a more serious note: this topic will not go away. Many economists have been arguing for years that GDP is only one measure of well-being and a not very good one at that. Household wealth and income may be one better measure as long as it includes a measure for leisure and work at home. Plus environmentalists have argued for a quotient for sustainability. The Europeans also want to include the benefits of socially provided services more accurately: if someone receives health benefits, but does not pay for them directly GDP undervalues that activity. If the same person purchases the same service and pays out of pocket then GDP rises accordingly. But the same social value has been created in both cases. The Europeans argue that GDP undervalues their standard of living as a consequence of things like this. And they are right.

But right now we are stuck with GDP – it is relatively easy to compute and nearly everyone worldwide does it the same way. So those obsessed with international comparisons will still prefer GDP until there is consensus over the alternative.

Meanwhile the French, never afraid to be unique, will start to produce a new version of GDP soon. And we have an economy that is recovering when measured the good old way.

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Recession’s End? Absolutely.

The Institute for Supply Management can hardly be described as a ‘happening’ or ‘fun’ crowd. The entire concept of supply chain management is enough to make most of us yawn with indifference. So it’s very hard to get a crowd wound up over the ISM Monthly Report on Business. But perhaps today is a little exception.

That’s because today’s ISM release is the most tangible piece of evidence so far that the recession is over.

Each month the ISM diligently gathers data from its members. It asks detailed questions about their perceptions of business conditions, and compiles the information across both industries and supply chain process stage. The output is what we would expect from a bunch of industrial engineers: careful, methodical, timely, and excruciatingly dull. Nonetheless through the years the overall index of business conditions has won a central place in the hearts of all of us who follow the economy.

Why?

Because it has provided a very good indicator of where the economy is headed. It is a modestly successful predictive tool.

With that said, and with great fanfare, let it be known that today’s information points to a growing economy. The index now stands at 52.9%. Any reading over the magic 50% mark is associated with growth. This improvement brings the index to its highest level since June 2007, and compares with its cyclical low of 32.9% back in December 2008. Obviously things are headed in the right direction.

More to the point the majority of industries are now talking of growth, and the issues now coming to the fore are related to increasing demand: things such as slower supply deliveries and declining inventories.

Many analysts have been calling this part of our recession a ‘typical’ inventory cycle, and today’s data certainly sustains that view. Inventories have declined for 40 straight months, they did last month as well. This process of meeting sales from inventory, rather than from current production, has left most businesses and manufacturers with very empty shelves. So even a modest increase in demand – and let’s be honest: demand has scarcely moved – has a magnified effect on production. Factories have to swing into gear sometime, and they appear to be starting now.

So this is very encouraging news.

Perhaps the most encouraging single data point is the news that new orders index jumped 9.6% and is now comfortably over the sustainable growth level at 64.9%. So there is no doubt that underlying business conditions have turned upward: the economy has started to grow.

Naturally the news has some darker side to it: the 13 month decline in the ISM employment index is still continuing. There was a modest uptick last month so conditions are not as bad as before, but the employment index remains stuck stubbornly below that 50% level.

We should all treat this news with caution because of all the caveats I have talked about here before. That employment component is worrisome. We need more jobs to get overall demand to grow at anything like a sustainable rate over the medium to long haul.

I know this sounds circular: we need more jobs to get growth, and we need growth to get more jobs. The important point to keep in mind is that we seem to following a very typical path currently. Recessions, and indeed depressions, have a way of ending – they follow a ‘natural’ course – with the depletion of inventories being a sure sign that things are about to restart. Once we scrape the bottom of inventory we have to start production come what may. And that usually feeds into new hiring and a rapid upturn in activity.

The cautionary point at the moment is that the nature of business has changed considerably since that ‘typical’ story line was written. In fact the last couple of recessions have been followed by very shallow employment gains. And even those modest gains came many months after the recovery had begun. I attribute this laggardly performance to much tighter cost control in business, where re-hiring is delayed much longer than before; to a radical change in the mix of the economy, we have much less of our employment in manufacturing than before; and to the effects of globalization, much of the sharply cyclical employment we used to have is now ‘off-shored’, so we don’t experience the immediate benefits of our increased spending.

This combination of factors has dulled the economy’s cyclicality, at least on the upside.

So we remain vulnerable to any potential ‘shock’ that might de-rail us.

But let’s set that aside for a moment and bask in the good news.

The recession is over.

Now we have to wait for confirmation when the GDP numbers come out for the third quarter.

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GDP and Unemployment

The release today of the revised second quarter GDP figures was a bit of a dud. Most of the other recent data has been suggesting we would see a slight revision upward of the preliminary figures. Instead there was no change: the economy shrank at an annual rate of 1.0% between March and June. That’s a considerable improvement over the first quarter disaster when GDP fell at an annual rate of a whopping 6.4%. So, clearly things are improving.

Well yes and no.

Here are the numbers [I have rounded them all off]:

  • Consumption -0.7%
  • Business Investment -1.1%
  • Residential Investment -0.7%
  • Inventories -1.4%
  • Trade [Exports minus Imports] +1.6%
  • Government Spending +1.3%
  • TOTAL GDP -1.0%

Ok what do we make of these numbers?

First: consumption was a disappointment. It’s contribution to the overall decline was a fall of 0.7%. This is after having been positive in the first quarter debacle. Clearly the economy will not spring to life if consumption -which accounts for two thirds of the total – languishes like this.

Second: private sector investment isn’t helping at all. Business investment is still shrinking, it has for seven straight quarters now, and residential investment also is declining. There is no surprise in these numbers: businesses are still retrenching and avoiding making any long term commitments to the future. With the enormous slack that now exists – idle factories, stores, and unemployed workers – there is no incentive for business to invest in anything new. I think it will be a while before this sector gets going. Likewise residential investment. There has been a little life recently in new home construction, but nowhere near enough to spark a recovery: even if construction perks up more over the summer I doubt that will last into the winter months as long as the unsold inventory of houses remains as high as it is. So I expect investment to sputter for a couple more quarters.

Inventories are another matter. Last quarter’s decline brings the ratio of sales and inventories to low levels. This is usually an indicator that businesses are about to increase production. I expect this ‘normal’ response to take place this quarter, and it is the reason that the third quarter GDp may well be positive – this is the ‘classic’ inventory driven recovery the media are all hyping.

Third: those trade figures are deceptive. The entire trade balance continues to shrink, not because of some extraordinary export successes but simply because our domestic consumption was heavily import based and since we are consuming less we are also importing less. The sharp drop in imports is also driven by changes in commodity prices – things like the drop in oil prices have a big impact – which do not necessarily represent an important indicator of future GDP growth. I expect that, as soon as the economy starts to grow again, our trade balance will shift back deeper into the red and therefore reduce GDP in future quarters. This imbalance is something that needs fixing over the medium and longer haul: look for the dollar to decline if it doesn’t.

Fourth: the only sector where the second quarter story gives us an indicator of the future is government spending. The entire private sector, excluding those specious trade figures, was negative still – it was government spending that kept the decline in overall GDP to a minimum.

So the picture is very mixed.

Yes things improved. But quite a bit of that improvement is more a quirk of the statistics than a concrete aspect of the economy. Clearly the government stimulus is having an impact, one that will increase as the various programs gather momentum. And inventories seem poised for rebound. Together these will probably pull us out of recession – they are as we speak. But the private sector generally still looks anemic. That should give us pause for reflection – this recovery still looks very weak and vulnerable to shocks.

I am yet to be convinced that next year will be much to write home about.

Today’s other news comes in the form of the weekly data for new claims for unemployment insurance – which gives us an idea of how the job market is doing. Here the news is decent: new claims fell last week by 10,000. Any time we see an improvement we should be happy, but the gain was small and the total remains stuck stubbornly high: it was 570,000 last week. That is just not very good.

Clearly the economy is still bleeding jobs. We cannot claim much advance in the economy while we are still losing over half a million jobs a month.

I have said repeatedly: this recovery has all the makings of being ‘jobless’. That is not something to cheer about.

So, talking all this together what do we have?

A weak recovery seems to be in the works. It will be driven by an inventory rebound and the government stimulus. These two will provide enough of a ‘kick’ that the private sector sputters back to life early next year. But I use the word ‘sputter’ purposefully – the huge slack in the economy hangs over the employment and investment markets and will dampen spending. Trade also could revers its gains if commodity prices start to rise as the worldwide recovery gains momentum – most of the world is now back to growth which drives up demand for things like oil and thus prices also.

We still have considerable risks to worry about that could ‘shock’ us back into recession.

The banks are very weak. Toxic assets still clutter up balance sheets and could explode at any moment. Commercial real estate is in the process of melting down and will produce big loan losses. Likewise continued high unemployment will accelerate the rise in personal loan losses – credit card and mortgage defaults will peak next year.

Debt remains high. Especially in the context of the loss of wealth implied by the combined stock market drop last year and the huge loss in [paper] value of houses. Households are still trying to ensure solvency let alone liquidity. That suggests a very low rate of recovery in consumption.

Above all else the job market is stuck in reverse. Until jobs become plentiful the economy will teeter on the edge. I realize this sounds like a tautology – which drives which? jobs or the economy? but experience indicates that households will remain cautious as long as the job market appears dismal. We need to reach an inflection point in consumer confidence before we can argue that the recovery is self-sustaining and that the government can take its foot off the gas.

Which brings me to one last thing: the stock market.

Stock prices have surged since earlier this year. that’s great for all those 401K plans you have. But I am a little skeptical about the underlying strength of the economy: I think the stock market has run ahead of the recovery somewhat and over-valued stocks in the short term. Exuberance is the norm on Wall Street – they all have a tendency to overshoot on both the up and down sides of a cycle. At the moment I think they are building in profits that are yet very uncertain: businesses have done very well to retrench and maintain some semblance of profit. But that came at the cost of a huge contraction in activity – hence the recession and all that slack I mentioned above – getting back onto a growth track is neither as easy, nor as certain, as the stock market seems to think it is. So don’t be surprised to see stock prices give way a bit over the next month or so.

It’s still a bumpy ride ahead.

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