The financial markets have been ailing for more than a year but the economic troubles are only just beginning, as today’s batch of sobering updates reminds.
Perhaps the most damning evidence is the news that
Nor can the sharp pullback in spending be blamed on income, which rose 0.3% last month, up from September’s meager 0.1% gain. The chart above suggests that consumers are now committed to saving more and spending less. In one respect, that’s encouraging. The savings rate in the U.S. has been falling for years, largely because consumption has taken wing. Those trends are now reversing, as they eventually would. In the short term, however, the implications are clearly negative for the economy, which is highly dependent on consumer spending to the tune of about 70%. As such, the sharp pullback in consumer spending hints that Q4 GDP will be materially worse than the Q3 pullback of -0.5%.
Monthly Archives: November 2008
THE GREAT EXPERIMENT
Have we seen this movie before? It certainly sounds familiar.
Once again, the government steps in to bail out a financial institution and Mr. Market takes kindly to the idea. Initially. But then reality sets in and the process starts anew. Perhaps it’ll be a true sign of a bottom when the Feds engineer a bailout and the market tanks on the news.
But not yet. The latest installment of rescue centers on the once mighty Citigroup. Meanwhile, the stock market is soaring, as is Citi’s stock, as of mid-morning, at least.
A giant among giants, this behemoth of financial behemoths surely fits the bill as too big to fail. If such a thing exists as a financial institution that must be saved at any cost, Citigroup looks like the poster boy for this idea.
Total assets for Citigroup were a bit more than $2 trillion in September. For those who like to keep score, that’s roughly 14% of the annualized value of U.S. GDP for this year’s third quarter.
UNSAFE AT ANY YIELD?
This year will be remembered for many things, most of them negative, brutish and just plain ugly. But 2008 will likely to go into the history books for other reasons, too, including a year that extended extraordinary gifts to strategic-minded investors. No less extraordinary will be the dearth of investors willing or able to accept the gifts from the financial gods.
So it goes in the money game. When prospective returns–long-run prospective returns–are thin, the crowd can’t get enough. At the other extreme, when risk premia is soaring, Mr. Market finds few takers. All the more so when fears of depression are swirling about.
Consider the chart below, which is but one example of the astonishing repricing of risk now underway. The recent spread in junk bonds over Treasuries is currently at levels last seen, well, almost never, at least since the modern notion of high yield bonds as an asset class was minted in the 1980s. Today, the asset class can be had at a yield spread of nearly 1,700 basis points over a 10-year Treasury yield. For reasons that need no explanation, there are few takers, which is one factor for why the spread’s so high. By comparison, in June 2007, the spread was compressed at one point to less than 260 basis points, a level that investors were happily accepting.
There are, of course, many reasons for shunning such rich spreads, just as there were many reasons for accepting the narrow spreads in June 2007. Indeed, juicy yields invariably come prepackaged with economic contraction and higher rates of defaults in the junk bond universe. They don’t call ’em junk for nothing.
THE DECLINE AND FALL OF PRICING POWER
Deflation may or may not be coming, but the Treasury market’s forecast is clear.
After yesterday’s news of a sharp drop in consumer prices, which came on the heels of something similar in wholesale prices the day before, traders in government securities took the hint. Yesterday’s closing yield of 3.391% for the benchmark 10-year Treasury isn’t the lowest we’ve seen, but it’s getting close.
Back in June 2003, the 10-year briefly dipped to the then-astounding low of just under 3.10%. At the time, some observers of the financial scene said the trough would stand for generations as a low-water mark. A reasonable call at the time, based on the available information. But the forecast has been abandoned in light of recent trends, and rightly so.
The economic news of late gives reason to think that the 2003 low may soon give way. In the current environment, any news of weakening demand promotes the expectation that prices generally will fade for the foreseeable future. The latest example comes in this morning’s update on initial jobless claims, which jumped again last week, rising to 542,000, the highest since 1992. The message in this leading indicator is clear: the labor market will continue to shed jobs. Unfortunately, there’s a surplus of similarly discouraging trends in everything from retail sales to manufacturing activity. Pricing power, as a result, becomes weaker by the day, and the shift is quickly finding traction in interest rates, as recent changes in the Treasury yield curve remind.
No wonder, then, that the inflation forecast coming out of the Treasury market has crashed. As of last night’s close, the 10-year forecast for inflation was an annualized 0.4%, based on the yield spread between the nominal and inflation-indexed 10-year Treasury (see chart below). As recently as October 22, this inflation outlook was over 1% and just this past July it was above 2%.
The change in the state of economic and financial affairs in the past year or so–the past two months!–has been extraordinary, perhaps unprecedented in the modern age in terms of the pace and depth of the reversal. The magnitude of the change suggests that the recovery will be slow in coming and even then the rebound may be weak for an extended period. The smoking gun for this prediction comes via the generally high level of indebtedness among consumers. Leading the charge is the still-sinking real estate market, which continues to pressure household finances. The burden, already heavy, will be even more onerous if and when deflation arrives in earnest.
DEFLATION WATCH: DAY 2
Yesterday it was producer prices; today it’s consumer prices. The collective message is all the clearer: the risk of deflation is rising.
Consumer prices dropped 1% last month–a huge decline for a single month and the biggest on record, based on historical data on the Labor Department’s web site going back to 1947.
Core inflation, which excludes food and energy, dipped by 0.1% in October, suggesting that the falling prices depicted in headline inflation is more than just a function of slumping commodity prices. And since the Fed focuses on core readings of inflation, last month’s dip in core CPI reminds that the central bank is losing control of the pricing environment. Indeed, the last time core CPI dropped on a monthly seasonally adjusted basis was in July 1980, which proved to be a one-time event.
It’s not clear that the negative signs in CPI this time are set for a quick fade. The perfect storm of recession, rising unemployment, a consumer population burdened with historically high levels of debt, the implosion of Wall Street, a housing crisis and a weakening global economy threaten to inject the poison of deflation into the U.S. economy.
D-DAY
One month a trend does not make, but today’s update on wholesale prices invites the obvious speculation about what may be coming.
As for assessing the here and now, it’s clear that the deflationary winds are blowing. Producer prices posted a jaw-dropping 2.8% tumble last month, the Labor Department reports. That’s the deepest monthly decline for this series since the Great Depression, although that’s just an educated guess since the Labor Department’s PPI archive on its web site only has numbers going back to 1947. Since then, last month’s drop is by far the biggest.
Monthly declines in the PPI series are hardly unprecedented, even if the magnitude of last month’s drop is in a class of its own. But that’s not the issue; rather, the economic context of the moment, coupled with a massive price decline in wholesale prices, suggests that an extended bout of deflation may be at hand. Tomorrow brings the October update for consumer prices, and the news is expected to be better, i.e., prices are expected to rise. We’ll see.
Why all the anxiety about the potential onset of deflation? To be blunt, avoiding the Big D is always a priority for policymakers. Typically, the inflationary bias does the heavy lifting on that front, leaving governments to worry about other things. But sometimes the pricing landscape turns upside down. Is such a moment at hand? As always, the future’s unclear, but it may be time to err on the side of caution about deflation’s threat.
Although the prospect of falling prices has obvious appeal for consumers, economically speaking it’s a virus that, if allowed to fester, creates any number of problems. The reason is that if deflation takes root, the normal incentive to buy and borrow takes a holiday, which elevates the odds for economic contraction. The fact that the U.S. is already in recession only makes the additional threat of deflation all the more troubling.
FACING REALITY
The financial ills that began in August 2007 metastasized sometime over the past few months into an economic contraction. The exact moment is unknown, but there’s no mistaking the trend now. The only question is whether the global economy overall will suffer a recession. The risk is rising by the day, largely because the developed world is already in a slump. If the emerging markets succumb too, the next few years will be quite difficult, perhaps more than is generally expected.
The IMF forecasts that the advanced economies will contract by 0.25% next year (see chart below). If so, the downturn would mark the first fall in the developed world’s real GDP pace on an annual basis since World War II. The good news, or so the IMF advises, is that a rebound will commence sometime in late-2009 and that emerging markets will still expand by respectable if no longer spectacular rates.
In the meantime, the U.S. has already reported a dip in GDP for Q3 and more of the same looks likely. The sharp drop in October’s retail sales, as reported on Friday, is the statistical poster child for expecting a string of negative numbers in the coming quarterly GDP updates here.
“Consumer confidence is beleaguered,” Bill Martin, CEO of ShopperTrak, a Chicago-based retail analysis firm, tells The Christian Science Monitor. “There is no good news to look for anywhere. People are just squirreling away money.”
That’s an especially pernicious problem for U.S. economic activity, which is heavily reliant on consumer spending. The challenge is only compounded by the ongoing real estate correction, rising unemployment and similar ills now swirling throughout the globe. Can you say perfect storm?
MORE LABOR PAINS
This morning’s update on initial jobless claims is both sobering and clear: the economy is contracting and the trend has legs.
There’s no debate on this point now, nor is there much to be done in the short term to alter the fate that now awaits the U.S. The wave is crashing and the unwinding will have its way. Yes, government can and should soften the blow, particularly for the least fortunate. But in macroeconomic terms, there’s no stopping the recessionary forces now unleashed.
Unfortunately, this process is still in its early stages and so the pain has only just begun. Indeed, for the first time in this cycle, last week’s new filings for unemployment benefits–a forward-looking indicator–rose above 500,000, as the chart below shows. The nation’s unemployment rate, as a result, is sure to rise further in the months to come.
For all the bearish news of the past year or so, much of it has been finance related. The fallout is now taking its toll on the broader economy, which is to say consumers, who collectively represent about 70% of GDP. If nothing else, everyone needs to recognize what awaits. The storm is here and will blow for some time.
DON’T EVEN THINK ABOUT IT
Ours is a world hopelessly addicted to looking at the past. The recent past in particular. That’s how the mind of homo economicus is wired and only with hefty doses of discipline can we alter the psychological fate that otherwise awaits the crowd. And so we all look over the past 2 months or so and come to hard and fast conclusions about where we’re headed.
That includes the temptation to announce: We dodged a bullet. Yes, there’s still a lot of pain out there, and more is probably coming. But the risk of all-out catastrophe seems to have passed, leaving us with something approaching a more routine, albeit still serious downcycle in the U.S. and probably the global economy.
The stock market suggests as much. For the time being, at least, the days of 800-point rallies and declines in the Dow Industrials have been replaced with relatively mundane losses and gains. The tone is still decidedly bearish, but it’s a bear that growls without frightening the children.
THE WONDERFUL (AND SOMETIMES CONFUSING) WORLD OF DIVIDEND YIELDS
You read about such things in books; you gaze at the historical charts; but rarely do you live through such events in real time. Such is the nature of extremes in economic and financial cycles.
Reviewing history with the safety and objectivity of distance, it’s easy to pledge grand schemes for taking advantage of the great buying opportunities the next time they come around. But talk is cheap. Who among us would have the courage, the fortitude, the discipline, the temerity to buy stock in, say, 1932? Or 1974? Looking back, the timing was right, although that is obvious only with hindsight. Nonetheless, some mustered the discipline to buy in those and other dire moments. Yet such intrepid actions were–and always will be–the exception.
So it goes in times of crisis, which also describes the current predicament. It is the height of irony and frustration that the financial gods only extend great bargains when the broader financial and economic context looks darkest. Analyzing that recurring state of affairs is easy; acting on it is atypical, to say the least.
All of this comes to mind as we look at trailing dividend yields. The chart below graphically captures the drama in global equity markets of late, October’s close in particular. The trend needs no explanation. The question is whether the latest data points are compelling? And if not, why not?
We’ve discussed dividend yields before and so readers are encouraged to review the debate, including this post, and its predecessor here. No, trailing dividends aren’t a magic solution for easy profits, largely because only the past is revealed with full clarity. As such, dividend yields have been known to mislead us at times–sometimes it’s a trap. But not always. Trying to distinguish one from the other is what’s known as risk analysis. And risk is always lurking, including these ever-popular worries:
* Are dividend cuts coming, thereby diminishing the allure of the trailing yields?
* Is inflation headed higher, which makes real dividend yields less attractive than they appear to be in nominal terms?
* Will capital losses overwhelm dividends going forward?
And on and on we go. There’s always a reason to question an apparent gift. One might wonder why such worries are on everyone’s lips in a bear market but tend to be missing in action in a roaring bull market, but we’ll leave that for another day.