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Out of the woods? – Michael J. Parks

Out of the woods?

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Feb 152012
 

[updated Feb. 25, see below]

Is the U.S. economy finally out of the woods? Stock investors seem to think so. The time-honored (but relatively narrow) Dow Jones average of 30 industrial stocks is up by more than 14% since Nov. 25. The much broader Standard and Poor’s 500, covering America’s most valuable companies, is higher nearly 17% in the same period. With Apple leading the charge — we wish we had bought last summer after visiting its teeming Palo Alto store — the tech-heavy NASDAQ index is up almost 21%.

Greece is a mess, and a reminder that the global financial crisis that arguably started five years ago with the failure of two Bear Stearns hedge funds is far from over. Moody’s downgraded the debt of six countries in Europe Monday, echoing Standard and Poor’s. Notably, it put the U.K. on credit watch, citing (as reported in the Wall Street Journal) the U.K.’s “weakening ability to implement measures aimed at reducing debt” .

Europe is flirting with a double dip. Output fell 0.3% (or at an annual rate of 1.2%) in the 17-member euro zone in Q4. The decline was much sharper in the poorer southern countries overburdened by high debt. Italy contracted at an annual rate of 2.8%. It already meets the street-corner definition of recession, two consecutive quarters of output decline. Belgium, Portugal and Greece are all in recession.

Commentary that I read suggests Europe’s recession will be brief and shallow, but that’s small consolation. Recession is the last thing Europe needs as it struggles with the intertwined problems of weak banks and weak sovereigns. Willem Buiter, Citigroup’s chief economist, wrote in Financial Times that “until the fundamental drivers of the euro area sovereign debt and banking crises are addressed, volatility will remain a constant companion and recovery and growth absent friends.”

By comparison with Europe, the U.S. economy looks vigorous. The February 3 employment report was stronger than expected, and included sharp upward revisions to November and December data. Government employment is declining slightly, but private employment is coming in stronger than expected. Pay and the work week are up slightly. Both unemployment rates — the headline rate and the broader U-6 rate covering people working part-time involuntarily or discouraged and not looking — have  ticked down.

Consumers seem to have the wherewithal to spend more (some perhaps from savings). Put a few extra dollars in the pockets of American consumers, and they reliably head to the mall or auto dealership. Banks are accommodating them. Consumer credit grew at an annualized rate of 9.3% in December.

Housing, which usually leads the U.S. economy out of recession, is showing signs of shaking off its five-year funk. Although there is lots of foreclosed inventory, especially in the “sand” states (California, Arizona, Nevada, Florida) where the bubble was most frothy, housing starts have started to tick up. Rising rents, driven in part by those who have lost their homes or cannot get mortgages, signal a tighter housing market, a positive for construction activity in the future.

Economist Ed Yardeni, writing in the Financial Times, argues that the U.S. could experience a “second recovery” following the weak first recovery from the 18-month recession that technically ended in June 2009. Writes Yardeni: “The second recovery could take off as the pace of hiring quickens, housing activity finally picks up, auto sales head higher and state and local governments stop retrenching. If so, then the US would finally enjoy the benefits of a broad- based recovery.”

All that said, don’t break out the champagne just yet. The Economist reminds us in the current issue there was a similar bout of optimism about this time last year. Then came several setbacks, including higher oil prices resulting from the Arab spring, supply shocks flowing from the Japanese earthquake and tsunami, and “policy errors” both at home and abroad (at home the fight over the debt ceiling, abroad the euro crisis or crises).

As always, we need to be wary of the Black Swan, the disruption that can’t be forecast. We don’t know what we don’t know, but tensions between Iran and Israel could ignite, pushing oil prices sharply higher and dampening consumer spending. I assume that Greece will eventually default. The question in my mind is whether this happens in an orderly way within the euro, or whether it collapses in a disorderly way. The latter could bring down the euro. In the worst case, the global economy is at risk.

China’s transition to a new generation of leadership (the “princelings,” sons and grandsons of revolutionary leaders) holds great potential for political instability. Gridlocked Washington could fail to tackle expiration of the Bush tax cuts which with automatic spending cuts could rapidly shrink the U.S. economy next year. Better U.S. economic news also eases the pressure on politicians to tackle U.S. entitlement spending that is unsustainable at current growth and tax rates.

While I’m generally an optimist, I’m well aware that the period we are in may turn out to be a false dawn for the U.S. economy. As Bruce Pile reports at the blog Seeking Alpha, a pair “reliable and beloved” leading indicators usually in agreement and “with decades of goods track records” now are pointing in opposite directions. These are the Conference Board’s Leading Economic Index and a proprietary index of leading indicators published by the Economic Cycle Research Institute.

I check every week to see whether ECRI has withdrawn its U.S. recession forecast distributed to its paying customers in late September and made public in early October. It has not. ECRI’s  Lakshman Achuthan is scheduled to be interviewed by Bloomberg’s Tom Keene on Feb. 24; I’ll be tuned in. [Update: ECRI’s Lakshman Acuthan reaffirmed his recession call on radio (Bloomberg Surveillance) and TV (CNBC) on Feb. 24. Acuthan and Gluskin Sheff‘s Dave Rosenberg, quoted by Alan Abelson in Barron’s cover-dated Feb. 27, remain the most prominent bears on my radar screen.]

Perhaps Bridgewater Associates, the world’s biggest hedge fund, with roughly $120 billion under management, subsribes to ECRI. Robert Prince, co-chief investment officer, told the Wall Street Journal in early January that Bridgewater is preparing for at least a decade of slow growth and high unemployment for the big developed economies. He described he U.S. and Europe, in particular, as “zombies” and said they will remain that way until they work through their mountains of debt. Prince told the Journal:

What you have is a picture of broken economic systems that are operating on life support.  We’re in a secular deleveraging that will probably take 15 to 20 years to work through and we’re just four years in.

Not that it will necessarily announce a change publicly or promptly, but I keep checking every few days to see whether Bridgewater has modified its views. It hasn’t as far as I can tell.

I am an optimist, but I’m also prudent, or like to think that I am. That’s why I keep the forecast of ECRI and comments of Bridgewater on my radar screen. And why I try not to forget that a Black Swan can appear quite unexpectedly.

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