During this recession, the spike in U.S. wholesale inventory/sales (I/S) ratios has proven to be the largest since the 1981-2 recession. Despite just-in-time inventory systems, the demand shock this time around was simply too sharp and swift for firms to adjust orders and production quickly enough.
Wholesale I/S ratios tend to peak during recessions, with the bulk of the drawdown accomplished in the early recovery phase of the business cycle, when wholesale shipment growth revives. The inventory adjustment does not need to be complete to end a recession – the I/S ratio merely needs to peak, which appears under way.
Consumer credit growth remains moribund. Ratcheting up of minimum payments and interest rates is reducing the willingness and ability of households to substitute these sources of credit for housing-related credit. Bucking the trend is nonrevolving credit growth provided by saving institutions, although this has proven a very volatile source of funding for households. We do not see the private deleveraging theme ending anytime soon, as discussed in prior monthly letters. Policy to force banks to escalate lending in the face of the new frugality evident among U.S. consumers is likely to be thwarted, just as it was in the early 1930s. Weekly chain store sales have clawed their way back to flat and slightly positive territory over the past month. As with the wholesale results reported above, this is consistent with a less severe phase of the recession after the Q4 2008 freefall. Tax refunds, mortgage refinancing and price discounting may be helping those households still employed in stabilizing their spending before the fiscal package hits.
The past four weeks have shown some stabilization in initial unemployment claims, right around the same spikes of the 1982 recession. Initial claims tend to peak as a recession is closing out. While employment is generally a lagging indicator, initial unemployment claims have more of a coincident or slightly leading indicator tendency at cycle turning points. Since the maximum growth shock appears to be loaded into Q4 2008, it would make sense that the layoff response would peak one quarter later. A peak in the pace of layoffs is not to be confused with a peak in the unemployment rate, which we do not anticipate until Q2 2010 at the earliest. Still, if the high for the recession is developing in initial unemployment claims, and active fiscal stimulus is about to hit, this combination should help equity investors regain their nerve.
Refi applications continue to climb to their prior highs despite a slight rise in mortgage rates. While bank acceptance of mortgage refinancing applications remains restricted, this is an important channel for households to reduce their expenses and rebuild their savings. It also adds to fee income at banks. Purchase applications remain subdued, although they have picked up a bit in recent weeks.
The monthly U.S. trade deficit is shrinking at a dramatic pace as imports implode faster than exports. Falling oil prices are part of the import reduction, but with consumption cratering, imports are off nearly 30% versus a year ago. The turn in trade is clearly more than just price effects. In fact, U.S. export price deflation is running close to a 7% year-over-year pace as producers struggle with a collapse in global trade.
From a financial balance point of view, the more dramatic the turn in the U.S. trade balance, the easier it will be for the U.S. private sector to return to a net saving position. However, that poses serious challenges to production in the export-dependent economies abroad, and we continue to see harsh production cuts coming out of Asia. We would much rather see the U.S. trade balance turning with export growth remaining robust – instead, we have global trade collapsing because so many countries geared their growth strategies to an ever-indebted Western consumer. While many institutional equity investors have piled back into emerging equity markets over the past month because they are perceived to be the highest beta play, we remain concerned that excess capacity will prove to be a serious challenge for these nations as the globalized economy adjusts to a less-leveraged Western consumer.
All in all, the message continues to be one of a still sharp recession in the United States, with mounting evidence that the most violent portion of the downdraft is behind us. Evidence of a peak in I/S ratios, a peak in initial unemployment claims, improved refi activity and a dramatic reversal in the U.S. trade balance are all consistent with a recession that is still challenging, but not as overwhelming as the free-fall state that gripped the United States in Q4 2008. This is a better setup for the fiscal package to get some traction, although we continue to believe the earliest we might expect a positive U.S. real GDP result is in Q4 2009.
Technical measures of U.S. equity indexes continue to flag an extremely overbought condition. Given the run-up in the face of “less bad is good” news, we suspect equity investors have gotten ahead of themselves as they discard disaster scenarios. As mentioned last week, weak Q1 earnings results should be a catalyst for a pullback, although we are not convinced the prior lows will be violated, as too many institutional investors want to get onboard the rally train. We also are becoming increasingly concerned about the Fed’s gambit with regard to Treasury yields. Once again, 10-year U.S. Treasuries approached 3% last week, which we would suggest is the informal yield ceiling the Fed is likely to impose.
The catch, as we see it, is as follows: If the Fed is forced to accelerate its Treasury purchases to keep yields from climbing above 3%, bond investors will tend to view the subsequent expansion of the Fed’s balance sheet as “monetizing” the fiscal deficit. Foreign investors are likely to be especially wary of this, and the weakness in the currencies of nations with central banks pursuing quantitative easing has been conspicuous in the past few weeks.
In addition, to the extent the Fed is suppressing interest rates, and that successfully pushes investors into riskier asset classes like equities in order to earn adequate returns, Treasury bonds become a less attractive investment. Either way, the success of the Fed in these operations strikes us as making it harder for the Treasury to sell new bond issuance to private investors. The Fed could be unwittingly setting itself up to become the largest buyer of Treasuries, which we believe would aggravate the monetizing fears mentioned above. The movement in platinum, palladium and copper of late suggests monetization fears are present even in the face of outright deflation appearing in a number of final product price measures in many countries.
for Markets and Money