Newsletters 2008 Newsletters First Quarter GDP Still Positive (5/08)
Thursday, 15 May 2008 00:00
The U.S. economy and stock market have demonstrated enormous resiliency in the face of significant shocks:
- the ongoing collapse in the U.S. housing market characterized by plummeting values, escalating foreclosures and rising inventories;
- arguably the worst financial and credit crisis in modern history, fueled by risky bets on subprime mortgages made by overleveraged institutions; and
- soaring energy costs, catapulted by the weak dollar, seemingly insatiable global demand and rampant speculation on the future price of oil.
Despite these very real and substantial negatives, U.S. GDP grew by .6% in the first quarter of 2008, the same pace as the fourth quarter of 2007. While this rate of growth is hardly blazing and obviously slow, it remains positive nevertheless. Despite the considerable negatives, the U.S. economy has managed to claw its way to growth.
Keys to GDP growth during the last two quarters and offsetting the weakness in housing is our export economy. Housing accounts for just 4% of GDP, while exports account for three times housing’s impact. Given the weak dollar and strong foreign demand, especially in emerging economies such as India, China, Brazil, Russia and throughout Eastern Europe, exports are expected to contribute almost a full percentage point to GDP growth this year. Meanwhile, government spending and business investment remains steady, and personal consumption has yet to turn negative.
In spite of all the headwinds, the U.S consumer, which accounts for 70% of U.S. GDP and an even more amazing 18% of global GDP, continues to hang in there. The fact is that personal consumption rose by .8% in the first quarter, driven mainly by expansion in services, and even retail sales surprised to the upside in both March and April. Personal consumption has managed to rise even before the massive monetary and fiscal stimulus has funneled its way through the economic system. The Fed has relentlessly cut the Fed Funds rate, including another 25 basis points on April 30, in seven of the last eight months to 2% from 5.25%. This steady barrage of rate cuts and some $110 billion of imminent tax rebate checks ought to help consumer spending going forward.
Since consumer spending did not go negative during the last two quarters, a period characterized by the peak of the credit crisis, it is difficult to imagine consumer spending turning negative in the coming quarters. By extension, it is equally difficult to imagine GDP turning negative. At the very least, it is difficult to imagine any downward economic spiral or the kind of worst-case scenario that has been touted by many pessimists and journalists.
Essential to the stubborn persistence of the U.S. consumer is the great strength of the U.S corporate sector, excluding financials. There remains approximately $2 trillion of cash on the balance sheets of companies in the S&P 500 and amazingly, corporate America has enough cash on hand to completely wipe out all corporate debt outstanding. The fact that corporations are so under-leveraged has muted the impact of the credit crunch. After all, companies are far less dependent today on borrowing to meet their expansion priorities than they have perhaps ever been. Corporate profits as a whole remain resilient, albeit slower than the last several years and, outside of financials, wage growth remains steady and employment near full capacity. Job security and wage growth have a much higher impact on consumer spending than the decline in housing prices.
Wage growth has grown higher than inflation at an average 3.3% this decade. And while unemployment claims are rising, the current payroll trend of minus 80,000 jobs per month is equivalent to a .6% annual rate of decline and consistent with an approximate 1% rate of GDP growth, not recession. If this level were to remain steady for the next few months, it is not difficult to imagine stronger employment trends as the strong dose of monetary stimulus already enacted kicks in. The non-financial U.S. corporate sector did not require the same degree of monetary stimulus as ailing banks and brokerage firms, so the benefit to corporate America should be more notable and even more stimulative than for the financial sector, leading to a quicker-than-expected rebound in real business activity.
So are we in a recession? Though the technical definition of two consecutive quarters of negative GDP growth may not be met, the National Bureau of Economic Research may ultimately decide that there were sufficient coincident indicators to declare one. Yet as we have discussed in previous newsletters, the stock market decline during the first quarter of 2008 seemed to already discount a high probability for recession, whether we were to actually have one or not. The Monday morning St. Patrick’s Day shocker of Bear Stearns selling to J.P. Morgan with $30 billion of Fed financing gave the market ample opportunity to panic and sell through the recent lows – yet this did not happen - the market successfully tested its recent low and has rebounded quite nicely since the Bear Stearns debacle.
S&P 500 operating earnings are expected to come in at $92.31, an 11.8% advance from the $82.54 earned in 2007. The expected absence of major asset write-downs in the financial sector should make a significant difference in third and fourth quarter earnings. With the market currently trading near 1400, this equates to a PE of 15 on expected 2008 earnings. With the yield on the 10-year note at 3.9%, stocks are attractively priced. There is a long-standing relationship that the 10-year yield runs approximately equal to the forward earnings yield (the earnings yield is the inverse of the market’s PE ratio). The expected earnings yield for the year currently stands at just under 7% compared to 3.9% on the 10-year, indicating that either stock prices or interest rates must rise to bring this historical relationship into equilibrium.
With the recent 25 basis point cut in the Fed Funds rate, the Fed signaled it might pause in cutting rates. The statement that accompanied the rate cut announcement differed from previous statements by describing the rate cuts already implemented as “substantial” and by removing reference to “downside risks” to the economy. The potential “25 and done” implication in the Fed announcement was telegraphed prior to the Fed announcement in a Wall Street Journal article by Greg Ip. It has been reported that Mr. Ip is an unofficial sounding board for Fed policy. So on the day of the Ip Journal piece, the dollar enjoyed its biggest one-day rally against the Euro in years, energy prices fell and the stock market rallied. One day does not a trend make, but we suspect this may be a blueprint in the making.
We expect the Fed to now stand pat with monetary policy and seek alternative, creative ways to continue the process of thawing out the credit freeze. Currently the futures market expects the Fed Funds rate to remain at 2% throughout the summer and then even rise into year-end. And the yield curve has steepened recently with the 10-year Treasury having risen to 3.9% from 3.5%. These higher and stable interest rates will restore the Fed’s inflation-fighting credentials and stabilize the U.S dollar, which will decrease the speculative value of energy as an inflation/weak dollar hedge and subsequently lower energy costs and abate inflationary pressures attributed to rising commodity prices.
We believe that it is likely to see both moderately higher interest rates and moderately higher stock prices in the intermediate term, and are sticking to our year-end target for the S&P 500 at 1610 – an approximate 10% increase over year-end 2007. Ned Davis Research surveyed the bottoming process for the stock market for all recessions since 1945. On average, the S&P 500 has been up 16% three months after the low, 24% six months later and 32% one year after the recession bottom. The evidence thus far suggests that the bottom is behind us – so if today’s returns after this recession low approximate historical returns after recession lows, our year-end target is well within reach.| < Prev | Next > |
|---|