Slow Patch or Worse?

Since the early days, the US economic recovery has depended significantly on manufacturing and exports to sustain its momentum until consumer spending and housing could begin pulling their weight. But disruptions in the supply chain from Japan, brought about by the tragic earthquakes and tsunami, have taken a greater than anticipated toll on manufacturing. Add the weight of Europe’s debt crisis and Asia’s monetary tightening and one might reasonably ask the question of whether sufficient momentum remains to get us over the hill? 

Manufacturing growth is slowing all over the world. Bloomberg reports today that China’s factory index fell to the lowest level since February 2009 and the 17-nation euro area saw manufacturing slip to an 18-month low. In the US, manufacturing has been slowing for a couple of months now, largely blamed on Japan. The composite index from the ISM manufacturing survey in May dropped 6.9 points to 53.5 (anything above 50 indicates expansion).

Emerging markets, which largely propelled the global markets, are now plagued by inflation. China’s rate of inflation was reported at 5.5% in May, the fastest since 2008 and exceeds the government’s target of 4%. In Vietnam, inflation exceeds 20%, while people are protesting in India over rising prices. As a result, Asian central banks have been the quickest to withdraw monetary stimulus. India, South Korea, Thailand and Taiwan all raised their benchmark rates last month to contain rising prices and China ordered lenders to set aside more cash as reserves.

China has been integral in the US’s and the world’s recovery as they have eagerly bought US and European exports. However, their current growth spurt may be coming to an end. Bloomberg’s Gary Shilling points out that China remains largely an underdeveloped country with political and economic policy tools that are crude by Western standards. “Those tools can spur impressive growth, but they also mask some deep structural weaknesses in China’s economy.” He adds that it’s relatively easy for developing countries to grow by emulating the technology of advanced nations or, in China’s case, by forcing them to share it as the price of doing business, or by simply stealing it.”

When China introduced their $586 billion stimulus program their gross domestic product jumped from 6% in early 2009 back to double digits. According to Shilling most of the money was channeled through government-controlled banks, whose lending increased by $1.4 trillion, or 32%, over the course of 2009. It had been flat since early 2006.

Bank loans financed public and industrial infrastructure and real estate purchases. “Property prices in January 2010 were up 9.5% from a year earlier, according to government numbers, and much more by private realistic estimates. Employment gained along with economic activity, and in the third quarter of 2009, there were 94 job openings for every 100 applicants, up from 85 in depressed 2008, and close to the pre-crisis average of 97.”

Here’s the rub according to Shilling. “This kind of growth is unsustainable, and it won’t be able to cover up China’s underlying vulnerabilities forever. China’s reliance on exports and a controlled currency for growth, for instance, will no longer work if US consumers are engaged in a chronic saving spree, as I believe they will be. Chinese export growth, which averaged 21% per year in the last decade, is bound to suffer.”

While exports drive the Chinese economy, consumerism drives ours. Over 70% of the US economy is comprised of consumer spending. But consumers are hurting. The latest blow was a dramatic doubling of the cost of gasoline and a significant rise in grocery prices. But their biggest worries are from job security and home values. These concerns are not new and show few signs of improvement. We saw consumer spending stagnate in May for the first time in this recovery. It was the weakest since June 2010. And sentiment as measured by Reuter’s/University of Michigan dipped 2.5 points in mid-June from a final May of 71.8.

Job security is vital to consumer sentiment and it continues to be a drag. The June employment report showed that jobless claims remain stubbornly over 400,000. As of the June 25th week they were reduced by 1,000 and stood at 428,000. Fed Governor Sarah B. Raskin called the latest employment situation report “bleak.” She indicated that the job market is worse than indicated by headline numbers.

She said the headline unemployment numbers don’t capture the 8.5 million workers who are ‘part-time-of-necessity’ or ‘underemployed’ because their hours have been cut back or they are unable to find a full-time job; there are also 1.4 million workers who are ‘marginally attached’ to the labor force because, while wanting a job, they have not searched for one in the past four weeks; and there are 822,000 ‘discouraged’ workers who have given up searching for employment because they do not believe any jobs are available for them.” These statements from a speech this week imply she and others at the Fed are clearly more concerned about unemployment than they are inflation.

The other chief concern of consumers is home values. This one is showing some signs of improvement. The Case-Shiller data for April showed a bottoming in prices in its index of home prices in 10 major metropolitan areas. The National Association of Realtors reported that pending sales of existing homes rose a strong 8.2% in May to an index level of 88.8. But the gain in May fails to offset an even greater decline in April of 11.3%. Unfortunately, today’s release of construction outlays didn’t confirm the trend. Outlays in May weakened by 0.6%, and followed a revised 0.6% (originally 0.4%) drop in April.

Equity investors have moved to more defensive positions since February. And confidence among institutional investors, as measured by State Street, shifted into slight safe-haven mode in June as their index fell more than five points to a sub-100 level of 99.2. The stock market, as measured by the Total US Market Index peaked on April 29th, but it has rallied 5% this week on improving news on the Greek debt situation. The market had fallen 7.3% since its peak, and is now only 2.5% off its May high. Stock investors appear to believe the US economy will weather the soft patches caused by Japanese supply shortages, European debt woes, and Asian monetary tightening.

Bonds are moving in the opposite direction from stocks, which might confirm the views of equity investors that the recovery will resume. But don’t forget the huge dislocation of market forces in US bonds caused by the Fed’s $600 billion purchase of US Treasuries known as Quantitative Easing 2 (QE2). The Fed essentially stopped its massive buying program yesterday. The recent decline of 2.8% in the 7-10 year US Treasury index may be completely due to selling pressures of short-term traders unwinding their bets on QE2. The Fed has stated that they will hold their $600 billion position in Treasuries steady on their balance sheet buying bonds as they mature. That means they will not be selling the huge chunk of bonds any time soon, which would certainly depress Treasuries prices further and drive rates up.

The fate of our economy now depends less on momentum and more on confidence; investor, business, and consumer confidence. Confidence rests on knowledge, trust, and hope. What we know about our current economy is that it is weak and slowing. We trust that our leaders will come to agreement and answer the major questions regarding entitlement spending, taxation, and regulations soon. And we hope that there’s enough fuel left in the tank and that enough of us have the confidence to juice the throttle just enough to pull this world’s largest and much abused machine over the hill yet another time.

Have a Happy July 4th weekend. Our office will be closed on Monday for the holiday.