Adam Matthew Waitzman : Northwestern Mutual - Economic Commentary - February 2009 : Article: Economic Commentary

Economic Commentary - February 2009

Christopher Bremer

Senior Investment Consultant

Overview

In Joseph Heller’s classic post-WWII novel, “Catch-22,” the protagonist desperately wants to get out of flying bombing missions and learns that any pilot who is insane can be grounded if only he asks. The problem is, that concern for safety in the face of danger is “the process of a rational mind,” so asking to be grounded proves the pilot is in fact not insane, and therefore cannot be grounded.

Many investors and economic observers have experienced this sense over the current economic environment in which a desired solution seems impossible to attain due to inherent flaws in the logic. One such Catch-22 rule pertaining to the current economic situation might read, “Inflation is bad, unless there is deflation, then inflation is good.” This circular logic and the tug of war between current deflationary forces and potential future inflationary consequences emanating from policy moves will have a critical impact on how the U.S. comes out of the current recession.

In early 2008, the Federal Reserve (the Fed) was criticized for not being tough enough on inflation. Commodities, especially oil, were ascending rapidly, and many economists feared energy inflation would creep into “core” inflation, or the common prices consumers pay for goods and services. Then, beginning in July, oil and commodity prices reversed course, leading to the worst quarter ever for commodity price returns. This reversal in energy related to inflationary trends, combined with the grave concerns over the stability of the global financial system, translated into pervasive fear over the prospects of deflation. (Figure 1.)

Against this overwhelming backdrop, the markets have placed considerable reliance on the ability of Washington, D.C., to help prevent economic losses and lead the initial stages of a recovery. The Fed has responded by flooding the banking sector with liquidity, ultimately setting a moving target for its federal funds target rate, an interest rate banks charge each other, between 0 percent and 0.25 percent. This current policy favoring reflation over disinflation, while intending to halt the free fall in asset prices, may lead to future accelerations in price inflation in excess of a recovery in economic growth.

While many are looking forward and attempting to forecast an economic rebound, the recession has not yet passed, and the magnitude and duration of the recession are not yet evident. The outcome of the tug of war between inflation and deflation will play a significant role in determining the severity of the current economic slump. This is the tug of war the Fed is trying to manage to a stalemate.

The underlying forces of deflation are reflected in declining consumer prices, falling home prices (among other asset declines) and deterioration in the labor markets. Efforts to “reflate” to the Fed’s target inflation range include global monetary easing, federal targeted relief programs and stimulus legislation.

Deflationary Forces at Work

In a deflationary environment, asset prices fall, including housing, stocks and non-U.S. Treasury bonds. Risk assets, particularly equities, tend to perform poorly as companies endure poor earnings during periods of economic distress. To combat the current deflationary cycle, the government is providing massive amounts of stimulus into the economy, stimulus that typically leads to inflation. The implication for investors is profound, as the outcome of the inflation-deflation struggle may determine the success of investors’ portfolios and net wealth.

Both the Fed and the markets have agreed that the current danger is deflation. Government yields are at record lows, equity prices reflect depressed corporate earnings, and as of the end of January, Treasury Inflation Protected Securities (TIPS), which are structured to increase the principal of the security based on positive movements in the rate of inflation, are pricing in little to no inflation 10 years from now.

Consumer Price Index

The cost of living in the U.S., as measured by the Consumer Price Index (CPI), fell in December to the slowest level in 50 years. The CPI is the U.S. government’s most extensive measurement of costs for goods and services. Prices that consumers pay for items and service such as medical visits, airline fares and movie tickets cover almost 60 percent of the CPI. (Figure 2.)

The energy component of the CPI plunged 8.3 percent in December and was down 21 percent in 2008, the largest decline since records began in 1958. Gasoline prices fell 43 percent last year, also the largest decline since records began in 1937, according to Bloomberg, a provider of real-time and archived financial and market data, pricing, trading, analytics and news. Even medical care, which typically turns in consistently higher year-over-year gains, rose at the slowest pace since 1964 (2.6 percent).

The CPI’s drop from a 5.6 percent year-over-year gain in July 2008 to a 0.1 percent year-over-year gain in December 2008 represents a significant decline in the general level of prices for goods and services. Should

the CPI year-over-year reading fall below zero, the economy would technically be in deflation. If continued falling prices generate the expectation that prices will continue to fall further, this technical deflation could very well translate into genuine deflation, a scenario feared by Federal Reserve Chairman Ben Bernanke. In fact, Federal Reserve Bank of San Francisco President Janet Yellen opined that it is not acceptable for policymakers to let inflation fall to “levels that are unhealthy.”

Retail sales are likewise experiencing record declines, dropping 2.7 percent in December, a record sixth consecutive drop. In response to the worst holiday season in more than 40 years, retailers are

cutting prices to entice consumers to spend.

Housing

The current recession is still a fundamentally housing related problem, and until housing bottoms, the consumer is unlikely to increase consumption. On an annualized basis, housing starts fell to the lowest level since 1946. (Figure 3.)

The pace of decline through November actually increased. The sharp drop in housing starts and permits suggests residential investment will continue to be a substantial drag on the economy and employment through the summer. On the other hand, the magnitude of deceleration may actually be a positive for the housing markets and the economy by moving the housing market closer to a bottoming process.

For example, recent home sales data from Southern California present two diverging trends. Home prices in the region fell 35 percent in December from a year ago. However, sales increased 51 percent over the previous year as foreclosures made up 56 percent of total homes sold.

Employment

Substantial revisions in the jobs reports underscored further deterioration in employment. Nonfarm payrolls fell by 525,000 in December, while November’s revised report showed a loss of 584,000, the most since December 1974. All told, more than 2.6 million jobs were lost last year as the unemployment rate increased to 7.2 percent. (Figure 4.)

Until the full cycle of Fed easing combined with implementation of a stimulus package plays out, consumer and business spending is likely to remain dormant. Monthly job losses may continue in the 400,000 to 600,000 range well into 2009, pushing the unemployment rate even higher.

Under deteriorating employment conditions, deflation may arise as consumers reduce spending on two accounts: they retreat from discretionary expenditures due to concerns over economic security, or they hold off in anticipation of further price declines. This is the vicious counter-spending cycle that has many economic watchers concerned.

Employment is a lagging indicator, in other words, the data reflects what has already occurred in the labor force. By the time employment data is released, the jobs have already been gained or lost. In a recession, businesses typically wait until demand strengthens for several months before hiring more workers.

Reflating the Economy

As a result of price declines in gasoline and other energy-related goods, nominal consumer spending on energy-related goods and services is materially lower today than it was a year ago. The economic benefit of these price declines serves as an effective tax cut. This economic benefit to consumers, however, is offset by huge declines in personal wealth through housing and equity market asset declines and lower aggregate employment.

The U.S. government is trying to reflate the economy, using fiscal and monetary stimulus in order to expand a country’s output. Because central banks are worried about falling prices rather than rising prices, target policy rates are low, and in the case of the U.S. are as low as they can get. Global central banks have joined the Fed in a coordinated effort to ease monetary policy.

Global Easing

The Fed first responded to the financial crisis in the fall of 2007 when it began its aggressive easing of monetary policy. The Fed continued its easing campaign, cutting the federal funds rate from 5.25 percent in September 2007 to a range of 0 percent to 0.25 percent currently. The most remarkable aspect of this aggressive policy easing is that from the first 50-basis-point cut on Sept. 18, 2007 to June 30, 2008, the Fed slashed the target rate by over 60 percent while the price of oil skyrocketed almost 80 percent. In order to cut rates so aggressively, an inherently inflationary act, the Fed had to make a calculated bet that the rise in inflationary pressures during this time reflected a temporary supply/demand dynamic for emerging countries in need of raw materials, rather than general inflationary pressures. (Figure 5.)

The Fed’s calculation proved correct, as commodities (Reuters/Jefferies CRB Commodity Index, the definitive benchmark for price levels and movements within the commodities markets) fell 50 percent in the second half of 2008, led by a 68 percent drop in the price of oil. In a January 2009 speech, Bernanke noted that “overall inflation has already declined significantly and appears likely to moderate further… At this point, with global economic activity weak and commodity prices at low levels, we see little risk of inflation in the near term; indeed, we expect inflation to continue to moderate.”

Global central banks have followed the Fed’s lead resulting in unprecedented coordination of monetary policy easing. (Figure 6.)

What to Watch For

The fall in the CPI has been dominated by declining energy prices. A rebound in commodity and energy prices would help reduce deflationary pressures. While the price of oil may be representative of a greater commodity trend, market observers can also monitor equity and commodity-related stocks. Historically, energy and commodity-related companies tend to outperform as inflation begins to take hold.

Within the credit markets, an increase in government bond yields coupled with the narrowing of corporate bond spreads would indicate a resurgence in risk-taking and an implicit view that the Fed’s reflationary agenda is beginning to take hold. Corporate bond spreads represent the difference the yield companies are required to pay investors relative to a U.S. Treasury bond. (Figure 7.)

Credit is essential for economic growth, as consumers and businesses alike depend on it for improvements in standards of living and profit growth. High corporate spreads are indicative of economic uncertainty and a larger risk premium required by investors. Through late January, spreads have retracted modestly from the record highs reached in the fourth quarter of 2008, but issuance of corporate debt has yet to respond accordingly.

Falling corporate spreads are only as good as the ability of companies to raise capital in the bond markets…that is, to issue debt. There has been some recent bond activity, although modest. As corporate spreads fall relative to U.S. Treasuries, the cost of issuing bonds declines and corporations have more incentive to raise capital this way.

Upside surprises? As with the equity markets, expectations for the economy are so low that upside surprises may be possible. For example, many companies last year confronted credit constraints and declining demand by reducing production (and jobs). If consumer demand is better than expected, albeit still low in absolute standards, then companies will have to boost production. A small surge in materials to meet output demands could stabilize and even push up commodity prices.

Many market observers watch one indicator for signs that another will take hold, for example, looking at credit spreads as a signal for equities to advance. More likely, the same metrics will underpin both scenarios; a return to a more normal lending environment and improvement in overall economic and market confidence.

Where Are We Headed?

A result of the Fed’s decision to cut the federal funds target rate to near zero is to make it so unpalatable to hold Treasury debt that investors will begin to look for alternatives to earn a better return. The S&P 500 dividend yield relative to the yield on 10-Year U.S. Treasuries is at historical levels. For the first time in decades, stocks are out-yielding government bonds. (Figure 8.)

The break even between the implied inflation rate and the 10-Year U.S. Treasury is attractive on a historical basis. Recognizing this relationship may provide investors with an attractive opportunity, but just like investing in any other sector, investors would be wise not to bet exclusively on either extreme inflationary or deflationary outcome.

The stimulus package from Washington, D.C., will likely play a critical role in shoring up economic confidence, if not immediately in the implementation, then in the perception. Estimates of a stimulus bill range from $800 billion to $1 trillion. While the specifics were still unknown as President Barack Obama was sworn in on January 20, the equity markets have already reacted to the President’s support of government spending on infrastructure.

More important than the nominal dollar amount of the stimulus package is the distribution of funds. Public sector spending alone, however, may not solve the problem. While infrastructure development is a necessary and worthy objective, the allocation of the stimulus should favor consumers and businesses.

There often are limits to how much fiscal policy can do. For example, stimulus measures are usually lagging, there is implementation risk, and much of the infrastructure monies are unlikely to be spent until later in the year or into 2010. The government is limited in how much money it can get into the economy quickly.

Since the forces that typically fuel inflation concerns, monetary policy easing, low government bond yields and rising commodity prices are the same forces required to drive the economy forward, should investors be concerned about inflationary influences? Yes, to a certain degree and in due time. Inflation itself is usually not the challenge, but rather unanticipated inflation that historically hurts portfolios and economic prospects.

Over the short term, we believe inflation is unlikely to accelerate beyond the Fed’s targeted comfort range. Will producers already hit by declining sales turn away more customers by increasing prices? Will workers recently laid off demand higher wages should they be fortunate enough to secure new employment? We think not for a while.

Current year economic outlooks predictably encompass a wide range of potential outcomes, from depression and deflation to recovery and reflation. The first view implies that lack of credit will prevail leading to further falls in demand ultimately continued strength in government bonds. The recovery view points to the concerted attempt in Washington to reflate the economy, leading eventually and inevitably to inflation. Under this scenario, investors would likely migrate from the low yields and safety of government bonds into riskier assets that provide higher returns in inflationary environments.

According to Bloomberg, the general consensus among economic forecasters calls for annualized GDP of 1.2 percent for the third quarter of 2009. If history is any guide, the consensus expectations for the beginning of an economic recovery in the second half of 2009 should provide contrarians with some pause for thought. The more likely scenario is that the economy will muddle in the middle for quite some time.