Double-dip Recession Unlikely; Slow or No Growth More Likely for the Short-Term

On Friday July 9, 2010 Ian Edmondson of the Wall Street Journal reported that Maersk, the world's largest container-shipping company, expects 2010 profits to be approximately $3.5 billion versus a loss of $1.5 billion the year before. Germany's TUI AG raised its guidance, citing a recovery in global container shipping. Taiwan's Evergreen Group is ordering 10 new ships each able to carry 8000 20-foot long containers. The DOW transport index has not fallen as far as the other indices and remains above its closing price on 12.31.09. Mr. Edmondson's report seems to suggest a robust economy is here to stay. 

Not so fast. Contradicting that report, however, is the 14-month decline in the Baltic Exchange's main sea freight index which closed on Friday at $1,902 per metric ton. It had been as high as $4,000 per metric ton last May. This index moves based on shipments of iron ore, cement, grains, coal, and fertilizer. Slower shipments to China and South America of grains as the end of the season approaches plus reductions in iron ore exports may have something to do with it. Shipments by sea account for about 90% of all export trade; so clearly there has been a slowdown recently.

Let's look at some factors that suggest slow growth. Consumers have not significantly increased buying activity and are unlikely to do anytime soon. They are paying down debt at a rate not seen in years. As of March 2010, the US household debt was 122% of disposable income compared to 131% in early 2008. Some economists believe that 100% is the appropriate level. If that is correct, then consumer debt levels are still too high. For the near-term, whatever that turns out to be, we do not see robust consumer spending. The consumer debt-reduction trend seems sustainable.

Further support for the forecast that consumer spending may remain tepid for the near-term is the anemic rise in personal income. Employers are not giving out significant raises.  Employees are working more hours as indicated by the year-over-year increase in average hourly earnings. New hires have been very low or non-existent year-over-year. James Investment Research reports that since 1949 personal consumption has averaged 5.5% per year. Since June 2009 it has grown only 1.7%.  We don't see how consumer spending can be robust without a robust increase in personal income.

New job creation is nowhere near the 200,000 a month that this US economy needs to sustain a robust recovery. It is true that the last report show new job creation for the month of June 2010 at 85,000. However, new jobless claims remain above 400,000. In fact new jobless claims for the week ended June 3, 2010 decreased by a paltry 15,000 to 454,000. Weekly initial jobless claims have been over 400,000 for 100 straight weeks. This is topped only by the 116 weeks during the 1981-1983 recession. It is entirely possible that that record will be topped soon. We believe it will take years before this economy can affect a turnaround of over 600,000 jobs per month in order to produce a positive result on the jobs front. The only countries seeing significant job growth are China, India, Brazil, and Australia.

Mark Whitehouse, reporter for the Wall Street Journal, published an article in the Saturday July 10, 2010 issue that compared Japan to the US and the UK. Mr. Whitehouse writes that in Japan there have been many years of falling prices, including housing, and false recoveries. As a result, Japanese companies lack the confidence to hire new workers. Guess what the unemployment rate in Japan is? It is 3.3% and they still have economic stagnation. While it is disputable as to whether the US and Japan situations are sufficiently similar to draw valid conclusions, there is no disputing the fact that prices have fallen in the US, that the recovery is starting to look tired, and that companies are not hiring new workers at a robust rate. Mr. Whitehouse goes on to say that the risk is not a double-dip recession. The risk is a prolonged period of stagnation.

Standard & Poor's 500 companies are expected to post record profits again for Q2 2010. Forecasts project a 27% increase in profits versus Q2 2009. During June, new job growth, retail sales, and housing activity was weak. Can anyone guess why companies are so profitable? If you guessed "off the backs of present employees" you would have been correct. However, there is only so much productivity you can extract from an already overworked underpaid employee. We think productivity increases are going to slow. Further, cost-cutting in other areas we think will slow. There has already been massive cost-cutting. We have concerns about how sustainable profit growth will be in future quarters.

The European debt crisis has not been solved and fears still persist somewhat that their problems could become our problems. Obviously the market in May and June 2010 has responded by sniffing out a perceived recession. That response was overdone, the market oversold  we think, and a rally is in the cards for the month of July. We don't think the debt problem is going away. The US economy cannot grow when government is crowding out private capital demand.  There are many Americans who think government spending has gotten out of hand and the present projected debt increase through 2020 is unsustainable.

My read of professional money manager sentiment, based on very limited listening to CNBC, is that it is split between those who think we are tracking the 1937-1938-1942 period and those who think we are going to slug through slow-growth and sub-par financial markets for some time to come. Sentiment among money managers is important to listen to, but not as important as the data, and the data seems to indicate a slow-growth economy.

The present government antibusiness attacks, including but limited to higher taxes to come which will hurt small businesses, social spending programs such as healthcare, cap-in-trade taxes on energy companies, and tough new regulations such as the Dodd-Frank financial "reform" bill,  are similar to the Roosevelt government's handling of the 1937 recession followed by the 1938 double-dip. The antibusiness "attacks" are not helping the business environment in the US and could be a major reason for the slow job growth. President Roosevelt did finally see that businesses were important.... about the time he declared war on Japan. He needed businesses to build the war machine. However, by 1941 it was too late to prevent the double-dip recession that lasted until the war began. We are not confident that the present US government will avoid repeating the mistakes of the past.

The Economic Cycle Research Institute's leading US index fell 0.7 points in the week ended July2, 2010 to 121.5, the lowest since July 2009. The index's year-over-year growth rate was a negative 8.3%, versus a negative 7.6% one week ago. This drop in the index may corroborate the data showing a slowdown in the US recovery. Is the ECRI index reliable? It was among the first to foresee the timing and strength of the 2009 recovery.            

Robert Wiedemer , writer for the Financial Intelligence Report, writes in the July 2010 issue that, to quote, "We're on the Road to 10 Percent Inflation." His theory is that the expanded money supply, which he says has increased by 300%, will result in 10% inflation. I wish he could have told us when. His argument that we are like Germany in the 30s doesn't strike us as relevant. Germany had experienced rapid economic growth and had a 1% unemployment rate. The US reported 2.7% growth in GDP in Q1 2010 and the unemployment rate is currently 9.5%. There's no similarity there, not yet anyhow. Mr. Wiedemer argues that the velocity of money will increase and that only will produce inflation of 10%. We believe the velocity of money is related to economic growth and we don't have much at the moment, although we agree with the theory. Mr. Wiedemer also argues that the Federal Reserve is powerless to act to stem inflation because they need to promote economic growth first. We disagree. We believe inflation risk will rise as job growth and the accompanying economic activity rises. That's obviously not happening. We believe we should become concerned about inflation when we see significant job growth. All of which says to us that bonds are not a bad risk right now. We did note the
Barron's article warning about the bond bubble, which reminded us about the low 3% rate of 10-Yr Treasuries.

There are those positive thinking souls who sincerely believe that more government stimulus will bring prosperity and rejoicing in the land. Well, we don't think so. Historically it takes $7 of government spending to increase private sector spending by $1. Which is why tax cuts make so much sense. But the government seems to be listening to other voices.

Last, but not least, the Federal Reserve has weighed in with their forecast when the Open Market Committe met in April. Here is what they said. "Household spending is increasing but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software has risen significantly; however, investment in non-residential structures continues to be weak, and employers remain reluctant to add to payrolls. Housing starts remain at a depressed level. Financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad. Bank lending has continued to contract in recent months. Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be moderate for a time." The Committee went on to say that they would keep the federal funds rate at zero and that these exceptionally low levels will continue for an extended period. We would add that sales of single-family homes fell 32.7% in May to a seasonally adjusted annual rate of 300,000, the lowest since the government began tracking numbers in 1963.

In summary, after thinking about the data, we think it is time to revisit asset allocation. We had been following a strategy that assumed growth of between 2 1/2% and 3 1/2%. We no longer believe that rate of growth will be achieved in 2010 and 2011.
We have a definite strategy going forward that we think will reduce equity risk while preserving a chance for better total returns. With client support we will be implementing the strategy in July.

John A. Epeneter, CPA/PFS, CFP®, CFS, CCPS, Master of Science in Financial Planning

Copyright © July 2010