Perhaps we can all agree that the major economic imbalance in the US and, in fact, the global economy was too much debt. That imbalance, which has been building over the past quarter century, is being addressed under the surface. Consumers are improving their balance sheets by repaying (or, in some cases, foreclosing on) their debts. Likewise, financial institutions are reducing leverage and boosting capital. Overall debt in the system, however, is not being reduced as governments are assuming more responsibilities to forestall systemic failures and spur economic growth.
In listening to many market analysts tout the health of this recovery, we are reminded that most tables rest on a foundation of four legs. The same has been true of post World War II economic recoveries. Those four legs have been robust improvements in 1) inventories, 2) employment, 3) consumer spending, and 4) residential construction. Only one, a notable turn in the inventory cycle, is present in this recovery.
Although this recession began with increasing stresses in the financial system, recessions are actually measured by declines in production, spending and employment, which are dominated by the goods and nonfinancial services segments of the economy. You may recall that the collapse in home prices caused an immediate halt in bank lending. As unemployment spiked, consumers went on strike.
When the business cycle turns negative, manufacturers, wholesalers and retailers see their sales weaken. Cuts in production and orders accelerate as the turn picks up speed. Inventory/sales ratios become unsustainable as sales decline. Inventories are reduced to keep up with falling sales. Despite improvements in inventory management through bar coding and just-in-time inventory delivery, liquidation of excess inventories continues to be an important part of recessions, and that has certainly proven to be the case in this one, too. In fact, the reduction in inventories this time has been the most severe since World War II.
A positive turn in the inventory cycle begins with a decline in the rate of inventory liquidation followed later by actual increases in production and sales. Reductions in inventory liquidation contributed to growth in the second half of 2009. The Institute for Supply Management (ISM) reported that its March manufacturing inventory index was above 50, indicating the first increase in stock building in four years. The Commerce Department reported increases in business inventories of 0.2% in January and 0.5% in February. And the most recent quarterly GDP report showed inventories contributing half of the increase in real GDP. Although the February inventory/sales ratio for retailers has turned down, it was still positive for wholesalers and manufacturers. A genuine restocking of inventories will on depend improvements in the three other legs supporting a healthy economic recovery.
From July 2009 (the estimated, yet undeclared, end of the recession) to March 2010, payroll employment was still down 0.5%. That is not unusual because recessionary job losses are taking longer and longer to be reversed. Recent improvements in the employment picture are somewhat distorted by the hiring of temporary census workers. Jobs continue to be scarce, wages are falling and wage cuts are spreading. Involuntary furloughs without pay are becoming more frequent. Due to budget constraints, states are now reluctantly facing unpleasant choices in addressing employment and benefits of public employees. It looks like there will be pressure on employment for some time to come.
A weak labor market will not contribute to consumer spending, the third leg in supporting a vibrant recovery. Consumer incomes have been supported by massive government stimulus. Transfer payments in the form of unemployment benefits, social security and personal tax cuts, while contributing to modest improvements in spending, seem to be going more toward saving and debt reduction. Rising energy costs, interest rates and taxes, along with other forms of fiscal discipline, will put pressure on the ability to consume. Since consumer spending is over 70% of GDP, this leg of the recovery is important.
Part and parcel of a typical robust post World War II recovery has been residential construction. Because housing construction is interest sensitive, it is usually one of the first areas of the economy to revive. It usually takes six months to a year for reductions in interest rates to work their way through the economy. That is because it takes approximately six months to build a house and more for an apartment complex. It has been 55 months since the Federal Reserve started reducing the Fed Funds rate and 16 months since it has been near zero. Despite historic lows in fixed mortgage rates, homebuyer tax credits, massive purchases by the Federal Reserve of mortgage backed securities, and diligent attempts by the Government to modify mortgages and keep people in their homes, we have seen a tepid increase in new home construction. Excess inventories persist and may depress prices another 10%.
As we crawl out of the depths of the Great Recession, citizens and investors will have to be patient. This slow recovery will face many challenges and will be vulnerable to unanticipated events. Investment approaches that worked admirably in the past will likely have different outcomes in this cycle. As governments, both large and small, around the world are forced to reduce their debt burdens in the context of slow economic recoveries, we can expect volatility to be a recurring investment issue.