Wednesday, May 27, 2009

The Incredibly Uneven Recovery?

The Dow Jones industrial average fell almost 175 points Wednesday, erasing most of the previous day's rally as a jump in government bond yields fanned concerns that higher interest rates will sap strength from the economy:

A steep drop in the price of the benchmark 10-year Treasury note pushed its yield up to 3.75 percent from 3.55 percent late Tuesday and to the highest level since November. Bond investors were selling on concerns that the huge amount of debt the government is selling to fund its bailout programs will ultimately keep Treasury prices down.

Along with increasing borrowing costs for the government, rising yields on Treasury debt could hamper an economic recovery since they are used as benchmarks for home mortgages and other kinds of loans. Higher mortgage rates could delay a recovery in the battered housing market.

"The equity market is getting worried about the 'green shoots.' I think the deer have nipped off a few and I think a few turned out to be weeds," said Hank Herrmann, chief executive of Waddell & Reed. Herrmann was referring to early positive signs in the economy that Federal Reserve Chairman Ben Bernanke has called "green shoots."

While Wall Street has been rallying for most of the past three months on those early signs of recovery, it has also been vulnerable to unexpected turns such as the jump in Treasury yields.

"Stocks are following bonds," said John Brady, senior vice president of global interest rate products at MF Global. "Will the economy grow and expand vigorously in the face of sustained higher interest rates?"

Late today, the WSJ reported that Pequot Capital Management -- a pioneering and well-connected hedge fund that gained fame for racking up years of strong returns -- is shutting its doors amid a revived insider-trading probe.

[Note: Talk of a major hedge fund shutting its door always spooks the market as people fear liquidation. Watch to see if traders buy this dip.]

In other news, the National Association of Business Economists (NABE) came out on Wednesday to say that the US economy is poised to emerge from recession in the second half of the year:

The National Association for Business Economics said a survey of 45 professional forecasters found that the consensus believed the end of the prolonged recession that began in December 2007 was finally was in sight.

"While the overall tone remains soft, there are emerging signs that the economy is stabilizing," according to NABE's latest survey and its president, Chris Varvares.

"The survey found that business economists look for the recession to end soon, but that the economic recovery is likely to be considerably more moderate than those typically experienced following steep declines," said Varvares, who is president of Macroeconomic Advisers.

The NABE outlook showed that panelists expected gross domestic product (GDP) -- the country's goods and services output -- to shrink by 1.8 percent in the second quarter.

But the NABE panel, in the survey taken between April 27 and May 11, downgraded the outlook for the next several quarters.

The panelists said a sharp pullback in business investment was stoking near-term weakness, and cited rising government spending as a "vital support" to the ailing economy.

The consensus forecast continued to see a "modest" rebound in the second half, beginning in the third quarter, "followed by steady improvement," NABE said.

But overall the lackluster rebound was expected to post a meager 1.2 percent annual pace, "well below trend," in the second half of the year.

That would include growth of 1.0 percent in the third quarter and 2.1 percent in the fourth quarter.

For 2010, meanwhile, the NABE pegged average growth at just 2.0 percent, down from its earlier projection of 2.4 percent growth.

NABE said the key downside risks continued to loom large: steep job losses, extremely tight credit conditions and falling home prices.

"These same forces are causing consumers to remain cautious, a feature that NABE panelists think is here to stay," the association said.

Consumer spending is considered key to economic recovery since it represents about two-thirds of US output.

The NABE panel predicted that labor market conditions would deteriorate further, but the pace of job losses would decline through the rest of the year.

"A total of roughly 4.5 million jobs are expected to be lost in 2009, driving the unemployment rate to 9.8 percent by year-end," NABE said.

The panelist projected "modest" job gains in 2010 that would trim the unemployment rate to 9.3 percent by the end of next year.

[Note: To view the NABE US Outlook Survey click on these Slides].

Another prominent economist, Martin Feldstein, told Reuters on Tuesday that there will not be a sustainable recovery in the United States before next year even if there is positive growth in the second quarter:

"I still hold the view that a sustainable recovery in the United States will start in 2010, if we are lucky," said Feldstein, a Harvard University professor who sits on U.S. President Barack Obama's Economic Recovery Advisory Board.

"We may see some positive growth in the second quarter but it will not be the beginning of a sustainable recovery," he said on the sidelines of an economic conference in the Greek capital.

Feldstein is a member of the panel of experts tapped by Obama to help shape his response to the economic crisis.

"I think the fundamentals are for the dollar to come down. We have an enormous trade deficit," he said. "I don't think inflation is a problem in 2009 and probably not in 2010. The big problem now is how to get the economy growing again."

"The dollar's (decline) will certainly weaken economic recovery in Europe. And this has to be seen by European officials as a long term problem," he said.

Mr. Feldstein is right to be concerned. According to the OECD, Gross domestic product (GDP) in the OECD area fell by 2.1% in the first quarter of 2009, the largest fall since OECD records began in 1960, according to preliminary estimates, and followed a fall of 2.0% of GDP in the previous quarter.

And Mr. Feldstein is right, the dollar's decline will weaken the economic recovery in Europe, which is a downer for world economic recovery:

Nine months into the worst economic downturn since the Great Depression, the free-fall in the United States appears to be giving way to a more measured decline, but economists are struggling to find a steady pulse in European and other industrialized nations, such as Japan, where the world's second-largest economy is also slowing the global recovery. These countries' recessions are shaping up to be both deeper and longer than the one in the United States, where the pace of job losses has eased and there are fresh signs of life in financial markets.

There are hints of stabilization in the Old World -- in Germany, for instance, investor sentiment is up amid indications that factory orders are stabilizing after months of sharp drops. But many economists now say Europe will trail the United States in pulling out of recession by at least three months.

Critics charge that this is partly because Europe is still moving slowly to roll out government stimulus programs and right its own ailing financial system. Some countries, like Ireland, are so cash-strapped that they've raised taxes in the middle of a deep recession, making things worse. In addition, European leaders have only recently signaled their willingness to conduct broad, systematic stress tests on their financial institutions, similar to the ones on major U.S. banks already concluded by the Treasury Department.

Indications are that they need such tests, and fast. While U.S. banks have already written down about half the estimated $1.1 trillion in troubled loans and toxic assets on their books, Europe's financial institutions have thus far written down less than 25% of their $1.4 trillion in bad debts related to the crisis, according to a report from the International Monetary Fund. Many major Western European banks are also heavily invested in hard-hit Eastern Europe, where the risk of a fresh wave of corporate and consumer defaults is considerable.

"Recovery here depends on recovery abroad," U.S. Treasury Secretary Timothy F. Geithner told a House Appropriations subcommittee last week. "Our financial reform effort in the United States must be matched by similarly strong efforts elsewhere in order to succeed." In the face of congressional criticism of Europe, however, he defended the actions taken by its governments thus far, saying they were "better than you think."

Nevertheless, Europe's troubles are bad news for a global recovery. The 27-nation European Union accounts for almost a quarter of the world's economic activity, and its sluggish emergence from the crisis is likely to slow any rebound in world trade and foreign investment.

"The net effect is that Europe will not be an engine in a global recovery; in fact, it will be quite the opposite," said Eswar Prasad, senior fellow at the Brookings Institution and professor of trade policy at Cornell University. "Europe is going to be a drag on the world economy for the next one to two years."

Bloomberg reports that the U.K. recession probably will end in the second half of this year, according to strategists in Edinburgh at fund managers overseeing 237 billion pounds ($378 billion). Then growth may stall again over the next two years.

[Note: Read my comment on the W-recovery.]

The Guardian reports that Nouriel Roubini on Wednesday said the end of the global recession is likely to occur at the end of the year rather than the middle, and that U.S. growth will remain below potential afterward:

"We are not yet at the bottom of the U.S. and the global recession," said Roubini. "The contraction is still occurring and the recession is going to be over more toward the end of the year rather than in the middle of the year."

"There is still too much optimism that a recovery is just around the corner," said Roubini, a professor at New York University's Stern School of Business and chairman of RGE Monitor, an independent economic research firm.

Roubini, who is widely credited for predicting the current economic turmoil, was speaking at the Seoul Digital Forum.

"A more sober analysis suggests we're closer to the bottom; there is light at the end of the tunnel, but it's going to take a while longer, and the recovery is going to be weaker than otherwise expected."

Once the recession ends, "U.S. economic growth is going to be below potential for at least two years," he said, amid multiple imbalances in the housing sector and the financial system, and the rise of public debt.

Roubini said the outlook for Asia was more positive than for Europe, Japan and the United States, thanks to stronger fundamentals.

"The latest economic indicators from Korea ... suggest there is the beginning of an economic recovery, and growth might be already positive in the second quarter."
The downside risk, Roubini said, was if advanced countries did not recover fast enough and if China's rate of growth started to slow again.

Roubini predicted China would post a 6 percent growth rate this year, a "hard landing" considering it grew by 10 percent for a decade.
A robust recovery in Korean, China and other countries in the region would depend upon relying less on external demand and export-led growth and relying more on domestic growth, he said.

Reuters reports that the People's Bank of China said on Wednesday that China's economy has seen signs of improvement but still faces considerable downward pressure:

The central bank said in a report on region-by-region financial conditions that the global economic crisis was still spreading and that China's recovery to date was not yet on solid ground.

It sounded an optimistic note about China's longer-term development, saying that growth was spreading more strongly to less-developed inland provinces, a process that could become a driving force for the economy in coming years.

In the short term, though, the export outlook remained bleak and local governments needed to adjust their policies to provide more support for exporters, the central bank said.

It added that financial institutions should also extend more credit to exporting firms hit hard by the slowdown in external demand.

"Although our economy is showing some positive signs, the foundation is still not solid and downward pressure on the economy remains quite strong," the central bank said.

It appealed to local governments throughout China to implement Beijing's crisis-fighting strategy of stimulating domestic demand, stabilising external demand and promoting "stable and quite fast" economic growth.

Turning to how different regions should position themselves, the central bank said that the east coast, the wealthiest part of China, should try to expand links with international markets while also developing its service, high-tech and advanced manufacturing sectors.

It said that China's poorer central and western regions should focus on improving their basic infrastructure and reducing bottlenecks.

"Our country's interregional economic development is becoming better balanced, more complementary and more sustainable," the report said. "Regional economic development will become a new bright spot of economic growth."
Clearly global economic recovery is tenuous at best. There are signs of stabilization, but no indication that a sustained recovery in underway.

Moreover, I agree with the folks at Merrill Lynch who in a recent report state that surging global liquidity of the kind we’re seeing now, could result in another bubble — very possibly in energy. That in turn, could potentially put a quick stop to any impending global recovery — or make the current downturn worse.

Finally, take the time to read the Digital Rules blog comment on the incredibly uneven recovery:

Prior to this recession, the most notable feature of the late 20th/early 21st century economy was its volatility. The silicon chip, the Internet and globalism were accelerants to the renaissance of entrepreneurial capitalism that began in the late 1970s. Around the world, the storyline was familiar. New products, services, distribution paths and business models would appear out of nowhere and cause damage to the old and slow.

The global consultant, McKinsey & Co., summarized this effect in a famous 2005 paper called "Extreme Competition" (published in McKinsey Quarterly). "Extreme Competition" said top companies, across all industries, faced a 20% to 30% probability of falling out of leadership in a five-year period. The chance of toppling from the top ranks had tripled in a generation.

Will this pace of disruption and churn continue during the recession and recovery? I think so. It is tempting to see a recession as a yellow caution flag that slows all cars in the field. But in fact, recessions tend to shake out the old, slow and bloated that masked their decline in flusher times.

The 1973-74, 1980 and 1982 recessions dealt death blows to the incoherent conglomerates created during the 1960s. The 1990-91 recession killed off the minicomputer industry and nearly did in IBM. The recession of 2007-09 has shredded the Michigan auto industry. Big city dailies are falling everywhere. Were they killed by the recession or Craigslist? (By both.)

Recovery from this recession is likely to be weak. Rising oil prices amidst increasing supply and falling demand is proof of U.S. dollar weakness and portends stagflation. Real growth for the American economy when recovery starts will be in the 1% to 2% range, instead of the usual 3%. It will be the 1970s again.

But remember: GDP growth is an aggregate number. Peel back this pedestrian top line figure, and what you'll see is a jagged landscape of booms and busts. Some companies, industries, cities, regions and skill sets were never hurt much and will experience a robust recovery. Others will be mired in permanent depression.

As one example, the New York Times columnist, Bob Herbert, points out the disproportionate problems of uneducated young males:

"The Center for Labor Market Studies is at Northeastern University in Boston. A memo that I received a few days ago from the center's director, Andrew Sum, notes that 'no immediate recovery of jobs' is anticipated, even if the recession officially ends, as some have projected, by next fall

The memo said: 'Since unemployment cannot begin to fall until payroll growth hits about 1%--and payroll growth will not hit 1% until [gross domestic product] growth hits at least 2.5% to 3%--we may not see any substantive payroll growth until late 2010 or 2011, and unemployment could rise until that time.'

"We've already lost nearly 5.7 million jobs in this recession. Those losses, the center says, 'have been overwhelmingly concentrated among male workers, especially among men under 35.'"

As another example, today's Wall Street Journal has a fascinating tale of two Michigan cities, Ann Arbor and Warren:

"The divide between Ann Arbor, with a population of 116,000, and Warren, population 126,000, is large and widening. Ann Arbor's unemployment rate of 8.5% in March trailed the nationwide rate of 9% and was well below Michigan's overall rate of 13.4%, based on nonseasonally adjusted figures. By contrast, Warren's unemployment rate of 17.3% is among the highest in the state. The average family income in Ann Arbor was $106,599 in 2007, compared with $69,193 nationally and $60,813 in Warren.

"That economic gulf wasn't always there. In 1979, the average family in Warren made $28,538 annually, not much below Ann Arbor's average of $29,840. But in the past 30 years, the U.S. economy has undergone a sweeping transformation that has benefited cities like Ann Arbor and hurt manufacturing hubs like Warren.

"Warren is suffering from its reliance on the auto industry.

"As transportation and communication costs fell, and countries like Japan and, now, China, increased their manufacturing capability, Michigan's advantages have faded. Those same forces of globalization benefited educated workers--an area where Michigan largely fell short.

The science fiction writer, William Gibson, likes to say: "The future is already here--it is just unevenly distributed."

Likewise, the economic recovery has already started. But its distribution will be highly uneven.

In my opinion, the distributional effects of this recovery will ultimately determine its sustainability. If policymakers don't figure out ways to counterbalance these uneven distributional effects, we risk heading into a protracted period of subpar growth.

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