Two Soft Patch Views

There are two views on the softening economic data that began in April and has continued unabated.  The majority view is that the U.S. (and world) is in a “soft patch”, similar to the one that occurred last summer.  The disasters in Japan have caused supply chain disruptions which are blamed, along with $4/gallon gasoline, for the economic slowdown.  The view is, now that the supply disruptions are ending and gasoline prices are on the decline, consumption will expand thus ending the soft patch.

The minority view, and the one that I espouse, sees howling headwinds which threaten to turn the soft patch into outright recession.  What follows is a discussion of those headwinds.

1. Employment is one of the two biggest issues facing the U.S. today even if one believes that the 9.1% unemployment number is accurate.  The headline Establishment Survey data is beset with issues from unstable seasonal factors to significant upward bias from an arcane birth-death business formation model which automatically adds approximately 50,000 jobs per month, as the Bureau of Labor Statistics believes that there are significantly more small businesses being created than are being closed.  Apparently, these folks haven’t left the Washington, D.C. area for the last couple of years. (See the work of John Williams at Shadow Government Statistics.)  It is more likely that the U6 unemployment rate (15.8%) is closer to reality.  The recent fall we have seen in the “official” rate from 9.8% in November to 9.1% in May appears to be more due to a falloff in layoffs than a rise in hiring.  Over taxation and over regulation are often cited as reasons businesses won’t hire, and I suspect this is partly true.  But, it appears that lack of demand and credit availability are the bigger culprits.  Data show that real wages have been flat to down since 1997, and that the expansion of ’02-’08 was based on debt alone, a condition that won’t occur again anytime soon.
2. The other big issue in America today is mortgages.  More than 28% of them are underwater in the U.S.  On top of that, in ’06 at the height of the housing insanity, financial institutions were issuing 100%+ loans with negative amortizations for the first 5 years at variable interest rates.  Today, 5 years later, many such loans must begin full amortization, more than doubling the mortgage payments.  The vast majority of these will default.  Thus, we have at least 18 more months of significant foreclosure activity, falling home prices, and, as a result, continued low levels of new construction activity which used to be a significant economic driver.  The continued downward pressure on home prices will weigh heavily on consumer sentiment, consumer balance sheets, and consumption levels.
3. According to David Rosenberg (Gluskin-Sheff), while QE2 certainly caused equity prices to rise, the wealth created in the past 8 months in the equity markets benefitted those least impacted by the slow economy, while the ongoing losses in home values hit middle America and the ordinary consumer much harder.  Without the payroll tax decrease at the beginning of the year, Rosenberg asserts that consumption would have declined in the first quarter.
4. There are several news stories daily regarding state and local finances.  Either there are announced layoffs or workers are accepting lower wages, lower benefit levels, or must contribute more heavily to those benefits.  That leaves much less discretionary spending.  All levels of state and local governments are cutting spending.  A similar drama, of course, is now playing out in Washington, D.C.  The current soft patch will not be met with additional government spending or, according to the Fed, QE3.
5. Remember, the soft patch of the summer of ’10 ended with the QE2 stimulus and additional deficits with the extension of the Bush tax cuts.  The result was at least $600 billion of money printing to purchase the Treasury Notes required by the deficit.  In addition, the sub-par recovery to date has been supported by the most massive fiscal and monetary stimuli in history.  Without such additional support, either through additional deficit programs or QE3, the soft patch could easily turn into outright recession.
6. Like its predecessors in Japan and the U.S., the European debt crisis will be a long-term drag on world consumption.  No matter what the outcome is for Greece and the other weaklings in the European Union, the European banks are stuck with a lot of underwater sovereign debt.  There has even been some negative impacts on the U.S. muni market as one European bank, Dexia SA, a large insurer of U.S. muni debt, is overly exposed to Greek bonds resulting in rising yields on those U.S. muni issues.  The experience of Japan for the past 20 years and that of the U.S. for the past 2, along with the now famous  research of Rinehart and Rogoff, strongly suggests that, when banks hold impaired assets that aren’t recognized in their financial statements, lending dries up.  The current Dexia situation is a good example.
7. And so it is in the U.S. as lending continues to disappoint.  Commercial and Industrial loans at U.S. commercial banks peaked in October ’08 at $1.6 trillion and fell to $1.2 trillion by last October (or by nearly 25%).  Since then (as of May) they have risen 4.3%, but most of that was due to student loans with federal guarantees.  The banks all comment that there is really no loan demand.  Clearly, large cap corporations have excess cash on their balance sheets, and they all use the credit markets for their borrowing needs.  That means that small and medium size businesses that must borrow from a financial institution either don’t want to borrow or don’t qualify under current bank lending standards.  In either case, since small business drives employment, the lack of lending is not a good sign.
8. The only really good sign has been large cap corporate profits.  But even these are worrisome.  Having grown at double digit rates since the doldrums of ’09, forecasts of profit growth are now migrating to single digits with a downright negative tone to guidance going forward.  And, speaking of the markets, Treasury yields have fallen dramatically over the past 4 months.  The 10 year Treasury yield has fallen below 3% from 3.72% in February and 3.57% in April.  Usually, the bond market sees the correct direction of the economy before the equity market.  Bonds seem to be indicating more than just a “soft patch”.
9. Lastly, recent statements by Fed Chairman Bernanke, usually the biggest cheerleader in Washington, D.C., and Fed Governor Dudley indicate that they see trouble ahead.  Dudley recently said that “the recent disappointing data suggest that downside risks to the outlook have increased”, and he specifically mentioned a) high oil and commodity prices, b) declining home prices, c) slowing consumer spending, and d) aggressive government spending cuts or tax increases.  In a June 7 speech, Bernanke was downbeat about the economy and sounded somewhat frustrated.  “Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established,” he said.  If these guys are worried, I think we all should be.

Conclusion

There are so many headwinds that the most rational view appears to be that the “soft patch” will likely turn into recession.  Employment and Housing are not improving; there is negative stimulus emanating from all levels of government, and, because this is a balance sheet recession, the economy has not responded well to massive stimulus. Lending in the U.S. has disappointed, and the European debt crisis will turn the lending spigot off there as well.  Corporate guidance has turned negative, and the bond market is indicating economic issues ahead.  Finally, the Fed itself is worried.  Initially, there won’t be QE3.  But, I suspect that, if a recession begins to unfold, we will see a QE3 and more fiscal stimulus.  The dollar will weaken further.

Robert Barone, Ph.D.

June 17, 2011