From the July-August 2010 issue of Treasury & Risk magazine

Keeping Expectations Real


Optimism about the U.S. economic outlook took a tumble recently amid reports showing employment gains may be petering out, the housing sector is still weak, and manufacturing has cooled. Joel Naroff of Naroff Economic Advisors dismisses the speculation about a double-dip recession and says the economy is working its way toward a new, more subdued, rate of growth. Craig Thomas of PNC Financial Services Group argues that companies' need to invest in capital expenditures will provide the basis for a healthy recovery. Ward McCarthy of Jefferies & Co. notes that when the Federal Reserve starts to tighten policy, the unwinding of the massive securities purchases it made during the financial crisis is likely to steepen the yield curve.

Watch for the Fed's Portfolio Moves

By Ward McCarthy
Chief Financial Economist & Managing Director
Jefferies & Co.

The U.S. economy has now enjoyed four consecutive quarters of growth following the severe recession that ended in mid-2009. Based on the metrics of GDP growth and job creation, the recovery to date has exceeded the performance of recoveries since 1990 but has not matched the robust nature of other post-World War II recoveries. Since mid-2009, GDP growth has averaged 3.5%, and to date in 2010, the U.S. has generated more than half a million private sector jobs. The recovery has been moderate and erratic, but it appears to be sustainable despite a variety of downside risks.

The recovery faces headwinds that are the legacy of the housing and financial crises. For example, consumer spending has remained moderate due to an ongoing restructuring of balance sheets, modest income growth, a heavy reliance on transfer payments and an erosion in consumer confidence.

Manufacturing, which is a relatively small component of the economy, has led the recovery. The much larger service sector has lagged manufacturing but is beginning to catch up. Because it accounts for more than 80% of GDP, the trajectory of the recovery going forward will depend heavily upon the service sector.

Inflation has been decelerating since early this year. The bifurcated nature of economic activity is reflected in the inflation data, with the commodity components of CPI up 3.7%, while service components are up 0.9%. The ongoing distress in the housing sector has also left an imprint, with the housing components of inflation indexes contributing significantly to the deceleration in inflation.

The recovery also faces downside risks at home and overseas. The crisis in Europe has shaken financial markets and increased the probability that the euro will decline toward parity with the dollar. Domestically, the housing sector is struggling to stabilize even as the market attempts to absorb a large inventory of foreclosed properties. State and local governments remain in severe fiscal distress.

Fortunately, monetary policy has been extremely accommodative. Since the crisis, the Fed has complemented its interest rate policy with active management of its balance sheet. In addition to maintaining the fed funds rate near zero, the Fed's purchases of $1.75 trillion of Treasury, agency and mortgage-backed securities contributed to the current low interest rates and liquefied the banking system by expanding excess reserves. Were the economy to deteriorate, the Fed would not be able to push the funds rate below zero, but it could again expand its balance sheet by buying more assets.

But the size and composition of the Fed's balance sheet are a threat to the Fed's profitability, independence and credibility. The securities portfolio stands to lose sizable sums were the Fed to raise short-term rates before liquidating mortgage-backed securities. Given the toxic political environment in Washington and the anti-Fed sentiment voiced by a number of elected officials, losses on the securities holdings could trigger more political action that reduces Fed independence. So the Fed will need to shrink its balance sheet by selling securities once it begins to remove the current extraordinary accommodation.

Consequently, it is probable that the Fed will feature asset sales early in the exit strategy with a transparent program of predictable and manageable sales of mortgage-backed securities.

The securities sales will also cause the behavior of the yield curve--the relationship between short- and long-term interest rates--to differ from the typical cyclical script, in which Fed tightening boosts short-term rates, resulting in a flatter curve. If the Fed sells assets first, the slope of the curve will remain steep at a minimum and probably steepen further in response to the asset sales.

When the Fed starts to unwind the portfolio it acquired during the crisis, it will cause a rise in interest rates, including mortgage rates. For that reason, the Fed will wait until it is clear that the economy, and the housing sector in particular, is able to withstand higher rates. This argues for the Fed to hold steady until the second half of 2011.

Capital Spending to Spark Expansion

By Craig Thomas
Senior Economist & Vice President
PNC Financial Services Group

Perhaps the most common question asked of economists these days is: What could drive future economic growth? Armchair economists, saturated with discussions of stimulus programs, temporary Census jobs and unemployment insurance extensions, are hard-pressed to remember why our economy tends to thrive more often than it stumbles. Today the economy can seem more like an emergency spending program than the self-sustaining system of exchange that it is. But let us not forget what we really do all day long in our offices, factories and shops. It is our efforts to be more productive that spur our economic expansions, and these efforts require a healthy measure of capital investment.

Businesses compete by combining financial, human and physical capital in hopes of making their products and services uniquely compelling. The marketplace guides these efforts, but information is never perfect and sometimes leads us astray. The products that bubbled to the top during the most recent expansion--investment properties, large gas-guzzling passenger vehicles, exotic securities and business models built on excessive leverage--have given way to newer preferences. Unfortunately, the adjustment means that many have found themselves in vocations and industries now out of fashion.

The outcome, as with any recession, is jarring; given the depth of the recent recession, this one was a bit more jarring than usual. By mid-2009, the U.S. was shedding jobs at a year-over-year pace of almost 5%; capital investment in equipment and structures used to produce goods and services dropped almost 20% (see chart) year-over-year adjusted for inflation.

The chart shows that the economy has been here many times before. Investment in human and physical capital inevitably gives way to periods of retrenchment, until productive capital is rearranged and technological progress motivates firms to invest in order to gain competitively and increase revenue. The good news is that in recent quarters, we've seen the economy moving toward recovery.

In fact, PNC recently surveyed middle-market businesses around the country and found nearly one-third (32%) plan on increasing capital expenditures in the months ahead, following a period of near universal decreases in capital investment. The PNC Economics Group expects inflation-adjusted capital expenditures to rise at an annualized pace of nearly 10% in the second half of 2010 and continue to accelerate into 2011. PNC's forecast of 3.1% GDP growth in 2011 assumes capital expenditures will be among the strongest forces for expansion, making up fully one-third of overall growth.

Myriad variables will facilitate this resurgence in investment. Both the manufacturing and services sectors are expanding. To date, companies have largely coaxed increased production from their existing capital stock, resulting in strong productivity growth during the recession and the initial phases of recovery. However, we are now observing a significant decline in that rate of productivity growth, indicating the need not only for additional workers, but for new software and equipment, and the space in which to house it.

Current high vacancies in stores, offices and warehouses will weigh on the pace of non-residential construction, but the acquisition of more productive technologies is a growing imperative that most companies have held back on since the "great recession" first began. Also facilitating investment will be the impressive rise in earnings in the last few quarters, as well as the loosening of borrowing terms.

If the economy is missing any ingredient for its recovery, it is the motivation to go along with the means. While most surveys show business confidence rising, it remains tepid. The depth and swiftness of the recession, and the pain that it caused, are still fresh in executives' psyches. Moreover, exogenous factors have emerged recently to play on emotions, such as the Greek budget challenge, the Gulf oil spill, and the still unexplained "flash crash" that hit the markets in early May. Yet PNC fully expects that the elixir of rising orders and strengthening financials, as well as the need to innovate to compete in today's global economy, will increasingly overwhelm concerns, setting off a wave of capital expenditures that will provide a sound foundation for a sustainable recovery and expansion.

Seeing Past the Mirage of Growth

By Joel Naroff
President & Chief Economist
Naroff Economic Advisors

With the economy's performance during the first half of 2010 on the books, it's time to ask where we go from here. The economy started the year on a roll, with growth booming and thoughts of a strong recovery dancing in our heads. Unfortunately, those great expectations have been dampened and there's now worry about a possible double dip. In reality, the economy never had a chance to grow strongly this year, and the fears of a renewed downturn are more an issue of dashed hopes than an accurate reading of the economic tea leaves. The recovery is likely to continue at a modest pace until the headwinds holding back the expansion fade.

Six months ago, when economic bulls were running strong, what the U.S. economy was experiencing was not the start of a V-shaped recovery but a return to reality. In the spring of 2009, there was panic, and businesses and households assumed the "turtle position." The game plan for companies was to survive until 2010, and that meant cutting expenses, including workforces and inventories, to the bone. Individuals stopped spending.

By last fall, conditions were improving, leading to "the head fake." The spring reductions had been so sharp that companies were operating at too low a level of production and with too few workers. Households that had survived the worst were spending again, but also from depressed levels. Consequently, the upturn looked robust.

That pace of growth was artificial and not sustainable. One example makes that clear. Motor vehicle sales rose 20%, to an annualized rate of 11.2 million units in December from about 9.2 million units in September. While that appeared to signal that consumers were back in spending mode, it was largely a statistical mirage, a large change from a low base. The absolute level of vehicle purchases remained extraordinarily low. After the economy moved off the bottom, the many problems still facing it brought the expansion back to earth.

For the economy to move into a full expansion phase, it must overcome a number of significant restraints. The most important is credit availability. While banks are healing, they are not healthy. Credit is still being rationed. The slowly improving housing market is keeping construction down and wealth restrained. Houses are no longer ATMs driving consumer demand. Uncertainty about the recovery and government policy has restrained job growth, and the soft labor market is creating consumer angst, limiting confidence and spending. Even the public sector is moving toward contractionary policies as state and local governments cut spending and their workforces.

These issues were with us for the last 12 months, but investors looked past them. The rebuilding of inventories led to a surge in production, and that was viewed as sustainable. It wasn't. Once empty shelves were restocked, demand naturally slowed. Similarly, after companies rebuilt their staffs to levels commensurate with growth, the surge in job gains had to ease.

Though the recovery has been under way for about a year, it's not clear how strong future growth will be. A little bit of perspective is needed here. Over the past two decades, growth of roughly 3.75% has been regarded as strong. However, during both decades, that pace of growth was largely fueled by bubbles--dot-coms in the 1990s and housing over the last decade.

In the 1980s, when bubbles were not the driving force, solid growth was considered to be about 2.75%. That is probably a more realistic growth rate. Unfortunately, it is about 30% slower than the U.S. has seen recently. And with the continued concerns about credit and housing, as well as low levels of confidence, reaching even that pace may be a challenge.

My outlook is for sluggish growth to continue for the next year, probably in the 2% range. But that is not a recession, and another dip does not seem likely. It's just that too many people seem to believe anything below 3% is a recession. What needs to change is the perspective on what constitutes decent growth. If, as I suspect, it is a lower figure than in the recent past, households, businesses and governments will have to adjust to that "new normal."

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