From the July/August 2011 issue of Treasury & Risk magazine

Wobbly But Still Standing

Healing has been too slow for comfort, but some vital signs are improving. Three economists weigh in.

James SwansonThe U.S. economy continues to run cool to tepid. A recent flurry of weaker-than-expected data cast doubt on the stamina of the recovery. But James Swanson, chief investment strategist at MFS Investment Management, says the improvement in businesses’ capital expenditures will eventually generate job growth and bolster the economic expansion. Ethan Harris, co-head of global economics research at BofA Merrill Lynch Global Research, expects some improvement in job growth in the second half, but he notes that the economy remains vulnerable to shocks. And M. Cary Leahey, senior economist at Decision Economics, points to the housing market, with its huge inventory of unsold homes, as an impediment to a more vibrant U.S. economic recovery.

Business Spending Crawls Up

James T. Swanson
Chief Investment Strategist
MFS Investment Management

It is common to hear that the U.S. economy is in terrible shape, with press reports referring to it as “beleaguered” and “mired in slowness.” This is contrary to the scope and strength of this particular post-Lehman business cycle and also contradicts historic cycles.

Capital expenditures are very much related to the hiring of new workers and this in turn is a driver of the business cycle. The hiring of new workers follows the flow of new business spending orders with a predictable lag. What is currently happening with the flow of new spending orders? Big-ticket business spending is on the rise. Skeptics could say that these business outlays are not as robust as in earlier cycles, but they cannot ignore the upward slope of the capital expenditure line.

Taking into account the last two business cycles, we can observe that capital outlays by publicly traded companies have lagged usual measures. What are those measures? Capital spending on big-ticket items can be compared to gross sales, existing plant property and equipment, or, probably best, to depreciation rates. Spending has been below normal against all such measures for some time. This has resulted in a sizable amount of “deferred” spend, or pent-up need to replenish and refurbish existing facilities. 

Why has this slowdown in spending occurred? During the ’90s, excess capacity was put in place in almost every sector. During that period, vast fiber optic cable networks, distribution facilities, new intermodal containers and the like were all built at a very rapid rate. This excess capacity hovered over the market for many years but now is slowly being used up, and predictable obsolescence is creeping in. Companies need to spend to stay competitive in the global trading landscape.

In fact, the age of plant, property and equipment (including installed computers and software) in the United States is by most measures the oldest ever recorded.

Is the cash available for companies to spend more? The answer is a profound yes. If companies wanted to increase their capacity to do business, they could tap the publicly traded bond markets, where they can now obtain some of the cheapest long-term financing in decades.

Second, and more importantly, publicly traded companies are piling up cash balances at a rapid rate. Free cash flow is at record levels, exceeding the peak seen prior to Lehman’s collapse, and free cash flow as a percent of the market’s value is at record highs. In addition, cash sitting in company checking accounts has reached 12% of assets, the highest recorded level since 1955.

As concerns about the course of the economic recovery persist, this should give the doubters some hope. If one looks at the chart, one can see that during these business cycles, there is a close relationship between capital expenditures and the labor markets, but with a noticeable lag. What seems to be the explanation is that when spending on physical plant and information technology (capex) is increased, workers are needed to care for and operate the new equipment, buildings and software.

The capital expenditure line in this cycle has definitely turned upward. The labor markets are responding, but slowly and with a lag. By the second half of 2011, we should see a continuing trend of capital expenditures by businesses. The cash is certainly there to fuel the expansion and refurbishment of the existing physical plant. And with a secondary follow-on step, we should see the number of new workers grow, bringing more spending money into the economy and therefore enough fuel to push the now somewhat sluggish U.S. economy forward to a more normal, but not spectacular, real growth rate of closer to 3%, a much higher rate than the first half of 2011.


Ethan HarrisWaiting for Real Healing

Ethan Harris
Co-Head of Global Economics Research
BofA Merrill Lynch Global Research

The U.S. economy is in “rehab,” slowly recovering from the wounds inflicted by the financial crisis. As such, it is important not just to watch the ups and downs in the data, but to look under the surface and ask: “Are the wounds healing?” There are four rules for this rehab.

First, growth will be slow. GDP normally jumps about 7% in the first year after a major recession and 5% in the second year. However, history shows that growth is very weak following banking and real estate crises. The anemic 2.8% annualized growth in the first seven quarters of this recovery is about par for the course.

Second, domestic inflation pressures will be low. The global recovery caused upward pressure on commodity prices and wages in emerging markets, and some of this has leaked into the U.S. economy. However, with persistently high unemployment, a significant pickup in U.S. inflation is highly unlikely. Wage growth is very weak and workers will have a tough time negotiating cost-of-living increases. Companies came into this year hoping to pass along costs; we expect them to face increasingly resistant consumers.

Third, the Fed will be patient. Since the recession ended almost two years ago, the markets (and many forecasters) always seem to expect rate hikes six to 12 months ahead. In our view, these forecasters are making two mistakes. The Fed is waiting for real healing. We expect the Fed to tighten when the unemployment rate is about halfway back to normal. And the markets put too much weight on the views of FOMC hawks. Chairman Ben Bernanke and the core of Fed policy makers are comfortable with unconventional monetary policy; in their view, extraordinary times call for extraordinary measures. The hawks want to end unconventional policy as fast as possible. Who decides? Bernanke.

Fourth, the economy will be vulnerable to shocks. In normal times, it probably would have sailed through some of its recent trials. However, these are not ordinary times. The corporate sector, which is in great health and should be expanding, remains very concerned about the recovery, and it doesn’t take much to convince companies to pull back. This is why the job market seems to gather momentum and then abruptly slows down.

The job market is central to the rehab process. Stronger job growth heals consumers’ balance sheets: It allows households to raise savings without cutting consumption. It helps the housing market, spurring demand for homes, slowing new mortgage delinquencies and stabilizing prices. And job growth makes it easier for banks to work through their nonperforming loans and get back to the business of growing the economy. With job growth, the rehab continues; without job growth, the rehab stalls.

There is a case for cautious optimism on jobs. Severe cuts in hours worked during the recession and the early stages of the recovery have created pent-up demand for workers. For example, from Q4 2007 to Q4 2009, nonfarm businesses cut hours worked by nearly 10%, even though output fell only 4%.

The good news is that the cuts have been so deep, companies are now forced to hire as their business expands. In effect, we have a “just-in-time” labor market. When GDP picks up, job growth quickly follows; if businesses sense a slowdown in activity, jobs quickly weaken.

We expect job growth to remain weak in the next several months as the economy continues to absorb the blow of higher oil prices and disruption to Japanese supply chains. Companies will also hesitate to hire as long as the debt ceiling impasse continues in Washington. Job growth should reaccelerate in the second half if—and it is a big if—there are no new shocks.

So keep an eye on three potential traumas. First, and most important, watch the Middle East: if there are no further supply disruptions there, we would expect oil prices to ease further, taking pressure off the economy. Second, keep an eye on Europe: The debt crisis could cause collateral damage to the U.S.

Finally, watch the U.S. fiscal policy debate. If Congress does not act and raise the debt ceiling, it could shock the economy and put further upward pressure on the unemployment rate. We hope and expect there will be a last-minute extension, helping revive the economy and labor markets.


Ethan Harris is co-head of Global Economics Research at BofA Merrill Lynch Global Research. This column is copyright 2011 Bank of America Corporation and reprinted by permission.


Cary LeaheyHousing, the Problem Within

M. Cary Leahey
Managing Director and Senior Economist
Decision Economics

The U.S. recovery and expansion remain disappointingly slow. After the worst downturn since the 1930s, with GDP dropping almost 4%, economic output has risen at an annual pace of less than 3% since mid-2009. Unfortunately, growth is expected to remain sluggish at 2.5% this year, achieving a slightly stronger pace of 3% in 2012.

Consumer spending, which is roughly two-thirds of aggregate spending, is unlikely to expand much faster than GDP, constrained by slow job growth and a focus on reducing debt. Capital spending will be relatively better, particularly spending on equipment. Firms are substituting (cheaper) equipment for (more expensive) labor. But the ongoing weakness in commercial construction will hamper overall gains in capex.

Government spending growth will be anemic at best. Federal spending growth is decelerating, with war-related spending scheduled to decline and some belt tightening imposed on nondefense spending to reduce the deficit. And further outright declines in state and local spending are likely to continue through at least this year.

Finally, there is some reason for optimism on exports, with exports to the fast-growing emerging market economies booming. While slower growth in expected in emerging markets, major economies like India and China are expected to see growth in the 6% to 9% range.

Still, the economic outlook is a problem, as growth of 3% or less will be unable to lower the unemployment rate much below 8% by the end of 2012. A major drag on growth is the residential housing market. After falling roughly two-thirds from its 2006 peak, housing activity has at best gone sideways since mid-2009. While stable housing activity might not sound so bad after the horrors of 2006-2009, this sector normally rebounds before the rest of the economy. The U.S. expansion was robbed of about three-fourths of a percentage point of GDP growth in both 2009 and 2010 because housing went sideways instead of way up. Housing is the problem within the economic problem. It is hard to imagine the U.S. economy reaching the 4% glide path needed to make a real dent in the unemployment rate without some major improvement in the housing market. 

The paradox is that housing is very affordable, with low financing costs and relatively low prices, but sales are very weak. Why? There are at least three reasons. First, the labor market situation is difficult. Unemployment is very high, and job creation has been anemic. People are reluctant to buy a home, perhaps the most important purchase in their lifetimes, with the employment picture so poor.

Second, people are worried about home prices. After falling nearly one-third from 2006 to mid-2009, home prices rebounded a modest 7% by mid-2010. Since then, prices sagged again and are now almost as low as in 2009. Many housing analysts expect them to fall another 10%, which would bring home prices in line with the average relationship they had with rents prior to the boom. If prospective homebuyers are worried that home prices will fall another 10%, it will pay to wait.

Third, clogged bank lending and tighter credit standards adopted by banks, including much larger required down payments, have restrained demand.

Falling home prices and the prospect of further declines make homeowners poorer because their home equity has fallen, and many have homes worth less than their mortgages. This further constrains demand. Visible housing inventory is about 3.9 million homes, split between 3.7 million existing homes and 200,000 new homes. That visible inventory is equal to about eight months of sales, much higher than the four-month supply considered normal.

On top of the visible inventory is the so-called shadow inventory of homes that are seriously delinquent (90 days or more), in foreclosure or real estate owned (REO) by lenders. The shadow inventory is not easily estimated, but some analysts put it at 2 million units. So the total excess supply—visible and shadow—approaches 6 million homes. 

Until that excess supply is cleared out, there can be no meaningful rebound in the housing market. Unfortunately, like many analysts, we do not look for that inventory to be cleared out until 2013 at the earliest, putting a serious damper on the overall economic outlook.

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