Macro Picture – “A Look at What Could Go Right”


Source: Liz Ann Sonders, SVP, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

  • The expectations bar has probably been set low enough to be easily hurdled as the big market rally may be indicating.
  • Not only is recession risk fading in the near term, a very positive longer-term story is emerging, even though very few are in tune (yet).
  • Investors have gotten used to digesting worst-case scenarios … maybe it’s time to ask what could go right.

I often begin client presentations, Market Snapshot videos and talks to outside organizations with a comparison of the bearish and bullish arguments about the economy and markets. Accompanying those, I usually make the following comment: “I’m always most intrigued by the story no one is telling and least intrigued by the story everyone is telling.”

Today, the story everyone is telling is the bearish story:

  • The cycle of debt deleveraging will be a significant weight upon economic growth for as far as the eye can see.
  • Job growth is moribund and economic growth is unlikely to increase sufficiently to bring down the unemployment rate.
  • Housing—the lifeblood of the last economic cycle—is at best bouncing along the bottom, with no sign of a meaningful lift.
  • The more acute debt crisis in Europe means financial system contagion risk and a severe weakening of economic activity in that region, which itself has contagion risk.
  • China’s growth is slowing, and given its importance as the key global engine of growth, this bodes ill for global growth.
  • Finally, the US political situation is toxic and the consensus about the debt super-committee deliberations is that there’s no room on either side for compromise, suggesting the “grand bargain” that markets are hoping for will not happen.

It’s a recipe for stagnation, if not something worse. But what if a few things actually went right? What could happen that would make us look back 10 years from now and think: “What do you know … we did it again. We pulled out of the slump and the economy powered ahead.” A pipe dream? Not necessarily.

I write this without blinders to the obvious plights still facing the economy and the psyche of many individuals who are struggling. I write it with hope for the future and as a contrarian who always likes to look down the path on which few are looking.

Shorter-term aspect of what’s going right

I think the recent 17% stock market rally in less than a month may be sending a signal that the expectations bar has been set either too low, or at least sufficiently low such that hurdling that bar has become easier.

[The market remains partly beholden to events in Europe, but this report will not address the eurozone debt crisis or last week’s announcement of the latest details behind a rescue plan. You can see ongoing commentary on the subject from Michelle Gibley.]

Recession risk fading quickly

Only a month ago, the consensus was that a new recession was likely. That was never my view, but I certainly took some heat. I breathe easier today given the string of much stronger economic data received in the past couple of weeks, including:

  • 2.5% real gross domestic product (GDP) growth in the third quarter, up from 0.4% and 1.3% in the first and second quarters, respectively (with the third quarter likely to be revised higher)
  • Real GDP now in “expansion” having surpassed 2007 high
  • Thirty-nine-point positive reversal in the Philly Fed Index, which had been an initial trigger of the recession consensus
  • Sixteen percent year-over-year S&P 500 earnings growth reported so far for the third quarter, with 10% revenue growth
  • Consumer confidence down, but retail sales up sharply
  • Homebuilding stocks up more than 40% in past month, suggesting a greater likelihood of a bottoming process than many believe
  • Ten-year Treasury bond yields up 0.7% from late September through recent high
  • M2 money supply growth up nearly 20% annualized over past 18 weeks; bank lending picking up, too

Real GDP now in expansion

From the list above, let’s dive in a little. Starting with GDP, as you can see in the chart below, both nominal and real (inflation-adjusted) GDP are now in expansion mode, the latter happening in the third quarter.

Nominal GDP Surging While Real GDP Plays Catch-Up

The fact that nominal GDP was up 5.0% in the third quarter and is now 5.4% greater than its 2008 peak helps explain the continued surge in corporate profits.

Inflation is what separates nominal and real GDP. Whereas much of the earlier downward revisions to real GDP were from a higher deflator, going forward, given the drop in commodity prices, the deflator is likely to come down—giving a boost to real GDP. It will also free up many global central banks to either stop their tightening moves, or even consider loosening monetary policy.

You can see the breakdown of where US GDP growth has come from in the chart below. One of the most resounding of the bearish cries has been the impact of public sector deleveraging and austerity on the economy.

Only Inventories Kept Third-Quarter Real GDP Subdued

Although there was no impact in either direction from government spending in the last quarter, it’s clearly likely to be a negative driver in the near term. However, the entire weight of the public sector (federal, state and local spending) within GDP is less than 20%. What we witnessed when the 2009 stimulus package was passed and put into motion was support to the public sector offset by a massive contraction in the private sector. Now we’re facing the opposite phenomenon: a public-sector drain from the economy being offset by a growing private sector.

The only hit to real GDP last quarter was from inventories: In the quarter, real business inventories increased by only $5.4 billion, much less than the $40 billion implied by monthly data. This undoubtedly reflects weakened confidence by business leaders, but odds favor an upward revision and a stronger fourth quarter given that demand has been more resilient than confidence (more on that below).

Weak confidence, but resilient demand

I continue to believe that an under-appreciated story both in the short term and longer term is business capital spending and exports as new bigger drivers of US GDP. US corporations are sitting on record amounts of cash ($2.1 trillion, including what’s overseas) and there’s been a dearth of investment relative to the increase in corporate profits. It likely won’t take much of a boost in confidence to unleash more of that investment capital.

Another of my bulleted highlights above is about the relationship between consumer confidence and spending. This is one of the particularly unique dichotomies that have developed in the recovery. As you can see in the chart below, never before have we seen such a wide spread between what consumers are doing and what they’re saying.

Spending Belies Confidence

The plunge in consumer confidence also has implications for the stock market, but they’re likely not what you’d expect. Ned Davis Research has done a study on stock market performance around consumer confidence zones, and the findings are intriguing. The best stock market returns have come when consumer confidence was weakest, reflecting the lagging nature of confidence and the leading tendencies of stocks.

Consumer Confidence

Dow Jones Industrial Average Annualized Gain

> 110
66-110
< 66

-0.2%
6.4%
12.5%

Source: Ned Davis Research, Inc. (Further distribution prohibited without prior permission. Copyright 2011 (c) Ned Davis Research, Inc. All rights reserved.) February 28, 1969 – September 30, 2011.

Longer-term aspect of what could go right

About three years ago, I took my first trip to China to speak to several large groups, including Schwab clients, local reporters and, notably, the American Chamber of Commerce (AMCHAM as it’s called there). I was there again in the summer of 2010 speaking to similar groups.

There was a theme I heard at AMCHAM in 2007 and even more clearly last year: The differentials in wages and other costs (notably real estate) that had driven so much business to China from the United States were narrowing and favoring a move of business back to the United States. This is a force for the future of the US economy that isn’t getting the attention it deserves.

It’s been a theme of mine for a while now, and I’m thrilled to see it as a pillar of others’ research recently as well, including my friends at ISI Research and Yardeni Research. Just last Friday in its Daily Economic Report, ISI noted the following 10 structural/secular positives that could make the next decade for the US economy better than expected:

  1. United States versus fractured eurozone
  2. Demographics
  3. Flexible labor markets
  4. Cheap energy sources
  5. Low dollar
  6. Technological innovation
  7. Entrepreneurial activity
  8. Best universities
  9. Many of the best companies in the world
  10. Deep/liquid capital markets

In addition, my friend Ed Yardeni had this to say in recent reports: “America is rapidly developing very cheap domestic sources of energy. At the same time, the relative cost of labor is declining in the United States as it rises more rapidly in China. These two developments are already starting to reindustrialize America.”

An Economic Impact Study released in September concluded that developing the Utica shale gas formation in eastern Ohio could create more than 200,000 jobs by 2015, boosting wages and tax revenues. There’s already a land rush in the area, with farmers receiving $5,000 per acre and a royalty of 19.5%. Gas wells require tons of concrete and steel. Northeast Ohio’s steel producers are already seeing rising demand.

American ascendancy!

There have even been some interesting developments among private-sector unions, as Ed noted. The United Auto Workers recently signed a new contract with Chrysler which increases the wages of newly hired workers only, and instead of automatic bonuses, the contract includes a profit-sharing plan that would align the interest of the union with the company. “Imagine the positive implications for the US economy if this cooperative approach spreads among both union and non-union workers.”

There’s a new book out that’s on my must-read list: “The American Phoenix,” by Hong Kong-based economist Diana Choyleva and her colleague Charles Dumas, from Lombard Street Research. What’s unique about this book is that it turns all we think we know about the interplay between the United States and China on its head.

One interesting twist highlighted by Choyleva is how China’s financial proximity to the United States is a larger problem than many believe. By attaching itself to the US dollar and garnering over $3 trillion in currency reserves, China has effectively merged itself with the US financial system. With record-breaking easing by the Fed, it’s caused a bigger inflation problem in China than in the United States.

Many believe China is in a stronger position than the United States. But China may actually be trapped in an addiction to cheap US financing and could increasingly feel its side effects, weakening its competitive position. Let’s never forget that Japan was supposed to take over the global economy about 30 years ago; a lot can happen that isn’t anticipated.

In a recent edition of The Telegraph, Ambrose Evans-Pritchard, its international business editor who generally leans bearish, was nearly euphoric about the likelihood that global economic power is swinging back to the United States, noting: “The American phoenix is slowly rising again. Within five years or so, the United States will be well on its way to self-sufficiency in fuel and energy. Manufacturing will have closed the labour gap with China in a clutch of key industries. The current account might even be in surplus.”

I’ll write a lot more about this theme in coming reports. Until then, I’ll end where I began: I’m always most intrigued about the story no one is telling (except a brave few).