The Economy, Bailout and Capital Markets

This past Friday’s  unemployment report was truly shocking. The reported drop of 533,000 lost jobs in the month of November was substantially larger than the 350,000 median estimates by many economists and our own estimate of 300,000-400,000 for the month. This level of monthly job loss is greater than was experienced in the last recession of 2001-02 and rivals any of the worst recessions in the post-war period. In addition, the job losses previously recorded for the months of  September and October were dramatically revised downward to levels averaging over 350,000 for the two months, 100,000 greater than the average previously reported. Thus, the job market, like much of the rest of the U.S. and international economies has declined severely and precipitously since last summer. But the November unemployment report is far worse than the surface numbers indicate. Yes, the job losses are widespread and worsening in the service sectors as well as manufacturing and construction. This continues the pattern of increased job erosion seen since the second half of 2007. However, the level of 500,000 monthly job losses was not expected to be seen until the first half of next year when it was expected the level of unemployment might be peaking. To be at this level in November when the economy is still declining is daunting and obviously raises the possibility of monthly job losses in the 750,000 range. Such additional job losses would easily take the unemployment rate to 7.5% or higher which would confirm the worst expectations of many economists, including ourselves. But there is something else in the government’s employment report that is causing us to look at unemployment in the current recessionary cycle as unlike anything we have experienced since the Great Depression of the 1930’s.  The government report on Friday mentioned that there were 1.9 million people who were available and had looked for work over the past 12 months and not found employment and according to the government’s report “were not counted as unemployed because they had not searched for work in the 4 weeks preceding the employment survey” for November. If we add this 1.9 million to the 10.3 million reported as unemployed in the report, we get an unemployment rate of 7.9% based on a civilian labor force of approximately 155 million per government statistics. We believe this 7.9% level of unemployment is a more accurate measure of job destruction than the reported unemployment rate in the government release. We believe this is validated by the “free fall” of the U.S. economy since the second quarter of this year particularly when measured by consumer spending and retail sales over the past three months. While U.S. GDP contracted at .5% in the third quarter, we believe GDP in the fourth quarter of this year will contract at approximately 5% with another 3%-5% contraction in the first quarter of 2009. We continue to estimate virtually no growth in U.S. GDP in 2008 as economic decline in the second half of this year outweighs the modest growth in the first half. Please see our recent Economic Presentations on our Presentations Page on our website for more detailed analyses, forecasts and conclusions.

Earlier in the week, the National Bureau of Economic Research (NBER), a committee of largely academic economists, that is the official arbiter of economic cycles, declared the U.S. economy has been in recession since December, 2007.  It confirms our analysis of the economy in our article, “We Think We Are Here”, March 10, 2008 in which we stated that we thought the economy was entering recession in the first quarter of this year. It was based on a sequence of weak economic data which included increased unemployment over the second half of 2007 and the first quarter of 2008; weakening industrial activity; increased credit losses in the financial system; worsening financial condition of U.S. consumers; spreading real estate weakness from residential to commercial markets; weakening corporate profits and weakening economies overseas.  Since we wrote that article, all of these important facets of the economy have steadily deteriorated led by intensified weakness in the consumer sector.  We have been concerned about the state of consumer finances for two years and we have consistently written about the housing bubble and overextension of consumer spending versus their income. And we warned about the doomsday scenario of a depleted consumer “knocked out” by a weakening economy leading to unemployment. Likewise we cautioned in our article “Postscripts on the Credit and Private Equity Cycles”, June 24, 2007, that the adverse credit cycle was going to get increasingly worse with dire consequences for the financial sector. In fact our byline on that article was “When a credit cycle turns negative, it does not turn negative a little bit”. Since the summer of 2007, we have witnessed the worst meltdown of the international credit system since the Great Depression of the 1930’s.  The responses of world governments and central banks to the increasing credit crisis were traditional post war economic stimuli, i.e. lower interest rates and taxpayer rebate programs. We wrote in several articles, (“Can the Fed Save Wall St.”, Part 1 and 2), August 12, 2007 and September 21, 2007 and “The Treasury Plan. Is this the Solution?” December 7, 2007 the lack of success inherent in those programs given the depleted financial condition of U.S. consumers and the necessity of expunging bad debts off the books of banks and other credit intermediaries. We also believed corporate profits, the backbone of the economic and stock market growth over the 2006-07 period were weakening sooner and faster than most market analysts had expected. But in two articles, “And Then There Was…” , October 21, 2007 and “GE, The Earnings Cycle and Food”, April 14, 2008 we warned about the rapid deterioration in corporate earnings which had been a bulwark in the corporate and stock market renaissance of the 2003-2006 period. Indeed, S & P 500 Index earnings in the third quarter were down over 20% year over year and would have been at an all time low were it not for earnings from the oil industry. So what began as a mild, containable credit air bubble in subprime mortgages has ballooned into a pervasive credit finance meltdown which has resulted in a zero demand environment in both business and consumer sectors. Now, as mentioned above, chronically worsening unemployment threatens to make the current recession deeper and more extended than previously expected. We now believe GDP for the U.S. next year could also be at zero on a December to December basis. That would make U.S. GDP growth for the 2007-2009 periods less than 1% on average for the three years.

As bad as the recession is in the U.S. it has spread in full force overseas as we recounted in our articles “Is This the End”, September 9, 2007 , “The Other Shoe”, January 7, 2008 and our International Economics article, “The Virus Has Spread”, August 6, 2008 and it is worse overseas as we stated in the August 6th commentary. The U.S. recession has suppressed the exports many foreign economies depend upon for their growth, credit losses from international and domestic asset declines have created an international banking crisis, and the collapse of commodity prices has torpedoed the high flying economies selling oil and other industrial and agricultural commodities that led world economic growth since 2004. The results are economic recessions in Western Europe, Japan, Australia and now Canada in addition to the U.S. While not in recession, India and China, the locomotives of world economic growth over the past four years have slowed dramatically to mid single digit rates and in fact have had to institute multi-billion dollar stimulus programs to keep their economic growth from falling further. In addition there are major economic stimulus programs underway in Europe and Japan. The weakness overseas is expected to be a major depressant to world economic growth in 2009.

With most major industrialized and emerging industrialized economies instituting economic stimulus programs to battle the worldwide recession that has taken hold, it is appropriate to evaluate the theory and success of these programs. We have commented in previous articles on the futility of the U.S. rescue programs (“Can the Fed Save Wall St”, Parts 1 & 2, August 12 and September 21, 2007 and “The Treasury Plan. Is This the Solution?”, December 7, 2007) up to the current time. Finally, last March, the U.S. government caught on to the need to remove bad credits from lenders and pump massive amounts of liquidity into the banking system. That restored credit stability within the banking system and then inexplicably, the U.S. government recently switched gears and decided to back consumer loans to mitigate increasing losses. We and a number of other analysts are puzzled by the unevenness of the U.S. government’s response to the current credit crisis. The capital markets have rallied recently hoping the new economic team of President elect Obama will have a more successful program. However, given the aforementioned severe increase in unemployment and the cutback in consumer spending, we believe nothing less than a targeted second consumer rebate program IN ADDITION to a resumption of purchasing bad credits from lenders and capital infusions to the banking industry is the formula for ultimate recovery from this recession. If consumers are expected to consume, they need to get their balance sheets de-leveraged and have enough liquidity to begin to exercise discretionary spending. Giving money to banks and auto companies will not move “goods off the shelves” in the current demand freeze. In the absence of a resuscitated consumer, this recession will last well into next year.

Likewise, the stimulation of overseas economies by government spending programs will have limited success for two major reasons. First, nobody will get exports “cranked up” as long as the U.S., Western Europe and Japan are in recession. Second, the collapse of commodity prices will severely depress the stimulative spending of commodity based economies like Canada, Australia and now the Middle East. So in the end, worldwide economic recovery will depend on the U.S. as it has since World War II.
To be sure, the U.S. and foreign governments and their central banks are sparing no expense or spending to cure the worldwide financial crisis and recessions. As a result fiscal budget deficits and increases in national debt will increase substantially over this year and next. We have previously written about the large future cost to U.S. and other credit and currency markets to the deteriorating national balance sheets, particularly for the U.S.
Consistent with the worldwide recessions and deteriorating economic outlooks for 2009, worldwide capital markets have virtually collapsed this year. U.S. equity markets are down approximately 40% year to date and overseas equity markets which have outperformed those of the U.S. for the past three years, are down by more than 50%. In addition, international credit markets have been crippled in the non-government sectors by the international banking and mortgage security losses. Now the spread of recession to the corporate sectors have depressed corporate bond prices and increased the spreads over non-government securities. This will continue until economic conditions stabilize. After outstripping all other asset markets over the past four years, the recent collapse in commodity prices has thrown previous profits in commodity assets into big losses since the summer. In addition, one of the biggest capital market casualties this year has been the hedge fund industry. After excessive proliferation over the past four years, a “shakeout” of this industry was inevitable. The demise of leveraged derivatives, the collapse of equity and non-government bond markets, the cutoff of bank credit and finally a stampede of redemptions by investors have caused hedge funds to sell marketable assets further depressing capital markets and have resulted in an increasing number of hedge funds to close.  In addition, the “drying up” of credit and the erosion of corporate profitability has put an end to the leveraged buyout mania of private equity funds. We had warned about the speculative excesses of the merger and acquisition craze in our article “Caution: Asset Bubble Building”, November 19, 2006 and the demise of this cycle is creating quite a bit of pain for the managements and investors in these firms who have “overpaid” with high amounts of leverage for firms that are now “reeling” in this recession. As a result of the credit and capital markets meltdown will be a new era of regulation, transparency and more financial discipline in investing. The attrition and change in hedge fund and private equity strategies is positive for sound investment in these sectors going forward. In fact we believe a shift of private equity firms to infrastructure investment is very attractive for investors.

Going forward, we view worldwide equity markets, particularly U.S. equity markets, as much undervalued looking forward 2-3 years.  Many market analysts are increasingly of the opinion that much of the bad economic news is already known and discounted in the U.S. stock market. However, our more pessimistic outlook on unemployment and the uncertainty of a more successful economic rescue program add to the continued downside risk to U.S. and overseas equity markets. As a result, the risk in equity markets at this juncture is that the U.S. recession lasts longer than calendar 2009 and is more severe in terms of corporate earnings declines and failures. For bond markets, there is more risk in that this is still a credit erosion cycle. Non-government bonds will continue to sell at inflated spreads over U.S. Treasuries until the recession bottoms. Longer term, we believe there will be a dramatic increase in interest rates as economic and financial conditions stabilize and then improve in the 2009-2011 period. The huge financing of the current economic stimulus and recovery programs will necessitate large bond offerings that will cause a large increase in yields from current levels. Commodities and commodity stocks will be depressed for most of 2009, reaffirming our economic forecast in our August 11, 2008 article on the “Dollar, Commodities and Geo-Politics”. We would still maintain a defensive posture in regards to capital asset strategy with well above normal cash positions. We would avoid fixed income instruments, particularly sovereign debt. There are some attractive fixed income opportunities in municipal debt markets but here also selectivity and credit due diligence is required. State and local governments are another big casualty of this recession and their creditworthiness is being increasingly strained. Downgrades in municipal credits are to be expected over the next two years. Once the current economic cycle bottoms, we expect huge stock market rallies led by U.S. equities and followed subsequently by overseas markets. We continue to be attracted to infrastructure investment as the long term need for infrastructure upgrade and expansion is large. Other sectors we view as attractive for investment include electric power generation, energy conservation, agriculture, water conservation and development, healthcare and education overhaul.

We invite questions regarding our current views and forecasts of the economy and capital markets for the remainder of this year and next and the longer term economic and capital market outlooks

Question about economy

how did the economy cycle work during the great depression?
I am writing an essay on the economy cycle during the Great Depression and was wondering these things:

*Explain how the economy works as a cycle.

*Describe how both a flourishing and a failing economy follows a cycle.

*What types of events could cause a break in a successful economy, causing an economy to fail?

Response would be greatlly apriciated, thanks!