Mar 12, 2010

A Crisis In Confidence

And the problems were not confined to the United States.  Greece, with $400 billion in national debt, threatened to default on its bonds, which would throw the European Union and the euro into turmoil.  As soon as austerity measures were proposed to deal with the problem the whole country went on strike.  The fear was that even if the problems of Greece were temporarily solved, Spain, particularly, and other marginal European countries would follow with similar problems.

So I guess it was no wonder that the Conference Board survey of consumer confidence sank ten points in a single month, the largest drop since last February (but the largest drop on record was 23 points in October 1990).  The world was facing a broad range of problems and even if solutions could be found, they would be hard to implement.  A bi-partisan commission was established in the United States to deal with the budget deficit problem, but unless Congress is prepared to cut entitlements and defense spending, a meaningful decline in the deficit is unlikely.  Up until now the U.S. has been able to finance its deficit at attractive rates, but our largest creditor, China, failed to roll over some of its short-term Treasury holdings in the fourth quarter, ceding the position of our first place lender at the end of 2009 to Japan.  The Chinese may be pulling back on their Treasury purchases because of dissatisfaction with our position on certain foreign policy issues.  They are upset that President Obama met with the Dalai Lama since Tibet represents so large a portion of the Chinese land mass and they view the spiritual leader as an innocent pawn in a serious and potentially hostile political matter.  They also disapprove of our sale of arms to Taiwan.  They do not believe that these actions are consistent with the partnership that America claims it wants to achieve with China.

I have long believed that China would not engage in a broad program of selling U.S. Treasuries, but if they buy fewer bills, notes and bonds when we are being forced to sell more of them to finance the deficit, we could be in trouble.  This is one reason why I see interest rates rising more than the consensus expects this year.  The Federal Reserve increased the discount rate modestly during February and many dismissed the move as meaningless.  I thought it represented an inflection point and it will be followed by further increases in short-term rates as the economy continues to show signs of improvement as I expect.  The Fed would not have taken this step if it thought business conditions were about to worsen again.  Federal Reserve Chairman Bernanke testified that he expects rates to remain low for a prolonged period but I think he will change his mind if the economy continues to strengthen.

It is ironic, then, that economic conditions in the U.S. are actually getting better.  I had thought that the February employment report which came out on March 5 would show that jobs were being created for the first time since the recession started.  The bad weather during February held back hiring by perhaps as many as 100,000 jobs even though business conditions had improved.  I am confident that the March report which will be released at the beginning of April will be favorable.

Probably the most encouraging sign that the economy is improving is the data on industrial production.  During the first seven months of the recovery this series has increased at a 9.7% annual rate, faster than in the recoveries after the 1973-74 and 1980-82 recessions.  Employment has always shown improvement after increases of this magnitude in industrial production.  It is notable that there is so much strength in the manufacturing sector since the popular perception is that services are showing some early signs of life but goods producers are still in the doldrums.  The facts do not support that view.  According to International Strategy and Investment (ISI), semi-conductor orders were increasing at an annual rate of over 600%, machine tool orders over 100%, steel production close to 90%, heavy truck sales at 75% and rail car loadings over 20%.  Those are very strong numbers.

Housing is key to the growth outlook and the Case-Shiller index of housing prices has increased 7% through November compared with the prior six months.  Families are starting to buy homes again.  The furniture buying index is up sharply and people are taking advantage of attractive mortgage rates which are still below 5%.  There is still concern that foreclosures are about to surge, flooding the market and depressing prices, so that is something to watch.  Fourth quarter mortgage delinquencies were down from the peak, however, and with the stock market’s recovery and the economy back on a growth path, household net worth has improved and the general attitude toward home-buying has become positive and that has started to show up in the data.  Recent housing figures were disappointing but this was probably weather-related.

There are other reasons for optimism.  Only 40% of the stimulus program has been spent and the Administration announced in February that they would be following through on programs which should put $200 billion into the economy through the rest of this year.  Tax cuts yet to come through should add another $200 billion.  In addition to the natural forces of recovery, capital spending and inventory building, which were cut sharply during the recession, we have a series of government measures which should contribute to growth.  Corporate profits are likely to be extremely strong since a recovery is taking place not only in the United States but throughout the world.  I had an above consensus estimate for Standard & Poor’s 500 earnings of $80 at the beginning of the year, but now there are forecasts out there pushing $90.  Corporations are very liquid.  This bodes well for further capital spending, which pretty much came to a standstill during the recession.  Technology, in particular, should benefit.

All this good news is reflected in the leading indicators which are increasing at the fastest rate since the 1983 recession.  If the current economic data is favorable and the outlook is good, why is there a prevailing negative mood?  The answer may be in the longer-term outlook for employment.  According to ISI, 73% of the civilian population aged 18-69 was working in 1999.  At the end of 2009 this had dropped to 64%.  According to their studies, payroll employment would have to increase at a rate of 200,000 per month for twelve years to bring us back to 73%.  We are hoping for job-creation of 100,000 per month just to absorb the new entrants into the work force.

Perhaps the dark mood that pervades consumer attitudes comes from the belief that opportunities in the future will be much more limited than they have been in the past.  There will be fewer jobs for young people getting out of college and limited options for those with less education.  Economic growth will be slower and the stock market may only rise modestly while volatility could be unsettling.  We can only get control of the budget deficit by cutting health care and retirement benefits and trimming the military and there is no appetite in Congress or at the state and local level to do that.  If our creditors abroad show a reluctance to lend to us, interest rates could rise sharply, diminishing the prospects for growth.  When I talk to groups of investors, most believe their children will have a lower standard of living than they have enjoyed (not withstanding anything their parents are likely to do for them); however, a gradual decline in our standard of living does not yet represent a significant threat.

Part of the dour mood may also be related to a lack of confidence in the institutional forces that determine our future.  The public believes our representatives in Washington are prey to well-financed lobbyists when they are in the capital and to the pressures of fundraising to finance their campaigns when they are back home.  Scandal has plagued former presidential candidates, governors of several states including New York (twice) and Illinois, and sports figures.  Everyone seems to be blaming Wall Street for the financial crisis.  There are few heroes to encourage your children to emulate.  If you are insecure about your own future and don’t have confidence in the leaders in business and government, it is no wonder that confidence is at low level.

Confidence is key to the performance of the financial markets.  When investors believe that economic growth can be sustained and the leadership in Washington is strong enough to pass constructive legislation, multiples are likely to expand.  When uncertainty pervades the investment environment, investors are less willing to capitalize earnings generously.  The common view that Wall Street has benefited disproportionately from the recovery doesn’t help.  The feeling among many is that financial service firms are profiting from the pain of people doing the productive and useful work of the country.  Beyond finance the auto companies are struggling to recover market share.  Toyota, which became the auto industry leader, is engaged in a broad scale recall of units.  Although planes seem to be full and ticket prices are high, except for deals, airlines are having difficulty and schedules are being cut back.  China’s companies are finding qualified workers in short supply while American unemployment remains high.  Beyond business, in spite of unimpressive test scores in science and math compared with other industrialized countries, pressure on state and local budgets is leading to discussions about cutting back the school day.

The challenge for the Obama administration is to restore the sense of optimism that prevailed in the United States during the 1980s and 1990s after the recession of 1980-82.  Over the short term the economic news is likely to be good, which could provide a platform for a constructive change in Washington.  If business and the general population believe government is on their side and can actually get something done, then optimism about the outlook can return.  For that to happen the polarization of Congress into extremes on both the right and left preventing compromise on proposed legislation has to end.  The European Union has to get back on solid financial footing.  Employment in the United States has to show consistent increases.  All of this could happen between now and year-end and the mood at Christmas could be very different.  Right now everyone seems to be betting against that view.  Perhaps I’m guilty of wishful thinking but I’m not.

The Blackstone Group L.P.
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Byron Wien
The Blackstone Group
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New York, NY 10154
Tel: 212 583 5055