Aug 02, 2011

Looking Beyond the Twin Crises

In spite of this, the financial markets began the third quarter by moving higher.  The fundamental backdrop was hardly favorable.  The employment report for June showed that the economy produced far fewer jobs than expected; auto production, which was expected to surge, only improved modestly; and consumer confidence declined sharply.  For several months I have been making the case that the second half of the year would be stronger for the U.S. economy than the first, but the skepticism I have encountered has intensified. 

I would like to believe that the rise in the U.S. equity market in early July is a result of investors looking beyond the current challenges and seeing some developing favorable trends.  There is also prevailing optimism that no matter how bleak the European credit situation or the strains caused by the budget deficit in the United States, somehow the intelligent, sincere, committed people in control will work out a solution, even it is only temporary and imperfect, and disaster will be averted.

That’s where I am.  I wish that the long-term prospects for economic growth in the southern tier of Europe were better and the willingness of their populations to endure austerity measures was stronger, but in the end, I am glad that the European Financial Stability Facility was able to provide loans of €109 billion enabling Greece to extend the maturity of its bonds and reduce interest costs.  Greece will not have to come to the bond market to raise funds until 2016 and similar terms would be provided for Portugal and Ireland, if necessary.  That’s one crisis put aside.  I know that there are looming credit concerns about Italy and Spain, but I think economic conditions in those countries are very different from Greece and Portugal and I am less worried for now.

In the United States, the problems are more difficult because they are more political than economic.  A deal presumably made by President Obama and House Speaker John Boehner, which would have reduced the budget deficit by $3 to $4 trillion over ten years, while cleaning up the tax code and raising some taxes to raise $1 trillion, was rejected by both parties for different reasons.  The Democrats thought the changes in Medicare and Social Security were too severe and the Republicans didn’t feel they could go back to their districts and say they had caved on the promise of not raising taxes.

I realize that raising taxes in a fragile recovery is dangerous, but running large deficits indefinitely has frightening implications for interest rates and the economy in the future.  It would seem that we need a combination of spending cuts and revenue-increasing measures over a prolonged period to improve our present situation.  We have to be careful not to try to do too much too quickly.  The economy is dependent on government expenditures, which represent 25% of GDP.  If we were to cut $500 billion in government programs in a single year, we could throw the economy back into recession.

The most serious problem facing the economy is the inability to create jobs.  In my opinion, one of the biggest mistakes President Obama made early in his administration was in setting priorities incorrectly by putting his healthcare program first and not job creation. He lost the opportunity to improve American infrastructure and create jobs in the process.  People who were working in construction prior to 2008 represent an important component of the unemployed, perhaps as  many as two million.  These workers have the skills to be employed effectively in infrastructure projects.  President Obama had control of Congress back then and he could have gotten the appropriate legislation passed.  By spending so much personal time and political capital on healthcare, which was the cornerstone of his campaign for the presidency, he lost an important opening for creating jobs and improving infrastructure. 

We can only create jobs through growth, and even that has its problems.  The relationship between growth and investment has become problematic.  In the early post–World War II period, it took only about $1.50 in investment to produce $1.00 of GDP growth.  The United States was the dominant economic power back then and Europe and Asia were rebuilding after the devastation of the war.  By 1980 Europe, especially Germany, was producing a wide variety of goods for export and Japan was making cars and consumer electronics products we all wanted to buy.  This competitiveness increased the investment required to produce growth and in the 1980s it took almost $3.00 of investment to produce $1.00 of growth.  Today, it takes more than $5.00.  If you assume that the dollar of growth has a 20% profit margin, that means that what was giving you a 13% return on investment in the 1960s and a 6.66% return in the 1980s is giving you only a 4% return today.  That’s why the strong capital spending taking place now is for equipment that gets the goods and services produced with fewer workers.  Capital is replacing labor in this cycle.  In the past, laid-off workers were hired back when the economy improved, but today equipment is being bought instead.  That’s one of the reasons it is proving so hard to bring down the unemployment rate.

As for the here and now, the news isn’t all bad.  Three quarters of Standard & Poor’s 500 companies reporting have exceeded analysts’ estimates for profits in the second quarter.  The troubled housing sector has begun to deliver some better data.  Both housing starts and building permits have improved.  There is still an enormous overhang of unsold homes, but at least some signs of a bottoming process are appearing.  There is also evidence that home prices are stabilizing.  The Case-Shiller index of home prices in twenty major markets was down .1% in April.  On a year-over-year basis, the decline is the lowest in a year-and-a-half. 

The Federal Reserve Bank of Philadelphia reported that its general economic index rose to +3.2 from -7.7, a major change.  Other regional manufacturing indexes are also showing improvement.  The Empire (New York) was up 4 points and Texas rose 16.  Vehicle production has shown strong week-to-week increases through July.  Both money supply and bank loans are increasing, providing the liquidity the economy needs after QE2, the quantitative easing program that expired at the end of June.  So it isn’t as if all the news is bad.  The recent durable goods report was a downer, however.  At this point the negatives are formidable.  The second quarter real GDP came in at 1.3% rather than the estimated 1.9% and the first quarter was revised down to .4%.  Second half growth greater than 3% is going to be harder than I thought.

There is considerable concern that the emerging markets, which have been the engine for growth for the world economy, are slowing.  Inflation is the principal problem in the developing world and central banks in these countries have been tightening monetary policy to control prices with varying degrees of success.  Investors worry that a side effect of this will be a reduction in the rate of growth of these economies.  While there is some sign that growth in emerging markets will come off peak rates, it should still be strong.  China grew at 9.5% in the first quarter.  Retail sales and employment levels in most developing economies are still favorable.  I do not expect major disappointments in this sector.

In the developed world, it is probably useful to think about the implications of a lack of job opportunities.  The unemployed may become an important force in the next election.  In 2008, 63% of the American population was engaged in full-time employment.  Now it’s 58%.  Of the 9.2% unemployed, 4% have been unemployed for twenty-seven weeks or more.  The previous peak was 2.5% in 1980.  The unemployment rate for those without a high school diploma is 15%.  If you look at the number of part-time workers who would like a full-time job, the situation is even worse.  Part-time employment has been strong in this cycle and that has been refuge for some of those out of work, but even that has softened lately.  A similar condition existed in 2002–2003, so the weakness is consistent with a mid-cycle slowdown.  In 2004, temporary employment picked up sharply.  Incumbent presidents since Roosevelt have had difficulty getting re-elected if the unemployment rate is over 7.3%, and it may be hard to create enough jobs to get down to that level in the next fifteen months. 

The Republicans will argue that economic policies of the Obama administration have been ineffective and the Democrats will defend themselves by saying that they were able to get the economy growing again after the financial devastation of 2008, which was created by eight years of Republican rule.  It is too early to know who will be more persuasive, but the economy is likely to be the key issue in the 2012 election.  When times were tough in the 1930s, there was a movement to the left in American politics.  The early signs are that this time the resonating arguments may come from the right.

Contact Information:

The Blackstone Group L.P.
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Byron Wien
The Blackstone Group
345 Park Avenue
New York, NY 10154
Tel: 212.583.5055
wien@blackstone.com