Dec 03, 2009

Wondering About 2010

What has caused economists to abandon historical precedents, one of the most cherished tools of their trade, is the belief that a series of circumstances have made this cycle different. To cite a few examples, consumers entered the recession carrying a heavy burden of debt which they are now unwinding and which is holding back their spending. Because of the decline in home values and the stock market consumer net worth is down $7 trillion. Manufacturing competition from abroad has discouraged capital spending. A heavy inventory of unsold homes and high mortgage delinquencies have dimmed the prospects for residential construction. Office vacancy rates of 17% have slowed commercial real estate projects. Finally the U.S. government itself is running a budget deficit of 10% of GDP, the highest ever in peacetime, raising the prospect of higher interest rates and inflation.

While all of those factors give me plenty to be concerned about, what troubles me most is the employment data. The jobless rate is 10.2% (October) but if you add in the “underemployed” (part time workers who would like to have full time jobs), you increase the number to 17.5%. Looking behind the numbers is even more disturbing. In this cycle, 56% of the currently unemployed have permanently lost their job, according to Ned Davis Research. This means that these people have not been temporarily laid off because business is slow and they will be hired back when conditions improve. These workers have lost their jobs because plants have closed, jobs have moved overseas or companies have gone out of business. The peak in earlier recessions (1982 and 1991) was 43%. Moreover 36% of those unemployed have been out of work for 27 weeks or more. In previous recessions the peak was 24%. These considerations support the view that the United States is suffering a structural employment problem and that the unemployment rate will head higher into 2010 and may decline very slowly when it does start to improve.

The data is pretty convincing that jobs will be slow to come back (even the Fed thinks so) and the economy is likely to remain soft if the work force isn’t increasing. Even people with jobs may be insecure and reluctant to spend if they believe the economy isn’t humming. So what’s the other fork? First, initial unemployment claims are declining (the four week moving average is now 514,000 down from 650,000) and temporary employment is strong. Companies may be putting temporary workers on the payroll rather than hiring permanent employees because they are uncertain about the direction of the economy and the incremental cost of health care reforms and they want to maintain maximum flexibility. Even so manufacturing employment is showing improvement. The decline in the dollar is helping exports. According to International Strategy and Investment (ISI) vehicle production increased even after the “cash for clunkers” program expired, steel production is up close to 60% over the past six months and rail car loadings are up 9% over the past four months. Economies around the world are showing exceptional strength. The Baltic Dry Shipment index is up almost six times from its low. The United States has to share in some of that movement of goods.

The Purchasing Manager Survey done by the Institute of Supply Management was at 56 in November up from 32 at its low at the end of 2008. Any reading over 50 suggests growth in the economy. Employee layoff announcements have subsided and are almost back down to the level they were at during the expansion from 2002-2007. Jobs have to be the most important priority for the Obama Administration. If the unemployment rate remains above 10% a year from now, I believe that the Democrats could lose their majority in the House of Representatives. This would be a clear setback for the Administration and would endanger the passage of the key programs on its agenda. Even with 60 Senate seats and a clear majority in the House, the Health Care Reform legislation is struggling. The plan for further regulating financial services is likely to have an even harder time. If the Administration wants to move forward on education, energy and the environment, it must have the votes in Congress to accomplish these goals. Obama’s approval rating (Gallup) has slumped from 66% before he was inaugurated to 49% now. That must be reversed over the coming year if he is to have a successful first term.

A second stimulus program may be an alternative, but only 25% of the first program has been spent and most of that has been in Health and Human Services and the Labor Department. Very little has been spent on infrastructure projects where jobs would be created. That must change over the coming months. Obama knows he has to do something about jobs but he is also starting to become concerned about the deficit. Rahm Emanuel, his Chief of Staff, speaking at the Wall Street Journal Chief Executives Conference recently said that the deficit would be a key focus of the January State of the Union address. The total national debt today is about $12 trillion and the cost of servicing it is about $200 billion or 14% of this year’s $1.4 trillion deficit. But interest rates are unusually low at the present time because of risk aversion and the so-called “carry trade” where the investment institutions can borrow at current short term rates near zero and buy 10–year Treasuries yielding 3.25%, thereby earning a spread on “risk free” assets. The White House estimates that the cost of servicing the debt will rise to $700 billion per year ten years from now because of the additional borrowing the United States will incur as a result of continued budget deficits over the next decade. Over the next three years alone government debt is expected to increase $3.5 trillion. At present 36% of the national debt comes due in the coming year and is financed at very low rates. If rates were to rise next year with the debt also increasing as a result of additional deficits, the cost of debt service could increase by 50%. 

The sheer size of the debt is frightening enough, but what is also disturbing is that a large proportion of it is financed by overseas investors. China and Japan combined own 13% of our debt and other foreign governments own another 16%. The Social Security Trust Fund and other U.S. government entities own 36% of the debt. Private investors own a little more than one-third. The fear is that overseas investors decide they own enough U.S. Treasury securities and slow down their buying of newly issued bonds. Also at some point in the future the baby boomers will retire and the Social Security Trust Fund will begin to sell bonds. Under these circumstances interest rates would probably rise to clear the market.

Another big issue threatening the economy and the financial markets is housing. The Case-Shiller index of house prices has shown improvement over the past few months and sales of existing homes have been rising. In addition the University of Michigan Survey of consumer attitudes shows a substantial improvement in the “Good Time to Buy a House” reading and affordability is favorable because of low mortgage rates and the decline in house prices. New home sales rose 6.2% in October, but it took a record of 13.5 months to sell one. There is no reason for complacency since the first time home buyer tax credit may be helping sales. The Wall Street Journal reported that 23% of households have mortgages which exceed the value of their homes. That’s almost 11 million homes. While many of those homeowners will try to maintain their mortgage payments rather than move, many who are unemployed will be unable to do so. About half of the mortgages are 20% higher than the value of the house and 520,000 homes are already in default. The overhang of houses in trouble is surely going to put a damper on residential construction which is running at about half the level of family formations. Home building has been an important source of employment in the past and is unlikely to improve any time soon. The housing situation is not only a problem for the job outlook and financial institutions, but also for the government. Providing additional aid to homeowners in trouble is likely to put additional pressure on the budget deficit.

Finally there is the issue of populist rage. More than a year after the financial crisis the general public has concluded that it got a raw deal. The government restored the health of the financial service industry and commercial banks and investment banks are in a position to pay out healthy year-end bonuses, but the average working American has not benefited to the same extent. Unemployment is high and increasing. Many of those with jobs are nervous about them. Corporate profits are improving but that is mostly because of cost cutting rather than revenue growth. At the beginning of the year many believed Obama would work to improve the lives of average Americans, but now there is a growing feeling he hasn’t done enough. The payment in full on credit default swaps with taxpayer money is being viewed as government favoritism toward Wall Street. It’s easy to criticize the government for making too sweet a deal on the credit default swaps, but you have to have some sympathy for the kind of pressure officials were under during that fateful weekend in September 2008. Not only was American International Group in danger of failing, but so were the nation’s leading investment banks that held the swaps. Secretary of the Treasury Paulson, New York Federal Reserve President Geithner and Fed Chairman Ben Bernanke may have wanted to pay the swaps in full as a way to bolster the finances of these cash-strained institutions and retain the sanctity of contracts. Nobody could have known, during that stressful period, that a year later the investment banks would be thriving.

There will be pressure on the Administration to be tough on regulating financial institutions which are believed to have gotten an unfair share of the benefits of government measures to deal with the financial crisis. At this point the recession is no longer something Obama inherited. He owns it and it is up to him and his team to figure a way out of it. At the start of his term in January, President Obama was viewed as a champion of the less privileged because he was one of them and would represent their interests. Somehow, perhaps partly because he promoted Tim Geithner to Treasury Secretary and reappointed Ben Bernanke as Fed Chairman, two people associated with aiding troubled financial institutions, and partly because he has backed away from his sharp criticism of Wall Street, he and his Administration are now being viewed as too sympathetic to the business establishment. It is not healthy for the country at this time to have an adversarial relationship between the average working person and government because sacrifices are going to have to be made by everyone as we resolve our current economic problems. One of Obama’s major challenges in 2010 will be to win back significant support of the American people. 

The investor mood has darkened over the past few weeks and the equity market has lost a great deal of its post-March momentum. That was to be expected since you couldn’t count on prices to keep rising at close to an annual rate of 100%. If we are going to have a favorable market in 2010, it will have to be fueled by more than the animal spirits that John Maynard Keynes first wrote about. There will have to be evidence of fundamental economic strength, revenue growth and continued earnings improvement. I believe the signs are better than the current consensus view and so I am willing to take the positive fork in the road at this point. But the favorable evidence must continue to build and the focus of the Administration must turn to job creation for me to be right.

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