Here Comes the Long Hangover..But First a Few More Drinks

Posted by jeff

Mon Aug 3rd, 2009 08:52 PM

Doing%20Shots.jpgI'm feeling better about the economy! Despite the fact that my wife was recently laid off and our world is being rocked by forces beyond our control, I am actually feeling much better about life for the rest of Urban Digs readers, in the short term.

I was driving back from a long weekend upstate when Bloomberg played some interviews with Timothy Geithner and the Maestro himself, Alan Greenspan. Geithner was interrogated by ABC's "This Week" interviewer George Stephanopoulis on the budget deficit and how the administration was going to deal with our staggering debt load. Now my predilection, from reports about Geithner prior to this crisis, was to like him. My understanding was that he was a fair-minded individual, firm in his convictions and adult in his conduct. But hearing him interviewed, I couldn't help but feel he was another silver-tongued bureaucrat (and apparently not always so). Despite being completely backed into a corner by the interviewer and asserting several times that "We will do what must be done" regarding not only decreases in spending but also the obvious need to raise government revenue, Geithner steadfastly refused to admit that taxes needed to be raised. He was clearly hiding behind the idea that once the economy is stabilized then we will do what must be done, when he said:

“We can’t make these judgments yet about exactly what it’s going to take and how we’re going to get there.”

That attitude unfortunately seems to embody a relentless optimism that still lurks in the American psyche - one that I am not sure is justified, given the financial pickle we're in. I see this optimism in banks that are routinely reporting much higher non-performing assets, but raising their charge-offs much less than those increases. It seems that they think that when they get the properties back and sell them, they will end up being made whole. This thinking rests on the idea of a durable recovery that boosts rents and convinces buyers to lower the risk premium they are currently demanding to provide liquidity of any kind in this environment. It also embodies a belief that debt to bolster purchases of assets will be made available, by someone whose balance sheet hasn't blown up (anyone fitting this description please contact me, particularly if your current plan isn't to sit on the sidelines for a good long time before putting any of your carefully shepherded capital at risk).

Of course, fixing healthcare was paramount on Geithners' list of what the administration hoped to do to address the long-term financial problems of the U.S., but paying for the "fix" was not something he would elaborate on. Geithner had only praise for even the detractors like Robert Altman, the past Deputy Treasury Secretary, and the office of OMB, who are challenging the fuzzy math on healthcare reform and deficit reduction. He explained why they didn't get it and the administrations' great respect for all dissenting opinions (at least when they come from persons who might matter to public opinion).

The Geithner interview was followed by an interview with The Maestro, who in his prior appearance averred that the financial system meltdown was by far the worst he had ever seen and still had a long way to go (this was of course right about the time of the bottom in world stock markets). I know it will come as a great relief to all of you that Greenie the Great One now says that "collapse, I think, is now off the table." While he worries about a potential double dip in the housing market which could cause "a significant acceleration in home foreclosures," Greenspan believes that we have likely already hit bottom on the economy and that we will soon see positive year-to-year growth in GDP, as soon as this quarter, albeit accompanied by continued, though decelerating, job losses. Greenspan, though noting Geithner's praiseworthy diplomacy, voiced certainty that the government will need to eventually raise revenue in order to fund the Medicare shortfall being imposed by the negative demographic effects of aging baby boomers. His belief being that the least-worst solution would be a VAT (value added tax). Greenspan also speculated that interest rate increases could be needed sooner than Ben Bernanke's forecast of a couple of years out.

So with the S&P 500 just points away from a 38% Fibonacci retracement of its recent crash, let's step back and reassess. Economies overshot on the downside due to the CNN effect of collapsing markets. Inventory liquidation, coupled with a lack of financing for big-ticket items, caused a draconian cutback in industrial production, well below even recession-adjusted demand. Let's do a little quick math on how this worked. As an example, in the U.S. we scrap about 12 million cars annually due to obsolescence and we add about 2 million new drivers each year, so base demand is maybe 12 million automobiles per year. If we knock 1 million off this for a wicked recession, we get to base demand of 11 million units per year. Now the rate of sales fell to an annual rate of less than 10 million earlier in the year.

2009%20Auto%20SAAR.jpg

With some rays of light on the economy shining through, some return of financing and the cash for clunkers program (pulling forward future demand), JP Morgan analyst Himanshu Patel says demand could rebound to a 13 million annual sales rate. This situation has occurred throughout supply chains across the world. Electronic supply chain management and just in time inventory practices almost assure that in a shock situation - which few would deny the Lehman/AIG/Money Market Funds debacle was - inventory and production will be cut well below sustainable demand, even when that sustainable demand has been significantly reduced.

ISM%20Inventories.jpg

As I have discussed here recently ( "Every Upturn Starts with Restocking") it's going to take quite a restocking effort to get back to a reasonable rate of economic activity despite the actual decline in consumer purchasing power. Not only that, as Greenspan pointed out in the interview, consumer purchasing power is highly variable, as the stock market has just re-instated some $3 trillion of consumer wealth that was previously taken away.

It is for this reason that I believe that we will see at least a couple of more quarters of strong economic rebound and one to two quarters of public companies surprising to the upside on earnings estimates. Let's look at the puts and takes:

Positives:

  • Inventory rebuilding


  • Continued stock market increase and wealth effect


  • Capital raising/balance sheet bolstering


  • Exports and commodity demand


  • Stimulus money still to come


  • Restructured industries regain pricing power/margins (e.g., banks, brokers, auto dealers)


    • Negatives:

  • Business cash flows which are paradoxically bolstered by declining needs for working capital while shrinking, start consuming working capital as they begin to gear up production again


  • Energy/Commodity cost rebounds


  • Interest rate increases


  • Increased savings rate


  • Continued losses on longer-tailed assets like real estate hamper banks' ability to provide credit to meet additional demand


  • Government size/budget deficit reduction a drag on the economy


  • State size/budget reduction drags


  • Higher taxes
    • My guess is that the stock market will begin to figure out that the opposing forces at work in the economy will result in very slow GDP growth and a modest future outlook, sometime before year-end and markets will begin to adjust. I don't think it will look anything like the bear market we have just been through, but it could be the beginning of a multi-year period of ups and downs, like the 1970s or the last Japanese decade. But first let's party like it's 1998, just one more time.


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