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developments, market insights and other factors that may influence investment opportunities and strategies. Learn more about Byron. Denying the Double-Dip August 2010 The poor performance of the stock market since April has convinced many that the economy is going to slide back into recession. Some argue that over the years we have learned that the market often sees trouble coming before the weak data appears. While market valuations seem reasonable based on projected earnings, a resumption of the downturn would throw earnings estimates into question. Aside from the normal economic indicators, there is concern that health care costs will be increasing under new legislation, financial service regulation will be severe, taxes will be raised and the current administration in Washington is anti-business. The handling of the British Petroleum oil spill, the firing of General Stanley McChrystal and the uncertain progress in Afghanistan and Iraq have eroded confidence in the administration, and this has shown up in the decline in the President¶s approval ratings. The hostility and partisanship on the part of both Republicans and Democrats and the preoccupation with the outcome of the November elections rather than what seems to be in the best interest of the American people makes many feel that our government is dysfunctional. As for business itself, the oil spill in the Gulf raised the issue of whether companies care more about profits and executive bonuses than their employees and the community. Goldman Sachs, arguably the leading investment banking firm, agreed to pay the largest Securities and Exchange Commission settlement ever, $550 million, to put fraud charges behind it. Finally the ³Flash crash´ in May and high-frequency trading have made investors think that technology has gone too far and long-term fundamental portfolio managers don¶t have a chance against quantitatively based strategies with a short-term horizon. Against this background it is a wonder that the stock market ever has an up day. While there is some basis for all of these concerns, I believe that our democratic system is sound, business and financial firms are trying to do the right thing, the economy will grow at around 3% in 2010 and long-term investors can still make money in equities. The double-dip view is based on the present condition of several factors: inventories, housing and employment. There was enormous inventory liquidation in 2008±09 as a result of the recession and the recovery that began in the spring of last year was fueled largely by bringing inventories back to normal. That largely accounts for the 5% rate of real growth in the fourth quarter of 2009. By the middle of this year inventories had been rebuilt, no longer providing a boost to the economy. The second problem is housing. Starts are running at a record low level of 500,000 units monthly with residential vacancies at 2.6 million, again a record. Who would want to build a house with so many empty homes out there? During the housing boom many construction workers found it easy to find work, but now these people are unemployed and their prospects for finding a job are slim. House prices have stabilized in spite of the overhang, but if they head down again, there will be a further negative impact on consumer spending. Ordinarily in a recession unemployment increases about two percentage points, but when the recession is accompanied by a financial crisis as is the case with this one, the unemployment rate can increase more than three points. Moreover, a financial crisis makes employers reluctant to rehire and it can take
years for the unemployment rate to drop to its pre-recession levels. Washington is focusing hard on this problem because they know it is imperative to bring the jobless rate down below nine percent before the November election or the Democrats will be in danger of losing control of the House of Representatives. But it is difficult to do much about the problem without heavy government expenditures, and it will be hard to get these passed in the present political environment. With all the uncertainties in the outlook, corporations are reluctant to start major capital spending programs. With operating rates running at 73% they don¶t need to do more than replace obsolete or worn out equipment. In fact, with low inflation and low utilization rates in both the manufacturing and service sectors, there is a risk of deflation. Perhaps the bond market is right in pricing the 10-year Treasury below a 3% yield. My view is that the economy is going through a temporary lull and business conditions will improve later this year and in 2011. Europe may be an example. When the financial crisis hit and the markets were worried that ³contagion´ from a possible Greek default would not only put Europe into recession, but spread to other parts of the world, austerity programs were announced by many countries and they were expected to reduce demand seriously. Now the European recovery seems to be continuing, exports are strong and the surprises are occurring on the favorable side. The Bank of England monetary policy committee recently warned that economic conditions ³deteriorated a little,´ but Britain impressed economists there with a 4.5% increase in second quarter gross domestic product. Business confidence in Germany rose to the highest level since reunification. Both services and manufacturing were up in Britain. Exports led the way in Germany. While there is some criticism of the stringency of the methodology, the fact that most banks in Europe came through their ³stress tests´ well has bolstered confidence on the continent. Could that happen in the United States as well? Or is it only a temporary favorable phase in Europe? In preparing this essay I used research from Goldman Sachs, Lord Abbett, Credit Suisse and International Strategy and Investments for arguments on both sides of the double-dip issue. Credit Suisse has an eight-factor model that puts the odds of a double-dip at zero. Even I wouldn¶t go that far. At the beginning of the year I thought that one of the most important positives in the U.S. economy was the consumer. The savings rate during the recession had only risen to 6.5%, not the 10%±12% of 1973± 74 or 1980±82. I believed that the American culture had shifted from thrift to consumerism and once workers began to feel their jobs were secure they would start spending again. The savings rate has dropped to something over 3% now and shoppers have returned to the stores. Until May personal outlays were running at a 4.2% rate of expansion, but they then slowed to 2.4% and that¶s when everyone started to get concerned because the consumer is 70% of the economy. Personal income actually improved in May; it rose at a 5.4% annual rate compared with 4.4% during the previous six months, so spending should continue. The poor housing data may have been caused by the first-time homebuyer tax credit which expired in the spring and caused those wanting to purchase a home to make their decision early in the year. The inventory of unsold homes has dropped from 13 months to eight months and the median sales price has risen 5%. Housing should improve from here. In spite of low capacity utilization rates, capital spending plans have been a favorable aspect of the outlook. Shipments have been rising at a 3% annual rate, but new orders during the April±May period were running at an annual rate of 48% compared with 25% during the previous twelve months. Inventories are still being rebuilt, albeit at a slower rate than last year, and exports have been running 17% ahead of 2009. Imports are strong as well. The disappointing industrial production data for June may be a result of the exceptionally strong report for May. While the Purchasing Manager Index dropped to 56 from 60, any number in excess of 50 indicates the economy is expanding. The outlook continues to be confused by mixed signals. While the leading indicators are showing weakness in the economy, the strength in copper prices is encouraging. Blackstone¶s own experience with its private equity and real estate investments may be helpful here. Most, but not all, of our companies are reporting improving business conditions and our hotel operations are experiencing a notable increase in occupancy. These are not conditions indicative of a coming double-dip. There is a great deal of hand-wringing going on about China. The worry is that overbuilding of both
residences and offices will result in a sharp slowdown in the economy there. This is important because so much of the world growth in 2010 is coming from the developing countries and China is the most important factor among them. In July I spent a week in China visiting companies with my friend the hedge fund manager Richard Chilton and members of his New York and China based team. We saw companies ranging from consumer goods and services to technology, property and utilities. My conclusion is that China will grow this year and probably beyond at high-single-digit rates and the real estate situation, while representing an excess at the high end, is not likely to seriously impair economic expansion. Chinese authorities do not want growth to exceed 10% because of inflation fears and have imposed both fiscal and monetary restraint to dampen the expansion. In contrast to U.S. homebuyers, Chinese buyers of residences generally put up 30%±50% of the purchase price and more for second homes and 100% for third homes. China does not have a culture of equity investing so the purchase of second and third homes is an important investment alternative for many. Institutional Strategy and Investment believes that China is actually short five million housing starts a year. This is in sharp contrast to a rumor circulating recently that there are 65 million vacant residential units overhanging the market. The most surprising observation of the trip was how many companies are focused primarily on the Chinese market itself. Five years ago when this group started making these trips the focus was on exports to the West and other parts of Asia. The factors that argue against a resumption of the recession are the strong liquidity position of corporations which have 6% of their assets in cash, a level not seen since the 1960s, and the fact that both housing and autos are at low levels of production and not likely to drop further. Corporate profits are extremely strong, interest rates are low, companies are in great financial shape, houses are at record affordability and companies need to continue capital expenditures to remain competitive. So the stage is set for a better economy later this year. Perhaps employment is the key. As long as the unemployment rate stays above 9%, investors will continue to worry about a double-dip at worst or a jobless recovery with sluggish consumer spending at best. But there is good news here as well. Initial unemployment claims are generally moving lower (not every week) because the auto plants are not closing down and the government has laid off the last of the Census workers. Hopefully business can start to think positively about the outlook and replace some of the temporary workers with permanent employees and productivity can come down to a reasonable level. Right now productivity is too strong, indicating that the demands on the existing work force are too great. If unemployment could move into the 8% level, confidence would improve and the economy could start to build some momentum.
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