A Look Back At The Week

May 12, 2009

The week that was through the eyes of David Rosenberg.

1) Largest drop in real GDP since early 1980s

GDP fell 6.1% QoQ annualized in 1Q, well below consensus expectation of -4.6% and even below the BAS-ML forecast of down 5.5%. All investment-related segments of the economy showed significant pullback, reflecting the global recession and the ongoing credit crunch that is making it difficult to complete projects. Commercial construction fell 44.2% in 1Q, which is the largest quarterly decline ever recorded going back to the late 1940s. The BEA noted significant declines in energy-related drilling projects as well as sharp downturns in commercial, healthcare, power and communication building. Capex investment fell 33.8%, the 5th quarterly decline in a row and the deepest decline to date. The residential building sector fared just as poorly, down 38% in 1Q continuing a string of declines that stretch back to early 2006, but again the 1Q drop was the deepest decline so far in the cycle. Inventories were cut by $103.7B in 1Q and took 2.8ppt from top line growth; however, this was far short of our expectations and combined with the weaker than expected final sales pace suggests businesses will likely need to slash more inventories in the months to come.

The one bright note in the report was the consumer, which posted a 2.2% quarterly annualized gain, in the first upturn since 2Q 2008. Early tracking into 2Q, however, suggests that this positive pace likely will not be sustained – not surprising amid the steadily climbing unemployment rate. The saving rate continued to climb, resting at 4.2% in 1Q – a full percentage point higher than in 4Q. On the price side, the GDP price index increased by 2.9%, above consensus but in line with BAS-ML expectations. The more important consumer price index fell by 1.0% as expected and the core PCE advanced by an anemic 1.5% q/q annualized while the yearly pace slowed to a 4-year low of 1.8%.

2) Nominal GDP declines at a 3.5% annual rate

We must admit to being surprised at the bond market reaction as the yield on the 10-year note retests critical support around the 3% area, especially with NOMINAL GDP, which has the highest correlation with interest rates, in contraction phase. Nominal GDP declined at a 3.5% annual rate on top of a 5.8% slide in the fourth quarter of last year. This back-to-back slide dragged the year-on-year trend to -0.5% from +1.2% in 4Q and +4.7% a year ago. This is a historic event, in our view. Outside of the deepest part of the Great Depression from 1930-33, the only other times that nominal GDP was deflating were in 1938, 1946, 1949, 1954 and 1958. While the equity market turned in rather mixed showings during these periods, what is clear to us is that long-term bond yields traded in a 2-3% range with perfect consistency, which could be a signal that at current levels, we could have the makings of a pretty nice buying opportunity in the Treasury market. As for equities, a client made an interesting point to us in the aftermath of the data. The left side of the V does not surprise anyone anymore – it’s a done deal. What investors will likely have to see for this market to reverse course is the right side of the V prove elusive and end up looking like an L, an elongated U or a series of W’s.

3) Are the Fed and markets on the same page?

We find it rather difficult to square the Fed’s press statement this week with the extremely positive reversal in investor sentiment over the past several weeks. The equity market is, as we all know, a forward-looking barometer, and now seems to have gone further than merely pricing in “green shoots”, to discounting the right-hand side of the ‘V’. Mr. Market is to be respected, but he is not always correct. The Federal Reserve does possess the largest US macroeconomic model on the planet, and although the central bank acknowledged the obvious (that “the pace of contraction appears to be somewhat slower”, which was hardly a resounding endorsement for the second-derivative viewpoint, in our view), it seems to have a much more somber forecast of the economy (that “economic activity is likely to remain weak for a time”) compared to Mr. Market. Although the “outlook has improved modestly since the March meeting”, the operative word is “modestly”. In addition, the “remain weak for a time” quote resonated with us even if the market has largely shrugged it off. The Fed certainly does not have a perfect forecasting track record , but let’s just say that there does appear to be a disconnect between the central bank’s choice of words to describe the economic backdrop and Mr. Market’s ability to sustain this vigorous rally.

4) Deflation seen as the primary risk

As for Treasuries, the sell-off continues unabated, and came on a day when we learned that real GDP contracted at over a 6% annual rate, with confirmation of a deflationary environment with the gross domestic purchase deflator (GDP deflator ex trade) declining at a 1% annual rate on top of a 3.9% annualized slide in the fourth quarter of 2008. In fact, at no time in the past 60 years have we seen domestic prices fall this much over a six-month span. Perhaps the market was expecting that the Fed would announce more in terms of the size of its bondbuying program (which was not forthcoming) and viewed the press statement as a disappointment. But as we have stated, periods of deflation in the past were typically met with long-term yields in a 2-3% band with near consistency. The Fed may have tweaked how it portrayed the current climate in the statement, but what it did not change was its view that deflation remains a risk – “the Committee sees some risks that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term”.

The fact that the Fed can state this view, knowing full well that it has dramatically expanded its balance sheet and the money supply, is a testament to the view that the central bank has been leaning against the winds of deflation rather than creating inflation. In our view, the latter will be practically impossible to do in an environment where the underlying unemployment rate is approaching 16% and capacity utilization rates are at all-time lows of 66%. There is simply too much slack in the economy, in our view, for us to be worried over the prospect of inflation or a sustained bear market in bonds.

5) March spending decline implies weak 2Q start

Real consumer spending fell 0.2% MoM in March, after upwardly revised prints of 0.9% and 0.1% MoM respectively in January and February. Since so much of the 1Q gain was front-loaded into the beginning of the quarter it leaves an extremely weak hand-off of -0.4% (March/1Q annualized) heading into the second quarter. Thus the numbers are confirming our view that the 2.2% quarterly annualized gain in 1Q was little more than a short-lived rebound after the extreme bout of risk aversion seen in 4Q. Combined with the decline seen in April retail sales, this leaves our 2Q tracking for PCE at around -2.9%. Personal income fell 0.3% MoM in March, continuing an almost unbroken string of pullbacks dating back to last September. Real disposable personal income (DPI) was flat in March after a 0.3% drop in February, marking a renewed downturn after the boon to real income of the prior 6 months as energy prices collapsed. The statistical momentum (March/1Q annualized) of real DPI turned negative in March for the first time since last September.

6) This rally more rooted in technicals than fundamentals

We remain of the view that this is a rally more rooted in technicals than in fundamentals and that means that traders may well end up enjoying a further upleg to the 200-day moving average of 970. It is possible, though we choose not to participate. If you want risk, at least get paid something for the price of being wrong; for example, an 8-1/4% yield on a Baa corporate at least means investors will garner some income if the consensus view of a second half economic turnaround turns out to be off base. Everyone loves to point to that 1932-37 rally in the equity market when the economy bounced off its lows – then again, real GNP had plunged 33% peak-to-trough so there was space for a “bungee jump” and indeed, that stock market rally took place as the level of economic activity surged nearly 60%. We shall see the extent to which we see such a vigorous rebound this time around. For all we know, this is not 32-37 but perhaps the hiccup we saw in 1Q31 when we saw a 1.1% annualized growth rate followed by a 7.2% pop the very next quarter. We can only imagine how much excitement there must have been back then, but the reality is that the recovery in both the economy and the equity market was still more than a year away.

7) Homeownership out of vogue

Data from the Census Bureau on 1Q homeownership and vacancy rates revealed that the homeownership rate eased slightly from 67.5% in 4Q08 to 67.3% in 1Q09. Though down 2ppt from the peak of 69.2% in 4Q04, a reversion to the long-term average would still suggest another 2-3ppt correction. To date, the largest correction has been in the Midwest, where homeownership has dropped 3.5ppt from the 74.2% peak in 2Q04. At 62.8%, the homeownership rate in the West is now the lowest regionally – likely the result of surging foreclosure rates. By age of homeowner, those under the age of 44 years have seen the largest correction in homeownership, with rates falling to 40% for those under 35 years (from 43.3% in 1Q05) and to 65.7% for those between 35-44 years (from 70.1%) –this segment was likely the most active in market speculation and/or taking out subprime and Alt-A mortgages during the financing boom. The latest climb in delinquency and foreclosure rates suggests on ongoing shift of households into the rental market – a trend that stands to only add to current vacant housing stock.

19.1M homes stood vacant in 1Q – a record figure – including over 2.1M specifically for sale. Relative to pre-bubble levels, this is an 800K overhang of homes that can be expected to weigh heavily on prices for quite some time. In fact, at the current sales and housing start rates for single-family homes, it would take over 7 years to work through inventories. Simply calling an outright moratorium on homebuilding would require a 125% jump in new home sales to work through the housing stock in one year’s time. In short, these numbers indicate a work-out period in the housing market that will likely take quarters/years to resolve even with mortgage rates at record lows and affordability at record highs.

8) Consumer confidence — a hope and prayer

Consumer confidence jumped by the most in 3 years to 39.2 in April from 26.9 in March, almost exclusively on the expectation that the policies put in place will set the economy on a better glide path. This is still an extremely depressed level of sentiment, down 65% from the cycle peak back in February 2007. As such, we reserve judgment on whether the government policies will actually play out as optimistically as the US consumer predicts, but in the short term it is suggesting less of a pullback in consumer spending and a perhaps temporary slowing in the pace of saving rebuild.

Consumer assessment of the present situation rose by 1.8 points to a still very depressed 23.7 in April, with the job assessment (jobs plentiful minus jobs hard to get) up just 0.7 points to -43.4. Thus we have not changed our forecast for April payrolls of -670K with a 0.5ppt jump in the unemployment rate to 9.0%. Future expectations surged to 49.5 from 30.2, the largest jump since just after the Iraq invasion in April 2003. The net assessment of business conditions improved to -9.7, a 20-point jump from the previous month, which is the largest delta we have seen in this indicator since the end of the 1990 recession. Employment prospects performed equally as well as business prospects. Notably, however, the needle in income prospects barely moved, suggesting consumers remain wary about economic-based pay such as bonuses, tips and commissions.

9) March home price declines could be set to reaccelerate

The Case-Shiller home price index for the 20 largest US cities fell 2.2% M/M in February to stand down 18.6% Y/Y (a let-up from the record decline of -19% Y/Y in January). Results were in line with BAS-ML expectations but a tick lighter than consensus estimates. All 20 markets were in the red for the 6th straight month, with declines ranging from -0.3% M/M in Dallas (-4.5% Y/Y) to -5.0% M/M in Cleveland (-8.5% Y/Y). While the pace of deflation appears to have eased slightly in February, prices were still down -26.3% at a 3-month annualized rate. Further, sales transactions in March were driven by a higher share of distressed properties (50% versus 45% in February according to the NAR), suggesting that a reacceleration to the downside may lie ahead.

The hardest hit markets continue be those where sub-prime lending was pervasive and foreclosure rates have surged. Such areas include San Francisco, Phoenix, Las Vegas, Miami, and Los Angeles – all off by 40-50% from their respective peaks. At the same time, Cleveland, Detroit, Chicago and Minneapolis were among the cities to post the largest monthly declines in February, reflecting the spreading nature of real estate deflation. To be sure, malaise in the auto industry was also partly at play in some markets and can be expected to continue to weigh heavily on real estate prices in coming months. Looking ahead, depressed demand, tight credit, rising default rates and excess inventories will likely continue to lead prices lower. We estimate that an additional 10%-15% in downside is still in store, for a peak to trough decline of 40% (versus -30.7% at present).

10) Swine flu — a look back to SARS

With the world watching the swine flu situation, we thought it would be interesting to look at the market impact of the SARS breakout in the opening months of 2003, though we note that this cannot be considered predictive for the current situation. SARS certainly did exert a market impact, though it did not last for much more than 2-3 months. We also have to consider that at the time, the recession was over by well over a year and the economy was far less fragile than is now the case. Plus, the Fed had just announced that it was going to build a “firebreak” around deflation and was on the cusp of cutting the funds rate to 1%, and we also had the positive impact from the initial success in the Iraq war. But what was clear at the time was that (i) S&P food processors fell 15% as the stock market was building its base, and along with that we had airlines down 20%. The hotel/leisure/tourism segment of consumer discretionary pulled back 15% as well. The best ‘hedges’ were pharmaceuticals, which rallied 15%, and gold, which rose 10% during the peak of the pandemic. Emerging market equities were clocked, with the near-25% slide in the Korean Kospi at the time was just one indication. Commodity prices dropped 10% while bond yields managed to rally 100 basis points (though keep in mind that the Fed was still in the process of cutting rates)


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