Highlighted in last Wednesday's WrapUp was a broad-based deterioration in both business and consumer confidence that poses a significant threat to the economy's growth going forward. What is interesting to note is the divergence seen in various confidence indices and the stock market, where there is typically a close directional correlation that has now diverged as seen below.
Figure 1
Source: Moody's Economy.com
Figure 2
Source: Moody's Economy.com
Corporate America to the Rescue
There are several conjectures floating around this year as to why the U.S. will avoid a recession, which is likely leading to the markets diverging from confidence indexes as investors hold unto hope, not reality. One of those that keeps being thrown around is that U.S. corporations are in their best financial shape in decades and their appetite for borrowing has not ceased; both assertions are correct.
Figure 3
Source: Moody's Economy.com
Figure 4
Source: Moody's Economy.com
However, what is not correct is to assume corporations strong balance sheets will lead to a wave of capital expenditures that will offset any weakness in the consumer to support economic growth. As mentioned last week, CFO confidence levels are at their lowest levels in the last six years and the National Federation of Independent Business (NFIB) Small Business Optimism Index has plummeted. Not only has the small business optimism index fallen, but so too have business plans to expand, with both at recessionary levels.
Figure 5
Source: Moody's Economy.com
If businesses have turned sour on the economic outlook and are not planning any significant amounts of capital expenditures in the near future, then where are they spending the record amount of debt they have been accumulating? Look no further than the Fed's Flow of funds report that reveals a record amount in share buybacks and net dividends paid, both of which virtually make up for the entire increase in recent accumulated debt.
Figure 6
Source: Moody's Economy.com
Figure 7
Source: Moody's Economy.com
These actions point to corporations spending their cash by returning it to shareholders as opposed to investing in their future growth opportunities, which the CFO survey reveals as dismal. Growth companies rarely pay dividends or engage in share buybacks as they have plenty of growth opportunities to invest in while maturing companies begin to pay dividends as their growth opportunities slow. The net aggregate rise in share repurchases and dividends paid likely reflects dwindling growth opportunities for U.S. domiciled companies.
Despite many rosy economic forecasts by economists and analysts alike, some are starting to sing a different tune and do not share in the same rosy sentiment of the overall financial media. For example, economists at Morgan Stanley are now calling for a recession.
Recession Coming
We're changing our calls for US growth and monetary policy. Since the shock of tighter financial conditions surfaced in August, we've incrementally reduced our outlook for future growth. But the time for incremental changes is over. A mild recession is now likely: We expect domestic demand to contract by an average 1% annualized in each of the next three quarters, no growth in overall GDP for the year ending in the third quarter of 2008 and corporate earnings to contract by 5-10% over that longer period. Three factors have tipped the balance to the downside: Financial conditions continue to tighten, domestic economic weakness is broadening into capital spending, and global growth--for us, long the key bulwark against a downturn--is slowing.
By Richard Berner & David Greenlaw (12/10/07)
'Core-Corporate America'-- Export-Centered Corporate America to the Rescue
This brings us to the second consensus thinking argument that if corporate capital expenditures won't save the U.S. economy, then our export economy will do to the strong global growth story as the rest of the world decouples from the U.S.
This is almost an act of desperation to have something to hold onto as that which the financial press leans upon becomes smaller and smaller as they don't like what the data is saying. This is close to what the financial press does with inflation. Take the headline inflation numbers and if they don't paint a rosy picture, chop out food and energy until a comfortable number is found. Likewise, hang your hat on U.S. corporations and if the data doesn't look rosy, tout corporate America excluding all non-export companies.
The falling dollar has certainly helped boost our exports as the two move in opposite directions, but one of the unfortunate consequences of a falling dollar is import inflation, which Fed Chairman Bernanke and others in the financial press say is not a problem. If that is the case, then how does one explain away the 2.7% increase in November over October? That increase was the largest monthly increase since October 1990, led by a 9.8% rise in petroleum prices. This underscores that a falling dollar does have negative consequences that diminish the benefits from a rise in exports, that is if you count food and energy in your cost of living.
Figure 8
Source: Moody's Economy.com
Figure 9
Source: Moody's Economy.com
Although the global economy has decoupled from the U.S. economy, this is nothing new as global economies lag the U.S. as the U.S. economy still makes up for the bulk of global GDP; not global "growth," but aggregate global GDP. The old adage that "When the U.S. sneezes the rest of the world catches a cold" rings true today and is now putting to the test the decoupling theme so widely mentioned.
For example, the Organization for Economic Cooperation & Development's (OECD) leading indicator has turned sharply lower over the past few months and has yet to rebound despite the easing on the part of the U.S. Federal Reserve. This is highly significant as the 30 member countries of the OECD make up for two thirds of the world's goods and services.
Figure 10
Source: Moody's Economy.com, DismalScientist
Expansion occurs with the index above 100 while a contraction in economic growth is seen when the index is below 100. October's reading of 99.3 indicates a moderate downturn in two thirds of the world's economy.
Weakness is seen both north of the border and in pockets of Europe and Asia. Canada's housing market is following the U.S. with a two-year lag as building permits have fallen from a 25% year-over-year (YOY) percent change in May to roughly 6% currently. Virtually all of the growth in building permits came from the nonresidential sector just as the nonresidential sector in the U.S. is helping to offset weakness in residential real estate. Canada's current account has taken a large hit due to the weakness in the U.S. dollar relative to a strong Canadian dollar, with the strong currency movements showing how fast relative currency moves impact a nation's export economy and trade balance.
Figure 11
Source: Moody's Economy.com, DismalScientist
Figure 12
Source: Moody's Economy.com, DismalScientist
Over in Europe, consumer confidence in the U.K. dropped to a four-year low as consumers there are worried about past and future economic and financial developments as housing prices in the U.K. have decelerated considerably from their lofty levels earlier in the year. Decelerating homes prices are likely weighing on U.K. consumer confidence as consumers there are not as well prepared to handle falling home prices at a time of record indebtedness.
Figure 13
Source: Moody's Economy.com, DismalScientist
Figure 14
Source: Moody's Economy.com, DismalScientist
Figure 15
Source: Moody's Economy.com, DismalScientist
Turning to the Euro Zone, business and consumer confidence is falling there too as the economic sentiment index has plummeted from the high seen in late May. Part of the slowdown stems from the strong Euro currency relative to the dollar that is hurting their export economy as new orders are slowing with firms unable to move their inventories. This at the same time imports are rising as they are in Canada due to stronger currencies relative to the U.S. dollar, reducing the Euro Zone's current account.
Figure 16
Source: Moody's Economy.com, DismalScientist
Heading even further east shows weakness coming from Japan whose consumer confidence index continues to decline with November's reading showing an acceleration in the ongoing decline. Commentary from the DismalScientist is provided below
Figure 17
Source: Moody's Economy.com, DismalScientist
Behind The Numbers
A near perfect storm of uncertain global financial market conditions, deteriorating exports outlook, a housing construction industry in disarray, unemployment rising and food and fuel prices surging have decimated consumer confidence in the Land of the Rising Sun.
Back in the U.S., economic growth is rapidly deteriorating, and it is easy to understand Morgan Stanley's recession call as the Economic Cycle Research Institute (ECRI) Weekly Leading Index (WLI) is running at a smoothed annual growth rate of -2.7%, with commentary from DismalScientist below.
Figure 18
Source: Moody's Economy.com, DismalScientist
Behind The Numbers
The message being conveyed by the ECRI WLI is becoming increasingly pessimistic. The growth rate has now gone lower in each of the last 13 weeks, bringing it to its lowest point in five years.Whether the economy will head into recession remains to be seen, but the quick downward trajectory of the ECRI emphasizes that recession is a distinct possibility. Risks toward housing and the subprime market are weighted to the downside, but the key is likely business confidence. If businesses start to aggressively accelerate layoffs, then the current expansion would be in jeopardy.The slowdown in many countries is the result of the U.S. slowdown as well as currency appreciation that is hurting other countries' export economies. For this reason several central banks are following the lead of the U.S. Fed by lowering their rates as well to depress their currencies and support economic growth.
The Bank of England decided to lower its main refinancing rate to 5.50% from 5.75% on December 6th after having raised the rate in July, while Canada lowered its overnight target rate to 4.25% from 4.5% due to concerns of turmoil in the global financial markets and deterioration in Canada's manufacturing sector.
Figure 19
Source: Moody's Economy.com, DismalScientist
Figure 20
Source: Moody's Economy.com, DismalScientist
As the notion of corporate America coming to save the day has fallen by the wayside in terms of reality, so too is the decoupling theory that is used to support the notion that the U.S. will skirt a recession. As the subprime issue was labeled as 'contained' by Bernanke earlier in the year as well as the financial press and proven quite the contrary several months later, 2008 will likely prove that the slowdown in U.S. economic growth is not 'contained' but extends beyond its borders as the rest of the world is likely to catch the U.S.'s cold. Granted, economic growth in China is still booming as it is in India, but when growth is slowing in two thirds of the global economy (OECD), the decoupling theory is likely to be debunked.
Today's Market
The markets vaulted northward out of the gate on news of concerted effort by the U.S. Fed and other central banks to address elevated pressures in the credit markets. The U.S. Fed is working with the European Central Bank (ECB), Bank of England (BOE), Bank of Canada (BOC), and the Swiss National Bank, with the ECB saying it would make as much as $20 billion available to European banks.
The morning's sizable gains were slowly erased throughout the day as investors remained unconvinced that the Fed and other central banks would be able to ease the global credit crisis. The markets were able to stage a late rally to finish positive on the day with the Dow Jones Industrial Average rising 41.13 points to close at 13473.90 (+0.31%), the S&P 500 up 8.94 points to close at 1486.59 (+0.61%), and the NASDAQ climbed 18.79 points to close at 2671.14 (+0.71%).
Treasuries fell with the yield on the 10-year note rising 8.6 basis points to close at 4.076%. The dollar index was down, falling 0.03 points to close at 76.18. Advancing issues represented 55% and 50% for the NYSE and NASDAQ respectively, reflecting a mixed market.
