Economic perspectives – August 31, 2009

Russell T. Price, CFA – Sr. Economist

Second half growth prospects improve, but full recovery

• Confidence in second half recovery grows: Our confidence in U.S. economic recovery prospects have grown in recent months. However, significant imbalances remain to be worked out and a broad deleveraging process is likely to constrain the economy's growth potential over the intermediate-term.
• Recession's end in Q3?: We currently expect the U.S. Real GDP to show a moderate pace of expansion in the third quarter. Although recessions are no-longer measured solely on the basis of GDP performance, we believe the worst economic period in more than 70 years could well be at its end.
• Housing finally shows some life: The housing market has shown some encouraging signs of late. New and existing home sales were each higher again in the month of July and prices appear to be firming, in some cases even rising in some of the country's hardest hit regions.
• Not banking on the consumer just yet: We still expect the unemployment rate (a lagging economic indicator) to peak at about 10.2% by late 2009 /early 2010. Our research shows that stock prices have bottomed before the unemployment rate has peaked in every recession since 1945 with an average lead time of approximately 9 months.

Is a recovery finally here?

Recent economic indicators continue to provide evidence of improving fundamentals. Over the last few months home sales are a bit higher, consumer spending is slightly stronger, job losses are fewer, and new factory orders are well off their lows. These few examples certainly do not add-up to an immediate robust improvement in economic growth, but they do suggest that the economy is changing course and heading back toward an expansionary path - its natural state.

We have been encouraged by recent economic reports, especially with many measures of activity coming in stronger than expected. From an economic perspective we are "flushing the system" to correct many of the imbalances which have developed over the course of many years. Today we stand in much better shape in terms of the housing market, the trade deficit, business inventories and financial leverage. Some imbalances remain to be dealt with, and a rising Federal government debt position poses longer-term challenges, but these issues are likely to weigh on growth prospects over the intermediate-term rather than send us back into recession, in our opinion.

In this month's report we believe it bears value in evaluating a few of the economy's remaining imbalances, most notably the concerns for commercial real estate and the prospects for consumer spending amid a potentially weak employment recovery.

Commercial Real Estate: Just like their home-owning counterparts, owners of commercial property are having a difficult time paying their mortgages amid the current economic downturn. As shown in the chart below, delinquencies on commercial real estate loans are rising rapidly. These defaults will have a negative influence on the financial sectors recovery, but we do not expect the burden of these defaults to have near the sudden and sever negative consequences that stemmed from the residential mortgage market collapse of the last few years. The overall size of the commercial market is much smaller, the structure of the market implies less immediate hit to bank balance sheets and, as evidenced in the chart, these loans have a known history of cyclicality - something that recently came as a surprise to residential lenders.

There are a number of factors that separate the commercial real estate market from the residential real-estate problems that fed the crisis of the last year.

• Size: The total value of commercial real estate loans outstanding is currently about $3.5 trillion according to Federal Reserve statistics. This is about a quarter of the almost $14 trillion in residential mortgage loans outstanding at the peak of the housing cycle. Delinquencies in the commercial space are currently running just under 8% versus a current delinquency rate in the residential market of about 9%.
• Structure: A high percentage of commercial real-estate loans are typically held by the originating institution - often a regional bank. This gives the lender significantly greater control to work with the borrower regarding a work-out solution or a refinance. Accounting rules for held loans are also an easier burden for financial institutions as they can be written-down over time as opposed to the volatile "marked-to-market" rules required for securitized assets purchased (eg. RMBS).
• Expectations: As we noted earlier, commercial real estate loans are well known to be very cyclical (i.e. when the economy turns sour, so do these loans), thus loan originators factor this into their underwriting standards. Conversely, one of the "surprise" factors behind the residential mortgage implosion was that U.S. residential loans were thought to be very resilient to the business cycle. Never before had residential real estate actually lost value in any given year since statistics had been compiled.
• Cycle: Commercial real estate problems usually peak late in recession or early in recovery. Given where we believe we currently are in the business cycle, we believe significant write-downs and provisions have already been made against these loans although additional losses are very likely to be incurred.
• Stress tests: Potential losses associated with commercial real estate loans were considered in the "stress tests" recently conducted by the Federal Reserve and Treasury Department of 19 of the largest financial institutions. This is by no means a guarantee of any safety, but it does show that the risks are being evaluated and monitored.
• Government support is available: Under its $1 Trillion Term Asset-Backed Securities Loan Facility (TALF) program, the Federal Reserve has made approximately $300 billion available for investors seeking to purchase commercial real estate loans.

Can we have a consumer-less recovery?

One of the questions we get most often regards the contrast between our outlook for GDP growth in the second half of this year against our expectation for a rising unemployment rate through year-end. The unemployment rate is a classic lagging economic indicator, and as shown in the table on page 7 of this report, the unemployment rate has historically peaked about 9 months after the stock market has bottomed (as measured by the S&P 500). Should the unemployment rate peak in the first quarter of 2010 as we currently expect, and assuming the March 9th lows for the stock market were indeed the lows of the current cycle, this would place the experience for the current cycle generally in-line with these historical norms.

We also note that our expectation for economic growth in the second half has very little reliance on the consumer. We expect consumer spending to remain fairly flat in the third quarter followed by only modest growth in the fourth quarter. Deleveraging, unemployment and a higher savings rate should combine to keep any improvement in consumer spending relatively muted; but the 90% of Americans that are still employed should feel a bit better about their own employment status over coming months, and thus open their wallets and pocketbooks a bit more in response.

Overall consumer spending remains exceptionally weak, but retail sales, which account for 45% to 50% of total consumer spending, appear to have seen their worst. After a huge 10% drop in the second-half of 2008, retail sales appear to have stabilized and have even evidenced some modest growth. In the chart at right we show total retail sales excluding autos on a seasonally adjusted basis. We excluded autos as to avoid any message confusion stemming from the temporary benefit of the "cash for clunkers" program.

Chart source: Commerce Dept. and Baseline.

Economic outlook

The U.S. economy contracted for the fourth consecutive quarter during Q2, but the contraction was not quite as bad as forecasters were expecting. In its first revision to Q2 GDP, the Commerce Department said U.S. economic activity contracted by 1.0% on a quarter-over-quarter annualized basis. The result was notably better than the 1.5% decline projected by a consensus of forecasters, as well as our estimate of a 1.6% decline. The July 31st GDP report also contained many broad revisions to prior period data, an undertaking the Commerce Department conducts every 5 years or so. Overall, the revised data show the recession to-date has been a bit deeper than previously measured largely due to lower than previously estimated consumer spending. Through the end of the second quarter, the U.S. economy has contracted by 3.9% in the current recession. Though this is deeper than the near 3% declines of the 1970's and early 1980's, it is still well off of the 27% decline in Real GDP as registered during the Great Depression.

Chart source: AASI, U.S. Commerce Department.

On a positive note, given the negative revisions to consumer spending of prior periods, the personal savings rate was revised higher. The personal savings rate for 2007 and 2008 were revised to +1.7% and +2.6%, respectively. Still well below the 6% to 10% range most economists would likely deem optimal, but better than the negative rates previously reported.

Manufacturing activity: Over the last few months, respondents to the Institute of Supply Management's (ISM) Manufacturing survey have reported a strong recovery in new orders for manufactured goods. July's reading of 55.3 represented the best reading for new orders via this index since July 2007. Given the huge inventory reduction measures implemented across most industries in the last few quarters, we believe the improvement in manufacturing activity should be sustainable over the intermediate-term as producers seek to match output to demand.

The ISM Manufacturing Index — New Orders component. This is a diffusion index, meaning numbers above 50 indicate month-over-month expansion while numbers below 50 indicate mo/mo contraction.

Source: ISM, Baseline.

Going forward: Estimates of Q3 economic growth rise appreciably

In recent months we have seen improvements in a broad array of economic indictors. After very sharp declines in the second half of 2008, consumer end-demand appears to have stabilized; this combined with the inventory reduction efforts of the business community has equated to improving factory orders and production levels. Even in the housing sector, prices appear to have finally reached levels where they are re-stimulating demand. Existing single family home sales have risen in 4 of the last 5 months and new home sales hit an 11-month high in June.

Estimates of Q3 U.S. economic growth have grown appreciably over the last month. We now expect the U.S. economy to expand (yes, expand) by about 1.7% in the third quarter, as compared to our prior estimate for a 0.7% gain. Given recent economic data, we further believe our estimate may be too conservative as the economy seems to be trending toward a potential 2.5% gain for the period.

The much larger than anticipated inventory cuts accomplished in the second quarter are responsible for much of the upward adjustment to forward estimates. Given that GDP is measured on a quarter-over-quarter, annualized basis, inventories do not need to expand in order to be a positive contributor to GDP — smaller inventory cuts are all that is needed for this component to be a material positive contributor. For Q3, we are currently estimating inventory cuts of about $70 billion versus the $159 billion in cuts achieved in Q2. Such a result would provide a substantial 2.8 percentage point boost to Q3 growth, all else remaining equal. As we have said in the past, the larger the inventory cuts that are behind us, the better the potential rebound in front of us. Inventories can have a notable impact on GDP figures and can be a strong source of fuel for an economy once demand stabilizes and businesses look to replenish shelves that that were previously taken down to the bare minimum.

Our GDP growth estimates beyond the third quarter have also been adjusted higher, but by fractional amounts. Importantly, our forward estimates are NOT dependent on a material improvement in consumer spending at this time. We expect consumer spending to remain fairly flat over the second half of the year. This estimate is connected to our forecast for non-farm payroll cuts to moderate in the months ahead and average about 165,000 per month in the second half of the year versus average monthly cuts of 564,000 in the first half of the year.

Though the actual announcement of such may be months away, we believe the "Great Recession" may finally see its end during the current quarter.

Chart Source: Ameriprise Advisor Services, Commerce Dept.

Corporate profits: The lynchpin between the economy and the stock market

Corporate profits better than expected by a wide margin. Companies of the S&P 500 reported significantly better than expected corporate profits for the second quarter. According to Thomson Reuters, of the 491 S&P 500 companies to have reported results through August 28th, 73% posted better than expected results while only 19% came-up short. Profit outperformance was almost universally fueled by aggressive cost cutting as revenues were generally in-line to modestly below forecasts. This, however, is very normal at this point in the cycle. Revenue growth will eventually come as the economy recovers but we believe investors could be making a mistake in placing too much emphasis on searching for signs of revenue expansion just yet. Profits meanwhile should evidence the benefit of previously taken cost actions for another two or three quarters.

Although Q2 results outperformed estimates, corporate profits are still substantially below year-ago levels. Data from Thomson's First Call shows earnings in the second quarter to have been down 13% yr/yr. This is significantly better than the 31% yr/yr decline expected at the end of the quarter on June 30th, not to mention the best yr/yr performance for corporate profits in five quarters.

Estimates for the third quarter currently look for a 15% yr/yr decline while corporate profits for Q4 are expected to show a strong 34% yr/yr gain. The forecast for Q4 may appear overly-optimistic at first blush, but there are legitimate factors which we believe should boost results on a yr/yr basis by year-end. First and foremost, the huge losses taken in the banking sector during the fourth quarter of 2008 will make for very easy comparisons in this year's final quarter. According to Bloomberg data, write-offs and charges in the financial sector peaked in Q4-2008 as U.S. companies took charges and write-downs totaling a massive $243 billion. By comparison, charges and write-offs dropped to $102 billion in Q1-2009. Energy sector profits should also recover somewhat in the second half of this year as oil commodity prices will likely be significantly higher in this year's fourth quarter. Additionally, companies in a broad range of industries should continue benefit from recent drastic restructuring actions. Should these estimates for the year hold true, it would place trailing twelve-month S&P 500 earnings at a low of $57.53 by third quarters' end (we will refer to this figure later in our S&P 500 discussion) — a 38% decline from the cyclical high of $92.25 as attained in Q2-2007. By year-end, trailing twelve-month earnings are forecast to be $61.72.

Current estimates for the S&P 500 and its components:

Stocks typically bottom long before the economy

We have highlighted the following data in the table below for the last few months. We believe this historical view of stock performance during economic turning points offers valuable insights for investors at this stage so we intend to re-publish it for a few more months as well.

Our research, as reflected in the table below, shows that in almost every recession since 1960 stock prices have hit bottom about 9 months prior to the eventual bottom in corporate profits. The lone exception to this was the recession of 2001 when stocks had much more to "give-back" from a valuation perspective.

How to read the above table: Taking the recession of 1990-1991 as an example: from peak to trough Real GDP in the recession of 1990-'91 declined by 1.3% and there were two quarters between said peak and trough. Corporate profits meanwhile fell 37.5% from their peak to their trough during this period and there were 37 months between these highs and lows. The S&P 500 declined a total of 14.8% from its high point to its low point during the period (based on month-ending values) and there were 4 months between these occurrences. The stock market hit its low 24 months before corporate profits saw their low for the period and unemployment rose by 2.6 percentage points, from a low of 5.2% to a high of 7.8%. Stock prices also bottomed 21 months ahead of the eventual peak in the unemployment rate.

Putting this data to work

As investors, how can we use this information and apply it to the current cycle? We also went back and looked at how valuation multiples performed during prior cycles. Given that our research (as outlined in the chart above) indicated that stock prices typically begin to move higher 9.3 months ahead of the eventual bottom in corporate profitability, it equates that valuation multiples have historically also hit their low at the time of the stock market low. In other words, if this past February's month-ending close for the S&P 500 of 735.09 was indeed the low for this cycle, then we would expect the P/E ratio at that time to have also been the low for this cycle (i.e. because the denominator, earnings, are still falling). The P/E ratio at the end of February was 10.7. Historically, we have found that by the time corporate earnings did reach their lows (9.3 months later), P/E multiples were 68% higher on average. Excluding the 2001 recession when valuation multiples were still well above their historical norms, the average cycle low for the P/E metric was 11.3 with P/E ratios rising to an average of 18.3 by the time corporate profits hit their low. Thus, from these historical averages we can get a sense of where stocks prices could be headed. If we assume that the third quarter of this year will indeed mark the low in the current corporate profit cycle, and that current forward estimates are close to correct, we can follow the resulting math: $53.75 * (10.7 * 168% = 18.0). These numbers suggest a possible value for the S&P 500 of 1036 at third quarters' end — fractionally above the 1029 closing S&P 500 value of August 28th. Taking these assumptions out to Q4 ending values, however, suggests a possible 1044 level at year end. In these examples the resulting P/E ratio equates to 18.0 — slightly below the historical average. Our Senior Market Strategist, Marc Zabicki, CFA, currently forecasts a year-ending level for the S&P 500 of 1060. Based on First Call full-year S&P 500 earnings estimates this equates to an estimated year-ending P/E of 16.8.

Housing market update

The housing market has actually shown signs of life over the last few months. New home sales have improved for three consecutive months and four of the last five months, while existing home sales have posted gains in each of the last 4 months. New residential construction activity has also firmed sooner than we had anticipated with new starts rising for three consecutive months through July. As we have pointed out in prior reports, the number of new homes available for sale on the market has declined substantially and is now below historical support levels. Though we expect new home construction to bottom this year, we still expect average selling prices for existing homes to decline into 2010.

As shown in the associated charts, builders have cut back substantially in their new construction activity over the last 3 years. This has allowed the number of completed new homes for sale on the market to fall back near historical lows. Inventories are a key to correcting the prior imbalances of the housing sector as builders must eliminate excess inventory before the sector is likely to see a legitimate bottom. Fortunately, we believe strong progress is being made on this front. During the month of April, builders started construction on the fewest number of new homes for any month since 1959, when records were first compiled.

Source: Ameriprise Advisor Services, Inc., Commerce Dept.

Despite the collapse in new home sales, builders have actually curtailed new construction even more

Over the last thirty years, the absolute number of new homes available for sale has rarely fallen below 300,000, regardless of economic conditions. Inventory levels broke below the 300,000 unit mark in April and ended the month of July at 272,000 - just 24,000 units off the all-time low of 248,000 as set in October 1982. We further note that the chart at right has NOT been adjusted for population growth (U.S. population has grown by approx. 50% over the period shown). Over the last 6 months inventory levels have been dropping by an average of 11,300 units per month. We believe a moderate overcorrection however, is likely on this measure, but given the growing population and household formation we believe pent-up demand is building and thus will aid a recovery for the sector in the years ahead.

Chart source: Ameriprise Advisor Services, Inc., U.S. Commerce Dept.

Summary

We expect the U.S. economy to resume an expansionary pace in the second half of the year. We believe the growth drivers in the second half will come from a variety of factors. First, the vast bulk of spending under the Federal government's recently enacted stimulus legislation is slated to be allocated in the second half of 2009 and into 2010. Secondly, businesses have been cutting inventory levels aggressively and such actions will provide leverage to any improvement (even stabilization) in demand. Third, we expect consumer spending to show further evidence of stabilization and possibly even some slight improvement by year-end. Many consumers will face lower monthly mortgage costs due to recent mortgage refinancing activity, while higher stock prices should help rebuild consumer confidence and perceptions of wealth. Consumers should also enjoy comparatively lower energy costs in the months ahead, notably in the form of lower home heating bills amid the recent collapse of natural gas prices (utility supply contracts are typically negotiated in the late Spring). Finally, corporate restructuring actions should boost corporate profitability in the quarters ahead, and leverage profits when demand improves.

Significant economic challenges remain but we believe many of the economy's imbalances enter the second half of 2009 in much healthier condition, and still making progress. We expect further economic improvements to emerge over the months ahead, particularly as allocations under the Federal Government's fiscal stimulus plan ramp-up in the second half of the year and into 2010. We believe the U.S. economy could see an end to its current recession in the current quarter (Q3) but the pace of U.S. economic expansion through 2012 could be modest in our opinion. We have confidence in the economy's prospects for recovery, but the harm that has been inflicted on the balance sheets of consumers, financial institutions, businesses and government has been significant and will take some time to repair.

Risks

While we have confidence in our economic outlook, we recognize that serious economic and financial market challenges remain. Recent credit market turmoil has widely been seen as the greatest risk to the global financial system in a generation. Despite what we believe are signs of improvement in this space, notable risks remain evident and the improvements could unexpectedly reverse due to any number of unforeseen circumstances. The ongoing correction in the U.S. housing market also raises the risk of a prolonged or deeper than expected economic contraction especially if consumer access to credit remains constrained. Commercial mortgage default rates are also rising and could pose yet another hit to the financial system in the quarters ahead. Given these uncertainties, stock prices are likely to remain volatile over the intermediate-term. Terrorism and geopolitical turmoil are also significant factors capable of producing negative economic shocks.