Economic perspectives – September 30, 2009

Russell T. Price, CFA – Sr. Economist

Economy on the mend but consumers may need more time

• Near-term growth outlook improves: The U.S. economy may have expanded at its strongest pace in over two years in the third quarter. Intermediate-term growth prospects however, remain constrained in our view by the consumers' efforts to get their financial house in order. Consumer spending has stabilized, but we expect further improvements to materialize slowly.
• Housing finally shows some life: The housing market continues to show encouraging signs of life. Existing single family home sales recently turned positive on a yr/yr basis for the first time since 2005. New home sales, meanwhile, have risen for 5 consecutive months. Some momentum on the housing front may be lost as Federal government's new home buyer tax credit expires in December.
• High expectations for Q3 corporate earnings: Corporate earnings far outpaced expectations during the second quarter. The bar has been set higher for the pending third quarter as a result, but so far corporate guidance has been positive.
• Rebound likely to be modest: 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, and government has been significant and will take some time to repair.

When will the consumer begin to contribute again?

U.S. economic growth in the third calendar quarter appears on track to post its strongest growth in two or more years. We currently estimate growth for the period of about 3.2% but growth for the period could be as high as 4%. Modest improvements have been evident across a number of economic sectors but by far the largest single contributing factor to growth in the third quarter is set to come from reduced inventory liquidation efforts. The inventory cycle holds the potential to be a solid positive contributor to GDP growth for several more quarters. Eventually however, the U.S. economy will need the participation of consumers to maintain a lasting and healthy expansion. This is not to say that consumers must again outspend their means as they did in some recent years. Wage growth, productivity improvements, population growth and what we expect will be a slow decline in the unemployment rate beginning early next year, should over time combine to provide ample fuel for the consumer despite a higher savings rate. Given this longer-term outlook, this month we take a look at where consumers stand in their efforts to repair their balance sheets and the prospects for the sector's eventual return to growth.

To be sure American consumers spent beyond their means in the middle of this decade. Much of this excess spending was fueled by consumers taking cash out of their primary investment – their house. And why not? They could often refinance at a lower interest rate, take some money out their home's equity in the process, and their monthly payments would be little changed. Free money! Unfortunately, it was not free money and we all know how this story ended.

Our U.S. economic forecast expects very little growth contribution from the consumer until early 2010, and even then we expect the pace of consumer spending growth to emerge slowly. We expect consumer spending to remain fairly flat in the current, 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 over the near-term; 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.

Chart source: Baseline

Retail sales:

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 and sudden 10% drop in the second-half of 2008, retail sales 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.

Do consumers have the fuel?

Consumer incomes are down, but spending is down much more, thus leaving room for some spending improvement in our view. Wages and salaries, which comprise about 65% of total income, are understandably down given the higher unemployment rate. However, tax cuts related to the stimulus package and slight wage gains for those still employed have softened the blow to incomes somewhat. The chart at right shows consumer disposable income and spending at annualized rates. The second quarter's average personal savings rate of 5% equated to aggregate consumer savings of about $600 billion per year, or about $5,450/yr per U.S. household.

Chart source: Ameriprise Financial Services, U.S. Bureau of Economic Analysis (BEA)

Household net worth:

U.S. household net worth declined by an amazing $14 trillion (or about 22%) between the third quarter of 2007 and the first quarter of 2009. This decline will likely have a negative impact on consumer spending for some years to come, but net worth was able to regain about $2 trillion in value amid the stock market's recent rebound. Additionally, as shown in the chart at right, although household net worth remains well below its peak, it is still at fairly attractive levels in relation to periods as recent as 1990, 2000, or even just five years ago.

Chart source: Ameriprise Financial Services, Moody's economy.com, U.S. Federal Reserve

The consumer balance sheet:

Consumers have been making progress in repairing their balance sheet. Over the last year, total U.S. household debt has declined by a total of $167 billion. This is the first time since 1952, when the Federal Reserve began collecting such data, that consumers' have actually reined in their use of leverage. Much of the decline has come from paying down credit card balances. Since last July, revolving credit debt (i.e. credit cards) has declined by approximately $69 billion according to Federal Reserve data.

Bills, bills and more bills! The chart at right depicts the Federal Reserve's Financial Obligations Ratio. This ratio depicts the percentage of disposable income needed to remain current on financial obligations. The Fed defines financial obligations as the total of mortgage payments, rent, auto leases, homeowners insurance, property taxes, and consumer debt.

As depicted by the chart, consumer financial obligations are currently consuming about 18% of disposable income, in aggregate. This is approximately 80 basis points below the measure's all time high of 18.8% as recorded in Q1-2008. At its current pace of decline it should take about another 18 to 24 months before the ratio reaches its 1990's average of about 17%.

Source: Baseline.

Summary on the consumer:

The U.S. consumer remains under considerable strain and still has a fair amount of work to do in repairing their overall financial situation. Consumers in aggregate, however, are making steady progress in this effort and we expect the improvements should accelerate as the employment situation further recuperates in 2010. There is also some evidence that the consumers may be regaining their financial footing. In particular, credit card delinquency rates have shown some signs of easing in recent months and the number of homes just entering the foreclosure process (mortgages 30 to 60 days delinquent) actually declined in the second quarter at their fastest pace in three years, according to the Mortgage Bankers Association.

Until consumers are better able to support economic growth, other aspects of the economy including inventory adjustments, Federal fiscal stimulus spending and a stabilization of activity in the housing and business arenas, should facilitate a positive but lackluster pace of GDP expansion, in our view. This contrasts sharply with the consumer-led leverage expansion typically seen in most economic recovery periods. But on a positive note, the weak consumer recovery that we envision should also keep inflation pressures in check.

Economic outlook:

We raised our forward economic forecast again this month as economic data continues to evidence budding signs of recovery across multiple segments of the economy. We now expect the U.S. economy to expand by about 3.2% in the third quarter as compared to our prior estimate for a 1.7% gain, and our estimate of +0.7% in July.

Reduced inventory reduction efforts go a long way in boosting our third quarter expectations, but other key economic fundamentals have also been trending in a modestly positive and encouraging manner. Consumer spending has stabilized and shown some slight growth - even after factoring out the temporary benefit of the "cash-for-clunkers" program. Many components of the housing market have also improved notably in recent months and business spending appears to be stabilizing ahead of our prior expectations.

Businesses have already accomplished substantial inventory reductions over the last few quarters with total inventory levels across the economy down about 13.5% since last October. 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 – just smaller 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. Such a result would provide a substantial 2.6 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.

Chart Source: Ameriprise Financial Services, Inc.

Beyond the third quarter: We also raised our GDP growth estimates for Q4 and beyond. The revisions are not nearly as strong as the near doubling of our estimate for Q3, but we have been encouraged by recent data trends and we believe the odds currently favor further modest upward adjustments to our growth forecast in the months ahead.

Corporate profits: The lynchpin between the economy and stock prices

According to Thomson Baseline, second quarter operating earnings for companies of the S&P 500 Index were down just 13% versus the year-ago period. This result is much better than the 31% decline estimated at the end of the quarter on June 30th although we note that the actual numbers appear to have benefited somewhat from such items as the General Motors bankruptcy. As GM was removed from the Index, so too were its heavy financial losses.

Profit outperformance in the second quarter 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 if they place too much emphasis on searching for signs of revenue expansion too early in the process. Meanwhile, previously taken cost reduction actions should benefit profit margins for another two or three quarters.

Estimates for third quarter S&P 500 profits currently look for a 17% yr/yr decline. Thus far, pre-releases for the period have been heavily skewed to the positive with some firms even indicating improvements in demand. Tech sector names have been especially active with Intel (INTC; NASDAQ; $19.43), IBM (IBM; NYSE; $119.61), Altera (ALTR; NASDAQ; $21.51), Texas Instruments (TXN; NYSE; $23.69), and Microchip (MCHP; NASDAQ; $26.50) among the sector names to have guided expectations higher. Elsewhere, Procter & Gamble (PG; NYSE; $57.92), Best Buy (BBY; NYSE; $37.52), ConAgra (CAG; NYSE; $21.68), and FedEx (FDX; NYSE; $75.22) have also offered optimistic outlooks in recent weeks.

Earnings for Q4 meanwhile are now expected to show a strong 36% yr/yr gain. This forecast 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 are trending to be notably higher than their levels of Q4 and Q1 last year. Additionally, companies in a broad range of industries should continue to 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 $57.19 by third quarters' end (we will reference 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 $61.63.

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: $57.19 * (10.7 * 168% = 18.0). These numbers suggest a possible value for the S&P 500 of 1030 at third quarter's end (slightly below the third quarter's actual ending value of 1057). Taking these assumptions out to Q4 ending values, however, suggests a possible 1110 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 – equating to an estimated year-ending P/E of 17.2 assuming First Call full-year S&P 500 earnings estimates are correct.

Summary:

We expect the U.S. economy to resume an expansionary pace in the second half of the year as growth drivers should emerge 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. Fourth, residential construction activity finally seems to have reached a bottom. And finally, corporate restructuring actions should boost corporate profitability in the quarters ahead, and leverage profits as demand improves.

Significant economic challenges remain but we believe many of the economy's imbalances entered the final quarter of 2009 in much healthier condition and still making progress. Clearly however, some issues remain, and a rising Federal government debt position poses longer-term challenges. These issues are likely to weigh on growth prospects over the intermediate-term rather than send us back into recession, in our opinion.

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.