During the first quarter, the stock market continued to work its way higher as evidence mounted that the economic recovery was solidly underway.  For the quarter ended March 31, 2010, the S&P 500 Index rose 5.4%, bringing the stock market recovery to over 70% from its March 2009 low.  During the quarter, the economy benefited from a number of factors including a stabilization in residential house prices, an improvement in auto sales, and a general upturn in manufacturing activity.  The latter reflected a generalized worldwide inventory restocking cycle.

Despite these clear signs of economic expansion, the labor markets in the U.S. remained sluggish.  Businesses are reluctant to add workers and unemployment remained stuck at just below 10%.  The number of workers unemployed for longer than six months, regarded as “long term unemployed,” were about 40% of all unemployed workers compared to 26% in the recession in the early 1980s.  As a result, real disposable personal income (ex transfers) so far in the recovery is extremely weak.  According to ISI, “the recovery in consumer spending is running on transfer payments and increasing consumer net worth. If transfer payments decline and/or if employment doesn’t pick up, the recovery is toast.”1 (emphasis ours)

We have been concerned for some time that because consumer spending is two thirds of the economy, stubborn unemployment may seriously limit the scope of this recovery.  The problems of unemployment and under-employment are made much worse this cycle by problems in the housing market.  With nearly a quarter of all mortgages underwater because of the collapse in house prices, one has to think that many unemployed workers have less geographic mobility than in previous cycles and may therefore find it difficult to move when looking for work. 

The current economic recovery, like most previous recoveries, will likely develop a virtuous cycle at some point wherein recovery begets hiring and longer work hours, which result in greater consumer spending, which further stimulates recovery, and so on.  But for a number of reasons, we believe unemployment will not drop as fast or as far as in “normal” recoveries.

Nevertheless, housing remains problematic.  While there appears to be stabilization, there are still enormous problems in the housing sector.  Some 24% of all mortgages in this country are underwater.  Delinquent first-lien mortgages at least 90 days overdue now number over 1.5 million.2  What this means is that borrowers are not paying their mortgages.  Since banks are slow to foreclose, borrowers can sit back and wait, essentially living rent free.  Loans over 90 days in arrears now average 272 days delinquent, up from 204 days in 2008.  Said another way, the borrowers have not made a payment in about 9 months.  For loans actually in foreclosure, no payments have been made for about 14 months on average.3

So, for the moment, a lot of consumers have extra spending money for a while until they eventually get thrown out of their homes and have to rent somewhere.  When this actually happens, there could be a step down in consumer spending (ex rent).

Moreover, many mortgages are facing resets over the next couple of years.  Should interest rates go up over that time – something we regard as extremely probable – consumers would face rising mortgage payments, which would seriously crimp their spending on other items.

Another worry in this recovery is the inability and/or reluctance of banks to extend credit.  On the one hand, capital markets are wide open and larger corporations are able to issue bonds with ease.  On the other hand, banks are burdened with credit problems especially in residential and commercial loans and are not in a position to lend aggressively to consumers and small business.  Bank failures are a weekly occurrence and are expected to continue for some time.  Since small businesses create the most jobs in this country, lack of credit is likely to inhibit their ability to hire and is, therefore, a major hurdle to lowering the unemployment rate. 

Looking out beyond the next several quarters, there is another concern that is of great importance, namely the growing fiscal imbalances at the federal level.  The financial crisis that erupted in 2008 sparked a massive policy response that included enormous deficit spending aimed at propping up the banks and stimulating economic activity.  From around 1% in 2007, the Federal deficit is estimated to shoot up to over 10% of gross domestic product (GDP) in 2010.  As a result, Federal debt as a percent of the GDP has climbed from less than 40% to a forecasted 60% in 2010, and is expected to reach 70% in 2012.4  Many observers believe this is a fiscal train wreck in the making.  Longer term demographic trends (i.e. the aging baby boomers) coupled with government entitlement programs will make it difficult to avoid an accident down the road.

One need only look at the fiscal problems in Greece to get a foretaste of what may lie in store for us at some future date.  In this country, states like California are already facing a fiscal blow up and we are seeing job furloughs and layoffs that are contributing to unemployment and underemployment levels. 

Maybe we worry too much about all these things, but it seems to us that there is a certain inevitability to some bad news down the road.  The economy is complex and like the body is often capable of self-healing.  But also like the body it sometimes gets overwhelmed by disease and ends up in bed for a while.  So far the economy seems to be fighting off the pathogens pretty well.  We just think it is prudent to be alert to any signs of sneezing or runny noses.

As a result, we continue to maintain some cash as a hedge against potential correction and as a buying reserve should bargains present themselves.  Moreover, we continue to favor investment in companies whose fortunes are not solely driven by cyclical factors but are often a function of company-specific developments such as improved management, restructuring, new products and the like.  While we are reasonably comfortable with the very near term outlook for the economy, we are quite concerned with the longer term implications of the rising federal deficit and concerned about how the economy will perform as monetary and fiscal policy inevitability shift from maximum stimulus to a more neutral stance.  We, therefore, want to focus our “bets” more on individual companies than on broad macro-economic trends.

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1 Running on Empty, ISI Daily Economic Report, 3/30/10.

2 David Streitfeld, U.S. Plans Big Expansion in Effort to Aid Homeowners, nytimes.com, 3/25/10.

3 Paul Jackson, Housing Recovery is Spelled R-E-O, housingwire.com, 3/15/10.

4 End Game Issues:  Fairy Tales and Nightmares, The Bank Credit Analyst, March 2010 – Vol. 61 – No. 9.

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Past performance is no guarantee of future results.  This commentary contains the current opinions of the author as of the date above, which are subject to change at any time.  This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. 

 

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