Economic Commentary -- November 2011

By Christopher Bremer, Director, Private Client Services Portfolio Management
Northwestern Mutual Wealth Management Company

An Economic Seesaw
For months, market participants and policymakers have been involved in what seems like an elaborate game of seesaw. Policymakers make a decision or respond to an economic or political event and the markets react. In turn, the policymakers may – or may not – react to what the markets are doing. We’ve seen this behavior over and over again – in Europe with the sovereign debt and banking crisis and in the United States with the slowing economy and the Fed’s Quantitative Easing and Operation Twist policies.

The game of seesaw works as long as the participants do their part. When each player in the game moves opposite the other player, moving the seesaw up and down in concert, all is well. But what happens when one party stops playing? The game comes to an abrupt end as the remaining player is let down with a crash.

Such is the fear and uncertainty hanging over the markets these days. With unresolved economic issues in Europe (after years of problems), low consumer and business confidence in the U.S., and a slowing global economy that is perhaps teetering dangerously on the edge of a recession, no one is sure when this game of seesaw will end – and what will happen if it does.

In this month’s commentary, we look back at the events of the past few months in the markets and the global economy, examine the positive and negative economic signs that result, and identify signs to watch for in the coming months.

The Recent Economic Environment
The macroeconomic landscape during the past several months has been volatile. Continuing troubles in Europe, debt ceiling squabbles and political stalemate in Washington, D.C., and slowing growth in emerging markets are hindering the global economy.

August saw the U.S. debt crisis escalate and finally reach resolution. Congress and President Obama finally compromised and created a deficit reduction “super committee” charged with trimming at least $1.2 trillion from the budget deficit over the next 10 years. 

The super committee is scheduled to report its recommendations by Thanksgiving, and as of late October, committee members were mum on their progress – or lack thereof.

Meanwhile, the crisis in Europe drags on. Yields on Spanish and Italian government bonds rose sharply in August, threatening their access to bond markets to raise funds on an ongoing basis (Fig. 1). Both Spain and Italy passed austerity measures, and Standard & Poor’s then cut Italy’s credit rating from A+ to A. In Greece, the poster child for serial bailouts, talks continued in September and October regarding an additional bailout and potential write-down of debts. As economic growth shrinks in light of continuing austerity measures, it’s become evident that Greece will miss its deficit targets.

Eurozone ministers have discussed a number of possibilities for finally putting the crisis to bed, including issuing Eurobonds (which are bonds guaranteed by the eurozone as a whole), increasing the size of the European Financial Stability fund and recapitalizing European banks. Since past efforts to end the eurozone crisis haven’t succeeded, it’s hard to say what it would take for these efforts to really work.

October brought more urgency to the question of bank recapitalization, as Belgian bank Dexia received a large bailout. Other banks in France, Germany and the U.S. reported mixed results as their share prices were battered by markets that struggled to assess banks’ exposure to European sovereign debt.

All of these events unfolded against the backdrop of a global economic slowdown. Economies in the developed world, which seemed to be moving into more of a growth mode, fell sharply as we moved into the second half of the year. Events in the developed world impacted the developing world, where growth slowed as commodity-based inflation took its toll.

In September, the International Monetary Fund cut growth forecasts and warned that economic growth could be severely constrained if the eurozone failed to find a solution to its ongoing woes. A lack of resolution to the European crisis, the IMF stated, could result in a “lost decade” of economic growth, similar to what Japan suffered in the 1990s. Looking ahead to 2012, the IMF cut its growth forecast for the U.S. economy from 2.7% to 1.9%; in the eurozone from 1.7% to 1.1% and for Japan from 2.3% to 1.7%. The IMF expects overall global growth of just 4% for 2012, down from 5% in 2010 (Fig. 2).

“The global economy is in a dangerous new phase,” the IMF report noted. “Global activity has weakened and become even more uneven, confidence has fallen sharply recently and downside risks are growing.” Growth forecasts for 2012 are predicated upon resolution of the eurozone crisis, compromise between austerity and economic stimulus in the U.S., and stability in the global financial markets.

Reflecting these tensions, markets have seesawed up and down, with swings particularly evident around periods of crisis, especially the U.S. debt-ceiling crisis in July and August. Markets have been particularly sensitive to macroeconomic events, reacting strongly to events in Europe and to news regarding the solvency of banks and their exposure to Europe.

The Good and Bad News
As has been typical throughout this anemic recovery, the good news brings optimism and hope that the economy has turned a corner, while the bad news renews fears of a double-dip recession.

Let’s start with the good news. With commodity prices cooling off, gasoline prices are dropping, and natural gas prices are falling just in time for the all-important winter heating season.

Consumers have already seen relief at the pump, where gasoline prices have fallen from just over $4 a gallon earlier this year to below $3.50 a gallon in late October (Fig. 3). Many will also soon see relief on their energy bills, as nearly half of all U.S. homes are heated by natural gas. Natural gas prices typically rise in December as the winter heating season begins, but due to a supply glut, prices fell in late October to an 11-month low and they’re not expected to rise anytime soon. Futures point to prices settling in below $4 per million British thermal units come January, a level this market hasn’t seen since 2002. Low natural gas rates could save the average consumer between $300 and $350 this winter season.

The decline in commodity prices – which many believe was sparked by the Fed’s quantitative easing policy – is also showing up in a steadying of core inflation numbers, which were heading higher during most of 2011. Consumer prices rose a seasonally adjusted 0.3% from August to September. Underlying inflation, which excludes volatile food and energy prices, rose a modest 0.1%.

Though steadying now, inflation earlier in the year led to the government increasing Social Security payments for the first time since 2008. As a result, recipients will see a 3.6% increase in their benefit checks beginning in 2012.

Even the housing market showed some positive signs recently. In September, home building grew to its highest level in 17 months, and construction of single-family homes rose by 1.7% over the previous month. And while many borrowers who are eligible to refinance have already done so, record-low mortgage rates may spur additional refinancing activity. Average 30-year mortgage rates have been declining since the beginning of April and are hovering below 4%, a record low.

Although economic growth this year hasn’t been anything to write home about, the fourth quarter is shaping up fairly decently. According to the Fed’s latest Beige Book report, overall economic activity in the U.S. has risen slightly, led by higher demand for cars and strong tourism activity in many districts. The Fed described the pace of overall economic activity during the past six weeks as a “modest” or “slight” improvement over the previous reporting period.

Overseas, developing economies that have powered global economic growth are slowing down, but the news isn’t all bad. For example, domestic demand is picking up in China, a society that has traditionally saved a great deal and spent very little. There, higher domestic demand is making up for softening demand in exports. As a result, China’s retail sales rose 17.7% in September over the same period a year ago, and industrial output increased a higher-than-expected 13.8% in September.

On the other side of the ledger, there’s a fair amount of negative economic news concerning retail sales, unemployment, median income and home equity, to name a few.

Reports from large west coast ports indicate that shipping volumes, a key indicator of holiday shopping orders, have fallen to a low not seen since the Great Recession in the fall of 2009. Sobered by lack of consumer demand, retailers are keeping inventories lean, which could translate to a poor holiday sales season.

Unemployment remains high, stuck at 9.1% in September. Employers have been able to increase productivity and ask current employees to work more hours rather than hire additional staff.

Median incomes in the U.S. fell by 2.3% from 2009 to 2010, and real median income has fallen by more than 7% since its high in 1999, according to the U.S. Census Bureau. On top of that, consumers are allocating a higher percentage of their incomes toward housing-related costs, leaving less for other types of spending. Housing-related expenditures represented 33.2% of consumers’ overall spending in 2010, an increase over the 31.9% reported in 2005, according to CoreLogic.

In the past year, average home equity values have dropped by 10% and home prices have been essentially flat. This means that consumer spending is more likely to come from increased income rather than any increase in home equity, according to CoreLogic.

And although there have been some small bright spots in home construction numbers, those numbers are still far below what’s needed to consider the housing market healthy. Last month, home construction grew to a seasonally adjusted pace of 675,000 housing starts over the course of the year; however a healthy home construction market will see one million to 1.5 million starts a year.

In addition, newly issued building permits, a measure of future construction activity, fell 5% from the previous month’s levels to an annual rate of 594,000, the lowest rate in the past five months. If home sales continue at their current rate, only 300,000 new homes will be sold in 2011. That’s worse than the 323,000 sold in 2010, the previous low, and also the lowest level in 48 years of record keeping.

Lack of Economic Confidence
It isn’t just consumers who are still deleveraging and, as a result, reluctant to spend. Businesses are also sitting on cash and relying on technology to drive productivity increases instead of hiring. In this economic game of chicken, neither consumers, weighted down by low wage growth and deleveraging, nor businesses, stung by low sales, are willing to do what it takes to get the economy moving.

Much of this relates to a lack of consumer and business confidence. Recent research by the Federal Reserve Bank of Boston reveals that the bursting of the housing bubble has wreaked long-term damage on consumer confidence. Vast amounts of housing wealth have evaporated, leaving many consumers owing more than their homes are worth and causing many to believe that the economy won’t recover in a way that will meaningfully benefit them.

CEO confidence declined for the second consecutive quarter, according to the Conference Board. Of the CEOs surveyed, only 11% stated that economic conditions are better than they were six months ago compared to one third of those surveyed in the second quarter. CEO optimism regarding the short-term economic outlook became even gloomier, as only 19% anticipate an upturn in economic conditions during the next six months.

The Conference Board’s survey of consumers remained unchanged in September; however the index declined sharply in August and still indicates widespread pessimism. The Sept. 30 Thomson Reuters University of Michigan Survey of Consumers reported that consumer confidence improved somewhat, although from a very low level. While consumers were slightly more optimistic than they were the previous month, they still expect stagnant economic growth at best and little, if any, improvement in unemployment rates in 2012 (Fig. 4).

On a positive note, small business confidence did improve in September, according to the National Federation of Independent Businesses’ Small Business Optimism Index. The increase was largely because fewer small business owners expect inflation-adjusted sales to contract. However, just as with consumers and CEOs, overall confidence among small business owners remains weak. More small business owners plan to increase hiring, make capital outlays or increase inventories than in previous months. And more small businesses expect the economy to improve and believe now is a good time to expand.

What to Watch For
Markets are focused on Europe because so much of what happens with the global macroeconomic environment is dependent on how events there play out. As we go to press, European policymakers have been unwilling or unable to permanently resolve the Greek debt crisis. Without a lasting solution, Europe and the global economy at large will be vulnerable to a sovereign default, and the problems could spread to other countries, to the banks and ultimately to the entire financial system.

Should European leaders finally put this issue to rest, expect a major market rally as reluctant buyers come off the sidelines and put their capital to work. Without resolution, money will likely remain on the sidelines, and market activity will continue to be volatile as market participants evaluate potential solutions.

What’s an investor to do? Keep your eyes on market trends, not day-to-day volatility. Smoothed out periods like the 50-day moving average can help provide a sense of what the market is saying about economic growth or recession. A sustained downturn could signal a recession, whereas an upturn or neutral performance could mean economic growth or at least a continuation of the low growth environment we’ve been operating in recently
 (Fig. 5).

Within the U.S., keep watching key economic data, including unemployment claims, the unemployment rate, housing starts, inflation, retail sales and consumer and business confidence. These metrics continue to tell the real story about what’s going on in the U.S. economy and where it’s likely to go in 2012.

Where We Are Headed
We realize that many economists have said that the odds of our being in a recession, or entering one in the fourth quarter, have increased. That said, the real question in our minds is not whether we officially drift into a double-dip, but whether it would be jarring enough to trigger a complete retrenchment in consumer spending and a corresponding collapse in corporate profits. We tend to think that recessionary fears are already priced into the markets, and even if we witness a deceleration in corporate profits in the coming quarter, it won’t be enough to send the U.S. equity market into a tailspin. A more likely scenario is that the markets continue to trade in a rather wide range with continued volatility; in other words a run of up days offset by a run of down days.

Admittedly, a long list of issues are prominent on the agenda over the next few weeks, including the geopolitical risks associated with the Greek sovereign debt crisis, the state of the European banking system, and the work of the deficit reduction panel in Washington, D.C. Progress on any or all of these fronts could result in a reversal of fortunes for both equity and bond investors. In sum, as unsettling as the state of the global economy may be right now, the recent skittishness of the equity markets has produced better entry than exit points for investors with cash to invest or for those who are ready to rebalance their portfolios.
 

Christopher Bremer is the Director, Private Client Services Portfolio Management with The Northwestern Mutual Wealth Management Company. The opinions expressed are those of Christopher Bremer as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources. Northwestern Mutual Wealth Management Company, Milwaukee, WI is a subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and a limited purpose federal savings bank authorized to offer a range of financial planning, trust, fiduciary, investment advisory and investment management products and services. Securities are offered by Northwestern Mutual Investment Services, LLC, subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. Bond or debt investors should carefully consider risks such as interest rate risk, credit risk, securities lending, repurchase and reverse repurchase transaction risk. Greater risk is inherent in investing primarily in high yield bonds. They are subject to additional risks, such as limited liquidity and increased volatility. There is an inverse relationship between interest rates and bond prices. Government debts are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest when held to maturity.

Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss. All index references and performance calculations are based on information provided through Bloomberg, a provider of real-time and archived financial and market data, pricing, trading, analytics and news.

The gross domestic product (GDP) is the amount of goods and services produced in a year, in a country.

The International Monetary Fund (IMF) is the intergovernmental organization that oversees the global financial system by following the macroeconomic policies of its member countries, in particular those with an impact on exchange rate and the balance of payments.

The U.S. Census Bureau is the government agency responsible for the United States Census. It also gathers other national demographic and economic data. As part of the United States Department of Commerce, the Census Bureau serves as a leading source of data about America's people and economy.

CoreLogic, Inc. provides financial, property and consumer information, analytics and business intelligence. The company analyzes information assets and data to provide clients with analytics and customized data services. Data sources include property and mortgage information, motor vehicle records, criminal background records and tax records.

The Conference Board is a global, independent business membership and research association working in the public interest. The Conference Board is a non-advocacy, not-for-profit entity holding 501 (c) (3) tax-exempt status in the United States. The monthly Consumer Confidence Survey®, based on a probability-design random sample, is conducted for The Conference Board by Nielsen, a leading global provider of information and analytics around what consumers buy and watch.

The University of Michigan Consumer Sentiment Index is a consumer confidence index published monthly by the University of Michigan and Thomson Reuters. At least 500 telephone interviews are conducted each month of a United States sample which excludes Alaska and Hawaii. 50 core questions are asked.

The National Federation of Independent Business is a small, nonprofit business association representing small and independent businesses. The NFIB Research Foundation has collected Small Business Economic Trends data with quarterly surveys since 1974 and monthly surveys since 1986. Survey respondents are drawn from NFIB's membership. The report is released on the second Tuesday of each month.

The Federal Reserve Beige Book is published eight times per year and includes anecdotal information on current economic conditions in its 12 districts through reports from Bank and Branch directors and interviews with key business contacts, economists, market experts and other sources.

92-0381 (1111)