Bumps in the road

Slower economy? Yes, says our top economic analyst. Double dip or deflation? Unlikely.

With the economy in the doldrums and the stock market jittery, worries have mounted about a renewed recession or even the prospect of deflation. While acknowledging those risks, Lisa Emsbo-Mattingly, Fidelity’s director of economic analysis, thinks the evidence is still pointing toward economic expansion, albeit at a slower pace. She thinks the dramatic comeback in corporate earnings has put stocks at attractive valuations relative to Treasuries, which may amount to an opportunity for investors with a long-term view.

Q: With growth slowing, do we risk another recession?

Emsbo-Mattingly: The slowdown in growth we saw in the second quarter and likely this quarter is typical at this point in the economic cycle. We are likely moving from recovery to expansion. In other words, the speed of economic growth has been taken down a notch. One of the key drivers of the softer growth picture has been the continuation of weak purchasing power on the part of the wage earner. If you look at wage growth relative to CPI (Consumer Price Index), it’s been quite weak. So even though we don’t have headline inflation, workers may feel poorer because their wages have not kept pace with prices.

One of the key components of this slowing in growth comes from the industrial sector. Indeed, it appears that the rapid growth in industrial production we saw off the bottom last year has begun to slow. The ISM Manufacturing Survey probably hit a near-term high in April. On a year-over-year basis, the index of leading economic indicators probably peaked in March. Does that mean that growth is negative? Absolutely not, in my view. It simply means the rate of growth has been slowing. We are encountering bumps in the road. But based on history, that is consistent with this phase of the expansion.

Q: And corporate profits are up.

Emsbo-Mattingly: Yes, the corporate sector has been doing quite well over the past year by getting more output per worker. The kind of productivity gains we’ve gotten recently has been what I call cyclical productivity: You cut headcount during the downturn but there’s been very little increase in headcount as orders have risen. The benefit of that is you can get big margin expansion. That’s why corporate profits, as measured by the Bureau of Economic Analysis, were up 37% year-over-year in the first quarter, and operating earnings for the S&P 500 may be up 50% year-over-year in the second quarter. But the boom in profits is certainly not being felt by wage earners right now. I don’t think this state of affairs is sustainable. If the economy keeps growing, the wage earner is likely to begin to benefit more substantially from this recovery.

Q: So you expect companies will begin hiring?

Emsbo-Mattingly: Yes. Real GDP is down 1% from levels two years ago, while employment remains stuck at 2004 levels, down 5% from levels two years ago. The result has been the cyclical productivity boom of 2009 and the first quarter of 2010. But now things are changing. Second quarter productivity actually fell slightly. In my opinion, the ability of companies to continue to cut costs has largely come to an end. You can’t get blood out of stone. Going forward, I believe nearly every increment in real GDP will show up as labor demand. Otherwise, companies may not be able to keep pace with demand. As long as the economy grows, even at an anemic pace, I think job growth will show a much stronger profile. I believe we are in the same point in the cycle as 1993 and 2003, when job growth kicked into a higher gear.

Q: But in the meantime, the wage earner — the consumer — is cautious.

Emsbo-Mattingly: Right. From 2007 to the present, you’ve had a massive decline in household net worth, and consumers have responded by increasing their savings rate. They’ve been paying down debt, or defaulting on debt. But one way or another, they are de-leveraging. The financial service burden and the debt service burden, as measured by the Federal Reserve, is down to a decade-low.

Consumers’ high sensitivity to personal wealth was vividly displayed in the second quarter. The swoon in the stock market that began in April and became a violent and chaotic decline during the May flash crash led consumers to retrench and save more. While incomes were rising at a 4.1% annualized rate in the second quarter, nominal spending rose a very anemic 1.6%. The savings rate is now at 6.2%. That’s more than triple the savings rate just 3 years ago.

This large retrenchment of spending coupled with an end of new debt creation has begun to show up in improving credit trends. We’ve seen this retrenchment among households and companies. The result is an improvement in delinquency rates across almost all credit categories—in credit cards, auto loans, mortgages, high yield corporate bonds, investment grade bonds—as people and companies save and pay down debt.

Of course, the one exception is public debt. The public sector, especially the federal government, is increasing its debt dramatically, and that may have long-term economic consequences.

Q: In this de-leveraging process, do we run the risk of deflation – the so-called Japan scenario where growth stagnates for more than a decade, where everyone saves and no one borrows or spends?

Emsbo-Mattingly: Well, there’s always been a risk of deflation when you have a massively leveraged economy and asset price declines. But, as I said, I think consumers and businesses have been unwinding debt, and private sector debt levels are now at manageable levels in terms of debt servicing.

As for asset prices, I’m positive on housing prices, not in the sense that they’re going to be rising any time soon, but that they’ve stopped falling. Based on affordability, housing is actually cheap. And I’m very positive on equity prices because I think valuations are compelling.

To really fall into a Japan scenario, I think you need to have continued asset price declines. In that situation, people don’t want to borrow or spend because they think prices will decline further in the future. And in Japan, that’s what occurred. Despite declines, the Tokyo stock market never got really cheap. Land never got cheap. But I don’t think that’s the case here. It took 10 years for Japan to do what we did in the past two years.

Q: But even with this process, we’ve hit a speed bump. Can you explain what the Fed did recently to help the economy?

Emsbo-Mattingly: Well, if you go back to 2008, the Federal Reserve doubled its balance sheet, acquiring a lot of debt and injecting money into the economy in response to the freezing up of the credit system. Originally, its intention was to allow all the assets it acquired, like mortgage debt, to roll off its balance sheet as the economy recovered. But I think the Fed looked at money velocity and indicators on inflation, and saw that growth is still very weak and the risk of deflation was not insubstantial. If the Fed let its balance sheet decline, it would have actually been removing money from the economy and tightening implicitly. By reinvesting the assets as they mature, the Fed may avoid that implicit tightening. I think that’s extremely positive.

Q: But in this slow-growth climate, do you think stock valuations are attractive?

Emsbo-Mattingly: If I look at the after-tax earnings yield of the S&P 500 versus the 10-year U.S. Treasury bond, the market is the cheapest it’s been since 1979, and before that, since 1955. As you can see in the graph below, the spread between the after-tax earnings yield of the S&P and the 10-year Treasury bond is the widest it’s been since 1979. In 1979, and before that in 1955, the stock market had double-digit returns (annualized rates) for the following five and ten years as that spread narrowed. At the height of the market in 2000, the earnings yield was actually below the 10-year bond yield.

Now, one reason the after-tax yield is so high, or the market so low, may be uncertainty over tax rates: We don’t know what the tax regime next year is going to be so everyone is reluctant to act.

Q: So the tax uncertainty may be constraining the market?

Emsbo-Mattingly: Think of it this way: What do I want to do with my capital if I’m a company? Do I pay it out in dividends? Do I make capital investments? Do I hoard it? Do I acquire another company? A lot of those decisions are determined by expected returns, and tax policy is a key factor in how I measure those expected returns. I think one reason the market has been so skittish has been uncertainty over the tax regime, and once you get clarity, people can move on.

Don’t forget, companies are sitting on historic levels of cash on their balance sheets. At some point they have to act. They’re not going to spend all of it at once, but they’re going to spend a portion of it on something, even if it’s a dividend – which may act as a stimulus to the economy. But in my opinion, they are less likely to act until they get greater clarity on tax rates.

Q: What else would it take to jump-start the market?

Emsbo-Mattingly: Well, aside from taxes, it would be very helpful to get a good employment report. And right now, I’m hopeful. The Monster Employment Index of online job listings shows listings up 21% year-over-year. The American Staffing Association, which produces an index of employment hiring trends at staffing companies, shows a 27% improvement versus a year ago. You’ve started to get private sector hiring because, as I mentioned, the productivity story is coming to an end.

One negative, however, is public sector employment, since states and localities are cutting jobs. Could that overwhelm the positive trends in private sector employment we’re starting to see? It’s definitely something I worry about.

And, of course, if we do have a double-dip recession, then unemployment will increase. I just don’t think that we’re going into a double dip. You don’t have inventory buildup, credit cycle tightening, or irrational investor exuberance, which you typically have at a peak. I’m sure we’ll get that at some point, but I don’t believe we’re there yet.

Next steps

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