Wednesday, December 30, 2009

2010 Forecast: How's the gas mine? Is it paying off for you?

Well, its forecast time. I'm going to do this over the course of four posts, I think. Maybe more. This first post is going to focus on what I see for general economic growth in 2010 assuming basic conditions that exist today persist into the new year. The next post will discuss what I expect the Fed to do in response and why that might cause some problems for risk assets. The third post will look at what happens if the Fed doesn't do what they are supposed to do (a real risk to be sure) and what the consequences will be of that. The fourth post will answer whatever questions I get on the first three.

First I'd like to say that the economy is recovering, but not in quite the same way we've seen in the past. I know its become cliche to talk about a moderate recovery, so here is some nuance you aren't reading every where.

First, the industrial sector is enjoying a strong recovery. The ISM manufacturing survey and Fed's industrial production figures show above-average activity.

Other series confirm the same ideas. Durable goods orders are strong. Capacity utilization has risen from 68.3% to 71.3% in just 5 months. After the 2001 recession, it took over 2 years for capacity utilization to recover 3 percentage points.

It isn't terribly hard to see why industrial production has recovered so much. Look at inventories.

Knowing that demand was as low as it was in 4Q '08 and 1Q '09, the severe drop off in inventories points to virtually no actual production. Thus production has recently increased in a big way mainly as catch-up. For 6-months every one was so scared they did nothing. All that while inventories dwindled. Now in order to sell anything producers need to produce.

This is, of course, one of the textbook reasons why there is typically a boom period after a recession. Inventory rebuilding. That part of the cycle is hardly over. I went back and looked at inventory levels from 1960 to today and divided it by the current dollar PCE index. Basically its an economy-wide inventory to sales ratio.

At first glance this looks like a persistent decline over time. This can be explained by everything you were taught in business school about improvements in inventory management over time.

But take a second look. Basically the ratio is oscillating in a range from 1960-1980. Then there is persistent decline until about 2001, when the ratio gets stuck in the 14-15% range until 2008. Below I've zoomed in to the recent period.

You worry about those fighters! I'll worry about the tower! If firms were to increase inventories from 12.8% of sales to 14.5% of sales, holding PCE constant, it would require a 13.4% increase in inventory levels. That could add considerably to GDP in 2010.

So that's what's booming. You can guess what's mediocre. Consumers. Here's personal income growth.

Somewhat below average. And certainly far below average if we took out recessionary periods. Then consumer spending.

Same story. Below average and a good bit below average for non-recessionary periods.

What does this point to? A business-lead recovery. Its not impossible. Business spending can and does occur in the absence of strong consumer demand. We know that businesses have spent very little on capital replenishment. Below is non-residential private investment courtesy of the BEA.

You can see that the drop off is much more severe this recession than in 2001 or 1991. In fact, fixed investment as a percentage of GDP (9.5%) is at its lowest point since the early 1960s (although about the same as the 1990-1991 recession.) Since 1960, the average capital spending level as percentage of GDP is 11%. In order to get capital spending up to 11%, businesses would have to increase capex by 16%! Again, this could add considerably to GDP without a serious ramp-up in consumer spending. In fact, I'm modeling that fixed investment adds something like 1.1% to GDP in 2010.

Bottom line: I think GDP grows above 4% on average in 1Q and 2Q 2010, then drops off a bit into the mid 3's for the second half.

Next, we'll look at why a second recession is highly likely (but its 2-3 years out) if the Fed does its job right. Then we'll look at what happens if the Fed doesn't do its job right. Hint: think bell bottoms and burnt sienna couches.


Anonymous said...

The Spread between 6 month and 5 year Treasury notes will be 1/2 the yield on the 5 year note.

Economically, it's a repeat of the 1986-1992 recession in 86, false recovery in 88, second bottoming out recession in 91.

The real risk is, once job creation picks up, that there will not be anywhere enough experienced workers to fill the jobs. This is clearly shown by the mass exodus of people in the 55+ age range from the work force via layoff forced retirement and voluntary retirement to social security.

The federal government cannot afford such a conversion of taxpayers to benefit recivers especially when the free ride it has been getting from near zero inflation ends in the next few years. Inflation at 4% to 6% a year will consume most if not all of the federal budget over a 5 year time span.

The answers are, drastically GDP killing higher taxes and significantly lower benefits from the federal government.

There is also the real risk that a large number of pension plans will fail and shift to the federal government PBGC. UAW, Airlines, Mining, etc come to mind. This will be seen as an easy way for a company to drop 1/4th of its long term liabilities off the balance sheet. Unknown if any municipal plans in serious trouble (Detroit) will go this route since people paying for the benefits just need to move away.

Anonymous said...

Here... Barney made a prediction:

Anonymous said...

Why do we need to build inventory? Has anyone lost sales because of lower inventory? I see no empty shelves....

Steven said...

interesting article on the potential paths for the dollar and the price of gold in 2010:

it also discusses the role of the Fed as well as foreign central banks that are trying to diversify out of the dollar

Michael Krause said...

Nice post. I particularly enjoy the clarity in your economic analysis. Very straightforward.

Naturally, business sector spending translates into higher disposable incomes for consumers (since profits are out there to be had), which will counter the adverse force of debt deflation the consumer is currently feeling.

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Anonymous said...

Nice analysis but I have a question: "fixed investment as a percentage of GDP (9.5%) is at its lowest point since the early 1960s (although about the same as the 1990-1991 recession.) Since 1960, the average capital spending level as percentage of GDP is 11%" I agree with the first number, it is about 9.7% but it was much lower during 1990 (about 7%) and I see a long term average much lower than 11%. Best wishes for the new year.

ronald said...

The Nov ISM report doesn't appear to forecast industrial growth levels you are anticipating.
One would expect greater growth from fabricated metal products and machinery which was the at the low end of growth sectors rather then Apparel, Leather & Allied Products; Printing & Related Support Activities which had the highest growth rate, if industrial production is going to provide the GDP spike you anticipate.

Hope you analysis is correct and look forward to your next post.

John (Ad Orientem) said...

Interesting post (as usual). I tend to agree broadly speaking with many of your points. I think that the heavy stimulus (both fiscal and monetary) will provide for a modest recovery followed by a second deeper recession because in the long run the government can't create economic health and wealth. Given my relatively low level of confidence in the FED's ability to time interest rate hikes I look forward to your discussion of the bad FED scenario.

Merry (Russian) Christmas!

Flow5 said...

Real-output spikes in Jan., bottoms in May, and the economy finally reverses in Oct. (depending upon how the FOMC responds & compensates for these market turns).

Increasing rates of inflation expectations peak in Apr, but linger until Sept. I wouldn't be surprised if inflation (at times), grows faster than real-growth (or we have stagflation).

I'm an inveterate FED watcher (real-time, for 38 years). I remember that whenever the FED maintains an easy money stance, for extended periods, it sets in motion, the velocity of money (irrespective of lending and borrowing).

Because of the length of time the FED has increased the volume of legal reserves (since Sept 08), the velocity of money should have started to increase (and at increasing rates-of-change).

Then, when & if, the FED caps its seasonal accommodation in January, velocity might still increase, but the transactions velocity should, at a minimum, remain self-sustaining.

Thus some of the negative articles (Ambrose Evans-Pritchard: Apocalypse 2010) seem overly pessimistic. And some seasonal trading (commodities), pull backs might be limited.

It also seems probable that the FOMC will continue its mbs purchases as long as commercial bank credit (high 2008-10-22 9603.8), & (bottomed 2009-10-21 9028.3). remains weak & has started to fall again.

The markets are going to struggle through this.

Flow5 said...

ACCRUED INTEREST: The proxy for real-growth topped at .50 in Jul and bottoms at .01 in Nov. Nov. should be the time to enter shorts.
10/27/09 10:04 AM

That's why: "Consumer Credit outstanding fell a greater than expected $17.5b m/o/m in Nov..... and is the biggest monthly drop ever"

Contrary to economic theory, and Milton Friedman, monetary lags are not “long and variable”. The lags for monetary flows (MVt), i.e. proxies for (1) real-growth, and (2) inflation, are historically, always, fixed in length. However the FED's target, nominal gdp, varies widely.

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SatichDash said...

Business sector spending translates into higher disposable incomes for consumers which will counter the adverse force of debt deflation the consumer is currently feeling. Legitimate Work From Home

sfgirl said...

Even though the industrial sector seems to be doing better, i dont think this is a good indicator of a recovery.

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This is clearly shown by the mass exodus of people in the 55+ age range from the work force via layoff forced retirement and voluntary retirement to social security.

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