Saturday, October 24, 2009

The US - The Real Economy and the False Economy

Do you remember the stress tests for the banking system in the US? They were the subject of negotiations by the banks with regards to the outcomes, making them remarkably relaxed stress tests. There was an assumption in the stress tests for an unemployment rate of 8.9% (a curiously precise figure), and 10.3% in 2010. The unemployment rate had already reached 9.8% in September, with expectations of further rises. In other words, the worse case scenario was not indeed the worse case scenario.

Despite this, it appears that business as usual is continuing in the world of banking. When we consider that the stress tests were heavily negotiated and the worse case scenarios are being broken, this is a puzzle.

The real economy is, as you would expect, having an impact upon the banks. Bank of America, the second largest lender against credit cards is reporting massive losses on their lending, and bank failures continue at a shocking pace (106 so far this year). And then there is the exploding numbers of mortgage foreclosures, including prime loans, such that foreclosure counsellors are being deluged with requests for assistance. Commercial real estate loans in default have now reached about 6% of all loans. Small and medium size businesses are seeing continuing high levels of arrears on loans, with those that are moderately delinquent increasing (but a tiny fall in the numbers that are severely delinquent). PIMCO are warning of ongoing high levels of defaults on corporate bonds, but S&P are offering a more sunny outlook than their previous forecasts, but still at a high level.

Some might point to the positive increases in industrial output, and suggest that there is a genuine improvement on the horizon. However, it is not perhaps as bright news as it first appears:
September's increased output was due largely to a 3.5% increase in durable output, including a 7.4% increase in the production of automotive products. Nondurable output increased 0.5% in September. Within major industry groups, manufacturing output rose 0.9%, mining output rose 0.7%%, while utilities fell 0.7%
The first point of note is the increase in automotive production, which is likely the final residual effects of the 'cash for clunkers' stimulus working through the industry. This from the Wall Street Journal:

Retail sales fell 1.5% in September with the end of the "cash for clunkers" program, but consumer spending rose in many categories, lifting hopes that the economic recovery is gaining momentum at the start of the holiday shopping season.

Excluding sales of autos and parts, total retail and food sales increased 0.5%. It was a welcome sign of consumer activity after the deepest downturn in a generation. August sales were revised downward 0.5 percentage point to a 2.2% increase. The government's monthly retail-sales tally isn't adjusted for inflation.

The same article goes on to say the following:

Indeed, sales at motor-vehicle and parts dealers plunged 10.4% in September, following the expiration of the "cash for clunkers" trade-in program. But consumers spent more on smaller and less pricey items. Sales at clothing and accessories stores grew 0.5%. Restaurants, bars and grocery stores gained 0.2% and furniture sales rose 1.4%, in part because home sales have stabilized with help from the government's $8,000 tax credit for first-time home buyers -- a credit that is due to expire Nov. 30.

While they are heading back to stores, many consumers are doing so with trepidation. After a three-month shopping hiatus, Lauren Madrid, a 26-year-old who works in communications at a San Antonio university, returned to her regular haunts -- the mall and Target Corp. -- in August. But Ms. Madrid said she was making fewer shopping trips and going with a mind toward buying specific items. "I didn't buy a stack of T-shirts I'd never wear," she said. "Instead, I bought a cute summer dress that I knew I'd wear and appreciate properly."

The essential problem is that unemployment increases will continue to eat into consumer spending, and for those in employment, there is a shift from credit based expenditure to saving money. With the US economy having been distorted so far into credit based consumption, there can only be expansion in credit defaults across the whole US economy.

What this amounts to is the simple reality that the underlying point of the banking system, loans to individuals and commercial entities, is not a sector in a good state of health. In fact, in aggregate it is looking very ugly. A recent article in Forbes had this to say:

Do banks know something the rest of us don't?

Despite pressure from politicians to take federal bailout money and lend it to companies and consumers to kick the economy out of its doldrums, banks continue to horde cash in dizzying amounts.

Weekly data released Thursday by the Federal Reserve show excess reserves held at the Fed--the equivalent of banks stuffing bills into shoe boxes for storage--topped $1 trillion this week, a record, after climbing steadily since the markets froze up last October.

This is really no surprise. At this moment in time, would you want to be lending into the US economy? For all of the talk about recovery, the banks know that the economic crisis has a long way yet to run. They do know something that 'the rest of don't', and that there is no realistic prospect of a real recovery in the US economy. Despite this, the media, government organisations, and politicians continue to talk up the economy. For example, the Beige Book, the Federal Reserve's review of the economy, has offered a relatively upbeat review, albeit with caveats:

The Federal Reserve's Beige Book released on Oct. 21 reported "stabilization or modest improvements in many sectors," though often from depressed levels. Residential real estate and manufacturing were the more positive sectors of the economy that were helping the recovery. Reports on consumer spending and nonfinancial services were mixed, while commercial real estate was one of the weakest sectors. Transportation activity generally declined. Tourist activity was varied.

The Beige Book indicated that there were more reports of gains in activity than declines, although nearly every reference to improvement was qualified. That's consistent with what we've seen from the data and heard from Fedspeak. Regarding wages and prices, Districts generally reported little or no increases, but there were occasional references to downward pressures.

What we are seeing here is a positive spin upon the most modest of indicators, and disregard for the underlying state of the US economy. Of course, many will point to the stock market as a positive sign, and this article from Bloomberg appears to contradict everything I have said:

Oct. 22 (Bloomberg) -- U.S. stocks advanced for the first time in three days as better-than-estimated earnings at companies from Travelers Cos. to McDonald’s Corp. boosted speculation that the worst recession since the 1930s is over.

Travelers jumped 7.7 percent and McDonald’s climbed 2 percent to help lead the Dow Jones Industrial Average higher, while New York Times Co. and PNC Financial Services Group Inc. also rallied on better-than-estimated results. American Express Co. climbed 3.8 percent to a one-year high after Moody’s Investors Service said credit-card defaults declined.

Perhaps the most interesting part of the article is the report that credit card defaults declined, which appears to contradict the experience of Bank of America. With unemployment increasing, it is not clear what might actually be driving a decline in credit card defaults, so I view this with some suspicion. One possible explanation is that the decline is due to consumers pulling in their horns, which would mean that the relative numbers of defaults might be increasing whilst the absolute numbers are falling.

Another interesting point is that McDonald's will inevitably do well in a recession, as cash constrained consumers are more likely to trade down in their choice of food. In a recession there will always be winners as well as losers. However, this does not explain some of the positive improvements in earnings data over the estimates, and this needs some consideration. A long while back, a friend who had worked at the highest levels of a multinational FMCG company suggested that, if he were heading a company, he would manipulate the financial data to get the bad news of the economic fall-back over in one go, which would allow for earnings in the following year to appear to be positive. It does occur to me that this is a possibility, but I am unsure. However, the same Bloomberg report says the following:
Profits have topped estimates at 79 percent of the companies in the S&P 500 that have released results, according to Bloomberg data. That would mark the highest proportion in data going back to 1993. Earnings fell for a ninth straight quarter in the July-September period, according to estimates compiled by Bloomberg, and are projected to return to growth in the final three months of the year.
The point here is that there does seem to be some basic disconnects between the real economy, earnings and the stock market. With the economy in very bad shape, excepting the natural winners like McDonald's, the news should be relentlessly negative... but this is positive news due to exceeding estimates, not increases in earnings. This appears to fit with my friends assertion, but it is difficult to see how such a contention might be supported with hard facts.

What I am trying to do is paint a picture of the real economy and the false economy. On the one hand, we have banks that are now under stress greater than that which was the worst case scenario, we have huge numbers of bank failures, money being kept on the sidelines due to the terrible state of credit markets, rising unemployment, increasing numbers of foreclosures, and on the other we have a booming stock market.

Something is wrong in this picture. It looks very much like many people will be losing a considerable amount of money on the US stock market in the near future.

Note: I will probably conduct a similar review of the UK economy for the next post, as the picture looks to be very similar. This from Financial Advice:
Despite the fact that UK GDP (Gross Domestic Product) was a disappointing -0.4% during the last quarter, against an expectation of 0.2% growth, the UK stock market ended on a high today adding 60 points to 5268. But why is the UK stock market racing ahead when the UK economy appears to be going into reverse?
An interesting point - to be continued....

I would also like to return to one of my pet subjects at some stage, which is the $US versus the RMB. The plot continues to thicken, but I would like to review the UK economy first ('events' allowing).


  1. Im looking forward to your new review of the UK economy. From where I sit it looks as dreadful as ever. I wasn't surprised that we stayed in recession in the latest figures. I was surprised it wasn't worse.

  2. The FTSE 100 might be seen as being comprised of an international group of companies and hence its behaviour may not be a reflection of how the UK is performing but is rather an indicator of the global economy. The DOW may also be viewed in the same light.

  3. Nice indeed!
    Best wishes from an Estonian living in Italy

  4. See John Quiggin's blog for a brilliant refutation of the Austrian theory of Business cycles:

  5. Just how false is the US economy? Read on.

  6. Cash for clunkers did not help the auto industry, it just destroyed almost 700,000 cars that ran. This had a large negative impact on car repairs and car donation. It also caused used car prices to go up.

  7. "It looks very much like many people will be losing a considerable amount of money on the US stock market in the near future."

    Isn't this what they call 'pump and dump'?

    If recent stories on zerohedge and are to be believed, I guess with all the 'high-frequency trading' and whatnot that goes on these days there is no believing what the market says anyway.

    Everything I've been reading recently seems to suggest that we're just edging towards the next drop on the rollercoaster. Lots of talk about AIG and others getting their begging bowls out again some time early next year.

    Fasten seatbelts, etc!


    PS, I'm still a regular reader, but due to a recent addition to the family I don't have as much time to comment (except at un-Godly hours such as this!). Hope all is well with you and all the regulars here.

  8. Hi. Well, I'd love to be more optimistic than you are in your article, but unfortunately the facts and figures are too horrifying. The whole US is in great debt and I am afraid that the reforms such as the first time homebuyer credit have the reverse effect than it was intended. The problem is that Americans are too far used to living in debt, so sooner or later the financial crisis had to occur.
    All the best,

  9. Saw an interview with David Blanchflower this evening, and it was clear that he sees growth as the main objective, more-or-less stating that you shouldn't worry about how you get it, as long as you get it. (I have read articles by him in the past, and I am not impressed, by the way!)

    But this is one of the things I have mentioned in the past: is it the case that the economy *cannot* be allowed to go into recession, not just in a vain attempt to defer the inevitable pain of a correction, but because it is structurally incapable of functioning without growth? I see this as a vital point because, to use a fashionable phrase, the possibility of physical limits on growth seems to be the 'elephant in the room' which is never mentioned by the politicians even though they love talking 'green'. Perhaps they believe, as someone on the radio earlier in the week was suggesting, that strict green legislation would spawn a whole new industry that would provide the economic growth we need - which seems to be a similar argument to the one that advocates the state ordering the building of a large pyramid to encourage economic activity.


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