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Recession May End But Growth Prospects Low |
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FORECASTS & TRENDS E-LETTER Recession May End But Growth Prospects Low IN THIS ISSUE: 1. Finally, Some Good News For The US Economy 2. More Insights From The Latest GDP Report 3. Media & Obama Declare The Recession Is Ending
4. Consumer Spending Is Still The Key Introduction The Commerce Department announced last Friday that the US economy contracted less than expected in the 2Q. According to the “advance” estimate, Gross Domestic Product declined at an annual rate of only 1% in the April-June quarter. This is considered to be good news since the rate of decline was below the pre-report consensus. Never mind that the better than expected number was almost entirely due to greatly increased federal spending in the 2Q. Also, never mind that the government announced that 1Q GDP was worse than previously reported. The latest GDP report has caused many economists and analysts to declare that the recession is ending. Yet the report noted that most sectors of the economy and consumer spending are still contracting. While I would say that it is still too early to declare that the recession is ending, the latest data strongly suggests that we’ve seen the worst of this recession/credit crisis. We will look at the latest economic numbers and draw some conclusions as we go along. While it is possible that the recession will end in the 3Q and GDP could go into mildly positive territory, the unemployment outlook is likely to get worse for at least the rest of this year and possibly through the first half of 2010. Even President Obama conceded recently that the unemployment rate will almost certainly rise above 10% by the end of this year. Thus, we’re looking at another “jobless recovery” if we indeed pull out of this recession later this year. Next, as we all peer into the likely economic outlook for the balance of this year and next year, and try to formulate our investment strategies accordingly, I will summarize the latest survey of the nation’s largest hedge fund managers. What are they thinking about the economy and the investment markets; where are they positioning their assets now; and what do they think are the greatest risks down the road? I think you’ll find their predictions very interesting. Finally, Some Good News For The US Economy Last Friday, the Commerce Department announced that the US economy contracted less than expected in the 2Q. According to the “advance” estimate, Gross Domestic Product declined at an annual rate of only 1% in the April-June quarter. The GDP report came as a surprise to many, since the pre-report consensus suggested a decline of at least 1.5%, and many (including your editor) expected a decline of 2-3% for the 2Q. Of course, this is the first of three estimates on 2Q GDP, so it could well be revised lower over the next two months. Even so, this is good news for the economy. According to the latest report, GDP fell less than expected in the 2Q primarily due to the large increases in government spending. The Commerce Department report cited that the decrease in real GDP in the 2Q primarily reflected negative contributions from business investment, personal consumption expenditures, inventory contraction and exports. According to the report, these negative influences to GDP in the 2Q were mostly offset by positive contributions from the increase in federal government spending and to a lesser extent by state and local government spending, and a decrease in imports. The fact that the economy declined by less than expected in the 2Q primarily due to increased federal spending and falling imports is certainly not the desired scenario. But after four consecutive quarters of negative GDP growth, investors were happy to see a drop of only 1% in the 2Q. Consumer spending, which makes up apprx. 70% of GDP, continued to fall in the 2Q, but again not as much as had been feared. Personal consumption expenditures fell 1.2% in the 2Q, which means that consumer spending is still on the decline, but somewhat less than pre-report estimates. The latest GDP report was indeed better than expected, even if most of the improvement was due to increased federal spending. Unless you’ve been hiding under a rock over the past few days, you have no doubt heard the mainstream press cheering that the recession is ending and that happy days lie ahead. While we probably have seen the worst of the recession, we need to look at the latest numbers to get a better insight as to the bigger economic picture. More Insights From The Latest GDP Report As noted above, last Friday’s 2Q GDP report was better than expected, even though it showed that the economy contracted at a -1% annual rate in April-June. All the news in the report, however, was not so encouraging. The Commerce Department revised down its GDP report for the 1Q of this year from -5.5% to -6.4%. This means that the January-March quarter was considerably worse than earlier reported. I should also note that the Commerce Department upwardly revised GDP for the 4Q of last year from –6.3% to –5.4%, which largely offsets the downward revision for the 1Q of this year as noted in the previous paragraph. Most notably, however, the Commerce Department also substantially revised the GDP number for the 3Q of 2008 downward to a negative 2.7% annual rate. This was a huge revision that was not expected. Thus, we have seen four consecutive negative quarters in GDP in the last year alone: 3Q 2008 – down 2.7%; 4Q 2008 – down 5.4%; 1Q 2009 – down 6.4%; and 2Q 2009 – down 1.0%. This makes the current recession the worst since WWII, eclipsing even the previously worst recession in 1981-82. In addition to the headline GDP numbers noted above, last Friday’s report also revealed that consumer spending declined in the 2Q. Personal consumption expenditures (PCE) fell by 1.2% in the 2Q following the very modest increase of 0.6% in the 1Q. This was well below the pre-report consensus that was looking for an increase of 2.4% in consumer spending in the 2Q. So much for the widely heralded rebound in consumer spending, but we should not be surprised given that consumer confidence turned lower once again in June. Other indicators in the latest GDP report also suggest that the recession is not over yet. Durable goods orders decreased 7.1% in the 2Q, while non-durable goods orders decreased 2.5 percent, in contrast to an increase of 1.9% in the 1Q. Non-residential fixed investment decreased 8.9% in the 2Q, while non-residential structures decreased 8.9%. Equipment and software purchases decreased 9.0%. Exports of goods and services decreased 7.0%, while imports of goods and services decreased 15.1% in the 2Q. And the list of negatives goes on. How is it then that GDP fell only 1% in the 2Q? Answer: increased federal spending. According to the GDP report, federal government consumption expenditures and gross investment increased 10.9% in the 2Q, compared to an increase of 4.3% in the 1Q. While we can all be happy that GDP fell less than expected in the 2Q, there is little comfort in knowing that the main reason for the better number was increased government spending. Media & Obama Declare The Recession Is Ending Many in the mainstream media wasted no time last Friday in predicting that the recession is ending, if it hasn’t ended already. Since the 2Q GDP number was only down 1%, many now predict that 3Q GDP will almost certainly be a positive number. Predictably, President Obama took to the microphone on Friday afternoon to announce that we are now seeing the light at the end of the economic tunnel, and he attributed the better than expected GDP report to his $787 billion stimulus plan, even though only around 10% of the money has been spent. [Editor’s Note: FYI, more and more analysts are coming around to the idea I suggested in my July 21 E-Letter, that the government should scrap the apprx. 90% of the $787 billion that has not yet been spent. As an example, see the Investor’s Business Daily editorial in SPECIAL ARTICLES below. Of course, this will never happen because Obama and the leaders in Congress can’t wait to spend that money on their pork barrel projects.] The latest argument for the recession ending now goes as follows. Since the Commerce Department revised 3Q 2008 GDP down sharply to -2.7%, this means that the worst of the recession started sooner than we thought. For some reason that I cannot discern, this is supposed to mean that the recovery from the recession will end sooner than we think – as in now. Adherents to this suggestion point to the fact that the Index of Leading Economic Indicators has risen for the last three months in a row. Likewise, home sales and housing starts have risen modestly over the last three months in many parts of the country. No doubt, these are signs that the worst of the recession may be behind us, but they are no guarantee that the recession has ended. Nevertheless, there are now widespread forecasts that GDP will go positive for the 3Q. There is, actually, a credible reason that GDP could manage a positive uptick in the 3Q. Given the severity of the recession and the credit crisis, businesses across America have slashed inventories dramatically. According to the latest GDP report, US businesses have cut back inventories by almost $300 billion in the four months ended in June. Most analysts had expected that inventory rebuilding would have begun in the 2Q, but in fact inventories continued to contract in the 2Q. At some point, businesses will have to rebuild inventories, and some of my best sources believe that a modest rebuilding has begun in the 3Q. Companies that have weathered the worst of the recession and remain afloat will likely have to rebuild their inventories at some point just to stay in business. Plus, federal spending will remain high going forward, so it would not be a surprise to see a positive number in 3Q GDP. But we will not see the first advance report on 3Q GDP until late October. Unfortunately, a modestly higher GDP number for the 3Q will not necessarily mean that the recession is over. Consumer Spending Is Still The Key Personal consumption expenditures fell sharply in 2008 as a result of the housing slump, the credit crisis and the bear market in stocks. While there was a modest bump (+0.6%) in consumer spending in the 1Q of 2009, as noted above the latest GDP report showed that personal consumption expenditures declined 1.2% in the 2Q, well below expectations. As I have noted in recent letters, not only are consumers holding back on unnecessary expenditures, they are also boosting their savings. It is now estimated that the national saving rate has climbed to 7% and may be headed even higher. Consumers remain fearful about the rising unemployment rate and the continued record rise in home foreclosures. Unemployment typically continues to rise even after GDP starts to increase, so pain for workers is far from over. As noted above, even President Obama concedes that the US unemployment rate is headed to 10%, and it may well go even higher next year. The Labor Department noted that already 144 of America’s 372 largest metropolitan areas reported unemployment rates of at least 10% in June. Rising unemployment will mean less shopping and a slower recovery. While we have seen some mildly encouraging reports on home sales over the past few months, the home foreclosure rate continues to set new record highs. Just two years ago, the prediction was that only about two million Americans would lose their homes to foreclosure, a prediction based on the number of subprime mortgage loans with pending interest rate resets. As we know now, however, more than five million homes have been foreclosed on since 2007, and there were more than 336,000 foreclosure filings in June alone according to RealtyTrac. Thus, it is now predicted by some that ten million homes will be foreclosed on before this cycle is over. If that is remotely correct, we are only about half way through the cycle. With the unemployment rate and the foreclosure rate continuing higher, I don’t think we will see consumers boosting spending significantly anytime soon. The latest consumer confidence numbers show that Americans are still jittery, with the Confidence Index falling from 49.3 in June to 46.6 in July. Bottom line: The recession may well end later this year, but the recovery is likely to be disappointing. Those who are suddenly predicting 2-3% GDP growth in the 3Q and 4-5% in the 4Q are way too optimistic in my opinion. 100+ Hedge Fund Managers Offer Their Predictions The accounting firm RSM McGladrey recently published the results of their inaugural Hedge Fund Industry Survey. The survey, representing the thoughts and opinions of 102 hedge fund managers, offers some interesting findings about the state of the industry and their predictions for the economy, the investment markets and real estate. You may be wondering why you should care what hedge fund managers think. After all, the mainstream press continually demonizes them with terms like “secretive,” “risky,” “unregistered” and a whole host of other dubious adjectives. In the latest stock market crash, hedge funds were singled out for their shorting of bank stocks (a strategy that can actually make money on a falling stock), which some said helped to accelerate the stock market’s fall in the last quarter of 2008. And let’s not forget notorious hedge fund managers such as George Soros, who is known for being the man who “almost broke the Bank of England” in 1992, or Long Term Capital Management, a hedge fund managed by Nobel Prize-winning economists that almost caused a global financial crisis in 1998. These and other widely publicized implosions, coupled with the complexity and restricted availability of such investments, have generally cast hedge fund managers in a bad light, at least in the mainstream media. Yet the 102 hedge fund managers surveyed by McGladrey represent some of the brightest and most successful minds in the investment world. Some of these managers are very adept at reading the economic tea leaves, especially as they relate to the markets. This not only helps them to make money for their clients, but to make money themselves since they typically base their fees on a share of client profits. No profits, no pay. Thus, you can bet that the future prospects for the global economy continue to be where hedge fund managers are concentrating their research, and why we want to peek over their shoulders through this survey. A good portion of the survey deals with the new regulatory oversight of hedge funds that Obama has proposed and the managers’ reactions to it, since heretofore hedge funds have been largely unregulated. It was surprising to see that 42% of the respondents felt that the SEC needs additional regulatory authority to do its job effectively, while 50% said the agency should simply be better funded to enforce existing rules, not make a lot of new ones. While we might think all hedge fund managers would resist additional regulation of the funds they manage, another surprising result was that 37% of respondents believe there should be more regulation of hedge funds versus only 18% who said less regulation is needed. 43% of respondents believe that the current regulatory environment is the right amount. However, hedge funds are now in the crosshairs and Congress will no-doubt put them on a shorter leash. Knowing this, 75% of those surveyed worried about the regulatory pendulum swinging too far and becoming so restrictive that it stifles the markets. Note that this includes some of those managers who believe that additional regulatory oversight is needed. All in all, these results actually seem to indicate that a much larger segment of hedge fund managers are open to greater regulation than we might have thought. However, I think the real meat of the survey is in their outlook for the future of the economy and markets. 60% of respondents think that the current economic environment presents more investment opportunities than challenges. Knowing that some hedge funds “short” stocks in declining markets, a bear market expectation could be viewed as an investment opportunity for some funds. Thus, we need to look deeper into the survey’s findings. To begin with, 57% of hedge fund managers surveyed believe that the economy is now headed in the right direction (recession ending fairly soon), even though 83% of hedge fund managers believe that the unemployment rate will continue to rise, and 65% believe that consumer spending will decrease in the next 12 months. Over 80% of hedge fund managers believe that government spending, the Fed’s balance sheet and tax rates (income and capital gains) will all continue to increase over the coming year. This explains why 42% believe the economy is still headed in the wrong direction. Elsewhere, 59% believe that the stock markets have bottomed and are on the right track. However, respondents also acknowledge that there are still dangers lurking in the bushes that could derail the recovery. For example, 82% of respondents see both interest rates and inflation rising over the next year. While less than 20% expect either to increase “a lot,” they acknowledge that the Fed faces a very difficult challenge on both fronts. Since prospects for the stock markets generally depend upon the health of the economy, the survey asked hedge fund managers when they thought the US economy would return to positive growth. 33% of respondents felt that the economy would have positive growth by the end of 2009. 58%, however, believe that the US economy won’t return to positive growth until sometime in 2010. Of course, what we really want to know is what hedge fund managers expect the stock markets to do. After all, that’s where most of us feel they have the greatest area of expertise. To get a better perspective of their predictions, it’s important to note where the market stood when the survey report was written in mid-June 2009. Keep the following figures in mind as I discuss the stock market outlook of these hedge fund managers:
To make a long story short, most hedge fund managers surveyed expect little or only moderate growth to occur in the major market indexes over the next year. For the Dow, the opinions are pretty evenly split among four general ranges of future values. 22% of hedge fund managers believe that the Dow will be under 8,000 a year from now. Another 22% believe it will be between 8,001 to 8,500 and yet another 22% believe it will be between 8,501 and 9,000. The next largest group of 21% believes that the Dow will end up between 9,001 and 9,500 in 12 months. Clear as mud, right? About all we can glean from these predictions is that 87% of hedge fund managers think that the Dow will be between 8,000 and 9,500 in a year or so. Being so evenly split, I believe that these predictions fall in line with my best sources who think that the market will be in a trading range over the next year and possibly much longer than that. Predictions of the future value of the S&P 500 were somewhat less concentrated, but still followed the same general pattern. 64% of respondents expected the S&P 500 Index to be between 851 and 1,100 a year from now, again pointing to a trading range market. The Russell 2000, generally representing the small-cap stock universe, had the widest range of expectations with respondents fairly evenly spread among expectations ranging from under 400 to over 850. This result seems to say that anything can happen in small-cap stocks over the next year. What else is new? As this is written, I find it interesting that the major market indexes are near the upper estimates reflected in the survey. With the Dow currently near 9,300 and the S&P 500 Index breaking above 1,000 yesterday, the markets have benefited from a significant rally since the McGladrey survey was taken. Perhaps this means that these hedge fund managers were too pessimistic in their views. However, if you believe that we’re in for a trading range market, these levels could mean that we may experience some downward pressure on stock prices in the near future. While we typically think of hedge funds as being only involved with financial instruments such as stocks, bonds, derivatives, etc., hedge fund managers also weighed in on the future of real estate values. 70% of respondents expect residential real estate values to continue to fall over the coming year, while a whopping 83% believe commercial real estate values will continue to fall. If they are correct, this will continue to have a chilling effect on the credit markets. We all know that everyone from political candidates to the media leveled criticisms at the hedge fund industry for its part in the subprime meltdown and resulting credit crunch. The survey turned the tables and allowed hedge fund managers to rate the government on the job it’s done during the recent economic malaise. So, how do the managers of these funds feel about the government’s performance so far? Interestingly, the Fed and its Chairman, Ben Bernanke, both fared well in the eyes of hedge fund managers as did the FDIC. President Obama and Treasury Secretary Tim Geithner got mixed reviews, but sentiments were overall positive. At the bottom of the barrel we find the SEC, which has been under a lot of criticism for its delayed response to the economic crisis. One final question I’ll highlight from the survey dealt with who hedge fund managers thought would ultimately clean up the “toxic assets” at the core of the financial crisis. 41% of respondents felt that the public sector (i.e. – the government and taxpayers) would end up holding the bag. I think that many of us are in this same camp. However, 56% of managers felt that the private sector would provide the solution to cleaning up these hard-to-value securities. If that’s the case, then hedge funds are likely to be at the epicenter of these private efforts to rid the financial system of these toxic assets. Earlier on, I asked why we should care about the opinions of hedge fund managers. Perhaps the possibility that hedge funds may relieve taxpayers from some of the burden of having to clean up these toxic assets is the best reason of all to care about the opinions of those who manage these specialized investments. Conclusions While investors welcomed last Friday’s GDP report showing growth contracting only 1% in the 2Q (with two more revisions to come), we must keep in mind that this marked improvement from the 1Q was largely due to the large increase in federal spending. Consumer spending continued to fall in the 2Q and is unlikely to rise substantially anytime soon, as consumer confidence fell in June. Unemployment is likely headed over 10% well into 2010. There is now a broad consensus that GDP in the 3Q will actually be at least mildly positive. That may indeed occur as businesses are forced to rebuild inventories at some point, and federal spending will certainly remain high in the 3Q and beyond. However, one quarter of positive GDP does not necessarily mean that the recession is over. Even if the recession is ending, economic growth is going to be weak due to decreased consumer spending. Finally, there is the question of the stock markets. The meteoric rise of stocks since the lows in early March has obviously been a prediction that the credit crisis would ease somewhat and that the worst of the recession was behind us. Yet having risen apprx. 50% in just five months, even though the economy is likely to remain sluggish, this suggests that stocks may be testing their upper limits. While it looks doubtful that stocks will retest their March lows, given how much money is still on the sidelines, I would be hesitant to recommend that investors jump back in the market now – unless you do so with a professional money manager(s) that has the ability to move to cash or hedge long positions. Wishing you profits in a difficult market,
Gary D. Halbert SPECIAL ARTICLES
Pull Back Unspent Part Of The Stimulus
The Stimulus Lesson (why it isn’t working)
Has the Market Gotten Ahead of the Recovery? |
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