“Ten little Indian boys went out to dine; one choked his little self, and then there were nine. Nine Little Indian boys sat up very late; one overslept himself and then there were eight. Eight little Indian boys traveling in Devon; one said he'd stay there and then there were seven. Seven little Indian boys chopping up sticks; one chopped himself in halves then there were six. Six Indian boys playing with a hive; a bumble-bee stung one then there were five. Five Indian boys going in for law; one got in Chancery then there were four. Four Indian boys going out to sea; A red herring swallowed one then there were three. Three Indian boys walking in the zoo; A big bear hugged one then there were two. Two Indian boys sitting in the sun; one got all frizzled up then there was one. One Indian boy left all alone; He went and hanged himself and then there were none.”~Agatha Christie, And Then There Were None
One by one the supposed pillars of strength to the stock market and economy are falling, along with it many widely held assumptions. We were exposed to many beliefs in 2007 as to why the stock market and economy would hold up as risks were downplayed and bullish theories were held as infallible truths. Below are some of the most widely held assumptions that have since proven overly optimistic.
- Subprime mortgage fallout would be contained
- Corporations would support the economy with their strong balance sheets
- The global economy would decouple from the U.S.
There is no need to comment on the three assumptions above as they have since been debunked. However, today’s Market Observation focuses on the components of GDP and how the currently held assumption, that exports would keep the economy afloat and prevent a recession, will also be proven overly optimistic as one by one the components of GDP crumble. The accounting equation for GDP is given below, showing its components.
Y = C + I + NX + G
- Y = GDP
- C = Consumer Spending
- I = Investment = Residential + Nonresidential
- Change in private inventories is ignored in this analysis
- NX = Net exports
- G = Government expenditures
I would like to first look at investment (“I”), which encompasses residential fixed investment (RI) and nonresidential fixed investment (NRI). RI turned negative in the first quarter of 2006, though the positive growth seen in nonresidential fixed investment (NRI) helped to offset the drag in the former. While NRI held up over the last few years a decline was expected as NRI typically lags RI by one year, as the following figure illustrates. RI has shaven roughly 0.50% to 1.5% off GDP growth since early 2007 while NRI has contributed roughly 0.50% to 1.0% to growth, with the third quarter marking the first quarter that NRI contributed negatively to GDP since 2006, and the largest reduction in nearly five years.
Figure 1
Source: BEA
Figure 2
Source: BEA
RI was the first pillar of economic support to decline that has since been followed by NRI in the recent quarter, though the most significant development in the recent GDP report was personal consumption expenditures (PCE). Consumers have been slowing down their purchases for more than a year while the stimulus checks provided a temporary support in the second quarter. That one-time support has since given way to a significant retrenchment as PCE declined by a 3.13% annualized rate, the largest decline in 28 years. On a year-over-year (YOY) basis, PCE turned negative for the first time since the 1990 recession, displaying a sharp contraction over the past year. The source of the retrenchment in consumer spending stems from a contraction in durable goods purchases as consumers reduce spending on appliances, autos, electronics, while nondurable goods spending on perishable items remains strong. Durable goods sales declined by 6.25% while nondurable goods sales rose by 7.16% as consumers simply cannot cut back on essential items such as food and energy.
Figure 3
Source: BEA
Figure 4
Source: BEA
While it appears that the consumer is officially down for the count, something that pundits told us not to expect, exports still represent one of the last pillars of support for the economy, though it stands on shaky ground. A falling dollar has been a boon to the U.S. export industry as our goods have become cheaper to the rest of the world. However, the dollar staged a sizable rally in the third quarter that has weakened exports as our goods become more expensive. Net exports added 2.93% to GDP growth in the second quarter, though with the sizable rally in the dollar the contribution of net exports to GDP growth shrank to 1.13% in the third quarter.
Figure 5
Source: BEA/Federal Reserve Bank of Atlanta
Figure 6
Source: BEA/Federal Reserve Bank of Atlanta
A stronger dollar is not the only risk facing the domestic export sector as the global decoupling theory has clearly been debunked. The global economy has recoupled with the U.S. as it has done what it always does, lagged U.S. growth. Over the past few months, several global economic indicators have turned down signaling a global recession. The JP Morgan Global Manufacturing Purchasing Managers Index (PMI) dropped below 50 in May of this year signaling a contraction in global manufacturing activity, with activity plummeting to 41 in October.
Figure 7. JP Morgan Global Manufacturing PMI
Source: Bloomberg
Even China, the global manufacturing powerhouse, is contracting after a brief rebound post the 2008 Olympics. The Chinese PMI fell to 44.6 in October indicating Chinese manufacturing activity is contracting and posted the lowest number in more than three years. Also corroborating weak global activity is seen from the Baltic Dry Index that shows a collapse in shipping rates, as well as international air traffic which has recently turned sharply lower. A recent Bloomberg article explains the drop off in shipping activity, which can be read from the following link: The Shipping News Suggests World Economy Is Toast.
Figure 8. Chinese PMI Index
Source: Bloomberg
Figure 9. Baltic Dry Index
Source: Bloomberg
Figure 10. IATA Traffic Statistics Freight Traffic Total
Source: Bloomberg
With global economic activity contracting it’s not surprising to see weakness in global business confidence. Commentary from Moody’s Economy.com on their world business confidence survey is given below:
World: Moody's Economy.com Survey of Business Confidence (10/31/2008)
Behind the Numbers
Global business confidence has been shattered by the ongoing global financial panic. Sentiment fell to another new low during the last week of October as the survey results suggest that the global economy is engulfed in a full-blown recession.
Across the globe, the difference between the percentage of all positive responses and all negative responses to the various questions asked in the survey was negative 15% last week and negative 12% on a four-week moving average basis. In the U.S., business confidence stood at negative 18% last week and negative 17% on a four-week moving average basis. Readings between 25% and 30% are consistent with an economy that is expanding at potential. Survey readings below 10% are consistent with recession. The all-time peak was nearly 40% at year-end 2005.
Businesses say their sales are falling and equally as worrisome are the very weak readings on hiring intentions and investment in equipment and software. Throughout the past year businesses had been worried broadly about conditions but remained more upbeat about their hiring and investment. This is no longer the case. In the U.S., the survey results are consistent with monthly job losses of more than 150,000 and outright declines in real investment spending.
Businesses are also much more negative with respect to conditions more broadly. Nearly all respondents think current conditions are eroding and that they will not be any better six months from now. Pessimism regarding the outlook is overwhelming.
Reflecting the financial panic, confidence among financial and business service firms remain near a record low. Real estate firms who had been reporting more stable conditions turned much more negative last week. Manufacturing confidence also continues to slump and is approaching the lows set back early in the decade. It is disconcerting that sentiment is weak broadly across all industries.
Businesses' pricing power is fast evaporating. The net percentage of respondents who are raising prices has dropped from a high of close to 50% this summer when oil prices were peaking to just over 20% today. During the deflation scare of 2003, the net percent who were raising prices was about 10%.
Global business sentiment has never been as negative. The financial panic is too much for many businesses to bear. According to the survey the U.S. and European economies are in a recession and much of the rest of the global economy is fast devolving into one.
With such widespread pessimism across the globe coupled with declining global manufacturing activity, it was no surprise to see a sizable drop off in the Institute for Supply Management’s (ISM) Manufacturing Export Orders Index, which plummeted to 41.0 in October from the recent high of 57.0 in August. The ISM Export Orders Index leads the YOY rate of change in GDP exports, signaling that 2008 Q4 and 2009 Q1 GDP growth will likely decline significantly as the last private economic support to the economy falters.
Figure 11
Source: ISM/BEA
With the private components of the economy faltering (investment, consumption, exports) the only pillar of support left is coming from the government as it attempts to act as an economic stabilizer. This development was commented upon in a previous Observation (When the Transmission is Broken, Call a Tow Truck, 09/10/2008). During recessions and bear markets in stocks (stocks reflect economic activity) the government increases both its spending and borrowing to help get the economy moving again, as seen below with recessions marked by grey bars.
Figure 12
Source: BEA
Figure 13
Source: BEA
Figure 14
Source: BEA/Standard & Poor’s
While government spending is set to expand over the coming year, what is not entirely clear is where the funds will be spent. Currently, both nondefense and national defense spending is growing, though the share of total government spending is likely to shift between the two. With the fall of the Berlin Wall in 1989 and an easing of the Cold War, the door was opened to President Clinton to shift federal spending. Under his administration, national defense spending’s share of the Federal budget fell from 73% in 1990 to 64% when he left office, while nondefense spending rose from 26.7% to 36.2% over the same time frame. After the attacks of September 11th, 2001, President George W. Bush began to shift government spending back towards defense. With Obama to begin his presidency next year and with slow progress with the Iraq war, he is likely to shift again government spending away from national defense towards nondefense items, with infrastructure in the forefront. The government and its subsequent spending on infrastructure rather than the consumer or businesses as the source to pull us out of the current economic malaise were commented upon in a WrapUp last year (The Next Reflation: Where It Will and Will Not Be 09/12/2007).
Figure 15
Source: BEA
In summary, we have seen the pillars of economic support fall one by one with three private pillars of support (RI, NRI, consumption) contracting YOY, and the fourth (exports) likely to turn negative next quarter; the only remaining support over the next year or so appears to be the government. If Agatha Christie was alive today and writing a parallel to the current economic landscape, she might write the following.
Four private economic supports going out to sea; the housing bubble popped one, then there were three. Three economic supports walking in the zoo; the credit bear market hugged one and then there were two. Two economic supports sitting in the sun; one got over-indebted and then there was one. One economic support left all alone; global economies recoupled and then there were none.
The four private economic supports got all in a jam, thank heavens for good old Uncle Sam.
