There were a slew of economic reports over the past two trading days that have meaningful data points to review; hopefully, shedding light on the direction our economy is heading. The main economic releases to review are the Gross Domestic Product (GDP) report released last Friday, followed by the ISM Manufacturing Index and Personal Income today. The economy is transitioning in 2010 from inventory destocking (push) back to a consumer driven economy (pull). For this transition to happen smoothly we should see a few things happen, economically, including a peak in the unemployment rate, better credit flows, and an expanding global economy.
Right now the economic recovery is skating on thin ice. The consumer is deleveraging, unemployment is rising, and banks aren’t lending. Companies have been deleveraging as well, destocking inventories and slowing fixed investment. Herein lies the making of an economic recovery. Demand needs to rise. In order for that to happen, the American consumer needs a job to pay for goods and services. Goods and services need to be produced to create jobs. Credit needs to flow to fund fixed investment.
Now I’m not going to argue which came first: the chicken (consumption) or the egg (production) in this equation—I’ll leave that for the Austrians and the Keynesians to battle it out. As a fund manager I want to see that one of the gears in the economic machine is turning. The rest of the machine will start to work when this gear turns because all of the gears are interconnected. The consumer empowers the producer who in return empowers the consumer with a job.
Why is this relationship important? It’s the basis for our economic recovery. Inventory destocking has driven inventory levels down and appears to be near a bottom. While inventories are still falling, the rate of that change has drastically slowed down. The change in the change in inventories is what contributed to a large GDP number for the fourth quarter. The drastic slowdown in destocking added 3.4% to GDP, the largest that inventories has contributed to GDP in 25 years. The slowdown is occurring because production is starting up again. A gear is beginning to turn in the right direction for the economic machine.
While we’re talking about production, let’s look at the recent ISM manufacturing numbers. Over the past six months we’ve seen consecutive growth in the ISM manufacturing index noted by readings above 50. Here are the takeaway points from today’s ISM manufacturing index:
(Readings above 50 denote expansion while readings below denote contraction)
- Index increased by 3.5 points in January to 58.4, the highest since 2004
- New orders increased from 64.8 to 65.9, the highest since Dec. 2004
- Inventories increased to 46.5, up 3.5 points
- Employment index rose from 50.2 to 53.3
- Production index increased to 66.2, up 6.5 points.
- Order backlog increased to 56, up 6 points
- New export orders increased to 58.5, up 4 points
Altogether, the ISM manufacturing index is chock-full with economic recovery written all over it. The new orders versus inventory gap narrowed slightly from 21.8 to 19.4. This still leaves tremendous room for inventory restocking. In a Wall Street Journal report last month, "Caterpillar Inc. recently told its steel suppliers that it will more than double its purchases of the metal this year—even if the company’s own sales don’t rise one iota." Why is Caterpillar taking such a reckless course of action? Economists are calling the phenomena the "bullwhip effect".
When producers drop inventories drastically and suppliers cut production, there is a small lull in the speed at which the system can be turned back on should demand resurface. Bottlenecks can create shortages and price may increase just as more and more companies join in the restocking frenzy. Restocking affects everybody from TVs in Costco, to silicon in microchips, to steel in tractors, to oil in plastics.
Once inventory restocking begins to fade, production will more closely follow changes in consumer demand, which leads me to talk about the personal income numbers today. Personal income rose 0.4% in December following a revised 0.5% growth in November. Wage income and spending rose 0.1% and 0.2% respectively. The savings rate rose to 4.8% and spending rose 0.1%. We can clearly see that wages are stabilizing. Last Friday showed that the consumer is gaining more confidence in present conditions and expectations according to the University of Michigan consumer sentiment index, which rose to 74.4 from 72.5. Stock market gains and slowing job losses have improved the consumer’s confidence; however, the consumer is still uncertain about government reform, growing inflation expectations, high gasoline prices, the housing market, and an understated 10% unemployment rate. All of these factors will continue to weigh down on the consumer this year, but it also brings hope for the future as pent up demand is released.
2010 will be about how the economy transitions from the push of goods out of manufacturing (due to inventory restocking) back to consumer driven demand pull from two years of pent up consumption. Will the savings rate drop down to negative rates again, sparking another super bull market like we saw over the past two decades in the stock market and housing? I doubt it, but I think with inventory restocking and pent up consumer demand we have the makings of a cyclical economic recovery.
Most of that recovery is dependent upon continued growth in the global economy. That’s being called into question recently with the media’s and analyst’s interpretation of China’s bank reserve increase. Many analysts see China as a bubble. I see real structural economic reform as China transitions from an export driven economy, highly dependent upon overseas demand, to a consumer driven economy dependant on growing its standard of living. Recently, Yao Jian of the Ministry of Commerce stated that 51% of last year’s economic growth was attributed to domestic consumption.
There are two charts I think help debunk the recent China bubble argument regarding property values and inflation. The first shows the CSI China Mainland Real Estate Total Return Index, an index of real estate stocks in China, paired with the Shanghai Interbank Offered Rate. The chart clearly shows that we are nowhere near the 2007 peak for either real estate equities or interest rates.
The second chart I wanted to show combines a chart of China’s imports and proxy for global commodity prices (CRB index).
Notice the incredible divergence between Chinese imports and commodity prices? The reason, many believe, is that the Chinese are stockpiling while commodity prices are low. Does this country know how to do things right or what?! This also gives the Chinese better leverage to negotiate global prices because they can sit on inventory; however, while prices are still low (2008 relative) the Chinese will continue to import because the market is nowhere near equilibrium. Price will need to climb to stem global demand. The iron ore producers know this. That's why a lot of them are stepping away from the 40-year-old pricing system of annually negotiating agreed-upon benchmark rates. It makes sense to go to a short-term contract at the beginning of a global economic recovery to allow prices to rise. Locking in a 1-year contract at these low levels would be devastating to a producer should prices rise considerably… but I digress.
Not only do we need continued global expansion, of which China accounts for one third, but also credit to flow. Right now, the financial system is recovering from a disaster of incredible proportion. The banks have been in survival mode for two years. They have been provided a low-risk, steep yield curve to get their balance sheets back in order—earning the interest rate spread. Loans and leases in bank credit have fallen from $7.3079 trillion to $6.6946 trillion since December 2008, and continue to fall according to the Fed’s h.8 release. The banks will continue to withhold credit in the foreseeable future until they see the economy improve.
For the transition to happen smoothly from inventory restocking to consumption-driven growth, we’ll need continued global expansion, unemployment to peak, and credit to begin flowing again. The positive readings from the ISM Manufacturing Index were a step in the right direction as inventory restocking has clearly created jobs and commodity demand. It’s likely that restocking will continue to positively help the economy over the next two quarters. While the consumer continues to save, his or her confidence has improved considerably from the 2009 March lows and consumption is up. The last piece in the puzzle, once unemployment peaks, is the expansion of bank credit flows.
Economic recovery doesn’t happen overnight, but I believe a road has been paved towards the transition from push (manufacturing) to pull (consumption) economics. Eventually, the economic buzz words will shift from “inventory restocking” to “pent-up consumer demand”. Consumers have canceled vacations, media center upgrades, kitchen remodeling, and more all due to economic uncertainty. Many probably have missed out on a 45% move in the stock market because they’re in cash. There is pent-up consumer demand just waiting for conditions to improve enough to feel certain about making them. Some of that uncertainty is going to improve when jobs are being created to restock shelves—all up and down the supply chain.
