Bullish analysts have been calling since last fall for an economic recovery and vigorous economic growth in the second half of 2003. We’re now in the second half. So where’s the growth?
I forget who it was who advised us to remember always that we may be wrong, but it’s good advice, especially in the field of economic forecasting (in which field it’s almost universally ignored.) So let’s begin by looking at the factors suggesting that the U.S. and world economies are indeed on the verge of a period of renewed growth. They are, in ascending order of importance, sentiment, housing and productivity. If the strength currently apparent in these three factors holds up, then rapid economic growth is indeed likely to resume, probably within the next six months.
Sentiment, first, is measured for three groups of people, all of them important, consumers, businesses and investors. Consumer sentiment is currently somewhat subdued, having recovered from a sharp drop before the Iraq war; the latest (June) figure from the University of Michigan was 89.7, down from 92.1 in May and a recent peak of 96.9 in May 2002. The Conference Board’s consumer confidence index is similar, at 83.5 in June, down slightly from May and significantly from its post-9/11 high of 110.7 in March 2002. Business sentiment, according to Economy.com’s weekly indicator, is sharply up at 138.8 Monday. This indicator is however new and extremely volatile, having been as low as 45.1 in the week of March 14. Investor optimism, according to the UBS Index June 23 is at 77, very sharply up from a nadir of 9 in March, but still below the recent peak of 121 hit in March 2002.
The overall picture here is pretty clear, but mixed. Sentiment has recovered from a blue funk immediately before the Iraq war, but remains significantly below the levels reached even in the mini-recovery of spring 2002, let alone in the euphoria of 2000. This is actually somewhat negative news, since the U.S. stock market is up close to 30 percent since its March low, and hence investor sentiment at least should be pretty euphoric, while interest rates were until ten days ago close to a 45 year low, which should make the ever-borrowing consumers pretty giddy, too.
If sentiment continues to improve, particularly if it does so independently of further gains in the stock market, then a necessary pre-condition of recovery has been met; with positive sentiment, consumers are more likely to consume, businesses to undertake new projects and investors to invest. However, until sentiment has risen definitively above its early 2002 level, it will not provide a clear indicator of recovery. Look for the Economy.com index of business sentiment each Monday (but with the caveat that this index is not yet properly “benchmarked”) for the next University of Michigan Index of consumer sentiment on July 18 (preliminary) and August 1 (final), for the next Conference Board consumer confidence index July 29 and for the next UBS Index of Investor Optimism July 28.
Confidence data is thus ambiguous, but optimists can claim (at least until late July) that the trend is in the right direction. Not so housing data.
Housing has been extremely strong for so long that it takes an effort to remember that it was not always that way. The National Association of Home Builders Index was at 62 in June, up 5 points from May and not much below the peak of 64 in January 2003 — it must be remembered, however, that this index was above 70 for every month of 1999. New home sales in May ran at a record annual rate of 1.16 million, well above the 1999 levels, while existing home sales in May ran at an annual rate of 5.92 million, only just below January 2003’s record level of 6.10 million. Thus on the most recent data the housing market is at or near all time record levels, and has been a huge support to the economy in the last two years.
The bad news about housing is not actual but potential. The entire housing boom is dependent on interest rates — indeed housing, and construction in general (for which the latest month’s figures were notably weak) has been the sector through which the Federal Reserve’s easy money policy typically operates.
To see this, look at the figures for mortgage refinancing. On a base of March 1990 = 100, the Mortgage Bankers Association’s composite index stood in the week ended June 27 at 1,635.5, down just a touch from the peak of 1,856.7 four weeks earlier, but still at an extraordinarily high level. Within that index, the purchase sub-index was at 438.5, while the re-financing sub-index was at 8,599.1, both just a little down from peaks in the week of May 30. To see how extraordinary these figures are, they should be compared with 1998-99 (an extremely strong period for housing, as for the economy in general) and 2001-2, the period in which housing sales peaked for this cycle.
The purchase sub-index’s peak for 2002 was 414.0, around 5-10 percent below the level of the last few weeks, while in 1999 its peak was 315.7 in the week of November 19,1999, around a third below current levels. Still very healthy growth from a base of 100 in 1990, in other words.
The re-financing sub-index’s peak was 5,534.5 in the week of November 9, 2001; its previous peak was 4,389.1 in the week of October 9, 1998. In other words mortgage re-financing is currently running at double the peak bull market level of the late 1990s, and 86 times the level of 1990. This is a staggering statistic, and it goes far to explain why the Institute for Supply Management’s service index, announced Thursday, was sharply up — mortgage banks, after all, are quintessential service operations.
A moment’s comparison also shows that the volume of mortgage re-financing is currently up more from the 1990 level than was the NASDAQ stock index at the peak of the 2000 boom. Just like NASDAQ, this peak is unsustainable, and the bubble will burst when long term interest rates start going up again.
The bad news for bulls is that they have begun doing so. Since my column two weeks ago suggesting that bond yields had dropped too far and were due for a rebound, the yield on the 10 year Treasury note has risen from 3.34 percent at the time of my column to 3.73 percent at Monday’s close. The move has been little noticed yet in the media, as is typical when long term trends reverse, but even the move that has already taken place is very ominous for the housing market, and particularly for the mortgage re-financing market (the figures given above are for the week my column appeared, and therefore do not reflect the effect of the latest interest rate move.) The MBA’s index is published each Wednesday; expect the index published July 9 to be sharply down, and that published July 16 to be down even more sharply, particularly in the mortgage re-financing area.
As is well known, mortgage re-financings have been used only partly to save interest costs for homeowners, most of whom have mortgages at or close to current levels of interest rates in any case, but more usually to extract home equity and thereby pay down credit card debt and increase consumption. Mortgage re-financings are estimated to have added $200 billion to consumption in 2002, and will have been adding to consumption at an even greater annual rate than this so far in 2003.
Consumer credit outstanding in April 2003, according to the Federal Reserve statistics, was 1,755.7 billion. If equity takeout from home mortgage refinancing dries up, and consumption doesn’t change, an extra $200 billion per annum will be added to consumer credit’s rate of increase, driving it from $57.6 billion (in the year to first quarter 2003) to $257.6 billion, or an annual rate of increase of 14.7 percent per annum. Since consumers are already heavily overstretched, this is unsustainable even in the short run. Therefore, once equity takeout through mortgage re-financings has dropped, consumption must drop too. A $200 billion drop in consumption, at an annual rate, on the current consumption level of $6,671 billion is a 3 percent drop; it doesn’t sound like much, but it would form a very nasty “second leg” to a recession even without other factors coming into play.
As with sentiment, there is a chance that I am wrong. But for me to be wrong, the long term bond markets must speedily reverse their drop of the last two weeks, and surge forward into new price highs and yield lows. With the Federal budget deficit approaching $400 billion in the year to September 2003 and $500 billion in 2004, it doesn’t seem likely.
The third bullish factor is productivity, that favorite of Alan Greenspan and other Wall Street salesmen. If their mantra is correct, that in 1995 we underwent a “productivity miracle” putting the U.S. economy on a new path of much faster potential growth, then the current price-earnings ratio of 33 times on the S&P 500 share index, equal to the level at the very peak of the 2000 bubble, may be justified. Mind you, to justify a P/E ratio at that level, you have to assume that real interest rates will remain permanently at their current abnormally low levels, AND that labor productivity growth jumped in 1995 not only above its 1985-95 level of around 2 percent per annum, but also above its 1947-73 level of 2.87 percent per annum, since even at the peak of that earlier halcyon period stock market P/E ratios were barely more than half their current level.
Currently, productivity mavens pin their hopes on an apparent surge in labor productivity since the third quarter of 2001, that has, according to Bureau of Labor Statistics data, raised non-farm output per hour at an annual rate of 4.28 percent in the six quarters to March 2003. If that figure holds up, then even discounting a period of low productivity growth in the first three quarters of 2001, and a likely poorish figure in the second quarter of 2003, the evidence for a rise in labor productivity growth at least to around the 1947-73 level would be quite strong.
As I said, I may be wrong. But I doubt it. The BLS produces annual revisions to its productivity data in early August, usually to very little publicity. Each of the last three such revisions has revised historic productivity growth data substantially downwards, by 1.3 percent in the 2001 revision (announced August 9, 2002) so that by the BLS’s revised figures, productivity growth in 1992-2001 was 1.81 percent per annum, no higher than in the previous decade and far below the 1947-73 period.
In addition, you must remember that these figures are for labor productivity. The capital intensity of the U.S. economy hugely increased in the late 1990s, so that multi-factor productivity growth in the decade to 2001 was in fact significantly lower than in the preceding decade.
The BLS revisions for labor productivity data will be announced, if last year’s schedule is preserved, on August 8.
Quite a lot rests on them, to put it mildly. If I am wrong, and the productivity acceleration in 2001-03 is confirmed, so that labor productivity growth from 1995 now appears to be around 2.8 to 3 percent per annum, then stocks may currently be only about 20-25 percent overvalued (providing interest rates don’t rise, of course.)
If I’m right, and the 2001-03 productivity surge is revised away, so that labor productivity growth since 1995 is only about 2.0 to 2.2 percent per annum, and if I’m right about interest rates too, then stock prices should be in equilibrium at about half their current level. Look for excitement going forward!
As a young mathematician, my favorite method of proof was always “reductio ad absurdum,” in which you assume something to be false and prove that absurdity results. In this article, I have suggested that you will see for yourself in the next month whether I am wrong, and that if my being wrong is not absurd, it would at least be surprising!
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.