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June 02, 2002

The Corp. Of The Problem

Revisionist Theory...The recent revisions to the original 1Q GDP report a few weeks back deserve mention. If for nothing more than to reinforce the point that we're a long way from being able to characterize the current economic recovery as self sustaining. The headline number was only revised down to 5.6% from 5.8%, but as is usual, it's the messages that lurk in the shadows of the revision that are most important. Cutting right to the chase, in our minds, the most important component revisions to the 1Q GDP number can be found in final sales and inventories. In prior discussions, we have pointed out that the current year over year rate of change in final sales rests at a four decade low. Originally reported as a 2.6% gain in 1Q, the revision now shows a 2.0% increase. Completely coincidental was the fact that "final sales to domestic purchasers" was revised from 3.7% to 3.0%. It's not the end of the world, but certainly highlights one of two interrelated points that frame the character and texture of the current economy.

Final sales to domestic purchasers rests at a revised year over year rate of change low only seen during the final two quarters of 1991 (the jobless recovery), and then not since 1961. As you know, it is strength in final sales that will ultimately light the way to this recovery being something more than largely inventory driven. The reason we take a peek at sales to domestic purchasers is that it is possibly a more clear gauge of the health of the US economy specifically from the standpoint of broad based domestic-only consumption, as opposed to the aggregate final sales measure itself. It just so happens that the 1Q revision reveals downwardly revised segment growth rates in consumer, business fixed investment and government spending. Likewise, all major sub-components of these sectors experienced downside revision. Lastly, the Fed's own favorite little marker of final sales, real private final sales, was revised to 0.6% from 1.1%. Theoretically, real private final sales strips out the influence of government spending and inventories. Bottom line on all of this? Final sales, the next significant link beyond the inventory rebuild in an academically classic economic recovery, remains tepid at best by historical standards.

The second highlight in the revised 1Q GDP report was indeed inventories. In this case the upward revision to the positive impact of inventories on calculated GDP is a downward revision to inventory de-stocking. Instead of American companies burning through ($36.2) billion in inventory as originally surmised, they only used up ($25.7) billion in net inventories. Very quickly, a quarter over quarter decline in inventory reduction is additive to GDP. (Don't you just love those double negatives?) Bottom line? As opposed to accounting for an absolute 3.1 of the original 5.8% 1Q GDP number, the reduction in inventory de-stocking on the revision means that inventory activity alone accounted for 3.6 of the 5.6% new and improved GDP calculation. Plain and simple, without inventories, economic growth in 1Q was a heck of a lot closer to a 2% kind of affair than not.

It's a bit interesting in that given a current year over year growth rate in final sales similar to what was seen in 1991, that inventory reduction experience has been so much more dramatic an exercise this cycle. Maybe not so surprising in that the late 1990's was characterized by incredible capital spending and a resulting escalation in physical capacity. Relative to nominal GDP as a whole, the dollar amount of inventory reduction at its bottom this cycle was twice as much as what was experienced during the early 1990's recession nadir. The following chart is a look at the absolute inventory activity of each period:

The current revisions to 1Q GDP simply reinforce the message that inventories were the driving force behind the most current 1Q spurt of academic economic activity. At least for now. A bit disconcerting in that this type of academic lift to the GDP calculation is ultimately temporary and demands consumer, business and government follow through if it is to be nurtured ahead.

The Corp. Of The Problem...As you know, in addition to inventories supporting the academic rise in GDP, the consumer has been lauded for refusing to even temporarily jump off the consumption bandwagon during the so-called recession. Relative to historical precedent, consumers basically missed the fact that there has been a recession. Corporations, on the other hand, were fully informed and acted accordingly. As we look ahead, many of the tailwinds that at least psychologically supported household consumption during the fourth quarter of last year and first quarter of this year are dying down. The initial rush of tax rebates and refunds are now yesterday's news. Current refi activity is well south of record experience seen during the last six to nine months. The influence of 0% auto financing is largely gone, but being cushioned a bit by continued rebates of various form. And energy prices seen primarily in retail form at the gas pump are well up from 52 week lows. The majority of what have been very short term transitory or cyclical stimulants to consumption are behind us. Lastly, auto sales and the monthly variability in the price of gasoline have partially distorted the reporting of retail sales. Stripping out these two swing factors over the last eight months reveals a touch more sanguine view of aggregate retail sales than not:

There simply isn't a whole heck of a lot of weakness for the consumer to recover from, as seen in the above chart. This suggests to us that incremental growth in consumer spending from here will be linked directly to labor market conditions. And in the wonderful economic food chain of life, labor conditions will be driven by corporate profitability. Simple enough?

Simultaneous with the temporary stimulants to consumption dissipating, the labor markets continue to weaken at the margin. Last month we spent the bulk of the discussion addressing why we believed labor was in for further deterioration ahead. We simply did not have to wait long for validation of the thought process.

During the past month the unemployment rate has risen to a new high for this cycle. It has actually been seven and one half years since the official unemployment number in this country has kissed 6%. We have been living in a low unemployment rate world for such a long time that 6% now seems like one heavy number. The fact is that just prior to the rather painful recessionary period of the early 1980's, this is the number near where the unemployment rate bottomed before almost doubling into the recession itself. Early peaks, drops, and then subsequent reacceleration upward in the unemployment rate is actually the rule as opposed to the exception of recessions past. Although these movements often appear as blips on the screen, the so far current experience is typically similar to what has come before:

Given the current day to day anecdotes regarding the labor market in the aggregate, we have not yet seen the top in official unemployment for this cycle. It lies ahead.

Lastly, directly reflective of the current uncertainty at the corporate level regarding business conditions ahead is continuing jobless claims experience. As you know, we continue to see attention grabbing headline layoff announcements. But the anomaly of this cycle for now is continuing claims. Never in any recession of the last 30 years have continuing jobless claims peaked, dropped temporarily and then resumed their ascent to new highs. The pictures tell the story:

As you can see, during the recessions of the mid-1970's and twin recessions of the early 1980's, continuing claims made clean peaks and subsequent near vertical drops as recoveries took hold.

It was in the early 1990's that continuing claims remained stubbornly high in a period that came to be characterized as one of jobless recovery;

Although the early 1990's economic recovery began as one where the labor market remained weak for a good 18 months following the academic conclusion to the actual recession, the Fed at the time was just warming up in terms of getting ready to take short term interest rates into a kamikaze spiral to help the beleaguered banking system reliquify during the period. Interest rate actions that not only eventually helped kick start job growth once again, but also supplied a much broader liquidity stimulant to the financial markets as the 1990's bull market in equities was getting ready to lift off.

In our current circumstances, the Fed has already completed at least the bulk of its death defying interest rate plunge. Far surpassing the depths of what was seen in the early 1990's. Although we are still relatively early in the economic recovery game for now, continuing unemployment claims are acting much differently than anything seen in the past. This is where we find ourselves at the moment:

A sharp drop in continuing claims from here might suggest that the economy is about to accelerate independent of the short term influence of the inventory cycle. A move in claims to even higher highs might imply that the now consensus dismissed possibility of a double-dip recession may in fact turn into some type of quasi-reality. For now, the characterization of jobless prosperity heard far and wide in the early 1990's seems to fit the best with current experience to this point. Yes, the economy is recovering, but for the consumer, this reacceleration in continued claims is a new experience for a post recessionary environment. In our minds, the bottom line ahead for consumers rests with corporate profitability. The incredibly simplistic transmission mechanism is as follows. Corporate earnings increase, labor conditions improve, consumer incomes rise and consumer spending increases.

As you know, reported corporate earnings in 2002 already have one built in perceptual boost driven by lessened goodwill charges via accounting standards mandate. The influence on cash flow of the accounting change for goodwill is zero. Corporate cash flows in 2002 will receive a bit of a jump start from recent tax legislation that accelerates current depreciation allowances, academically lowering corporate cash tax liabilities. And lastly, cost containment measures at the corporate level have been and continue to be significant for this cycle. But a longer term recovery in corporate earnings is not going to be built on the back of cost cutting and tax changes. The drop in nominal corporate earnings during the recent so-called recession has been one of the worst experiences of the last half century. Without significant healing on the part of corporate earnings, sustainable employment growth is not in the cards near term. Without employment growth, from where will consumer income growth originate?The stock market? Another housing refi cycle? Or none of the above?

She Digs Her Heels In The Stallion's Flank Again...For now, the Fed is caught in a bit of a box regarding monetary policy, the need to resuscitate the corporate economy, and macro global capital flows. The confluence of these factors ultimately being crucial to the outcome of the current domestic economic chess match. Although many a corporation in the US has been increasingly denied access to the commercial paper markets, especially in terms of excessive issuance, as this period of financial reconciliation advances, a good portion of the cost of capital in corporate America is still quite beholden to the short end of the yield curve vis-à-vis the generosity of the interest rate swap market.

When an example such as a GE can cut back on low cost short term commercial paper placement, issue higher yielding longer term fixed debt as a substitute, and claim that their cost of capital remains unchanged, the importance of the interest rate swap market to the corporate community (and corporate CFO's in particular) is highlighted in flashing red neon. To make a long story short, corporations have not needed to issue actual commercial paper to be beneficiaries of commercial paper like rates (cost of debt), they simply need to call up their favorite derivatives desk and enter into an interest rate swap agreement. Hence, a good chunk of corporate debt these days is quite levered to the short end of the yield curve. Certainly this miracle of modern finance has not been lost on the Fed in terms of FOMC interest rate decision making.

Having said this, we suggest watching changes in money supply over time as a gauge of partial Fed accommodation actions outside of the interest rate mechanism. A perfect indicator? No, largely because credit (money) can easily be created outside of the in good part Fed influenced banking system. It just so happens that about $100 billion in new M3 has arrived on the scene over the last four weeks. Enough to catch our attention. Important in our minds in that we are firm believers in at least a partial linkage between money acceleration, activity in the financial markets, and the economy. In the following chart, we look at the monthly changes in broad money (M3 plus commercial paper) and the NASDAQ. Although it is certainly far from a perfect correlation, directional changes in broad money tend to lead subsequent directional change in an equity index such as the NASDAQ by about a month or so.

As is certainly no secret, the modus operandi of the Fed influencing money supply growth over the past half decade or so in response to potentially significant shorter term financial market and/or economic disruptions is now virtually an expectation. But the monkey wrench that has been thrown into the equation of the moment is global capital flows, as measured by the votes of currency traders far and wide - the value of the dollar relative to foreign currency alternatives. As we mentioned in a discussion very early in 2002, one of our main concerns for the year ahead was the continuation of global capital pouring into dollar denominated financial and real assets. Change at the margin has indeed come to foreign purchases of dollar denominated assets this year. Relative to prior periods, the rate of change in foreign based accumulation is slowing. Foreign investment in US assets has been one of a number of crucial cornerstones to continued global attractiveness of dollar denominated investments. A key link in the virtuous circle. The current value of the dollar is an implicit vote by the foreign community that rate of return in dollar denominated assets may be less than what is currently available in non-dollar denominated investments. Whether the absolute reality is true or not, it's the perception that counts short term.

This brings up the question of whether the Fed will now need to use the money supply to attempt to combat problems on yet another front - the battle lines of global capital movement. Although this is very short term in nature, the following chart reveals that temporary peaks in the dollar this year through the first quarter have been coincidental with peaks in M3 change.

Once again, money supply has accelerated upward substantially in the past month with an as of yet lack of corresponding move up in the dollar. Or the financial markets. Is the box within which the Fed finds itself constricting? Is the simultaneous need to reinvigorate corporate earnings growth (and hoped for employment and consumer income growth), maintain domestic financial market stability, and keep the dollar relatively stable or orderly in price action too much for the diminished financial ammunition box of the Fed?

Never in recent US economic experience has the Fed begun to raise rates prior to the domestic unemployment rate peaking. Never in recent experience has the Fed begun to raise rates prior to corporate capacity utilization bottoming and having turned up measurably in each cycle. Trying to juggle the current domestic economic recovery along with the dollar and the financial markets just may mean that the "nevers" of yesterday are about to be tested.

Shadow Boxing The Apocalypse?...To suggest that the historical price of gold has been driven at least in good part by emotion over the past thirty years is probably an inexcusable understatement. In trying to continually look for differences in the here and the now financial and economic environment relative to what history provides in the way of guideposts and markers, the price action of gold is a current anomaly. As you can see in the following chart, subsequent to every recession of the past 30 years, the price of the bullion has fallen. In some cases fallen for years afterward. No mystery given that falling inflation has been a hallmark of post recessionary periods.

If the current recession is over, why is gold acting differently relative to historical precedent? Of course the answers to that question are more than numerous. If indeed we are just living through a short term trading oriented and influenced price spike anomaly, history would suggest that the price of gold will fall as the economy recovers. If, however, gold continues to move higher, the price action may be suggestive of the fact that other financial and/or economic systemic factors are different today as opposed to the experience of prior recessionary precedent. Gold is fast approaching an important longer term technical downtrend top line begun during the late 1980's. A breakout above that downtrend line will certainly attract the attention of just about every technician on the planet (who has not already been attracted by the recent shine of the metal). But, if gold continues to move higher within the context of an economy that continues to muddle through in positive territory, the much larger message may be that macro economic and financial system reconciliation for this cycle is far from fully played out.

Market Observations
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Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

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