AN INCOMPLETE RECESSION
by Raymond Devoe
In my opinion, the "postwar period" ended on March 10,
2000 ("The Crazy Day") when the Nasdaq Composite hit
its all-time high of 5048. Although the recession
officially began a year later, I delineate March 10,
2000 as the end of the 18-year bull market. I put
asterisks next to October 19, 1987 and the second and
third quarters of 1990. The former was more of a
systemic mechanical breakdown associated with
"portfolio insurance," and the latter I attribute to
the temporary dislocations from the Gulf War.
Thus, in my view, the "post-postwar period" began on
March 10, 2000 with the popping of the Nasdaq bubble.
The index is now down 73.7% from that peak - and the
first recession of "the information age" started in
March 2001. Originally only the first quarter of 2001
showed a decline in Gross Domestic Product (GDP), and
many economists asked, "Where is the recession?" when
the following quarters had positive growth in GDP.
Subsequent revisions brought the second and third
quarters of 2001 into declines in GDP. The National
Bureau of Economic Research (NBER) uses other
measurements, including the "3-D's," Depth - how severe
it was; Duration - how long it lasted; and Diffusion -
how widespread it was throughout the economy.
The Commerce Department's release on October 31, 2002
showed that GDP grew at a 3.1% annual rate in the third
quarter, vs. 1.3% in 2Q02. Roughly half of the increase
in the last quarter was attributable to auto sales -
which are weakening for a variety of reasons. The chart
accompanying the release shows four consecutive
quarters of GDP growth, beginning in 4Q01-and it still
shows three consecutive quarters of GDP declines last
year. So, I guess the recession is official, and it's
officially over. Or, is it?
It's been a weird one - and again, unlike any other
recession since 1945. Two of the normal causes of
declines in GDP, housing and autos, remained strong
throughout the recession and subsequent recovery.
Inventories, which fell to their lowest level on record
relative to sales during 3Q02, was one factor. The
other would be business investment, which fell for
seven consecutive quarters before turning in the last
quarter, with an anemic 0.6% growth (annualized). I
don't know where the strength is, since virtually every
company report I see mentions that they are cutting
capital spending. The GDP release also showed that the
trade deficit grew to a new record of $437 billion, at
annual rates unadjusted for price changes. That's
closing in on a half a trillion dollars - but doesn't
seem to disturb many people.
The recession may be over, but it is incomplete, in my
opinion, in that it did not accomplish what recessions
traditionally do. Similarly, the bear market could be
over, but that also has not done what bear markets have
done - bring about "capitulation," among investors,
more reasonable stock valuations, and a widespread
suspicion leading to contempt for stocks. Perhaps, in
the information age, recessions and bear markets will
not behave as in the past, and correct the excesses
leading up to them. Thus, I have gone into why I
believe both are incomplete at this point. Perhaps they
will remain that way, but I am sceptical.
This "recession" began as a bust following the boom in
business-fixed investment, particularly in technology,
telecommunications and information technology. But it
was not confined to those sectors. Virtually every
significant area indulged in over-expansion, fueled by
low interest rates, that in real terms were near zero
and occasionally negative. This led to extensive
overcapacity that will take time to work off.
Much has been made of the bursting of the technology
stock bubble - but in retrospect, the economy was a
bubble itself. That is the main reason why the recovery
has not responded the way it traditionally has done to
eleven interest rate cuts last year. How will business
investment respond to the Fed's decision to cut 50 more
basis points to 1.25%? About the same way as the
reaction to last year's cuts, in my opinion. 25 basis
points was widely expected - but 50 might be
interpreted as an indication of panic at the Fed.
Business investment, with extensive excess capacity, is
not particularly responsive to interest rate cuts.
Prior to the last normal postwar recession (1982-83)
housing was extremely depressed due to 20% and higher
mortgage interest rates (if you could obtain one) - as
then-Fed Chairman Paul Volcker was fighting double-
digit (CPI) inflation. When interest rates were cut
then, housing surged, providing a strong stimulant to
the recovery. Now, twelve interest rate cuts by the Fed
have brought about a continuing boom in housing that in
my opinion, has become another bubble.
Interest rates recently hit a 31-year low of 5.98% -
for a 30-year fixed-rate mortgage - the lowest since
Freddie Mac started tracking them in 1971. The
associated refinancing boom, along with the "cash out"
feature, where homeowners take out increasing amounts
of the equity in their homes, has been a significant
prop for the economic recovery.
How much lower can mortgage rates go? The simple
answer: not much lower. The Federal Funds rate is now
1.25%, or 125 basis points above zero after Wednesday's
cut. However, a comparable decline in mortgage rates is
unlikely. The reasons have to do with fixed-income
investors' balance in portfolios and average maturity.
It is really a question of how much 30-year paper at
31-year low rates an investor wants to own.
Auto sales have also behaved in a non-traditional way,
and the Fed has had little to do with them this time.
Normally, when the Fed raises interest rates to combat
inflation, consumer durables go into the tank - and
revive quickly when the Fed lowers interest rates to
fight the recession they brought about. This time, auto
sales have been in boom, perhaps even bubble mode by
zero-interest rate financings offered by the
manufacturers. Today's headline in The New York Times
is: "Sales Drop 30% In October At Big Three
Automakers," and subtitled "Big Incentives For Buyers
Worry Analysts."
The overhang from high sales volume in previous months
was one factor - but essentially the Big Three (really
the Big 2« - one is German controlled) are buying sales
from the future. They are also wrecking their credit
ratings (Ford-[F-$8.43] most obviously) and drastically
cutting prices by as much as $3,500 per car. That's the
amount that analysts in The Times article estimate that
it costs General Motors (GM-$34.02) per vehicle sold
with zero-interest financing.
That's a rather severe price cut to move a car - but
the incentives have had another side-effect, wrecking
the used car market. Since almost all new vehicle sales
involve a trade-in, the used car market is glutted, and
prices are down significantly. When current new car
buyers turn in those cars in the future, the trade-in
value is likely to be well below levels that would have
otherwise prevailed. That's another cost, and another
story - including the cost in gasoline consumption -
since the best-selling items are gas-guzzling sports
utility vehicles (SUVs). The same question as above:
how long can auto sales remain above trendline?
The short answer, briefly, is based on incentives, but
eventually sales over time will revert to trendline.
Prior to the zero-rate financing gimmick, which costs
GM $3,500 per vehicle, the auto makers, their finance
companies and banks featured very attractive promotions
for car leases, rather than sales. Both schemes moved
the merchandise, but the leases are expiring rapidly
and cars/vehicles are coming off-lease. Combined with a
stagnant economy this has also contributed to used car
prices plunging. But it gets worse. "Residual value" is
the key in leasing, the educated guess of what the
goods will be worth when the lease expires and the
merchandise comes back into the market. In order to
make the lease deals more attractive two to three years
ago, the auto companies pumped up their assumptions on
residual values, so that the car lessee would have to
finance less, with consequently lower monthly payments.
Thus, the car makers will have 3.3 million cars coming
off-lease this year, into a market already glutted with
trade-ins from the zero-interest financing gimmick. The
fall in used car prices (already down 4% this year - to
the 1999 levels), combined with the overoptimistic
residual value assumptions to facilitate lease deals -
and the inability to find buyers, means that they are
being forced to auction off these vehicles for much
less than expected.
According to the November 11, 2002 'Boxed-In On The Car
Lot,' issue of Business Week, "Art Spinella, President
of CNW Marketing Research in Bandon, Oregon, an auto
industry consulting firm, says that auto makers are
losing an average of $2,400 on every off-lease vehicle
that they sell." But the good news - they had moved the
merchandise two to three years earlier. I consider the
former leasing program and the current zero-interest
promotions by the auto industry as the financial
equivalent of slitting your wrists and sitting up to
your neck in a bathtub of warm water.
Rereading Charles Kindleberger's book Manias, Panics
and Crashes - A History of Financial Crises (Third
Edition 1996), I was struck by another similarity with
what is happening in many sectors of the present
economy - deflationary pressures and the lack of
pricing power. This has occurred in virtually every
pre-1945 recession/recovery where the Fed has not
strangled expansion in its attempts to control
inflation. The $3,500 cost to GM in order to finance a
zero-interest sale amounts to a back-door price cut.
The October 21, 2002 issue of Business Week documents
this widespread price cutting in their article "Prices
Just Keep Plunging" and subtitled "Fears of deflation
are growing as a profits squeeze prompts more cuts."
They cite year-over-year declines of 20.9% for personal
computers (prices almost always decline-but never that
much), -4.0% for telephone services, -3.8% for air
fares - and a half dozen others in the accompanying
illustration. There are also major articles about
deflation in recent issues of The Economist and The
Wall Street Journal.
The Consumer Price Index (CPI) for September 2002
showed an increase of 1.5% (CPI-U) from September 2001.
The four largest gainers for the year, growing faster
than that +1.5% CPI increase are, Housing (+2.3%),
Medical Care (+4.6%), Education and Communication
(+2.7%) and Other goods and services (+3.2%-tobacco,
smoking products, personal care, miscellaneous personal
services). These sectors comprise over half (56.8%) of
the CPI. If these generally service areas were removed,
the CPI would be around break-even year-over-year -
perhaps slightly lower. During September, the Producer
Price Index (PPI) was definitely in deflationary mode,
with the PPI for finished goods declining 1.8% Y-O-Y.
The very significant and much-watched GDP chain-
weighted price index, the broadest indicator of price
levels has been trending lower, but is still in
positive territory. For the third quarter 2002, it was
up 0.8% down from the first half average of +1.3%. This
third quarter reading is the lowest since 1950.
However, the breakdown is not as reassuring - for
goods, the third quarter 2002 showed a decline of 0.8%.
It must be assumed now that deflation is no longer a
theoretical risk - and could become a problem, as it
did in the descriptions in Mr. Kindleberger's book of
pre-1945 experiences.
Two other factors that were not around in time to be
included in Mr. Kindleberger's book have also exerted
significant downward pressure on prices: the Internet
and globalization. Two of the significant advantages
that retailers have had over consumers in the past
would be consumer ignorance and lethargy.
The Internet can significantly lower these frictional
costs - since a consumer can go online and get an array
of prices for the merchandise desired. Used car prices
for trade-ins are also available online now, for
example. This forces the retailers to compete online
for the best price. It reverses the "advantage-
retailer" factor that existed previously. Lethargy
existed when the consumer negotiated with the retailer,
and when deciding whether or not to buy, considered
that he would have to get everyone back in the car and
drive 5-10 miles to another vendor - only to repeat the
process. The tendency was to avoid the hassle and buy
the merchandise. This is eliminated with Internet
shopping.
The New York Times reported recently that consumers are
increasingly haggling with retailers - even after the
merchandise has been reduced in price, sometimes after
two to three cuts. All these are significant
deflationary pressures that did not exist when Mr.
Kindleberger wrote his book. Globalization would be
another significant deflationary pressure. In the early
postwar period, the U.S. economy was essentially a
closed-loop business, since imports were not a
significant factor. I blamed the auto industry for
wrecking this system after doing a book review of The
Whiz Kids. It described how Mr. Robert McNamara used
the cost-effective methods developed for the Army Air
Corps in World War II to cut costs at Ford drastically
and produce a generation of lemons.
Since the other producers (there were more than three
then) were doing the same thing, the prevalent attitude
was that they had a captive market and the consumer
would have no choice but to take what they produced-
shoddy merchandise. Shortly, the consumer discovered
quality imports - particularly Japanese cars. That was
the beginning of "globalization"...and the pressure has
been intensifying ever since.
China, for example, must export for reasons of
political tranquility. The cost structures of Chinese
manufacturers are not divulged - but most state-run
producers are either marginally profitable or operate
at a loss. They must produce the goods to be exported
and sold. The price is not the primary consideration -
since the alternative is having 10, 20 or 30 million
unemployed workers. That could be an unendurable
political cost. So, they move the merchandise, and
bring about strong deflationary pressures in this
country.
This recession was the first of the post-postwar period
and also the first of the "Information Age." Consumers
are following the economy, not leading it - as was the
case in the past. Instead of a consumer-led
recession/recovery/slump business, investment has led
this one - the way it was done prior to World War II -
as described in Mr. Kindleberger's book. As he points
out, strong deflationary pressures arise after the
economic bubble has popped - and that is taking place
now.
Regards,
Raymond F. DeVoe, Jr.
For The Daily Reckoning
P.S. It is a rather eerie economic picture - and my way
of looking at it is that the three-quarter recession of
last year is incomplete. Traditionally, housing and
consumer durables go negative - but they remained
strong this time. Housing and autos never corrected -
but are looking increasingly shaky now. Consumer
spending never went negative. The trade deficit is
soaring.
Stock market valuations never fell to median historic
levels - much less the compressed values and higher
yields seen at other bear market bottoms. And,
significantly, consumer balance sheets never were
cleaned up. If anything, they are far more leveraged
than ever, unless refinanced mortgages, frequently for
much larger loans, are considered "off-balance sheet."
I am not forecasting deflation, just citing the
pressures existing in this eerie bust of the post-
postwar period. The widespread lack of pricing power
will make it a difficult period for profits, forcing
further cost cutting and particularly layoffs. Because
of the incomplete recession, I don't think there will
be robust growth until the excesses of the past have
been worked out of the system. And that is why the
recessions described in Mr. Kindleberger's book have
lasted longer than those in the 1945-2001 period, and
why recoveries were slower and more labored than the
traditional "V-shaped" ones of that postwar period. |
