Exports Should Rise Soon
07/31/09
The US economy contracted at a 1% annualized pace in the second quarter, a bit better than the consensus had expected. GDP growth for the 1. Quarter was revised down to -6.4% from -5.5%. The report on second-quarter gross domestic product released Friday seems to confirm that the second quarter will be the last in 2009 to see a decline in real GDP. Inventory de-stocking continued apace, with a record drawdown of $156 billion vs. $127 billion in the first quarter. In GDP accounting terms, inventory builds are adding to the GDP number whereas inventory liquidation subtracts from it. The inventory liquidation thus subtracted 0.8% from GDP this quarter. The data confirms nonetheless that inventories are lean and that the inventory liquidation is almost certainly over. Restocking of inventories is necessary because orders need to be filled and this means that production has to increase. Even if inventories remain flat in the current quarter, it will boost GDP, since it will mean that all of the demand is being satisfied by new production rather than from stocks on hand. And if, in later quarters, production not only must satisfy demand, but also add to stocks on hand, that will boost GDP even more. The precipitous decline in real GDP in the 4th quarter 2008 and the 1st quarter 2009 was not only caused by panic liquidation of inventories but also by the abrupt decline in business investment. The slide in business investment improved by sliding only an additional -9% in Q2 vs. -36.4% in Q1. In our last newsletter I pointed out that CEO business confidence was improving and that this improvement almost always leads to rising business investments. The chance that business spending in equipment has begun to flatten and will begin to grow next year is enhanced by the fact that this form of investment has started to contract in 2006 already. This trend is now 3 years old and should reverse sometime soon. All in all it seems a good bet that the decline in consumer spending may be offset to a certain degree by inventory re-stocking and improved business investment.
Another hopeful sign of an improving economy is the housing market. U.S. new home sales were much better than expected in June, jumping 11% month over month to an annualized pace of 384,000 vs. 352,000 expected and a upwardly revised 346,000 rate in May. The supply of homes for sale fell to 8.8 months from 10.2 and was the lowest since Oct 2007. Housing starts and building permits also showed improvements. If residential investment can show signs of life it should also help to turn the inventory and manufacturing cycle around. At this stage, the dollar remains vulnerable to good economic news. Friday, after the announcement of better than expected GDP numbers, the dollar lost a lot of ground against the emerging market currencies and against the Euro, Kiwi and Pound. Why would good news hurt the dollar? You may remember that in September 2008 dollars in circulation (most of which are held overseas) surged beginning in mid-September of last year, as fears of a financial market collapse caused people all over the world to stuff money under their mattresses. The demand for dollar cash and dollars in general (as a safe haven and to pay down debt) was so intense that the Fed had to resort to a massive expansion of the monetary base to avoid a sudden onset of deflation. This surge in the demand for dollars also meant that instead of spending money, people simply held onto it and at the same time wanted more of it. We talked about this plunge in money velocity which resulted in a sudden and massive decline in retail sales. That in turn caused a huge rise in inventories, and manufacturers were then forced to respond by slashing production. The panic started to subside last March. People began to decide they didn't need to accumulate more dollar cash. On the margin, the demand for dollars stopped rising. This is another way of saying that the velocity of money stopped falling. Currency in circulation has been flat since mid-April, but there are still lots of dollars sitting under mattresses. The demand for (and the price of) dollars in the world currency market has been falling since mid-March; the dollar is down over 10% against major currencies. The next chart shows a very strong correlation between the US equity market and the changing demand and price for dollars. A weaker dollar goes hand in hand with a stronger equity market, and vice-versa. Declining dollar demand today means that balances, which were kept as reserves, are likely to be spent, and that is lifting the economy and brightening the prospects for the future. Thus the need for (and the price of) dollars declines.
The second chart above was constructed by Bespoke Investment Group. The authors say that the six month correlation between the daily change of the Dollar and the S&P500 is at its most negative level ever. Dollar strength begets stock market weakness and vice versa. Stock market investors may therefore wish for a weak dollar but the chart suggests that in the not too distant future the inverse correlation may flip into a positive one. If that should come to pass, positive economic news may portend a rising dollar AND a rising stock market. It may take some time or it may start tomorrow but I am a believer in the reversion to the mean. The chart that Bespoke Investment group created tells me that we should be reversing the trend of this inverse relationship soon.
A recent Barron’s interview with Jim Paulson, investment strategist for Wells Capital Management, reinforces my belief. He believes like I do, that the dramatically improved savings rate and an improving trade deficit will help GDP growth in coming years. Deteriorating trade deficits subtract from GDP while improving trade deficits add to it. "Over the next decade, GDP should get a big boost from U.S. trade moving into rough balance between exports and imports," says Paulson. As a result, net exports should be able to supply about one percentage point annually to overall GDP growth over the next decade, rather than subtracting a similar amount from economic growth, as it has for much of the past two decades amid consistently poor U.S. trade performance. That would compensate for an expected decline in households' contribution to economic growth from the more-than-3% level during the expansions of the 1992-2000 and 2003-06 periods to, say, just one percentage point during the coming expansion. To summarize: The recovery from the recession trough has almost definitely begun. Smaller contributions by the US consumer will be initially offset by inventory restocking and later on by improved exports and rising capital investment. There is even a chance that by 2010, the economy will start growing at the turbo-charged rates of 5% and 6% that generally occur after a steep downturn. Even a (more likely) 3% to 4% rate of growth, however, should bring a double-digit rebound in corporate profits and that alone is good news for stocks.
Hermann Vohs
"The gap in our economy is between what we have and what we think we ought to have - and that is a moral problem, not an economic one."
Paul Heyne
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
