by Rick Reider, Managing Director, Fixed Income, BlackRock Investments
October 2010
Highlights
- On balance, recent economic indicators have displayed modest improvement over the past month, but the data also highlighted the overall weakness of the recovery.
- Lower-than-desired inflation levels have become a prime concern for the Federal Reserve, as its monetary policymaking committee indicated that added accommodation was likely.
- While high debt levels have dominated financial crisis discussions, the asset destruction witnessed by US households has been profound and has implications for the recovery.
Economic Review and Outlook
A number of September economic indicators displayed modest improvement over prior months, but overall the data continued to underscore weakness. So while retail sales data surprised to the upside, with a 0.4% gain (versus an expected 0.3%), consumer confidence declined meaningfully to 48.5 (consensus was 52.1), with a sharp decline in the “expectations” component, which may be suggestive of weaker sales in the months to come. As mentioned last month, one primary area of economic weakness remains the housing sector, where meaningful recovery is unlikely to come without a rebound in employment. Unfortunately, the labor markets appear range bound, no longer deteriorating, but not improving much either. Initial jobless claims in September remained between 450,000 and 500,000, which is generally thought to be a level consistent with an anemic (yet still modestly positive) private payroll recovery. The “mixed messages” we have become accustomed to seeing in recent economic data are exemplified in the recent September ISM Manufacturing data release. While the index level only came in a tenth weaker than consensus expectation (54.4 versus 54.5), and it remained well above the critical 50 index level that signifies manufacturing sector growth, there was considerable weakness in segments of the report. Prices paid and inventories were both higher, but production, new orders, exports and employment components were all down meaningfully. As with prior months, both inflation and inflation expectations continue to remain quite subdued. The Consumer Price Index came in at only 1.1% year-over-year in August, and when more volatile food and energy components are stripped out of the data, the inflation measure was 0.9%.
Federal Reserve Outlook
Inflation was a key focus of the Federal Reserve’s last monetary policy committee meeting, as the Fed downgraded its outlook for both growth and inflation. Specifically, the Fed noted that “measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the long run, with its mandate to promote maximum employment and price stability.” Moreover, beyond explicitly targeting a higher inflation level, the FOMC enhanced its language regarding added monetary accommodation, arguing that it would take steps (widely thought to include another round of quantitative easing) to “return inflation, over time, to levels consistent with its mandate.” We have previously argued that another round of quantitative easing, and a coordinated fiscal complement, would likely be required for the economic recovery to “break out” onto a more favorable growth trajectory, and the Fed’s statements seem to confirm our view.
Market Outlook
We believe effective monetary and fiscal policy, if implemented in a coordinated fashion, should be able to unlock capital on the sidelines and begin growing the economy at a more rapid pace. Still, it is worthwhile noting that the forces the Fed is fighting are genuinely unprecedented. For instance, never in modern financial history, until the depths of the financial crisis in 2008, has financial sector and household sector debt growth been negative; and Federal sector debt growth had never exceeded 25%. Moreover, while debt growth rates and high overall aggregate debt levels have dominated the discussions surrounding the financial crisis, in many ways the asset destruction witnessed over the past few years (see chart) is equally meaningful.
In aggregate, US households have seen their net worth contract in eight out of the last twelve quarters, and roughly $12 trillion in asset value has been erased from household net worth since its 2007 peak. Nearly two-thirds of that asset destruction has come in the form of declining financial assets, while the final third stems from the decline in real estate assets. Wealth destruction of this magnitude holds profound implications for consumer and investor psychology, and when viewed from this perspective, retail market capital flows toward fixed income assets and away from equities can be placed in broader context. Interestingly, until 2008, household net worth had never contracted by more than 5% quarter-over-quarter in modern history, yet this has taken place three times over the past two years. Clearly, the massive declines in both the equity and housing markets have resulted in a “negative wealth effect” that has strained consumers’ ability and willingness to spend, and has also altered their investment outlook.
A stabilization in housing prices and the equity market rally that has taken place since March 2009 has aided the situation somewhat, but the typical household is still facing considerable financial stress. Still, are households finally getting to the point where they may bewilling to spend again? While the change will likely come slowly, we think certain factors may indicate something of a turning point for the consumer may be close. Overall, there has been some marginal improvement in the consumers’ situation, with, for example, households’ debt service ratio and financial obligation ratios well off peak levels (although these improvements may be somewhat overstated, due to defaults). Moreover, consumer belt tightening, as witnessed by relatively low levels of non-discretionary spending (near 29% of total disposable income), should allow for increased purchasing once labor markets improve and confidence returns. Additionally, the corporate sector has displayed remarkable resilience through the crisis, and now holds formidable levels of capital that could be deployed in a productive fashion should favorable policy outcomes present themselves. The coming months of Fed monetary policy action and fiscal policy debate (complicated by the mid-term elections) will be vital for understanding the economy’s secular trajectory. Ultimately, the Fed must fight still considerable declines in household assets, while virtually all sectors of the economy attempt to de-lever, and meaningful organic growth in the economy still appears distant. There is no question that this will be a challenging policy path to navigate, with clear risks of policy-induced missteps, but it is also a necessity to set the US economy up for sustainable recovery and improved future growth prospects.
