Stocks and bond yields are sinking as Wall Street disses the debt deal and instead focuses on a likely double-dip recession.
Everyone is gloomy. But is this pessimism getting a little overbaked?
Granted, the economy is sputtering, with less than 1 percent growth in the first half of the year. But if there is a recession in the cards, it will be the first time one occurs when the yield curve is steeply positive (an ultra-easy Fed) and corporate profits are strong.
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And since we do have ultra-easy money and strong profits, I don’t believe we’re heading into a recession. Nor do I believe stocks will continue to swoon.
The principal reason for the sub-par first-half economy is the rise of inflation, which severely damaged real incomes and consumer spending. We experienced a mini oil shock, which has dampened the whole economy. Actually, it’s worth remembering that oil shocks and inverted yield curves, along with falling profits, are the most important leading indicators of recessions. We don’t have this right now.
Fortunately, oil and gasoline prices have come down well below their highs. That’s going to take pressure off the economy.
Of course, QE2 backfired as the dollar sank and the inflation rate temporarily jumped 5 or 6 percent. However, as energy prices have eased back down, the inflation rate as measured by the consumer deflator has fallen, and is up only 1.3 percent annually for the past three months. If the dollar can hold its current level and energy prices remain quiescent, the economy will be okay.
Not great. The second-half economy could grow by 2.5 to 3 percent. There are so many tax-and-regulatory threats out there that it’s hard to expect much more growth. But at least it’s not recession.
Recent reports from the ISM purchasing managers for manufacturing and services are not signaling recession. Car sales have actually bumped up. And at least employment is rising, although slowly.
It’s all sub-optimal, but it’s not recession.
Meanwhile, profits are at record highs as a share of GDP. Second-quarter earnings are coming in much stronger than expected. For some reason investors have chosen to ignore profits. But they’re still the mother’s milk of stocks and the economy. Stocks may well be undervalued right now.
At roughly $95 a share profits for 2011, stocks are running near a 13-times price-earnings multiple, which calculates to a near 8 percent forward-earnings yield. Compare that to a 2.6 percent 10-year Treasury bond or a 5.5 percent Baa investment-grade corporate bond, and you can see that stocks have good value. The equity-risk premium is very high.
At the same time, corporate credit-risk spreads are relatively narrow while financial conditions in general are vastly less stressful than they were a couple of years ago. This is not the stuff of recessions.
Regarding the debt-ceiling deal, no one is thrilled about it. But it is a step in the right direction: no tax hikes and at least some spending cuts. The level of discretionary spending will come down $72 billion over the next two years. Even if the budget caps don’t hold beyond that, it’s still a budget cut without a tax increase.
Some of the Paul Krugman left-wing Keynesian types think small budget cuts will throw us into recession. Not a chance. The GDP is roughly $14 trillion, and total budget spending is moving toward $4 trillion. So these are relatively modest cuts. Plus, if government spending more works to grow the economy, why hasn’t massive government spending already worked to grow the economy? Here’s the dirty secret: Smaller government is good for growth.
We will see what phase two of the debt deal brings. It will be an uphill climb. But at least the strong possibility exists that another $1.5 trillion will be taken out of the spending baseline. That’s not nothing.
And of course, Treasury-debt default was avoided.
Slowly but surely the Tea Party Republican coalition is turning the tide on spending. Too bad President Obama was out once again this week attacking millionaires, billionaires, businesses, and oil and gas with his usual soak-the-rich class-warfare redistributionism. This kind of politics has helped generate a capital strike by profitable and cash-rich businesses. It’s pure folly, and it’s holding back the animal spirits. Stocks dropped 100 points after Obama’s press conference on Tuesday, when he once again blasted free-enterprise incentives.
Which brings me to a final point: What’s missing from the whole budget debate is a true pro-growth tax reform that would flatten rates and broaden the base for individuals and companies. A fresh round of incentives would do wonders for our ailing economy.
Unfortunately, we’re going to have to wait until the 2012 election before we see any of that. In the meantime, despite an anti-growth administration, the free-market economy will continue to muddle through.
– Larry Kudlow, NRO’s economics editor, is host of CNBC’sThe Kudlow Report and author of the daily web log, Kudlow’s Money Politic$.
Come on Larry, when you can borrow at these rates, profits are easy. But, what happens when the easy money leaves the room? The emperor has no clothes. Profits without production are not real. There is no production. This is a sham of an economy and when the rates move up, the chickens will be coming home to roost. This next bubble should be called the printing press bubble. Thank you Helicopter Ben.
Although Mr. Kudlow makes some valid points, it's significant that the GDP figures have been revised downwards. If that happens again, it could well be enough to send them into negative territory. Looking ahead, inflation will probably rise, and this will also push real GDP downward. All it takes is two consecutive quarters of that to make a recession. If we're not there yet, we probably will be soon.
Larry, the yield curve might be steep, but the average Joe can't borrow at anything near those rates, and even if he could, he would be ill advised to do so for the sake of consumption.
As for profits, sure, they are up at big companies, largely due to continuing cuts of headcount to boost "productivity" ... meanwhile, small and mid-sized business are shuttering at an amazing pace, and the last time I looked that is where most of the jobs of America are being created.
If you think a bogus GDP number of barely over 1% is indicative of a recovered economy, remember that perhaps a third of that comes from government spending of money it has not yet "liberated" from the few remaining small- to mid-sized business-owners who were still in their creating jobs until they found their own profits being squeezed to provide 156 weeks of consumption support for the future voters of Obama.
Yes, everything is fine if you are a well paid member of the chattering classes rather than someone who has actually walked down Main Street in an average American town the last couple of years.
Comparing corporate profits of global corporations to national US GDP is irrelevant. P&G, Coke, IBM, Apple profits are from all over the world. A better analysis will be to check the trend in revenues and profits from the US from all these corporations.
All true and in fact the right read on the US. But then the market wasn't falling because of the US. Not US politics, not the debt deal, not the GDP numbers, not even double dip fears which Mr. Kudlow is right, are overblown.
No, the reason the market has been falling for the past week and even all summer, is Europe. The European sovereign debt crisis, generally. Italian and Spanish banks sinking into the abyss, to be more specific.
That is the problem and it is the only problem.
A default brainstorm coming out of populism in Germany and furthered by irresponsibility in Greece, is threatening to wipe out what capital remains in the European banking system. Every time new huge credit losses are dumped on money center banks, tney are forced to contract their sheets, and to sell assets of all kinds to realize cash and cover those losses.
Every dollar (or Euro) of losses the pols won't pay and instead want the banks to eat, destroys 20 times as much broad money, or prevents its creation.
Mainstreet America's defaults on mortgages induced the US financial sector to contract its collective balance sheet by $3 trillion since late 2008, and the Fed has counteracted only about half of that. But if Europe now decides that even sovereign governments are going to handle their financial problems by robbing their creditors, then 2008 will look like a picnic.
The default brainstorm needs to be destroyed. That way lies only sorrow.
Larry Kudlow's comments are meant to be considered in the context of the big picture over the long run, not as drive-by quips like the pablum spewed by most "pundits".
Of course he's not always right. But you'll be better informed in the present, and money ahead over time, if you listen to him carefully.
robnh - well the SP500 has returned 8.2% since then, despite the recent pullback. Nominal GDP is also up 5% since 1Q2010, the last figure out at the time of that comment. Not gangbusters, not zero either.
Gee, nominal GDP is hardly a ringing endorsement ... Adjust for inflation (actual, not official, please), and Real GDP is lower over the period ... Now, divide by a larger headcount, and per capita GDP is even lower.
With success like that, who needs enemies to topple us?
I am not as optimistic. We only have corporate profit through 2011Q1, and ominously, corporate profit growth (after taxes) in the GDP data was close to zero (although profits do remain high). Secondly, consumption has been flat or declining for two months in a row (June and July); consumption makes up about 70% of GDP, so weak consumption growth, or no consumption growth makes it much harder for GDP to have much zest unless the remaining GDP components grow very rapidly. Finally, the July ISM was barely above 50, suggesting very little growth in manufacturing in July.
Now, I grant that all of those may be temporary blips and the yield curve does argue against a recession. Nonetheless, current data are certainly worrisome. They most definitely suggest a third quarter that will not be much better than the second.
I've never subscribed to a successful Wall Street = successful economy philosophy. For my part, I think Wall Street has more in common with the Bellagio than with any relevant economic indicator. So profits are great, the market is at 11K plus, so what? It’s a small matter as it relates to the current economy. It won't be Wall Street or good corporate earnings that save America.
The reason profits are great isn't hard to see - the government budget deficit has to wind up as net cash flow to somebody or other, and US corporations are very good at grabbing it. Usually after it has passed through the hands of somebody or other with their hand out, sure, but it doesn't stay where it starts, it stays where someone is doing something useful, and that would be US corporations. Have they done a good job adapting to the new conditions created by the 08 smash? Yes, and they deserve credit for it, not populist brickbats. But policy has plenty to do with high current profits.
The reason that hasn't resulted in stronger broad economic growth is also easy enough to spot. Broad money creation remains at a crawl despite the active Fed. The US financial sector has contracted, banks stocks are still down 80-90% from 2007 levels. They aren't lending because Americans aren't paying them back, and that makes paying down debt a better policy.
There isn't any broad recovery without the financial sector. And that is also true of Europe. The present market decline is all about the Spanish and Italian banks, for instance. European banks as a whole are down about 25% since February. Why? Because sovereigns across Europe are flirting with default, and default is a Bad Idea (TM).
You are probably right, but seriously - these are not normal times, and so I am not sure if the yield curve and profits are indicating what they normally indicate as a function of the whole economy. It seems to me that they are indicating more the policies of the Fed and and the reaction to regulatory and future fears by corporations. The fact is that the consumer and banks are still deleveraging and if the European situation is not resolved or if it seems that it won't be resolved the global financial system is still on the brink of meltdown. So there is no recession technically, but assuming the European situation is solved, surely there could be a couple of quarters of negative growth assuming the whole planet doesn't go in to panic mode?
My joy at reading this upside-down reading of the world's economy, and at the same time being able to watch the market drop 500 points in a day is indescribable.
No real GDP is not down year over year. It is up about 1.5%. I thought that was obvious from the nominal figure, since inflation clearly isn't greater than 5%. In fact the overall climate remains deflationary, due to still elevated credit losses preventing any expansion of broad money.
As for the other poster's passing comment "assuming the European situation is solved", um, err, what? "Solved" by what deus ex machina, exactly?
The state in most European countries takes fully half of GDP. They can certainly afford to pay their debt service and solve this crisis, but doing so will require cutting their welfare states in half. We just saw in the US how difficult it is, even with a tea party and after a conservative victory in the 2010 elections, to cut even the rate of growth of government by half a percent of GDP.
The EU crisis isn't going to be solved by anything less than drastic reductions in the size of European welfare states. Nothing else will serve. Specifically, default will not serve and would in fact make the situation worse, repeating the Lehman mistake on a grander scale. Muddling along with bailout funds and looser monetary policy will not solve it.
The public credit in both Europe and the US can be restored if and only if the public credit is recognized to be more important than boondoggle giveaways to pet domestic spending constituencies.
So far, there is precious little evidence that this has been recognized on either side of the Atlantic, let alone acted upon.
JasonC @16:57 -- What is the basis for your statement? Are you doing 2011Q2 relative to 2010Q2, or do you have some other calculation in mind? BTW Final sales growth in the first quarter was zero (no growth) and I think it was 1% in the second quarter. In each case, final sales growth was below GDP growth, suggesting (unwanted?) inventory buildup. With consumer demand as weak as it is, the third quarter may not look much better than the second (and potentially worse).
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