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Cash rich yet subpar growth
I have been hoping that cash-rich US corporates will find new investment opportunities and help to drive the US economy into a “virtuous cycle” – positive corporate profits lead to improved employment and more labor income and more consumer confidence then more consumer demand. But there are signs that maybe the opposite is more likely to happen. Facing huge “unusual uncertainties” (Bernanke’s words), US firms, after completing their first inventory buildup, which has contributed to growth so far, now are unwilling to spend more on capital investment: they are looking at a prolonged unemployment scenario and consumer demand is likely to take very long time to recover. What the US needs now is how to sell more to overseas – for that, the US needs a new export strategy (I will come back later for this topic).
Here is a piece from WSJ today discussing the uncertainties the US firms are facing:
Here’s a puzzler for investors: Although second-quarter economic growth figures look rather weak, corporate earnings are nevertheless coming in reasonably strong.
Specifically, about a third of S&P 500 companies have released their second-quarter earnings so far, and 78% of them have beaten analysts’ estimates, according to Thomson Reuters. On average, earnings per share are up 42% year-on-year, compared with the 27% growth expected.
![[AOT]](https://sg.wsj.net/public/resources/images/MI-BE765_AOT_NS_20100725155235.gif)
Yet the market’s response so far has been lackluster. The S&P 500 is up only about 1.5% since the first earnings report July 12. It is hard to argue that such results were already priced in, as the market dropped by about 11% in the 10 weeks prior to earnings season. Why, then, the muted reaction?
Chalk it up to what Federal Reserve Chairman Ben Bernanke dubbed the “unusual uncertainty” over the economic outlook. For every upside surprise in corporate earnings, it seems there’s a disappointing piece of economic data.
The Commerce Department doesn’t release its tally of gross domestic product until this Friday, but it is expected to come in below the first quarter’s 2.7% annualized pace. Goldman Sachs economists last week cut their second-quarter GDP growth estimate to 2%, for example, and expect further slowing to 1.5% in the second half of this year. Moreover, they put the odds of another recession, or “double-dip,” at about one in four.
A double-dip would certainly wreak havoc on profits. But it increasingly looks as though the more likely outcome is that the U.S. economy muddles along for a while at roughly 2%, below the 3% average of the past two expansions. That doesn’t necessarily spell disaster for corporate profits.
For investors, the mixture of healthy, cash-rich corporate balance sheets but subpar growth “is not one we have a lot of experience with,” notes Credit Suisse U.S. Equity Strategist Douglas Cliggott. One likely outcome, he says, is that a higher share of total S&P 500 returns come from dividend yield as opposed to price appreciation over the next few years.
Indeed, companies like Procter & Gamble and McDonald’s may not be the most thrilling names on Wall Street. But with their above-3% dividend yields, they probably offer the best seat for investors to ride out the recovery.
Job picture is worse than you thought
Richard Barley at WSJ compares job loss in this recession to historical trend – the result is astonishing.
![[godek]](https://sg.wsj.net/public/resources/images/ED-AL908A_godek_NS_20100722182105.gif)
The number of nonfarm private jobs has been growing steadily since the 1950s. That number reached a peak at the end of 2007. Between 1958 and 2007, the number of U.S. jobs grew to 115.4 million from 43.5 million—about 2% per year on average. The steady upward trend reflects the long-run growth of the economy and increased participation in the labor force.
The chart compares employment and that trend. It shows the percentage difference between employment and the trend line generated from monthly employment figures over the past 50 years (July 1960 through June 2010).
What we see is astounding. For almost 25 years—between 1984 and late 2008—the level of employment never fell to more than 3% below the trend line. Over that period, total employment grew by more than 36 million.
Employment fell briefly to about 6% below the trend during two previous recessions: in 1975 and again in 1982-1983. During those periods, the unemployment-rate peaks were 9% (in 1974) and 10.8% (in 1982). The unemployment rate in 2009 peaked at 10.1%.
By 2010, however, employment had fallen to about 10% below the trend, far below any previous level in the last half-century. These figures indicate that as of the first half of 2010, the economy has generated about 12 million fewer jobs than expected. In other words, things are not as bad now as they were in the early 1980s; they are much worse. Recall as well that the unemployment rate of the early 1980s was the result of the ultimately successful battle against inflation.
update: 07/25/2010
Here is another disturbing chart looking at long-term unemployment in historical perspective (source: Greg Mankiw, click to enlarge)
Defects of finance reform bill
Gary Becker lists the major defects of Dodd-Frank finance reform bill.
Are you ready to bet on China’s successful restructuring?
Anthony Bolton, the fabled British stockpicker, is staking his reputation on a £460m ($702m) bet that the Chinese economy is shifting away from exports and towards domestic consumption.
Mr Bolton’s bullish stance pits him against big-name investors such as Hugh Hendry, head of Eclectica Asset Management, and Marc Faber, author of The Gloom Boom & Doom Report, who are betting that the Chinese economy will crash.
China’s Western Push
From 2000 to 2009, Chinese government has invested $325 billion in West China, and it promised to invest $101 billion for year 2010 alone. The push westward continues…(WSJ, 07/10).
China's push westward continues. Just don't confuse it with a major new stimulus effort.
Beijing this week announced the country's western region would see $101 billion of investment this year. That has some wondering if China's starting up a new fiscal stimulus, to follow the $586 billion spending plan announced in late 2008. That's inflating expectations too far.
For a start, it's not clear how much of the $101 billion—to be spent on 23 projects from airports to power plants—represents fresh spending. As Capital Economics points out, much of this could simply be a rehash of projects that were included in China's previous stimulus plan.
Moreover, investing in China's western region has been a long-term government project dating from the beginning of this century. From 2000 to 2009 the government announced some $325 billion worth of new investment projects in the west of China as part of a strategy to develop the region. The latest announcement should be seen in that context, rather than evidence China is gearing up for a new stimulus plan, even if this year's spending is the highest in one year in the past decade.
Nonetheless, it's likely there will be more government unveiling of "new" investment in the coming months, triggering talk of a second fiscal stimulus. Such announcements are inevitable in one sense: Plenty of projects begun in the 2009-10 period will need ongoing funds to bring them to completion.
More importantly, despite policy maker efforts to raise the share of household consumption in China's economic mix, government investment is going to remain a key element for some time yet. As UBS economist Tao Wang points out, if China's government pulled back on investment spending in the near future, "infrastructure investment would collapse and overall economic growth could drop sharply."
Further investment spending in China is both a necessity and an inevitability, not a novelty.
Why banks ain’t lending
Why American banks aren't lending out the cheap money? Credit risk or supply shortage? The following WSJ article offers some great insights.
Making money too cheap carries danger. First, it fueled the housing bubble. Now, counterintuitively, it may be crimping an economic revival. That wasn't the plan. By cutting rates to near zero, the Federal Reserve helped forestall economic collapse. Yet with the recovery flagging, some worry that super-loose monetary policy may actually turn the Fed into an agent of deflation.
At issue is why banks aren't lending, especially to small businesses that are the engine of growth. One answer is there isn't demand for loans. Clearly, that is a factor. A lack of loan supply, though, also may be playing a role—and not just because credit risk is high.
Ronald McKinnon, a Stanford University economics professor, argues that near-zero rates gum up the interbank market, which crimps lending growth. He reasons that bigger banks aren't lending to smaller ones because the derisory yield on offer doesn't compensate them for lending to potentially risky counterparties. That is a particular problem, he says, because many small businesses borrow through lines of credit. Banks won't extend these unless they know they can tap the interbank market at a later date. The amount of inter-bank loans outstanding was about $160 billion at the end of May, down 60% in a year, according to Fed data.
![[FEDHERD]](https://si.wsj.net/public/resources/images/MI-BE376_FEDHER_NS_20100705175714.jpg)
The result is a scarcity of loan supply, says David Malpass, president of research firm Encima Global. "Banks claim that there's a lack of demand, but it's a two-way street."
Banks, meanwhile, are trimming lending more broadly and hoarding funds. Their May holdings of Treasury and other government-backed debt rose 19% compared with a year earlier, Fed data show. Commercial and industrial loans fell 18%.
Smaller companies have been hit hardest. In the first quarter, debt outstanding for small businesses fell by about $70 billion, according to Fed data, even as larger companies saw debt increase by $100 billion.
The reluctance to lend is understandable. Banks can borrow cheaply and earn a handy profit investing in higher-yielding, government-backed debt, in what is known as the carry trade. That contrasts with the impact of near-zero rates on investors, who were pushed into riskier assets by the pain of no yield on cash.
Making money more expensive would risk harming the economy as some companies and individuals paid more on their floating-rate debt. But it could feasibly compensate banks to lend more in the interbank market. Meanwhile, banks would face shrinking profits from their safe carry trade, potentially encouraging them to seek higher returns from traditional loans.
In that case, "raising rates could actually have an inflationary impact," says Joseph Mason, a finance professor at Louisiana State University.
Even today's experimental Fed is unlikely to embrace such an unorthodox approach. But the central bank needs to consider the unintended consequences of its super-aggressive monetary policy.
Less to bank on China’s banks
Chinese government's rapid credit expansion to savage the demand slump due to the Great Recession will eventually come back to hunt its large banks, which still pretty much direct their loans under governments' orders (source: WSJ)
That Bank of China is seeking to raise money in both the mainland and Hong Kong markets is a surprise. It had earlier said there would be no need to raise extra cash in Shanghai. But the size of the rights issue—the bank is hoping to raise nearly $9 billion–means both markets are being called upon.
Assuming the issue runs smoothly, by the end of the year Bank of China's balance sheet should be back at a level that will satisfy cautious regulators. Its overall capital-adequacy ratio should be around 12% by end-2010, Goldman Sachs estimates, above Beijing's 11.5% minimum requirement.
But this small degree of clearance has broader significance. Bank of China hopes to keep its capital adequacy at around 12% for the next three years without any more calls on investors.
The implication is that it expects a much slower rate of loan expansion over the medium term, certainly than it has experienced since the end of 2008. Bank of China built its loan book faster than China's major banks in 2009, with its loan balance rising nearly 50%, as Chinese banks pumped out around $1.4 trillion of new loans to support economic growth. In that time, its capital-adequacy ratio dropped from 13.43% at the end of 2008 to 11.09% at the end of March this year.
This may not be an immediate problem, as long as Chinese policy makers are intent on taming last year's breakneck rate of credit expansion. But if the global economy dips again, institutions such as Bank of China will have less ability than before to help insulate China from any fallout.
In a crisis, the banking regulator might be prevailed upon to lower its required capital-adequacy levels again. Alternatively, Bank of China might find itself going back on its word about future capital raising.
Either way, what looks like a sure footing today won't be much to count on.
Back to New Normal
It looks more likely that the US is entering the New Normal, as predicted by PIMCO folks.