The mid-March and April 2009 market rally suggests equity investors are anticipating the recovery. There has been good news. A text book recovery would see the stock markets react to the good news about 60% to 70% of the way through the recession as firms prepare for a rapid recovery. But, Warren Buffett and Charlie Munger disagree. At Berkshire’s Annual General Meeting in May 2009, Buffett was downbeat short-term. Merrill Lynch’s outgoing US domestic economist David Rosenberg is also signaling caution. A rapid recovery is unlikely.
There are improving trends in the economic data: bank to bank short-term lending volume is up as the LIBOR improves, pending home sales increased by 3.2% from February to March and construction spending improve modestly after three years of declines, Freddie and Fannie borrowing cost are trending down towards historic ranges, consumer personal consumption expenditures are increasing at an increasing rate compared to twelve months back, and existing home inventories trended down from highs of about twelve months of inventory to the mid-nine month range. The housing market appears to be stabilizing.
These “green shoots” are buoying expectations but I’m going to side with Buffett, Munger and Rosenberg. The recovery will be slow, modest. Nine months of existing home inventory are still too many months. There are too few buyers to make it a sellers market. Until folks feel comfortable about their home’s value or their ability to buy a home, consumers will be parsimonious and save rather than spend. The USA personal savings rate for 2007 was about 0.2%, in March 2009 4.2%.
A recession is the part of the business cycle where firms must reduce inventory and everyone must reduce debt. If you think of labor as inventory, then layoffs also happen. Managers overshoot to conserve cash; “destocking” helps cash flow and layoffs reduce salary expenses. Layoffs come last. Some will retain some idle capacity – labor – to handle the eventual increase in demand. Later, new hires – long term, expensive decisions – will lag robust demand. Aggregate numbers on the idle capacity bear this out. For most of the 1990s and 2000s US capacity utilitization was about 81%. The April 15th figures from the Federal Reserve are 69.3% utilization, at historic lows. Manufacturing decline in Q1 at a 20% annual rate; we have significant excess capacity. This weeks US chain store sales report on indicated that sales are still declining from the same period last year, but at a slower rate. Watch out if gas prices move up again. Demand is still decreasing. The unemployed are months away from getting a job.
With the good news anticipating a recovery, large retailers and wholesalers will begin to rebuild inventory and we will see an up tick in the manufacturing numbers. The Institute of Supply Management report for March improved from 36.3 to 40.1, but new orders, production, employment and inventories are still contracting, prices falling, while supplier deliveries are faster. Greater than 50.0 indicates improving conditions. The Financial Times reported May 4th that large European companies are expecting second-quarter up ticks in manufacturing because the “destocking” process is ending. So far we’re following the pattern but retail demand is not yet driving the supply chain.
Firms and individuals are reducing debt, restated, increasing equity. Many assume that there are huge amounts of cash ready to move back into the stock market and into business investment. The latest bank loan officer survey conducted by the Federal Reserve Board shows banks are starting to ease tightening, particularly in the commercial sector, but reading the report in detail shows that they’re just not being as harsh with the next customer in the door. It is too soon to say banks are easing credit. Stricter loan down payments or debt to equity ratios will tie up a lot of that cash. Banks will be less likely to fund growth through lending until you put up more of your cash. The net effect is there will be less investment cash available.
First or second mover? Aggregate data are often 1 to 4 months old when reported by the Bureau of Economic Analysis or the Federal Reserve. The press and public react to time late data, extrapolate best case (we’re all optimist) and aggressive firms worry they will be slow ramping up – got to be the first mover! That is why there is usually a second inventory sell-off; folks react too soon. If I were positioning a firm (positioners are the CEO, CFO and sometimes Sales) I would be very patient and make sure retail demand is really increasing. In Q2 and into Q3, the reported activity is more likely to be just a slight up tick that occurs as the wholesale part of the channel begins to rebuild stock. We’ll see that data time late in Q4.
I’m pleased that most of my current and former clients are very well-run companies and most are reporting that sales are still growing at a modest rate. None expect 30% quarter on quarter sales growth though some wish it were still so. In this business cycle, we are still in the phase where you clean house, buff up your processes, and work closely with your best customers to help them do the same.