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Some companies are cutting compensation levels and hours rather than cutting employment. For example, here is a report on Visteon, the car parts supplier, that is putting 2,050 employees on a 4-day week and cutting their wages by 20%. If you Google “wage cuts” you get 529,000 responses.
Cutting wages and/or hours is a more humane way to downsize than firing people outright, in my opinion. But to the extent that wage and hour cuts has been and will continue to be a trend, it disguises the unemployment numbers. So real unemployment is and will be higher than the reported numbers for unemployment due to wage and hour cuts. Moreover, cutting wages is a paradigm example of deflation in practice. People do the same amount of work but earn less for it.
Rising unemployment does not per se constitute deflation but it reduces consumer confidence about their income which causes consumers to cut back their spending. Lower spending leads directly toward lower prices and changes in prices up and down is how economist measure inflation and deflation.
Where are we?
The question all investors are asking now - and always ask - is where in the economic cycle are we now and what will follow from here? The economy is clearly headed down and will be for a while, but we want to know for how long and how steep the decline from here will be. And the bottom line for investors is the impact on stock prices.
The Bear Case
A handle on these questions can come from looking at the cause of the recession. A “normal” post war recession starts with higher interest rates as the Fed takes away the punch bowl from an increasingly inflationary economy or as a bubble pops like the junk bond and savings and loan and real estate bubble of 1990 or the tech bust of 2000. All those post-war recessions have tended to be fairly short and the associated stock market damage was severe but did not last for an extended time.
Now, however, we are experiencing a crash in the banking system itself - as happened during the Great Depression. It is more of a crash in the unregulated shadow banking system of securitized loans, etc. than of banks with marble floors and brass signs, the “normal” regulated and government insured banking system. The former has collapsed and is not coming back any time soon while the latter is on life support and now seems to be recovering.
It is being said by some economists that when a recession follows a collapse of the credit system it is longer and more serious. Moreover, if such a recession leads to deflation it can be self-perpetuating and therefore much longer and deeper than otherwise would be the case. Here is what Krugman wrote in today’s Times: (my emphasis)
Here’s my nightmare scenario: It takes Congress months to pass a stimulus plan, and the legislation that actually emerges is too cautious. As a result, the economy plunges for most of 2009, and when the plan finally starts to kick in, it’s only enough to slow the descent, not stop it. Meanwhile, deflation is setting in, while businesses and consumers start to base their spending plans on the expectation of a permanently depressed economy…
So are we in the second or third inning of a long deflation? If so, it would seem that any stock market rally, including that which has ensued since December 24, is likely to be a “bear trap” - a temporary counter trend move up to be followed sooner or later by lower lows - rather than the start of a bullish trend.
The Bull Case
But not all observers - possibly not even a majority of them - believe that deflation is in our future. One respected economist, Albert Wojnilower was recently quoted in the Times thusly: “Like other forecasters, Mr. Wojnilower expects the just-ended fourth quarter to be the recession’s worst, with the G.D.P. having contracted at a 4 or 5 or even 6 percent annual rate. Also like the others, he expects the economy to be growing again by the end of the year, although at an annual rate of 1 percent or less, which feels like a recession and is not enough to generate new jobs.”
There are some common sense reasons to think that last quarter might have seen the greatest drop in U.S. GDP that is likely to occur. One is that car sales have declined 35% from 16 to 10 million per year. Car sales are unlikely to decline as rapidly going forward. In fact, it would not be illogical to think that with gas prices way down and with GMAC now financed by the Treasury and car companies back in the 0% financing business (or fantasy game, as I think of it since it just means the companies are borrowing sales from the future) car sales volume may stop falling much at all even though unemployment continues to increase.
Housing weakness also probably has longer to go and housing activity becomes magnified in its economic impact on related industries. But the enormous decline rate in home construction activity is unlikely to continue much further. In fact, like cars, the second derivative of housing weakness - the change in the rate of change - has probably bottomed out. Like cars, the absolute rate of construction may not grow and may continue to decline a bit further in the next year, but it won’t be anywhere nearly as steep a rate of decline as we saw last year.
Retail sales, on the other hand, may decline faster going forward than they have in the past and the consumer spending part of the economy, ex-cars and ex-houses, is extremely large. On the other hand, a great percentage of the goods that are bought by consumers these days are imported. So while reduced consumer spending will hurt the retailing sector and some manufacturing, it will not have the same impact on the rest of the economy as it would during past recessions when more goods were made in the U.S.
Services will be hurt but less so than other sectors. Medicine, education, and government will perhaps not grow, but are unlikely to decline substantially. In fact, it is likely that Team Obama will supplement spending on such services to a degree that may even make them grow starting in late 2009 and increasingly in 2010.
In sum
So my back-of-the-envelope summing of all this is that cars and housing will decline but at much slower rates going forward than during 4Q08; consumer spending will decline more rapidly going forward for the next one or two quarters but will have a muted impact on manufacturing ex-cars and houses; services will decline during the next one or two quarters but not at a serious pace; and the question of deflation is alive but is not conclusively baked in unless the Obama stimulus plan fails completely for some reason.
If 4Q08 saw the worst in the rate of decline in the U.S. economy, that might well bode very favorably for stock prices. In fact, stocks could have a banner year in 2009 if the second derivative of decline in the U.S. economy has already bottomed or if it bottoms early in 2009, and particularly if the public gains confidence in the future based on whatever fiscal stimulus plan is put in place. I don’t expect stock prices to be straight up from here and the bearish risks that Krugman points to are real. But if a strong stimulus package is put into effect stocks may well recover a lot of last year’s losses fairly rapidly.
That said, I also think that energy stocks are more likely to be good than to be great because in the near term I think the price of oil will be contained below $75. More to the point of my current hesitancy to pile back into oil stocks, I suspect that if the Israeli attempt to stop Palestinian bombardments of Israel is successful and does not escalate to involve Iran then the price of oil is likely to fall back and test its recent lows, perhaps offering a better entry point for oil investors.
Cutting wages and/or hours is a more humane way to downsize than firing people outright, in my opinion. But to the extent that wage and hour cuts has been and will continue to be a trend, it disguises the unemployment numbers. So real unemployment is and will be higher than the reported numbers for unemployment due to wage and hour cuts. Moreover, cutting wages is a paradigm example of deflation in practice. People do the same amount of work but earn less for it.
Rising unemployment does not per se constitute deflation but it reduces consumer confidence about their income which causes consumers to cut back their spending. Lower spending leads directly toward lower prices and changes in prices up and down is how economist measure inflation and deflation.
Where are we?
The question all investors are asking now - and always ask - is where in the economic cycle are we now and what will follow from here? The economy is clearly headed down and will be for a while, but we want to know for how long and how steep the decline from here will be. And the bottom line for investors is the impact on stock prices.
The Bear Case
A handle on these questions can come from looking at the cause of the recession. A “normal” post war recession starts with higher interest rates as the Fed takes away the punch bowl from an increasingly inflationary economy or as a bubble pops like the junk bond and savings and loan and real estate bubble of 1990 or the tech bust of 2000. All those post-war recessions have tended to be fairly short and the associated stock market damage was severe but did not last for an extended time.
Now, however, we are experiencing a crash in the banking system itself - as happened during the Great Depression. It is more of a crash in the unregulated shadow banking system of securitized loans, etc. than of banks with marble floors and brass signs, the “normal” regulated and government insured banking system. The former has collapsed and is not coming back any time soon while the latter is on life support and now seems to be recovering.
It is being said by some economists that when a recession follows a collapse of the credit system it is longer and more serious. Moreover, if such a recession leads to deflation it can be self-perpetuating and therefore much longer and deeper than otherwise would be the case. Here is what Krugman wrote in today’s Times: (my emphasis)
Here’s my nightmare scenario: It takes Congress months to pass a stimulus plan, and the legislation that actually emerges is too cautious. As a result, the economy plunges for most of 2009, and when the plan finally starts to kick in, it’s only enough to slow the descent, not stop it. Meanwhile, deflation is setting in, while businesses and consumers start to base their spending plans on the expectation of a permanently depressed economy…
So are we in the second or third inning of a long deflation? If so, it would seem that any stock market rally, including that which has ensued since December 24, is likely to be a “bear trap” - a temporary counter trend move up to be followed sooner or later by lower lows - rather than the start of a bullish trend.
The Bull Case
But not all observers - possibly not even a majority of them - believe that deflation is in our future. One respected economist, Albert Wojnilower was recently quoted in the Times thusly: “Like other forecasters, Mr. Wojnilower expects the just-ended fourth quarter to be the recession’s worst, with the G.D.P. having contracted at a 4 or 5 or even 6 percent annual rate. Also like the others, he expects the economy to be growing again by the end of the year, although at an annual rate of 1 percent or less, which feels like a recession and is not enough to generate new jobs.”
There are some common sense reasons to think that last quarter might have seen the greatest drop in U.S. GDP that is likely to occur. One is that car sales have declined 35% from 16 to 10 million per year. Car sales are unlikely to decline as rapidly going forward. In fact, it would not be illogical to think that with gas prices way down and with GMAC now financed by the Treasury and car companies back in the 0% financing business (or fantasy game, as I think of it since it just means the companies are borrowing sales from the future) car sales volume may stop falling much at all even though unemployment continues to increase.
Housing weakness also probably has longer to go and housing activity becomes magnified in its economic impact on related industries. But the enormous decline rate in home construction activity is unlikely to continue much further. In fact, like cars, the second derivative of housing weakness - the change in the rate of change - has probably bottomed out. Like cars, the absolute rate of construction may not grow and may continue to decline a bit further in the next year, but it won’t be anywhere nearly as steep a rate of decline as we saw last year.
Retail sales, on the other hand, may decline faster going forward than they have in the past and the consumer spending part of the economy, ex-cars and ex-houses, is extremely large. On the other hand, a great percentage of the goods that are bought by consumers these days are imported. So while reduced consumer spending will hurt the retailing sector and some manufacturing, it will not have the same impact on the rest of the economy as it would during past recessions when more goods were made in the U.S.
Services will be hurt but less so than other sectors. Medicine, education, and government will perhaps not grow, but are unlikely to decline substantially. In fact, it is likely that Team Obama will supplement spending on such services to a degree that may even make them grow starting in late 2009 and increasingly in 2010.
In sum
So my back-of-the-envelope summing of all this is that cars and housing will decline but at much slower rates going forward than during 4Q08; consumer spending will decline more rapidly going forward for the next one or two quarters but will have a muted impact on manufacturing ex-cars and houses; services will decline during the next one or two quarters but not at a serious pace; and the question of deflation is alive but is not conclusively baked in unless the Obama stimulus plan fails completely for some reason.
If 4Q08 saw the worst in the rate of decline in the U.S. economy, that might well bode very favorably for stock prices. In fact, stocks could have a banner year in 2009 if the second derivative of decline in the U.S. economy has already bottomed or if it bottoms early in 2009, and particularly if the public gains confidence in the future based on whatever fiscal stimulus plan is put in place. I don’t expect stock prices to be straight up from here and the bearish risks that Krugman points to are real. But if a strong stimulus package is put into effect stocks may well recover a lot of last year’s losses fairly rapidly.
That said, I also think that energy stocks are more likely to be good than to be great because in the near term I think the price of oil will be contained below $75. More to the point of my current hesitancy to pile back into oil stocks, I suspect that if the Israeli attempt to stop Palestinian bombardments of Israel is successful and does not escalate to involve Iran then the price of oil is likely to fall back and test its recent lows, perhaps offering a better entry point for oil investors.