United States *Recovery Myths* <http://www.morganstanley.com/views/gef/index.html> October 21, 2009
By Richard Berner <http://www.morganstanley.com/views/gef/team/index.html#anchorrichardberner>| London Three myths are fueling debate over the sustainability and strength of the incipient US economic recovery: The benefits from an inventory cycle will soon be over; the credit crunch will force consumers to deleverage for years; and store closings last year are artificially boosting current readings on consumer spending. If valid, those claims would seriously undermine our case for sustainable growth. And confirming evidence in renewed weak economic data would no doubt promote significant setbacks in equities, credit and other risky assets that already have a lot of good news in the price. A close look, however, suggests that all three are folklore. As we see it, the inventory cycle has a long way to run and will contribute to grow through 2011. Second, the credit crunch is abating, while consumers are concurrently and aggressively deleveraging and repairing their balance sheets. The latter process could reach a sustainable equilibrium by 2011. Last, same-store sales comparisons are relevant for stock pickers but don't affect published retail sales and consumer-spending data. Those data are famously subject to measurement error and revisions, but the results so far are consistent with our view that a modest consumer recovery is underway. Details for all three myths follow. *The inventory cycle has a long way to run. * US companies have been liquidating inventories for six straight quarters, one quarter shy of the record set in1982-83. But the cycle is far from over; as we see it, this inventory cycle will set a new record for longevity and will contribute to growth through 2011. With inventories still high in relation to sales, liquidation is likely to continue through the end of 2010, depressing the level of GDP. However, we expect that the contribution to GDP growth will be positive through 2010 as the pace of liquidation slows. And when stocks are leaner, companies may begin accumulating them again in 2011. In all, we expect that the inventory cycle will add 0.6 percentage points (pp) to growth over the four quarters of 2010, and 0.4pp over the course of 2011. The realization that inventories will add significantly to GDP growth in the third quarter is leading some to think that an inventory buildup is underway. That's simply untrue. So while we've discussed inventories extensively elsewhere, some background and analytics on this process may again be helpful. First, there is no inventory buildup in the works; the book value of manufacturing and trade inventories plummeted by 1.5% in August, declining for the twelfth straight month. Second, apart from motor vehicles, where stocks are now lean even in relation to post-‘cash for clunker' sales, inventory stocks are still somewhat elevated in relation to sales. We estimate that the real manufacturing and trade inventory/sales ratio excluding motor vehicles declined to 1.34 (months) in September - well below its January peak of 1.4 but above an acceptable 1.3 level and considerably above the 1.25 that might be considered lean. To attain those more normal levels, we expect that companies will still be liquidating inventories throughout 2010. Third, companies do not need to cut production further, nor do they have to increase production more slowly than the growth of final sales. On the contrary, with the level of output (GDP) roughly 1½% below the level of final sales (both flows) in the second quarter, and final sales beginning to grow, GDP can grow faster than sales until the two converge, and inventories will still shrink. That's arithmetically because the change in the stock of inventories (e.g., liquidation when it is negative) is essentially the difference between the level of output and sales. As that difference narrows, the pace of inventory liquidation will slow, but the contribution of inventories to GDP growth is based on the change in the change in inventories, and that has turned positive. Analytically, economists since the days of Roy Harrod and Lloyd Metzler in the 1930s and 1940s have analyzed these relationships between stocks of inventories and flows of production and sales using a so-called ‘stock adjustment' model - a cornerstone of business cycle analysis. Indeed, stocks in relation to demand are key metrics for gauging excess, and such adjustments typically call the tune for the business cycle. Changes in the stock of inventories relative to sales dictate production adjustments and thus inventory liquidation or accumulation. Importantly, the model predicts that, faced with uncertainty about demand, producers will make such adjustments gradually, which would stretch the inventory cycle well into recovery. Such adjustments, reflecting their ‘second derivative' nature, are called an ‘accelerator' mechanism. As output accelerates, it begins to generate renewed demand for inventories (and capital, or investment). Measured by the second derivative in output, or the change in the growth rate, the process began in the second quarter when the decline of the growth rate diminished from -6.4% to -0.7% - an acceleration of 5.7 percentage points. And in the third quarter, we estimate that GDP accelerated further by 4.6pp, to 3.9%, with inventories contributing 1.1 percentage points to that gain. According to metrics in the ISM survey, companies have incentives to run output faster; the gap between orders and inventories is strongly positive, and the level of customer inventories is now below normal. Of course, if demand (and orders) were to falter, the picture would change significantly. Headwinds restraining demand growth abound, so while downside risks have faded, they are still significant. But the intensity of those headwinds is what is now at issue. That leads us to consider the second myth, namely that the credit crunch is still strangling growth and that dire news awaits. *Credit confusion: The credit crunch is abating and deleveraging is underway. * The financial press and some analysts point to the decline in US consumer credit outstanding as evidence that the credit crunch for consumers is intensifying. In contrast, we think the credit crunch has abated - although it has not ended - and that the adverse feedback loop from credit to the economy is starting to turn virtuous. In our view, consumers are deleveraging, some voluntarily. If income is growing, it can support both debt paydowns and modest spending growth, and balance sheet repair will set the stage for more sustained gains in spending. Measured by debt/income and debt service/income, deleveraging at the end of 2Q was in line with the timetable we outlined in May (see *Deleveraging the American Consumer*, May 27, 2009). Debt/income was a bit higher (at 118%), and debt service/income was slightly lower (at 13.1%) than we expected. Those results, together with incoming data on consumer credit (down $31 billion in the past two months) make us comfortable with that timetable, which projected debt/income at just under 100% and the debt-service ratio going to 11.5% by end 2010. How does that rational demand story square with ominous stories about the supply of credit? Credit-card lenders are cutting credit lines and otherwise tightening lending standards for small businesses that have no access to capital markets, and even consumers with jobs and income are feeling pinched by such moves. Those stories are valid, in our view, but they are not new; indeed, at the margin, it appears that credit supply headwinds are ebbing. Lenders are still tightening lending standards, but according to the Fed's Senior Loan Officer Survey, they tightened aggressively last year and now fewer are doing so. Indeed, a small fraction eased standards somewhat in the third quarter. Only slightly larger fractions of respondents report having tightened standards and widened spreads to small firms compared with larger and medium-sized firms. The proportion of banks tightening credit card standards has fallen by half since the crisis began. Small business surveys like the NFIB canvass are showing a peaking in the credit squeeze. And while their direct access to the capital markets is nil, small businesses are benefitting from the revival of the ABS market, as finance companies who have access to it are lenders to small businesses. Business receivables owned or managed by finance companies rose by 1.1% in July (the most recent data), the first increase in a year. But looking to outstandings really doesn't help distinguish credit supply from credit demand, especially in the early stages of the recovery. Business demand always is weak early in recoveries as inventories are liquidated and companies cut back on capex. Moreover, writeoffs typically reduce legacy debt faster than new originations will boost outstandings; that's probably especially true today. Yet banks in the aggregate have begun to earn their way out of their failing loans, and they have substantially delevered. My colleague and large-cap bank analyst, Betsy Graseck, believes that banks under her coverage will cover their remaining losses in two years. Of course, the macro baseline assumption for Betsy's estimates is our moderate growth scenario. But even in a bear scenario, they should be able to cover them in three years. Through reserve building, a lot of yet-to-be-realized losses are already covered. To understand the demand-side fundamentals we look at corporate and household external financing needs. The former relative to GDP have plunged to record lows. The latter (as suggested by a generally rising saving rate) are now suggestive of writeoffs and paydowns as well as weak demand. Thus, some of the behavioral change we see is voluntary and prudent, reflecting wealth losses and recession-induced uncertainty. Unprecedented wealth losses and prospects for slow revival are prompting ‘life-cycle' consumers to save more, and uncertainty around the outlook for income has made all consumers more cautious. In contrast, some of the change is involuntary and immediate, as defaults, the credit crunch and income losses squeeze consumers. The recession and the credit crunch have promoted defaults, reduced access to credit, and a squeeze on income for ‘rule of thumb' and liquidity-constrained consumers. These changes are likely to depress the growth of credit even as some credit-sensitive parts of the economy, notably housing demand, are now starting to recover. If consumers are boosting saving to pay off existing debt, and lender writedowns and chargeoffs are slowly bringing down the outstanding amounts, then declines in consumer debt outstanding are likely to continue in our moderate recovery scenario. *Data disconnect: *Same-store sales are relevant for micro, not macro. Some observers think that the closure of underperforming retail stores and liquidation of some brands are materially boosting same-store sales reports, thus overstating reported growth in consumer spending. Our retail team believes this effect may be helping some retail chains, but we both agree it is irrelevant for official data on retail sales and consumer spending. Softlines (clothing, general merchandise) analyst, Michelle Clark, believes that the liquidation of two clothing and household retailers helped some stronger store brands. That consolidation has pushed consumers to buy at the larger chains, and Michelle believes that the math on the comp pickup indicates a benefit to them of roughly 50-100bp. However, she notes that "many of the softlines retailers are still growing their stores (albeit modestly), without closing underperforming ones (outside of the usual 5-10%, and that's not even happening for many). Only two chains are closing stores in any material way, and the big store closures at one have yet to start." Retail analyst, Greg Melich, believes that the demise of two large chains in his industry has had a bigger impact on same-store comparisons, especially in consumer electronics. He thinks that the benefit might be 200-250bp across retail, as US sales/occupied square foot this year are likely to fall only 1-2% while total sales are down 3-4%. Store closings have increased vacancy rates to 20% from 16%, but retailers are most often renters, so rising vacancies are generally the developers' problem. Whatever the relevance of these comparisons for individual companies, they are not relevant for the macro analysis of consumer spending using official retail sales data that were released last week or using the data on consumer spending that will be published on October 30. As David Greenlaw notes, the Census Bureau conducts its own sampling to compile these data. They sample by mail about 12,000 retail businesses that have paid employees, and make estimates for others by aligning the results with a more comprehensive Annual Retail Trade Survey. By sampling firms who pay taxes, they can update quarterly to reflect employer business ‘births' and ‘deaths', typically with a 9-month delay. Same-stores sales don't matter for those samples; Census wants to capture all sales regardless of where they are made. In turn, retail sales are used as an input for estimates of consumer spending, which rely on other source data, such as vehicle sales, surveys of services spending and reports from industry groups. In both cases, the reported chain store comparisons aren't used as inputs, and thus the biases reported above are irrelevant for those data. *Burden of proof. * We may have dispelled some myths about the recovery, but we still bear the burden of proof for the sustainability story. The economy still faces numerous headwinds, and assessing the balance between them and the effects of monetary and fiscal stimulus, the benefits of stronger overseas growth and the reduction of excesses will dictate the outcome. Given that tug of war, evidence for sustainability will accumulate only slowly, and it will be bumpy. So investors should focus on forward-looking metrics for validation. Hopefully, this analytical framework will help to distinguish head fakes from the underlying narrative. -- Best Regards, Jay Shah, FRM "Expect The Unexpected" Blog: http://fuzylogix.blogspot.com/ --~--~---------~--~----~------------~-------~--~----~ You received this message because you are subscribed to the Google Groups ""GLOBAL SPECULATORS"" group. To post to this group, send email to [email protected] To unsubscribe from this group, send email to [email protected] For more options, visit this group at http://groups.google.com/group/globalspeculators?hl=en -~----------~----~----~----~------~----~------~--~---
