Economic Commentary -- July 2011

By Christopher Bremer, Director, Private client Services Portfolio Management
Northwestern Mutual Wealth Management Company

The Hot Gates
In the historical novel Gates of Fire, Steven Pressfield recounts the Battle of Thermopylae (the “hot gates”). It is perhaps the most famous battle involving the Spartans. A Greek force accompanied by 300 Spartans and led by King Leonidas blocked off the only road available for the invading Persian army to pass. While the Spartans lost the battle, historians regard the stand as a turning point for the eventual Persian defeat in this “second Persian invasion.”

Right now, many investors feel like they are at the hot gates. The recent correction in the equity market has been caused by a number of factors: 1) concerns about the U.S. economy experiencing a double-dip recession; 2) an ongoing focus on the impact of potential sovereign debt default(s) in Europe; 3) uncertainty regarding monetary policy after the completion of the Fed’s quantitative easing program at the end of this month; and 4) the potential for a technical default by the U.S. should the debt ceiling not be extended by Aug. 2. In other words, we’ve hit some headwinds.

In Pressfield’s novel, Xeones is the sole survivor at Thermopylae and not only tells the story, but instructs the Persian king, Xerxes, about the philosophy of the Spartan mind. He writes, “Among the Lakedaemonians [Spartans], it is considered a matter of indifference of whom and in what the enemy consists. The Spartans are schooled to regard the foe, any foe, as nameless and faceless. In their minds it is the mark of an ill-prepared and amateur army to rely in the moments before battle on what they call pseudoandreia, false courage.”

In this month’s commentary, we’ll look at two specific data points causing concern about the U.S. economy – manufacturing and employment – and the resulting fear. The stock market correction started with downside surprises in these two key economic reports on the first and third days of June.

Here are the characters of our story today:

• The Spartans = your investment policy
• The foes = manufacturing, employment and fear
• The ill-prepared and amateur = those fleeing for cash

Foe #1: Manufacturing
On June 1, the Institute for Supply Management’s (ISM) manufacturing report, based on data compiled from purchasing and supply executives nationwide, showed that manufacturing in the U.S. grew at the slowest pace in more than a year. In addition, the ISM’s factory index fell more than projected - to 53.5 last month from 60.4 the previous month – bringing that index to its lowest level since September 2009 (Fig. 1).

While economic activity in the manufacturing sector expanded in May for the 22nd consecutive month, many casual observers wouldn’t know that based upon news articles published after the release of the report. An index reading above 50 signifies expansion.

The bear argument certainly looks like a formidable foe. The decline of 6.9 points is a 2.9 standard deviation downside event. For those statistically challenged, that means that of the 616 data points going back to 1960, this was the sixth worst. The month-to-month drop in the manufacturing index was the worst since 1984, and thus worse than any other drop during the recent great recession. The magnitude of the decline in the manufacturing index level was surprising based on consensus expectations. 

Two surveys released in mid June further revealed that manufacturing activity experienced a downturn in May. Both the Federal Reserve Boards of New York and Philadelphia’s May surveys showed similar trends in regional manufacturing activity. Both of their indexes reported the first negative readings since last fall: New York’s last negative reading was in November and Philadelphia’s was in October.

The severity of the decline in manufacturing activity in these regions was also far below analysts’ consensus predictions. In the New York survey, 25 percent of respondents – up from 11 percent in April – reported that business conditions had worsened. Optimism among those surveyed also fell, with more manufacturers expecting the economic environment to deteriorate rather than improve in the months ahead.

Demand for manufactured goods, as measured by the current new orders index in the Philadelphia Fed survey, showed a decline similar to that of overall manufacturing activity. Many of the firms surveyed reported declines in both inventory and unfilled orders.

Bulls counter that the ISM manufacturing index reading is still within the normal range for an economic recovery. Historically, when -2 standard deviation movements have occurred (the worst 2.5 percent of all reports), the average ISM manufacturing index reading six months later is 52.4. Of the 12 such occurrences, nine resulted in “expansionary” readings above 50. Furthermore, the S&P 500 has averaged higher returns over the ensuing six months than the average of all six-month returns going back to 1960. In other words, a drastic decline in the rate of expansion does not necessarily result in contraction, nor does such a downside surprise correlate to lower equity returns.

For sure, the growth may be tempered, but the extreme decline in just one month of data feels a bit more like a one-off. The lingering impact of the earthquake in Japan and a lag in demand due to surges in oil prices earlier this year may have played a role. At around 12 percent, manufacturing is not a primary component of GDP, but it is one of the most volatile.

Foe #2: Employment
Employment is to the current economic recovery what King Xerxes and his massive Persian army was to the Spartans: an epic adversary.

Only 54,000 non-farm jobs were added in May, far below what economists had predicted. May’s numbers were significantly lower than the previous three months; more than 200,000 jobs were added during February, March and April. Private payrolls for May came in at 83,000, the lowest number since last June (Fig. 2). Finally, the unemployment rate ticked up from 9.0 to 9.1 percent.

The reaction to May’s employment data was widespread disappointment. An unemployment rate above nine percent makes it difficult for Americans to ramp up spending. This helps explain why central bankers may keep interest rates low for the foreseeable future.

Furthermore, earnings improvements within the labor market have not been sufficient enough to keep up with inflation. Average hourly earnings rose a mere 0.3 percent during May. The average workweek of those involved in the goods sector of the economy rose to 40.9 hours, the highest level since July 2000, further confirming that businesses would rather work their current employees for more hours than hire additional workers. In sum, Americans are experiencing meager gains in hourly wages and are working longer hours for them.

The labor force participation rate came in at 64.2 percent for the fifth straight month (Fig. 3). That rate fell below 55 percent for younger workers, the lowest since January 1965 according to research firm Ned Davis. Bears argue, convincingly, that a stagnant or declining labor participation rate is a sign of deteriorating employment fundamentals.
Applications for unemployment benefits have also ticked higher. While fewer Americans applied for benefits in early June, applications have been above 400,000 for the past 10 weeks, indicating that while more employers are hiring, they aren’t hiring at a pace significant enough to put a major dent in unemployment.

Economists believe that a level of 375,000 or fewer unemployment benefit applications in a week signals sustainable growth in the job market. While applications were at that level for seven of nine weeks in February, March and April, they surged again in April to 478,000 – an eight-month high – and have stayed above 400,000 ever since (Fig. 4).

While few economists expect economic growth to decline – or the U.S. economy to fall into a second recession – at these rates, job growth and overall economic growth may seem like a mirage to many consumers.

The situation is most critical for the long-term unemployed, a group of 6.2 million consumers who have been out of work for six months or more. In this economy, the longer one is out of work, the longer it takes to reenter the workforce. As a result, the number of long-term unemployed is at its highest level since the Great Depression (Fig. 5).
 
Financial catastrophe has set in for the longest-term unemployed, who have run out of unemployment benefits. With Congress focused on deficit reduction, there’s no sentiment for extending those benefits, leaving the long-term unemployed at grave risk. The government has also revised job growth numbers downward for March and April. And although states are receiving more tax revenue than in the past, their fiscal condition is alarming, with many cutting jobs and services to balance their budgets.

The bullish arguments for employment hardly stand up to a Spartan shield and doru (spear). Employment growth in 2011 is ahead of last year’s pace. At this time in 2010, the private and public sectors had created a total of 662,000 jobs through May; in 2011, the total for that period was significantly higher. True, job creation did accelerate later in 2010, but job creation this year is already nearly two-thirds of the way to the entire 2010 total.

When breaking the numbers down by state, unemployment is declining in half of all the states as of May. While overall unemployment ticked back up to 9.1 percent nationally, 43 states and the District of Columbia have seen their unemployment rates drop in 2011. The most fortunate are those who live in North Dakota, which boasts a 3.2 percent unemployment rate, while the least fortunate are those in Nevada, where the rate is 12.1 percent.

Foe #3: Fear
When it comes to investing, fear is evident in two ways: through sentiment indicators and through downward revisions to economists’ and strategists’ economic and market forecasts.

Based on lower-than-expected economic data, sentiment views on the economy’s outlook have soured, signaling an erosion of confidence in the expansion. In fact, a Bloomberg gauge of economic expectations slumped to its weakest level since March 2009.

Both consumer and business confidence has dropped along with economic indicators (Fig. 6). The National Federation of Independent Business Small Business Optimism Index fell again in May after a drop in April. Of the small businesses surveyed, 25 percent stated that lower sales are their biggest concern, and many aren’t planning to hire additional employees in the near future.

In addition, 63 percent of those participating in the survey agreed with the statement that the current economic environment isn’t a good time to expand their businesses. Many are concerned about rising food and energy prices and the impact of potential inflation on their businesses.

The picture isn’t much rosier for consumers. In mid June, the Thomson Reuters/University of Michigan consumer sentiment index declined as consumers remained pessimistic about the stagnant job market and anemic wage growth.

Consumer spending is still hindered by the lagging housing market, high unemployment and slow wage growth. As a result, even though retail sales have been growing, they’re not growing enough to support robust economic growth. In May, after 10 straight months of increases, retail sales fell by 0.2 percent from April. However, sales were up 7.7 percent from the previous May. While a decline in retail sales is never welcome, bulls will note that the May decline was less than expected. Much of the decline between April and May was due to a decline in car sales. Overall, retail sales have increased 16.4 percent from their recession low and are now 2.3 percent above their pre-recession peak.

Along with many economists, the International Monetary Fund (IMF) cut its growth forecast for the global economy in mid June, citing Europe’s debt crisis and unexpectedly weak economic growth in the U.S. as the culprits. The IMF also blamed rising commodity prices, bad weather and Japan’s earthquake, tsunami and resulting nuclear catastrophe for unanticipated economic weakness. In its revision, the IMF lowered its 2011 U.S. growth rate projection from 2.8 to 2.5 percent and projected the 2012 growth rate at 2.7 percent.

What to Watch For
Research shows that economic recovery after a severe recession is often a slow and laborious process, and this recovery has certainly borne that out. It seems unlikely that the U.S. economy will slip back into a recession, but it is likely that the recovery will continue to be anemic and move in fits and starts.

Downside economic surprises, European sovereign debt, the upcoming end of quantitative easing II and political posturing over the U.S. debt ceiling have resulted in a market correction of about seven percent from peak to trough as of June 20. As a result, we have observed a significant uptick in investor anxiety, even more so than last summer’s double-dip recession concerns, and offer two points of reflection:

First, market corrections of this magnitude are normal. According to researcher Ned Davis, market corrections of five percent or more occur, on average, seven times per year. The current correction is the second of the year.

Second, many clients whom we have recently spoken with are surprised to learn that the actual market volatility during this correction is substantially less than the correction last summer and 12 percent less than the 20-year average.

Odds are it would take a significant economic shock – such as a major spike in inflation, the default of several of the weaker eurozone members, a prolonged lack of agreement in Washington over the debt ceiling or a banking crisis – to wrench the economy off the track.

Where We Are Headed
We believe growth will bounce back just enough later this year that we will avoid another recession. The recent retreat in commodity prices may ease inflationary pressures felt among gas and food consumers. And the Fed's monetary policy is likely to remain accommodative until the economy shows more signs of strength.

Keep in mind that while recent economic reports came in far worse than expected, much of the data remains at levels indicative of at least moderate growth. Deleveraging continues, placing a cap on GDP growth.

With the yield on the 10-year U.S. Treasury back below three percent and the Fed on hold until sometime in 2012, investors may want to use the recent correction as an opportunity to rebalance their portfolio holdings back to their long-term asset allocation targets. In many cases, this will mean reallocating from bonds and cash to equities. Specifically, despite bottoms-up analysts expecting continued strong growth in corporate profits – which we view as perhaps too rosy – valuations on U.S. equities are still attractive.

For the author of Gates of Fire, the Spartan defense at Thermopylae was more metaphorical than literal. How do we deal with adversity? The Spartans worried first and foremost about their own preparation: “Let the foe…come in elite unites or hordes of shrieking rabble, crack citizen regiments or foreign mercenaries hired for gold. It made no difference. None was a match for the warriors of Lakedaemon, and all knew it,” writes Pressfield.

The Spartans equipped themselves with their shield; they never went into battle without it. Nor should investors deploy their capital without the protection of an investment policy. A shield did not guarantee protection from harm, but it drastically improved the odds. Likewise, an investment policy aligned with long-term objectives serves as protection against the onslaught of economic data and attention grabbing media reactions thereto. As economists and strategists raced to downgrade expectations, the Spartan investor stood ground with conviction in their preparation and long-term policy resolve.

An astute and well-rounded reader will point to the fact that all 300 Spartans perished at Thermopylae. Yes, but the battle allowed the Greek armies to later defeat the second Persian invasion. As long as we have a long-term financial objective, there will always be losses along the way. The ability to make a stand with their investment policies separates the successful investors from the rest. 

Christopher Bremer is the Director, Private Client Services Portfolio Management with The Northwestern Mutual Wealth Management Company. The opinions expressed are those of Christopher Bremer as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.

Northwestern Mutual Wealth Management Company, Milwaukee, WI is a subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and a limited purpose federal savings bank authorized to offer a range of financial planning, trust, fiduciary, investment advisory and investment management products and services. Securities are offered by Northwestern Mutual Investment Services, LLC, subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. Bond or debt investors should carefully consider risks such as interest rate risk, credit risk, securities lending, repurchase and reverse repurchase transaction risk. Greater risk is inherent in investing primarily in high yield bonds. They are subject to additional risks, such as limited liquidity and increased volatility. There is an inverse relationship between interest rates and bond prices. Government debts are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest when held to maturity.

Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss. All index references and performance calculations are based on information provided through Bloomberg, a provider of real-time and archived financial and market data, pricing, trading, analytics and news.

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