With the US equity market now having staged the strongest of its several post-bubble snapbacks, there is growing conviction that the long nightmare is over. Financial markets are beginning to discount the time-honored magic of a full-blown cyclical recovery -- an upturn that is presumed to eliminate the risk of deflation and underwrite sustained momentum on the earnings front. I remain highly suspicious of this macro verdict. Here’s why.
When all is said and done, this boils down to a classic policy bet. Conventional macro has always hinged critically on policy levers. And America’s authorities have been unusually aggressive in manipulating those levers in the past two and a half years -- 550 bp of monetary easing and two large fiscal packages from the Bush administration that have taken the federal budget from a surplus of 2.3% of GDP in 1Q00 to a deficit of 2.6% in 1Q03 (as stated on a national income accounts basis). All the macro textbooks are unanimous in translating this stimulus into cyclical revival. The key assumption in this framework is that the US is in a classic business cycle environment, where policy multipliers work as they normally do -- albeit with the usual caveats of long and variable lags. The major difference between my view and this consensus prognosis is that I do not believe this is a classic business cycle climate. In my view, it is anything but. I continue to believe that America is in the midst of a unique post-bubble business cycle, where standard policy multipliers are largely dysfunctional -- having all but been neutralized by the excesses of the past eight years.
What do the markets see that I don’t? That’s an impossible question to answer with any objectivity. After all, the “truth” -- if there is such an animal in the macro debate -- is always in the eyes of the beholder. With all due respect to the loyal opposition, the bullish case for the economy does not exactly rest on the most credible of evidence. The key indicators that appear to be supportive of the so-called imminent upturn are largely “soft” expectational data from tiny samples of economic actors. The widely followed purchasing managers’ surveys of manufacturing and nonmanufacturing activity are cases in point; collectively, these surveys cover the sentiment of only 770 respondents -- 400 in manufacturing and 370 in nonmanufacturing. According to the US Census Bureau, in 1997 there were some 363,753 manufacturing firms in the US and some 6.0 million nonmanufacturing establishments. The manufacturing sample of purchasing managers is small, but nevertheless of acceptable statistical size. By contrast, the nonmanufacturing sample covers only 0.0001% of the full universe of companies -- a coverage ratio that wouldn’t make the first cut in an elementary statistics course.
Let the record show that the more reliable of these two barometers of purchasing managers’ sentiment -- the manufacturing PMI -- rose to only 49.8 in June. Not only did that meager gain fall short of consensus expectations (51.2) but it paints a picture of still-sluggish industrial activity that has yet to break into the expansion mode, which is generally considered to be north of the “50” threshold. The nonmanufacturing PMI did surge to 60.6 in June -- more than 5.5 index points above consensus expectations; this increase was widely cited as a key reason why the markets should ignore the all-important June labor market surveys. While such a pop seems encouraging on the surface, I must confess that I have long been suspicious of the integrity of this series. First of all, it has only been in existence since mid-1997 -- making this its first cyclical experience; in addition, as noted above, its coverage ratio is of America’s vast services sector is ridiculously small. Other expectations data are also painting a relatively flat picture of the US economy. That’s especially true of the University of Michigan’s consumer sentiment survey -- the most reliable of the various gauges of household psychology -- which actually slipped a bit in June, falling 2.4 index points below the May reading and remaining nearly 3 points below its year-earlier reading.
Meanwhile, the incoming “hard” data on the economy continue to be generally disappointing. That’s especially the case with respect to the June labor market surveys -- long the most important data point of any month. Nonfarm jobs fell (-30,000) instead of rose (+ 10,000 by our estimate) and the job count was revised downward in previous months; as an aside, in contrast to the purchasing managers’ surveys, which cover only 770 manufacturing and nonmanufacturing companies combined, the payroll survey covers some 160,000 business and government establishments. At the same time, the national unemployment rate shot up sharply to 6.4% in June (versus a consensus estimate of 6.2%) -- painting a picture of mounting distress for American workers (also known as consumers). Finally, the more timely high-frequency weekly jobless claims data show no sign whatsoever of any subsequent improvement in labor market conditions; new filings continued to drift up in early July and continuing claims had risen to 20-year highs at the end of June.
Moreover, incoming flow data on actual expenditures are mixed, at best. In sharp contrast to consensus expectations, capital spending trends remain especially disappointing. New orders for nondefense capital goods (ex aircraft) fell by 0.5% in May -- a second consecutive monthly decline -- and nonresidential construction activity fell for a second month in a row in May and for the third time in the past four months. At the same time, both residential and public construction trends have trended downward over the March-April period. In fact, the only meaningful gains in the monthly flow data have come in real personal consumption, but the bulk of the increases in consumer spending in April and May are traceable more to falling prices than to a resurgence of nominal expenditures.
Most economists are urging an increasingly bullish market consensus to look through the still-weak flow data. They are widely construed to be “backward looking” -- lacking the predictive capability of purchasing managers’ and other sentiment surveys. I have my doubts. The problem with this interpretation, in my view, is that it’s getting old. While each month we are told that the forward-looking soft data are getting better, those claims have not been validated by subsequent outcomes from the hard data; by contrast, the US economy has continued to hover on a subpar 1.5% real GDP growth path for the past three quarters, and there are no credible signs that the long-awaited second-half upturn is now under way. Maybe that is now about to change, but then again, maybe it’s not. Given the ongoing sluggishness of the hard data, the burden of proof continues to rest on the growth optimists, in my view.
As measured by the S&P 500, the US stock market had risen some 26% from its March 11 lows before slipping about two percentage points over the past couple of weeks; at its 17 June high, that run-up went about six percentage points further that the four previous post-bubble rallies, which averaged about 20%. I am beginning to worry that since the current rally has now distinguished itself from the previous false starts, market spin is starting to take over in driving perceptions of underlying economic activity. That’s exactly what happened in the late 1990s, when the bubble gave rise to a constant stream of “new wave” interpretations of the New Economy. And it may well be happening again today, as the sharp recent rebound in the stock market appears to have shifted the emphasis from hard to soft data. This time, it’s policy stimulus that is presumed to make a difference. But 550 bp of monetary easing and nearly five percentage points of fiscal stimulus later, the consensus call for a vigorous recovery remains nothing more than an unsubstantiated forecast. In my view, the issue of policy traction remains as contentious as ever. Yet try telling that to a stock market on the mend. To me, this is all starting to have an eerie sense of déjà vu.
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