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Brusca: Economic Signals Worsen

By Robert Brusca

Chief Economist, Ecobest Consulting

Jun 10, 2001 08:00 AM

Lately, a consensus has formed among investors and economists that the Federal Reserve is about to slow down its rate-cutting efforts. Fed officials have dropped a couple of hints, but we have no way of knowing for sure, and there's certainly been no formal announcement. Right now, the Fed is like a car in the fast lane, its turn signal on - it might change lanes and slow down, or it might just keep going, flashing us all the way.

Let's assume the turn signal means something. Is this good news for investors? Would less Fed easing mean that the economy has hit bottom? Would it mean that the economy has actually turned the corner?

I would answer a categorical "no" to all three questions. If the Fed slows down, it will do so because it thinks further rate reductions will exert little economic influence. Once someone dives off the high dive, it's too late to start pumping more water into the pool. The Fed is aware that the economy will do what it will do for the next couple of quarters - regardless of any Fed efforts.

Any monetary easing at this point will not affect the economy until late in the year or early next year. By then, the effects of past rate cuts will be running full bore and tax cuts will be taking hold. We are at - or near -- the end of the window for constructive monetary-policy easing. From here on out, the Fed will be more wary of going too far on the back of what it already has done and on top of the tax-cut effects that are now on the way. Given that stocks trade off current earnings reports and corporate guidance, stock prices remain at risk to any emerging downdraft.

New Risks: Just as Fed Governor Laurence Meyer, earlier this week, was talking about taking a more "calibrated" Fed approach, another Fed governor, Edward Kelly, as well as the Minneapolis Fed district bank president, Gary Stern, were warning about new inventory problems. Kelly sees the downside risks to the economy as still quite evident. Stern, while wrapping his statements in the mantle of "uncertainty," noted that we could have a "second inventory correction" if consumer spending were to slow.

And what happened this past week? Chain-store sales figures came up quite short. Of course, if consumers slow down, inventories will accumulate. But the really ominous news is how little the inventory-to-sales gap has been closed by all the inventory cutting that we have seen so far. Inventory-to-sales ratios are still well above their pre-cycle lows. For most industries, sales continue to fall faster than inventories. Pressure is still on and could get worse.

Are We In A Recession? The ongoing surge in jobless claims is evidence that the forces of recession are spreading. One disturbing factor is that, over the past 35 years, every time claims have surged as they are now, we have had a recession. And conversely, in every recession, claims have surged as they are now. Jumping jobless claims are a very robust indicator of recession: They reflect a very broad picture of the economy and they are very timely. When they rise substantially over a sustained period of time, that is an ominous signal.

Technically speaking the two 50,000-plus increase in claims over a period of three months for the data reported in May and April are the signals that say recession is here or coming soon. The reliability of this signal is undisputable. Questions remain, however, about just how much more weakness lies ahead.

New Economy To the Rescue? Maybe Not: The new economy will not rescue us from this downturn. In fact, the downturn largely springs from the new economy. Oh, yes, the Fed hiked rates, and there are those surging and pesky energy prices. Did I forget to mention those past drops in stock prices? But the slashing of capital spending is a high-tech phenomenon.

Moreover, since the new-economy effect began to kick in, there is strong evidence that the goods and services sectors became more closely linked rather than more independent. In recessions prior to 1990-91, the goods sector would lose jobs rapidly and services job growth would just surge right ahead. But by 1990, things had changed. Manufacturing firms had gotten better control of inventories. As a result, the 1990-91 downturn did not result in as rapid a downshift in goods-sector job creation. But services jobs evaporated more quickly than ever before in that downturn.

We are now left to wonder if all that "fat trimming" in the manufacturing sector has simply offloaded workers to the services sector who will now feel the brunt of an economic slowdown when it comes. That is why the current drop in manufacturing jobs and the ongoing inventory problem loom as even bigger risks than most appreciate. The goods sector is taking services down with it as never before.

Recession Risk: Some investors wonder if the service sector can hold things together while the capital-goods cutbacks occur. These new trends in job growth suggest that it can't. The new relationship suggests that things may get much worse. No rescue from the new economy here, folks.

Oh, things eventually will pick up, but not as soon as most investors hope. It will take time. The next saucer you see won't be a flying kind. It will be on graph paper and it will depict the shape of the economic downturn and recovery. The real risk is that the recession will be V-shaped, and not because of a strong recovery period so much as because of a much deeper trough than most commentators expect. The darkest hour is preceded by the darkest minute. Watch the weekly economic data closer than ever.

-- (M@rket.trends), June 10, 2001