We were rather intrigued with the following quote from Bridgewater Research, via John Mauldin’s weekly newsletter. We definitely think they are on the right track.
“Normally, labor markets lag the economy because incremental spending transactions are financed via debt, stimulated by interest rate cuts. But as long as credit remains frozen, spending will require income, and income comes from jobs. And debt service payments are made out of income. Therefore, in a deleveraging environment job growth becomes an important leading, causal indicator of demand and other economic conditions.
“… The bounce in the economy and the stabilization in markets reflect government actions that are big enough to impact near-term growth rates, but are not sufficiently directed at the root problem of excessive indebtedness to produce permanent healing. The deterioration in employment markets will continue because companies’ profit margins are so deeply damaged that a little bounce in growth won’t do much to alter their need to cut costs. This deterioration in labor markets will undermine demand and continue to pressure loan losses, which will keep the pressure on the banks and elevate the cost of capital for tentative borrowers, inhibiting credit expansion.”
So Bridgewater (and Mauldin too) are right to say that anyone who is telling you that recovery is near because employment lags, has it backwards. Bridgewater also has it right about weak profit margins; as this chart says, profits for the S&P 500 are down 90% year over year (h/t ritholtz.com).
If we understand Bridgewater’s thinking, they are telling us that employment lags during a “normal” recession that happens when the Fed tightens to head off inflation. The recovery from such a recession begins when the Fed gets around to cutting rates after it has accomplished its objective. We assume they are saying, that hiring would lag interest rate moves (and the economic recovery generated thereby) in such a scenario. And Bridgewater is saying, correctly, that this is a very different kind of recession, a recession caused by an overabundance of debt and the need for deleveraging in the private sector. In this recession, layoffs are actually helping to drive the recession forward rather than the other way about. Furthermore, interest rates are already at rock bottom and the low rates are failing to stimulate the real economy, because no one dares borrow, assuming the banks would be willing to lend in the first place.
We just feel at pains to make two obvious missing points. First, employment always lags the cycle because of normal business behavior. After all, when recovery starts, the first thing companies do to meet new demand is to ask existing workers to put in more hours. Only when employers are convinced that the rebound is for real, will they start new hiring. So… employment should usually lag changes in GDP, all other things being equal, no matter what the cause of a recession is.
The other point we would like to make is that the home mortgage interest rate reset problem has not gone away, and we can expect resets to force foreclosures on an ongoing basis for borrowers who can’t refinance. This in turn will continue to dump more distressed inventory on the market, provide more pressure on the banks, and keep housing starts depressed. We won’t really be finished with the bulk of mortgage resets moving through the system until 2012. And let’s not think about how brutal those reset rates could be, if the Treasury is forced to pay higher rates to place all the debt it will be issuing….
In this kind of environment we are left to scratch our heads when we wonder what can turn things around. The stimulus program should help some, and it is important to remember that it has not kicked in yet; only $100 billion or so has even been allocated. In addition we know that when consumer durables such as automobiles get old or wear out, people eventually have to replace them. The Calculated Risk blog claims that current rates of auto production would only suffice to replace the current US fleet in 27 years. Surely production will have to rebound from this level, right?
Most likely, but not so fast. After all, in our country, passenger vehicles outnumber licensed drivers. In a recession that is likely to be deep and prolonged, with people changing their spending habits, is it possible that the car population might actually drop in absolute terms as people scrap “extra” vehicles and don’t replace them? Or, less dramatically, could we see the ratio of cars to people drop as more families make new teenage drivers share an existing family car or pay for their own vehicle? We think both scenarios are possible. We like the idea of consumers returning to their senses, but we think we are just beginning to understand how that will look. Other than unpleasant for the economy, that is.