Health, Myths, Fraud and the Crisis

* *August 2010* **

My view is that the economy is going through a temporary lull and business
conditions will improve later this year and in 2011.  Europe may be an
example.  When the financial crisis hit and the markets were worried that
“contagion” from a possible Greek default would not only put Europe into
recession, but spread to other parts of the world, austerity programs were
announced by many countries and they were expected to reduce demand
seriously.  Now the European recovery seems to be continuing, exports are
strong and the surprises are occurring on the favorable side.

The Bank of England monetary policy committee recently warned that economic conditions “deteriorated a little,” but Britain impressed economists there with a 4.5%
increase in second quarter gross domestic product.  Business confidence in
Germany rose to the highest level since reunification.  Both services and
manufacturing were up in Britain.  Exports led the way in Germany.  While
there is some criticism of the stringency of the methodology, the fact that
most banks in Europe came through their “stress tests” well has bolstered
confidence on the continent.  Could that happen in the United States as
well?  Or is it only a temporary favorable phase in Europe?

In preparing this essay I used research from Goldman Sachs, Lord Abbett,
Credit Suisse and International Strategy and Investments for arguments on
both sides of the double-dip issue.  Credit Suisse has an eight-factor model
that puts the odds of a double-dip at zero.  Even I wouldn’t go that far.
At the beginning of the year I thought that one of the most important
positives in the U.S. economy was the consumer.  The savings rate during the
recession had only risen to 6.5%, not the 10%–12% of 1973–74 or 1980–82.  I
believed that the American culture had shifted from thrift to consumerism
and once workers began to feel their jobs were secure they would start
spending again.  The savings rate has dropped to something over 3% now and
shoppers have returned to the stores.  Until May personal outlays were
running at a 4.2% rate of expansion, but they then slowed to 2.4% and that’s
when everyone started to get concerned because the consumer is 70% of the
economy.  Personal income actually improved in May; it rose at a 5.4% annual
rate compared with 4.4% during the previous six months, so spending should

The poor housing data may have been caused by the first-time homebuyer tax
credit which expired in the spring and caused those wanting to purchase a
home to make their decision early in the year.  The inventory of unsold
homes has dropped from 13 months to eight months and the median sales price
has risen 5%.  Housing should improve from here.

In spite of low capacity utilization rates, capital spending plans have been
a favorable aspect of the outlook.  Shipments have been rising at a 3%
annual rate, but new orders during the April–May period were running at an
annual rate of 48% compared with 25% during the previous twelve months.
Inventories are still being rebuilt, albeit at a slower rate than last year,
and exports have been running 17% ahead of 2009.  Imports are strong as
well.  The disappointing industrial production data for June may be a result
of the exceptionally strong report for May.  While the Purchasing Manager
Index dropped to 56 from 60, any number in excess of 50 indicates the
economy is expanding.

The outlook continues to be confused by mixed signals.  While the leading
indicators are showing weakness in the economy, the strength in copper
prices is encouraging.  Blackstone’s own experience with its private equity
and real estate investments may be helpful here.  Most, but not all, of our
companies are reporting improving business conditions and our hotel
operations are experiencing a notable increase in occupancy.  These are not
conditions indicative of a coming double-dip.

There is a great deal of hand-wringing going on about China.  The worry is
that overbuilding of both residences and offices will result in a sharp
slowdown in the economy there.  This is important because so much of the
world growth in 2010 is coming from the developing countries and China is
the most important factor among them.  In July I spent a week in China
visiting companies with my friend the hedge fund manager Richard Chilton and
members of his New York and China based team.  We saw companies ranging from
consumer goods and services to technology, property and utilities.  My
conclusion is that China will grow this year and probably beyond at
high-single-digit rates and the real estate situation, while representing an
excess at the high end, is not likely to seriously impair economic
expansion.  Chinese authorities do not want growth to exceed 10% because of
inflation fears and have imposed both fiscal and monetary restraint to
dampen the expansion.  In contrast to U.S. homebuyers, Chinese buyers of
residences generally put up 30%–50% of the purchase price and more for
second homes and 100% for third homes.  China does not have a culture of
equity investing so the purchase of second and third homes is an important
investment alternative for many.  Institutional Strategy and Investment
believes that China is actually short five million housing starts a year.
This is in sharp contrast to a rumor circulating recently that there are 65
million vacant residential units overhanging the market.  The most
surprising observation of the trip was how many companies are focused
primarily on the Chinese market itself.  Five years ago when this group
started making these trips the focus was on exports to the West and other
parts of Asia.

The factors that argue against a resumption of the recession are the strong
liquidity position of corporations which have 6% of their assets in cash, a
level not seen since the 1960s, and the fact that both housing and autos are
at low levels of production and not likely to drop further.  Corporate
profits are extremely strong, interest rates are low, companies are in great
financial shape, houses are at record affordability and companies need to
continue capital expenditures to remain competitive.  So the stage is set
for a better economy later this year.  Perhaps employment is the key.  As
long as the unemployment rate stays above 9%, investors will continue to
worry about a double-dip at worst or a jobless recovery with sluggish
consumer spending at best.  But there is good news here as well.  Initial
unemployment claims are generally moving lower (not every week) because the
auto plants are not closing down and the government has laid off the last of
the Census workers.  Hopefully business can start to think positively about
the outlook and replace some of the temporary workers with permanent
employees and productivity can come down to a reasonable level.  Right now
productivity is too strong, indicating that the demands on the existing work
force are too great.  If unemployment could move into the 8% level,
confidence would improve and the economy could start to build some momentum.


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