The Commerce Department reported that GDP rose at an annual rate of 1.9% in the 1Q, up from the previous estimate of 1.4%, about in-line with expectations.  That followed growth of 2.4% in 2002.  The Consumer Confidence Index which leaped from 61.4 in March to 81 in April rose again in May to 83.8 but consumer spending declined.  Unemployment remained at 6%.  The economy continues to grow but it is a slow recovery.

To many, this economy feels more like it’s still in a recession rather than in a recovery.  Some have coined it the “jobless recovery.”   There is a reason for this.  Worker productivity is increasing faster than the demand for goods and services.  As a result, companies are able to cut their workforces even though the economy is expanding.  In this issue, we will look at the reasons for this trend and why it is bad in the short-term but very possibly good in the long-term.

Stocks are bumping up against overhead resistance as this letter is written.   It remains to be seen if they can break out this time.  BCA believes they will and that we could see stocks rally, generally speaking, for the next 6-12 months.  They are not predicting a powerful bull market, but they expect the rally will be worth participating in.

BCA also believes that bonds are due for a fall, especially Treasury bonds.  Bonds have been an increasingly popular place for investors to go over the last two years.  Historically, Treasury bonds have gone down when the economy recovers, and BCA believes this time will be no exception.  They say, “The bottom line is that Treasurys are very risky at these yield levels and we recommend below-average positions.  Speculative-grade [high-yield]corporates offer the best value because spreads should narrow further in line with improving corporate health.”   [Emphasis added, GH.]

Speaking of that...Capital Management Group, our recommended bond timer, is on a roll this year!  As this is written, CMG is up 12% in their regular program and 18% in their leveraged program (net of all fees and expenses).  I strongly suggest that you consider this outstanding program if you have not already.    Niemann Capital Management, Potomac Fund Management and Hallman & McQuinn are all up nicely this year as well.

Editor’s Note

The following discussion is largely a summary of some excellent economic analysis published recently by  Jon E. Hilsenrath of the Wall Street Journal.  Like most of you, I trust, I have not fully understood why this recovery still feels like a recession, but now I do.  In this issue, I will try to explain.

Recovery Or Recession?

To hear the gloom-and-doom crowd talk, you would think we never came out of the 2001 recession, and that we’re headed for a depression.  Of course, that’s what they’ve repeatedly promised for the last 25 years that I know of.  Admittedly, this recovery is not robust, but we are not in a recession.

So what is a recession, anyway?  The widely accepted definition of a recession is two or more consecutive quarters of negative growth in GDP.  Here are the GDP numbers for the last two years:

As noted on page 1, GDP expanded at an annual rate of 1.9% in the 1Q of 2003.

As you can see, the recession occurred in 1Q-3Q  of 2001, and we have been positive for the last six quarters.  So, why doesn't it feel like a recovery?  Why does unemployment keep going up?  Why are people having so much trouble finding jobs?

Why, In A Recovery, Is
Unemployment Still Going Up?

In the 4Q of 2001, consumers were spending more and economic output was rising, despite the 911 attacks on the US.  Since then, GDP has been in positive territory, as noted above.  Yet instead of expanding employment, companies are continuing to shed jobs at a furious pace - 525,000 non-farm payroll positions in the past three months alone.  Since early 2001, when the recession began, the U.S. economy has lost 2.1 million jobs, even though the economy, as measured by GDP growth, has been positive for six consecutive quarters.

The total number of people unemployed, including discouraged workers who would prefer to work but have stopped looking, is apprx. 9.2 million.   And the number of people who are working part-time because they can't find full-time work is 4.8 million, up 46% since 2001, according to the Bureau of Labor Statistics.  These are BIG numbers!

As Jon Hilsenrath points out, this slow economy has left behind a remarkably broad swath of workers -- from young to old, and from high school dropouts to the highly educated, even as the economy has started growing again.  Why is this happening?

Structural Change In The Labor Market

Across almost all industry sectors the trend is toward higher efficiency.  The labor market is undergoing a structural change, with most industries, from manufacturers to financial firms to airlines to hotels, adjusting to a new economic order after the boom of the late ‘90s.  Growing competition from abroad, slow growth at home and a relentless push for productivity are driving this change.  Yet this is not altogether a new phenomenon, actually.  Recessions have historically forced many industries to change how they operate.

But what is surprising economists is the fact that the current restructuring in the labor market is so harsh, especially considering that the recession in 2001 was a mild one, historically speaking.  Most economists predicted that the unemployment rate would peak and begin to fall last year.   Yet only recently has it climbed to 6%.  (We should keep in mind that 6% unemployment is still relatively low - more on this later.)

Economists are not only surprised at how long this restructuring is taking, but also how broad-based it is.  Very few industries are not feeling the pinch.

Laid Off Workers Don't Get Called Back

Erica Groshen, a labor economist with the Federal Reserve Bank of New York, recently studied employment trends in 70 industries over the past 30 years. She found that the structural change is vast.  She said:

“Before in a recession you had a lot of companies giving people temporary layoffs, saying, ‘We’ll call you back when we need you.’   That is not what firms do anymore.  During recessions in the 1970s and 1980s, about half of all jobs were in industries that tended to go through cyclical swings.”

When Ms. Groshen refers to “cyclical swings,” she is pointing to industries which periodically or occasionally see their business slow down.  During those periods, workers were laid off, but many of them would be called back as soon as business picked up again.  Groshen found that during the ‘70s and ‘80s , apprx. half of laid off workers were called back, while about half experienced permanent changes, meaning that jobs which were eliminated were never meant to come back.  So, half and half - part temporary layoffs and part permanent ones.

Yet this trend began to change radically after the last recession in 1990 and has intensified since then. Today, it is estimated that at least 75% of jobs are in industries going through a structural change - meaning that companies are reducing employees as a result of increasing productivity - on an employee-by-employee basis.  In other words, because worker productivity has increased so dramatically, workers who choose to leave or are laid off or are fired for poor performance, are not being replaced.  Their work is simply being taken over by existing employees.

The Jobless Recovery

As discussed just above, companies around the US have been in a transition.  Whereas in the past they would temporarily lay off workers, many are now reducing their workforces permanently (or at least for the foreseeable future) and cutting their payrolls. 

The result:  Payrolls in the electronics sector, and for producers of industrial equipment, have declined for 28 straight months.  In communications, payrolls have fallen for 24 months.  In the securities and airline industries, they have fallen in 16 of the past 24 months.  These are just a few examples.

In many ways, the latest rise in unemployment is the downside of a technology and productivity boom that developed during the 1990s.  We all know how much technology has advanced over the last 20 years.  Productivity per worker has exploded as well.  Over the last two years, this trend has accelerated, even as the economy has slowed significantly.  This is the key.

The Bottom Line

The bottom line is, worker productivity has been growing faster than the overall economy. That has allowed corporate executives to meet increases in demand while still eliminating jobs.  This is very unusual as you can see in the following chart.

Worker productivity historically increases in the early stages of a recovery, but this time the mismatch between productivity and overall economic growth is unprecedented.  There have been 10 recessions since 1949, including the recession in 2001.  In the recoveries following eight of those 10 recessions, demand grew faster than the increase in worker productivity.  Usually, demand far outpaced worker productivity.  The result: Unemployment actually declined, and more people went back to work following the eight recessions from 1949 to 1982.

However, following the 1991 recession, which was also relatively mild, demand and worker productivity increased at about the same rate.  But as noted above, worker productivity has exploded since then.  Here are the numbers for the latest recession:

GDP (demand) has expanded at an average annual rate of 2.7% since the 4Q of 2001.  Yet during the same period, the productivity of the nation's work force (defined as output per hour of work) has expanded at a much faster rate of 4.2%.  End result: higher unemployment.

Some Unusual Unemployment Demographics

Hilsenrath quotes more interesting statistics.  In the past, recessions tended to have the greatest impact on less-educated workers and younger workers. But in the 2001 recession and since then, the effects on unemployment have spread out across so many industries that they have created a broader class of job market casualties.  Age is no longer a significant distinction.  Also, well-educated workers, used to being sheltered in a slump, have been hit hard.  Probably everyone reading this has well-educated relatives or close friends who have lost their jobs as a result of the labor restructuring.

For example, in the last three years, the unemployment rate for college graduates over 25, who enjoyed the lion’s share of the economy’s gains during the 1980s and 1990s, has risen by 1.6%,  not much less than the 2.1% increase for high school dropouts.

Many educated workers were concentrated in industries that were hit the hardest by the downturn, such as technology and finance.  The unemployment rate for computer scientists and mathematicians rose from 0.7% in February 1998 to about 6% at the end of 2002, according to research by the Economic Policy Institute.

Longer To Find A Job

For the millions Americans who are now unemployed, the protracted nature of this labor restructuring means it has been excruciatingly difficult to get work again.  For some, job searches are dragging on long after their unemployment benefits have expired and they have plowed through their savings.  In the last year, nearly 2.8 million people exhausted their unemployment benefits.  Many others are scrambling in ways that don’t get picked up in unemployment statistics.

Educated workers seem especially prone to bouts of long-term unemployment in this downturn.  Hilsenrath found that of the 1.9 million workers who have been unemployed for six months or more, one in five is a former executive, professional or manager, according to a study by the National Employment Law Project, a nonprofit advocacy group for the unemployed.  Because these workers have specific, often technical, skills it is often harder for them to find a job that matches those skills.

Many people are being forced into taking lower-paying jobs, while others are going back to school to learn new skills and still others are becoming independent consultants and picking up small projects when they can.  One problem with today’s long bouts of unemployment is that the longer an individual stays out of work, the more likely he or she is to take a new job at a much lower salary.  This is all a part of the unusually long labor restructuring.

Manufacturing Moves Overseas

Permanent job losses in the US are also due to the increased competition created by the globalization of the economy.  Not only do many companies cut their workforces in the US, globalization has forced many companies to actually close plants in America and move them to places such as Mexico, China or India, where labor is much cheaper.  While this is not a new phenomenon, the trend has accelerated in recent years.

Many people believe this practice is un-American, and that many corporate executives are heartless and greedy.  Yet in many industries, corporations have had no choice but to move their manufacturing operations to countries where labor is cheaper.

So, in addition to increased worker productivity - fewer workers doing more work - the unemployment problem is further exacerbated by the globalization of the economy.  As a result, millions of workers are forced to leave shrinking industries and move into others where jobs are available.

The Solution:
The Economy Has To Grow Faster

The obvious solution to the unemployment problem is for demand to increase so that the economy can grow at a faster pace.  As noted above, the economy has grown at an annual rate of 2.7% since the 4Q of 2001 when the recession ended.  Yet unemployment has risen from 5.8% at the end of 2001 to 6%. 

Different economists have different estimates on how fast the economy would have to grow to stop the rise in unemployment.  Many believe that a 3% rate would stabilize unemployment, and most agree that a growth rate higher than that would actually begin to reduce unemployment.

Hilsenrath quotes Harry Holzer, a labor economist at Georgetown University, who says, “If you want people to have jobs, your demand-side growth has to be much stronger.  The nation would need a 3.5% growth rate in GDP for the unemployment rate not to get worse, but 3.5% is looking optimistic for this year.”

Professor Holzer may be correct in suggesting that a 3.5% growth rate in GDP is optimistic for this year, but we may yet be surprised.  The June issue of The   Bank Credit Analyst, for example, is even more positive than their May issue.  I will summarize BCA's latest analysis and advice for you in the pages that follow. 

Good Long-Term, But Bad Short-Term

Most economists agree productivity growth is good for workers over the long-run, because it tends to lead to higher wages.  But in the short-run, it is creating a problem in higher unemployment.  In the long-run, this weeding-out of less efficient companies will be a good thing, but in the short-term it is a painful adjustment.  This is how we have ended up with a “jobless recovery,” at least so far.

Conclusions

This recovery feels like we’re still in a recession, even though GDP has been positive for the last six quarters.  The reason is that worker productivity is increasing faster than the growth rate in the economy.  As a result, corporations continue to eliminate jobs.

This has happened due to the enormous technology boom which has occurred over the last decade and continues today.  Workers are so much more productive today that companies can cut back and/or not replace workers who leave, thus causing unemployment to go up.

 As noted earlier, the 6% unemployment rate is relatively low, historically speaking.  Actually, at 6%, the unemployment rate is only a little above its average of 5.6% during the past 55 years.  In 1982, in contrast, unemployment swelled to 10.8%.  In 1992, it reached 7.8%.  Nevertheless, the loss of 2.1 million jobs since the recession began in early 2001 is very significant.  At least we now know why.

The good news is that the economy is recovering, albeit slowly at this point.   Consumer confidence is rising and hopefully, consumer spending will continue to increase, although it did not in April.  As noted above, if the economy can get back to a 3% or better growth rate, unemployment should peak and begin to fall slowly.   Obviously, we are not there yet, but I believe we’ll get there.

Predictably, the Democrats are blaming Bush for the rise in unemployment.  The Republicans, of course, blame Clinton.  But as we now know, the boom in technology is primarily responsible for the recent mild rise in unemployment.  It probably would have  happened no matter who was in the White House.  Keep that in mind as the campaign unfolds.

BCA’s June OVERVIEW

“Highly stimulative policy conditions should ensure a recovery in U.S. economic activity in the quarters ahead. Nevertheless, the Federal Reserve may ease by another 50 basis points if the next round of data reports are soft.

[Consumer] prices will remain under downward pressure for a few more months, but the odds of a sustained deflation are slim. Indeed, the classic preconditions for increased inflation are in place.

The cyclical prospects for equities are reasonably bright. Valuation excesses have been unwound, earnings are improving and the liquidity environment is very positive. We recommend slightly above-average weightings.  [Emphasis added.]

Treasurys are very risky at current low yields and below-average positions are warranted. The only decent values left in bonds are in speculative-grade[high-yield] corporates.  [Emphasis added.]

The dollar bear market is due for a pause. However, a further significant decline is in prospect on a cyclical basis.”

BCA’s Specific Analysis

The BCA editors go on to say the following in their detailed June analysis:

Policy is Firing on All Cylinders.

The U.S. policy environment could hardly be more stimulative. The Federal Reserve has the monetary gas pedal to the floor, another major fiscal injection is on the way, and the dollar is falling sharply.  Financial markets are providing an additional boost with Treasury yields falling to 45-year lows and equity prices creeping higher.

Policy reflation should ensure that the pace of economic activity picks up during the remainder of the year and into 2004. Current fears about deflation should gradually subside and the Treasury bond bubble will deflate [burst].

As we discuss more fully in a companion report published this month, ‘ America, Inc. 2003 Annual Report,’ there is too much gloom about the U.S. outlook.  Fears that the U.S. faces a Japanstyle liquidity trap where policy is rendered powerless are misplaced.

Low interest rates have been very effective in supporting housing activity and consumer spending. Mortgage refinancing will boost consumer spending power for several more months, and the recently legislated tax cuts will be worth around $100 billion to the economy in the second half of the year.

Meanwhile, consumer and business confidence are reviving, and concerns about deep structural excesses [and impending deflation] are overstated....

During the past three years, the U.S. economy has faced an onslaught of shocks including the bursting of the technology bubble, the 9/11 terrorist attacks, a wave of corporate scandals, a spike in oil prices and two wars (Afghanistan and Iraq). The fact that the resulting recession was the mildest on record is testimony both to the underlying resilience of the economy, and to the impact of monetary and fiscal reflation.  [Emphasis added, GH.]

The economy has faced a series of  headwinds in the past few years, but these are gradually receding. A period of fierce retrenchment by the corporate sector has pushed both the inventory-to-sales ratio and the ratio of net investment to GDP down to record low levels  Meanwhile, corporate balance sheets have been restructured and profits have turned up. This helps explain why corporate bond spreads have continued to narrow.

The scene is set for a rebound in spending when business confidence returns, and a recent upturn in small business sentiment holds out the hope that the corner has now been turned.

The dollar’s decline is providing an important boost to profits for many companies. About one-third of the net income of U.S. multinationals comes from overseas affiliates, and of this, two-thirds comes from Europe and Canada. Thus, the dollar’s sharp drop against the Canadian dollar, the euro and sterling provides instant profit relief.

Of course, there are risks in the outlook. The pieces are in place for a revival in business spending, but persistent caution on the part of corporate executives could lead to self-fulfilling weakness in activity. Meanwhile, although the falling dollar is unambiguously positive for U.S. growth, large currency shifts have the potential to cause financial instability.

On balance, these risks are modest relative to the probability that economic conditions will improve, rewarding investors who bet against deflation. It is clear that it will be some time before the Fed is ready to start raising rates. In recent Congressional testimony, Chairman Greenspan again articulated the asymmetric risks facing policymakers. The dangers associated with easing too much for too long are small relative to those of not easing enough.

The Fed knows how to combat any inflation that may result from an overly stimulative stance, but it is not 100% sure about its ability to pull the economy out of a deflation. Thus, it is far better to ensure that a deflation never occurs in the first place.

BCA’s Investment Recommendations

There are a few key issues that separate us from those who are maintaining a bearish view on the outlook for the U.S. economy and markets. They can be summarized as follows:

l. We expect that the current highly stimulative policy stance will be successful in boosting economic growth in the quarters ahead. Fears about a structural overhang of investment and excessive consumer debt are overstated in our view.

2. The odds of a sustained deflation in the U.S. are slim.

3. The equity market is close to fairly valued, not massively overvalued as some contend.

If we are correct, then it is not appropriate to have a maximum conservative portfolio strategy that emphasizes cash and high-quality bonds. Some risk is warranted, with equity exposure at slightly above average, and a bias to build positions on any price weakness.

Fixed-income portfolios should have below- average weightings in Treasurys, and above-average exposure to speculative-grade corporate securities [high-yield bonds].  [Emphasis added]  

The above strategy represents a cyclical [market timing] rather than a long-term recommendation as the potential for a new sustained bull market in stocks is extremely limited. Nevertheless, on a 12-month view, stocks should comfortably beat cash and bonds.”

That’s the latest thinking from BCA.  They have the standard caveats, of course, but only if something really negative and unexpected happens.  Here is their specific analysis on the threat of deflation:

“What About Deflation?

Deflation is currently one of the top concerns on the minds of investors, helping to explain why Treasury yields have dropped below 3½%. The financial press is filled with deflation articles, and Greenspan has noted that the Fed has expended considerable effort researching the subject.

It is somewhat ironic that deflation fears should be escalating when many of the preconditions for increased inflation are in place. For example, monetary policy is very easy, the budget deficit is soaring, the dollar is collapsing, housing activity is hot, oil prices have spiked higher, and gold prices are in an uptrend. These are all classic signs of an inflationary environment.

The key point...is that demand is weak, creating a very competitive pricing environment. We view that as a cyclical rather than a structural problem. In other words, the downward pressures on pricing should ease as the economy revives in the months ahead.

It is important to remember that deflationary pressures are concentrated in the traded goods sector. The core inflation rate for goods has been in negative territory since late 2001. In contrast, the core rate for services is still close to 3%, or 3.8% excluding the rent-of-shelter component.

The decline in the dollar will go a long way in reducing deflationary pressures in the traded goods area. Non-oil import prices had already bottomed be-fore the dollar’s most recent slide. The 43% drop in the trade-weighted dollar between 1985 and 1995 was associated with a 46% rise in non-oil import prices. The dollar is set for a further large decline in the years ahead.

The deflationary impulse from overseas is also moderating in response to strong economic activity in Asia. China is widely perceived as being at the epicenter of global deflation, yet that country now has a positive inflation rate. China has a vast pool of cheap labor, but spare capacity has declined in response to booming growth. In addition, by pegging the exchange rate in the face of a large current account surplus, the authorities have created very buoyant monetary conditions. The M1 aggregate is rising at a 20% annual pace.

Currently, there is spare capacity in the U.S. economy and this means that inflation may well decline further in the near run. Nevertheless, the odds of a sustained deflation are very slim and fears should be greatly reduced by the end of the year.”

Obviously, BCAcould be wrong about deflation.  Certainly the gloom-and-doom crowd does not agree.  They predict a deflationary depression.  But, as noted earlier, they’ve said that for the last 25 years at least.  As long-time clients and subscribers know, BCA is right far more than they are wrong.  As you’ve seen, they are even more optimistic than they were last month.  Maybe the economy will get to 3-3.5% growth in the second half of the year, in which case unemployment will peak and head lower.  Let’s hope so!                                                           

*   *   *   *   *   *   *

CMGUpdate:
What Are You Waiting For?

Capital Management Group is having another outstanding year in high-yield bond funds.  Their regular (non-leveraged) program is up 12% so far this year, while the leveraged program is up over 18% (net of all fees and expenses).  I have been recommending CMG for several months now, yet many of our clients have not taken the opportunity to consider this excellent program.  I can only guess as to why.

Maybe it’s because CMG invests in high-yield - “junk” - bond funds, which some find too risky.  Ishould point out that CMG only invests in highly diversified, well known high-yield funds such as:

Goldman Sachs High Yield Fund
PIMCO High Yield Fund
Putnam High Yield Trust                                                         

These funds own hundreds of different high-yield bond issues, so the default issues associated with owning high-yield bonds individually are greatly reduced.

Maybe it’s because you think interest rates will turn higher, and bonds will get whacked.  This will probably be true for Treasury bonds.  However, high-yield bonds tend to do very well during economic recoveries, even when Treasuries are getting hurt.  In any event, CMG uses “trailing stop losses” on all positions in case the market turns against them, which would take them to cash.

CMG has an outstanding 10-year track record with an average annual return of +11.84% and a worst-ever drawdown of -3.28% in the non-leveraged program.     (Past results are not necessarily indicative of future results.)  The minimum investment is only $25,000.  While high-yield bonds are not suitable for conservative investors, most of you reading this are more sophisticated in your investments.  I suggest you seriously consider CMG by reading the enclosed Advisor Profile (You will need Adobe Acrobat Reader) on them.  Take a look - you’ll like what you see.