December 7, 2009

Unemployment and the Recovery

Pick a letter--L, U, V, or W--to describe the shape of the economic recovery. Combine that with a forecast for inflation or deflation, and you can reliably determine your asset allocation.

Or can you?

Those who forecast, for example, a v-shaped recovery with moderate inflation would naturally allocate a healthy dose of equities to their portfolios. Historically, a sharp economic recovery coupled with low to moderate inflation has been very good for stocks. That logic, however, ignores one variable that will likely obscure the importance of the alphabet soup of economic recovery scenarios.

Unemployment will have a greater role in forecasting returns in this market than the lettered descriptor of the shape of the recovery. Whether we face inflation or deflation, too, will be largely dictated by unemployment.

We are undergoing a structural shift in the economy, as jobs migrate from the manufacturing to the service sector. That transformation parallels the experience of the Great Depression, when the global economy shifted from an agricultural to a manufacturing focus. As Columbia Professor Bruce Greenwald explained in a recent interview in Advisor Perspectives, it was not until the industrial policy of the U.S. succeeded in moving large segments of our population from farming towns and industries to industrial centers that we emerged from the Depression.

I am not suggesting that we are entering another Depression. The U.S. economy of the next 50 years, though, will be very different from that of the last 50. Our automobile industry will not return to its pre-crisis production levels any time soon, if ever. Nor will any industries that are part of the automotive supply chain. Consumer spending will remain depressed, and as households defer their high-ticket expenses, key manufacturing industries--housing, appliances, and electronics--will remain depressed.

The consequence will be relentlessly high unemployment.

Forecasting when unemployment will peak is incredibly difficult. Gary Shilling, who publishes a widely read newsletter, Insight, has correctly predicted major turns in the economy and the markets over the last several decades, says it will peak at 11%.

Shilling has closely studied the relationship between changes in GDP and unemployment over the last 60 years. His data show that to keep unemployment from rising, real GDP must grow 3.3% annually. His Insight publication provides the following data illustrating the critical relationship between these variables:

If PIMCO's forecast of a New Normal proves accurate, real GDP will grow by a mere 2%, potentially increasing the ranks of the unemployed 10.7% annually. Therefore, one cannot reconcile Shilling's forecast of 11% unemployment with his data and PIMCO's New Normal. Greenwald said equilibrium in unemployment may be closer to 14%--a forecast which is more consistent with PIMCO's scenario.

As Shilling has stated, no political administration--Democratic or Republican--will allow unemployment to grow unchecked. Pressure will mount for additional fiscal measures (stimulus programs), either aimed directly at job creation or at unemployment benefits. Those measures, however, will not pass Congress easily, may be too small to be effective, or may be imperfectly structured, as many argue was the case with Obama's $787 billion stimulus.

Some combination of fiscal measures and economic recovery will eventually arrest unemployment, but that is not likely to happen soon.

In a talk he delivered in late November, Allen Sinai, founder and CEO of Decision Economics and a key advisor to the Democratic majority in Congress, said we are facing the "mother of all jobless recoveries."

The consequences of continued high unemployment will be severe, and in all likelihood are not reflected in current equity valuations. The stress tests used this spring to measure financial institutions' solvency assumed 10.5% unemployment as the "most adverse" scenario. That level may be exceeded by the time you read this (unemployment stands at 10.2% as I write). Financial institutions will be faced with rising foreclosures and consumer credit defaults, and their troubles will spill over into other sectors of the economy.

Broad-based U.S. equity investors are likely to fare poorly under this scenario. Some sectors of the economy, though, will fare well--industries with low labor costs and those that are able to nimbly scale their operations to decreased demand, for example. American companies have already demonstrated that they are able to slash costs--mainly through headcount reductions--as they did in Q3 of this year. That discipline will be necessary for continued outperformance.

Improved corporate earnings have come through cost reduction and not from top-line revenue growth. As David Rosenberg, chief economist at Gluskin Sheff, wrote recently, if companies start ramping up hiring in advance of growing their revenues, watch out. "In other words, be careful for what you wish for if you have been bulled up on equities this year," Rosenberg said. "Job creation may not be what you want to see."

The rate of job losses is undeniably slowing, but historically high unemployment will be a persistent problem for many years. Reducing unemployment will dominate government policy decisions. Investors that are properly positioned in the context of these trends will fare better than those who merely concern themselves with picking the letter of the alphabet that most closely resembles the shape of our recovery.

Robert Huebscher is founder and CEO of Advisor Perspectives, a Web site and newsletter serving the financial advisory industry.

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