F&M Investment Services
Division of Farmers & Merchants Bank

Weekly Commentary by Dr. Scott Brown

A Possible Endgame To The Recession
November 17 – November 21, 2008

Financial market volatility has remained extremely high in recent weeks. Large swings with no clear direction are indicative of the high level of uncertainty in the economic outlook. How severe will the current downturn be? How long will it last? Nobody knows. The consensus view among economists is that the current quarter will be terrible, weakness is likely to extend into early 2009, but global policy efforts should help support growth later next year. That said, the risks are still tilted toward the downside. What factors will make the hopeful forecast into a reality?

It doesn’t look good for the consumer. Inflation is coming down sharply, but real wages are still lower than a year ago. The loss in housing and stock market wealth will restrain spending, all else equal. Tight credit isn’t helping. The weak job market is not good. Beyond these impacts, consumer spending habits may be undergoing a sea change as they begin to save more.

The biggest driver of consumer spending is income growth. Adjusted for inflation, year-over-year wage growth turned negative earlier this year. Higher energy prices pushed real wages even lower through the summer. Since mid-July, energy prices have retreated significantly. Gasoline prices are about half of what they were at the peak. The drop in gasoline prices leaves consumers with more money to spend on other things. However, the impact arrives with a lag.

The wealth effect on spending is small. An extra $100 in wealth might result in $3 or $4 in additional spending. It’s a small effect, but changes in wealth are sometimes large. Moreover, the impact on spending is likely asymmetric. That is, consumers respond differently to increases in wealth than they do to declines. For those who have been in their homes for more than five years, the housing price correction is not that big of a deal. For recent buyers, it’s a huge problem.

The drop in home prices has made it harder to get a home equity line of credit. The extraction of home equity had been a strong force supporting consumer spending growth in recent years. However, credit is now tighter. The Fed has cut rates significantly, steepening the yield curve, which gives banks more incentive to lend. However, the Fed’s most recent survey of senior loan officers showed that banks further tightened terms and standards on consumer loans over the three months ending in October. Last week, the Fed, Treasury, and FDIC issued a statement that they “expect all banking organizations to fulfill their fundamental role in the economy as intermediaries of credit to businesses, consumers, and other creditworthy borrowers.” Such moral suasion has had mixed results in the past, and one can understand the reluctance to make loans in the current environment. However, over time, banks should begin to relax their lending to consumers.

Meanwhile, the job market has been falling apart at an increased pace. More than half a million people filed initial claims for unemployment insurance benefits in the latest week. The number receiving benefits is the highest in more than 25 years. Layoffs are going to get a lot worse before they get better.

Perhaps the greatest concern is that consumers may be adjusting their spending habits too sharply. It’s good that people save, but it’s bad when everybody tries to save more at the same time. In saving more, households would be spending less – and, since consumer spending accounts for 70% of GDP, overall economic activity would be a lot lower. There are signs that households not directly effected by job losses or tighter credit are cutting back, reducing discretionary spending. Whether this is a short, transitional phase or a deeper and longer-lasting trend remains to be seen.

So what will it take to get out of this mess? When times are bad, many assume that they will never get better. First, oil prices must remain low or fall further. Banks must begin to relax terms and standards for consumer loans. The adjustment in consumer spending habits (that is, increased saving) needs to be spread out more gradually over time. The Fed and other central banks appear likely to cut interest rates further. We should see further large-scale government efforts to stimulate the economy, either in the lame duck session or under the new administration and Congress.

There appears to be limited upside to the hopeful outlook, and the downside risks are considerable, particularly if consumers continue to retrench. However, the policy responses here and abroad have been swift and large – and there’s more to come. Despair is easy. Hope is hard, but not impossible.

Good Luck, Mr. Obama
November 10 – November 14, 2008

President-elect Barack Obama will be sworn into office on January 20. In the past, after a grueling campaign, the incoming president had the opportunity to take some time off between election day and the inauguration. Obama will have no such luxury. A number of pressing issues will await him in January. The economy will be the top priority as Obama sets his team and makes plans to hit the ground running.

The National Bureau of Economic Research’s Business Cycle Dating Committee has yet to make the call, but it looks all but certain that the U.S. economy has entered a recession. Most monthly indicators had suggested that the U.S. was on the cusp of a recession in the first half of the year. However, GDP growth was positive in both the first and second quarters, challenging the definition of “a broad-based decline in economic activity.” Nonfarm payrolls are now falling more forcefully, down by 1.2 million since December – and with 524,000 jobs lost in the last two month alone.

Consumer spending sank sharply in the third quarter, falling at a 3.1% annual rate, according to the government advance estimate. October data aren’t any more promising. Unit motor vehicle sales fell further last month. Retail chain store sales were poor. Lower gasoline prices will lift purchasing power, but a weak job market, declining wealth, and tighter credit will be more significant factors, restraining spending in the near term.

The unemployment rate jumped to 6.5% in October, vs. 5.5% a year ago. According to Okun’s Law (updated based on recent years’ data), a 1% increase in the unemployment rate corresponds to about a 2% reduction in GDP. About 10.1 million people were unemployed in October, according to the Bureau of Labor Statistics, an increase of 2.8 million over the last 12 months, and measures of “underemployment,” such as those working part-term but wanting full-time jobs, have surged.

So what’s the new president to do? Obama ran on a platform calling for a shift in tax policy, cutting rates for the middle class and raising the marginal rate at the high end of the income scale (from 36.5% to 39%). The middle class tax cuts are likely to proceed. Upper end tax increases will have to wait (these guys aren’t stupid). The budget deficit has been rising sharply. The national debt rose by $549 billion in October alone. Obama’s campaign platform implied a further widening of the deficit (to be fair, McCain’s proposals would have dug an even bigger hole, according to the Tax Policy Center). Bill Clinton ran on a platform of middle class tax cuts, but those fell by the wayside early in his administration as an emphasis was placed on deficit reduction. Obama will eventually have to face the deficit, but that’s the wrong thing to do in the current environment.

Some government stimulus is likely before the new administration takes office. Congress is working on a $100 billion plan centered on infrastructure projects, aid to the states, an extension of unemployment insurance benefits, and an expansion of foods stamps and other assistance to those hit hardest by the current downturn.

Much was said during the campaign about Obama being “a socialist.” That’s absurd. If the list of his campaign advisors is any guide, Obama’s economic team is likely to be highly competent, with a deep respect for the power of the markets, but with an appreciation for market failures and how to deal with them. Obama’s campaign was based on confidence and hope. Americans should be hopeful and confident that his administration will succeed.

Still, there’s little that the president can do to turn the economy around in the short run. The global economic crisis is a very large problem and efforts to counter it have been massive. For the most part, it’s a matter of time. It will take some time to work through the current economic difficulties, but we will, together.

Consumer Spending: Down And Out
November 3 – November 7, 2008

In the first half of the year, the economic data suggested that the U.S. economy was on the cusp of a recession. Nonfarm payrolls, industrial production, inflation-adjusted business sales, and personal income have been trending lower since the end of last year. However, GDP growth was positive in both the first and second quarters (at annual rates of 0.9% and 2.8%, respectively). The economy clearly took a turn for the worst in the third quarter. Real GDP fell at a 0.3% annual rate in the advance estimate, but underlying domestic demand was a lot weaker. Monthly data suggest further weakness in the fourth quarter.

Inflation-adjusted consumer spending fell at a 3.1% annual rate in the third quarter, the largest drop since the second quarter of 1980. Some of that decline represents a pullback from the effects of tax rebates, most of which went out in May and June. However, the drop in consumer spending was well beyond what could be explained by the earlier tax rebates.

Consumer confidence fell to a record low in October. Expectations, which had improved in August and September, sank sharply. Individuals said that jobs were much harder to get in October and were more pessimistic about future job availability. Granted, consumers don’t spend confidence. Consumer attitude measures dropped sharply after the September 11 terrorist attack, but we had record motor vehicle sales just one month later. Still, the October drop in confidence is consistent with broader strains on the household sector and further spending weakness ahead.

The major drivers of consumer spending are income, wealth, and the ability to borrow. Nominal income growth was moderate in recent months. However, inflation reduced the purchasing power of that added income. Adjusting for inflation, aggregate wages and salaries fell 0.8% y/y in September. Inflation is coming down sharply, following the retreat in energy prices. The drop in gasoline prices will act like an income tax cut of more than 1%, boosting the purchasing power of most households. However, a weakening labor market will limit nominal aggregate wage growth in the near term.

The wealth effect on consumer spending is relatively small. People may spend 3% to 5% of each added dollar of wealth. When changes in wealth are very large, as they were during the stock market boom in the late 1990s, or more recently, as they have been amid the housing price collapse and the recent stock market correction, the impact will more noticeable.

The tightening of consumer credit is a more immediate concern in the consumer spending outlook. Since the dawn of mankind, people have said that consumers have too much debt and must therefore cut back. The household sector is said to be “overspent and undersaved.” However, it’s not that consumer debt burdens are too high – rather, it’s that consumers can’t get any more debt. Loan growth is the engine of economic growth. With banks tightening terms and standards for consumer loans, the spending outlook has dimmed. Credit card companies are watching individual usage. A large increase in credit card purchases is seen as a sign of strain, and credit limits are being scaled back accordingly (to limit the company’s exposure).

The savings rate has been low for some time now. However, it is a flawed statistic (calculated as a residual, income less taxes and outlays). Capital gains don’t count as income, but are spent, lowering the savings rate. That said, there is plenty of evidence that people generally do not save enough. Having relied on their homes as a major retirement savings vehicle, consumers may find they need to start saving more – and if everyone saves more, they will be spending less out of disposable income. When we’re through all this, the new normal may not look like the old normal.

The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.

All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.

1429 Quintard Avenue
Anniston, AL 36201
Phone: 256-236-8875
Fax: 256-236-8366
Contact Us

Map & Directions

Securities and investment advisory services offered through
RAYMOND JAMES
FINANCIAL SERVICES, INC. 
Member FINRA / SIPC, an independent broker/dealer 

• are not insured by FDIC or any other bank insurance,
• are not deposits or obligations of the bank,
• are not guaranteed by the bank,
• and are subject to risks, including the possible loss of principal.

Raymond James financial advisors may only conduct business with residents of the states and/or jurisdictions for which they are properly registered. Therefore, a response to a request for information may be delayed. Please note that not all of the investments and services mentioned are available in every state. Investors outside of the United States are subject to securities and tax regulations within their applicable jurisdictions that are not addressed on this site. Contact your local Raymond James office for information and availability.

© 2008 Raymond James Financial Services, Inc., member FINRA / SIPC         Privacy Notice