'It’s a recession stupid!'

We are not on the brink nor the edge of recession, we don’t need to have two quarters of negative GDP growth to know when we’re in recession, it’s here and it’s now.

This isn’t fear-mongering, this is just the way it is. Every economic indicator, except for net exports, is either decelerating rapidly or in outright decline. To make matters worse, it is the consumer that is most affected, unlike the recession in 2001 when businesses imploded. Consumer spending makes up more than two thirds of the economy and the consumer is being hit on all sides.

The housing sector has been in decline for 2 years and it is deteriorating even faster now. Sales continue to plummet. Inventories of homes for sale continue to rise, aided by the increase in foreclosures. Tighter lending standards are making it more difficult for prospective buyers to borrow,  and mortgage rates are rising as inflationary pressures increase. It is no surprise then that home prices are falling even faster now by any measure and will continue to drop. Consumers no longer have any home equity to spend, but worse, the decline in prices has caused people to cut back their spending for fear of worse to come.

On top of that, as mentioned already, inflationary pressures are soaring. Record energy and food prices, consumer staples, are significantly reducing the amount of discretionary income consumers have to spend elsewhere. People don’t stop driving their cars or turn off the electricity when energy prices rise. Oil prices are at record levels and are probably going to continue to increase. In addition, food prices are rocketing. Demand from populous countries such as China and India, with increasing standards of living and greater desire for food products, as well as the increasing use of land to grow produce used in biofuels, have pushed food such as wheat, corn, and even soybeans to record levels. This means that the price of a loaf of bread is going to go up, soon, and significantly. People must eat, so this is more of the income being used up that could otherwise be spent .

Stocks are finally beginning to catch up with credit markets in that they are beginning to fall, just starting. Earnings projections for stocks across the board are still too optimistic, with expectations for a second half rebound that may or may not occur. All major sectors should continue to fall, except commodity stocks, some more than others. This is another area of wealth that is in decline, removing one more source of funds for consumers to spend and further eroding confidence.

Last, but most certainly not least, the most important source of income for a consumer to spend is typically wages, but the jobless rate is rising and set to soar. Payrolls fell in January, for the first time in four years, and are likely to continue to fall. Jobless claims are already rising to levels not seen since Hurricane Katrina. The jobless rate has plenty of room to move higher and this has yet to happen. This is the last shoe to drop for the consumer, and will make this recession worse than expected, deeper and longer. People will have little funds left to spend on anything but essentials. And a $600 tax rebate is certainly not going to help for more than a week or two at most.

Looking elsewhere, there is nothing to pick up the slack. The government will spend its stimulus package but there is little else left in the kitty with the economy slowing, rising budget deficits, and wars in Iraq and Afghanistan still left to fund.  Businesses are cutting investments, reducing inventories, recognizing the slowdown in demand from the consumer. When revenues are falling and the cost of raw materials is leaping, executives typically cut back on discretionary projects such as new equipment, IT projects, and advertising, hence the decline of Cisco and Google recently. Do not expect the government nor the business community to save the economy, even if they could.

Exports are soaring while imports are in decline, the former due to the weakness of the dollar and stronger growth abroad, the latter also due to the weakness of the dollar and the decline in domestic demand, another sign of consumers’ retrenchment. Trade is only a small part of the US economy and great as more exports are, the contribution to the economy is marginal against that of the consumer.

This leaves the Federal Reserve, our erstwhile savior. They have lowered interest rates at a pace not seen in decades if ever, but will it do any good? Unlikely, at least in the short term. The problem is, as the Fed has lowered interest rates, they have increased inflationary pressures, when commodities such as energy, food, and metals are already at or near record highs. This raises long-term interest rates, such as mortgage rates and those that businesses can borrow at. This negates the benefit of short-term interest rate cuts. Although beneficial over time, the Fed’s rate cuts will likely do little this year to improve the housing market, reduce commodity prices, improve corporate earnings, or create jobs. The consumer is tapped out and the Fed cannot help.

This is very likely to be be the worst recession in decades. It has already started but given that the unemployment rate has still to rise, worse is yet to come. From an investment perspective, the best place to be for the foreseeable future is probably in government bonds, or if you’re willing to take the risk like so many others, commodities such as oil, gold, and wheat. Start saving now, it is going to be a long year ahead!

Where to Invest Today?

I thought I would give a quick review of each of the major asset classes given the high level of volatility that we’re experiencing today, starting with equities.

Stocks

Given all the issues going on in the credit markets, the current economic recession, and the continuing downgrades in earnings forecasts, it is difficult to see stocks rising from here. Regarding a few sectors… Telecoms are looking soft due to growing fears of price war. Energy stocks will benefit from higher oil prices. Commodity stocks in general continue to rise, particularly mining stocks. The slowdown in capital spending is going to affect technology stocks such as Cisco, perhaps as much as in 2000. Consumer discretionary stocks are likely to continue to fall in line with the general economic slowdown. By contrast, consumer staples are benefitting as safe haven plays, with inexpensive soup flying off the shelves. Airlines, industrials, and transport stocks are being hurt by the higher oil price. Financials appear cheap, with some PEs as low as 6.5 times earnings, but are a risk given the persistent credit market issues. Real estate investments should probably be avoided until the house prices bottoms.

Bonds

Stagflation is the operative word right now, meaning a slowing economy while inflationary pressures increase. The Federal Reserve is worried about the “Japanese” outcome  and will cut rates to avoid it at all costs. Investing in short-term treasuries will benefit from capital gains in the short-term. Long-term bond yields have been on the rise due to growing fears about inflationary pressures, but have likely peaked and may fall as a result of the current economic slowdown. Treasury bond funds are a safe haven investment when other asset classes, particularly equities, are volatile. Although bonds do not provide the sexy returns, any positive return is better than a loss. I would stay away from corporate bonds for the time being, focusing investments in this sector on treasuries.

Commodities

“Commodities are the only investment now generating strong returns,” said one analyst recently. All commodities are benefitting from speculative inflows as other classes, such as equities and real estate, continue to suffer. They are also supported by higher inflation expectations worldwide, a weaker U.S. dollar, and slowing economic growth. Precious metals, such as gold, and now oil, are considered a hedge against inflation and a safe haven investment. The growth of emerging markets also continues to create strong demand for all types of commodities.

There are also individual reasons for the surge in commodities… “The needs of the masses are not likely to dwindle in the medium to long term.” This applies to oil and food, consumer staples.  Some analysts believe oil prices will continue to rise in spite of the recession as “energy (gas and electricity) is one of the last things people cut back on.” Inventories, as a proportion of daily consumption in OECD countries, have shrunk to a 3-year low at 51 days in spite of fears of a US recession and weaker demand for oil. However, some analysts still think “oil inventories remain healthy.”

Food is another such commodity, people always need to eat, and there are more people in the world today, with ever increasing living standards. Biofuels’ affect on demand (and supply of land) and demand from emerging markets such as China and India are expected to keep food prices high in the coming years. Corn used for ethanol also reduces land available to grow wheat.

Gold is the primary inflation hedge and safe haven investment, but weaker jewelry demand could hit it and other precious metals going forward. Platinum benefits from supply problems in South Africa. Zinc is also up on supply concerns in China due to power shortages. Copper rises and falls on the change in LME stocks. Demand for uranium should rise as more nuclear reactors come online and the global push for less carbon emissions takes hold. Plus uranium supplies have been hit in Australia.

Commodities in general are rising, but some, like food, may have a longer lasting run given that demand is increasing worldwide and supply is falling. Other commodities, such as precious metals, benefitting from speculative inflows, may fall as demand declines in line with slowing global growth and higher prices for jewelry.