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Why the Economy Will Recover Differently This Time

Economics / US Economy May 15, 2009 - 07:42 PM GMT

By: Hans_Wagner

Economics

Best Financial Markets Analysis ArticleEventually the economy will stop declining and start to recover. The manner in which it recovers will provide investors substantial profits if they have a well-founded theme to base their investing strategy. This recession is the result of substantive changes in the economy that will be with us for years to come. Once the recover begins, we should have a good idea how each sector will deal with a stumble along economy. Since the stock market anticipates a recovery by rallying earlier, it is important for investors to be prepared for the changes that are coming.


Drivers of the Recovery

In past recoveries, the consumer has been the primary driver behind the growth of the economy. Consumer spending was 71% of the U.S. GDP in 2008. The long-term average has been 65%. In a $14 trillion economy that is close to $850 billion in spending that will be lost.

The likelihood that the consumer will return to their former ways is doubtful. Their housing ATM has been turned off. Without all the mortgage equity withdrawals, the growth of the economy during the last ten years would have been negligible. Where will the money come so the consumer can keep up with their recent spending habits? It will not happen.

The stock market crash coupled with the crash in housing prices has had a devastating affect on the finances of consumers. They know that and realize they must save and invest smartly to recover. Consumers are curtailing their spending to provide  money to save. They also realize it will take many years for them to recover. We should expect many years with lower spending on goods and services by consumers.

Consumer spending is slowing and it will stay restrained for years. In the 1980’s consumers saved 7 – 10% of their incomes. At that time, consumer spending accounted for 63% of the GDP. Now that consumers no longer can depend on their homes to fund their spending and their retirement, they will curtail their spending and increase their savings. I believe the percentage of consumer spending that is part of the GDP will slowly return to the mid 60s.

This means consumer spending as a percentage of the GDP is going to fall and will not be a significant driver of economic recovery. This major shift in the foundation of the economy creates opportunities for investors who are prepared.

Affect on the Stock Market

In traditional recoveries, the early cyclical stocks like consumer discretionary, financials and technology sectors normally outperform the market during the early phase of the recovery. However, the massive government stimulus spending and three fold expansion of the Federal Reserve’s balance sheet changes the basis for a recovery. In fighting the potential for deflation, the Fed is striving to reinflate the economy. In this, they will succeed. In fact, by the time they realize inflation is back, they will have to ratchet up interest rates to much higher levels. Inflation will return, helping to avoid a deflationary spiral primarily driven by the rising cost of commodities, rather than wages and compensation.

As consumer spending declines to 65% of the GDP, capacity must be reduced throughout the supply chain. The U.S. economy has too many stores to sell stuff, along with too many malls distribution centers and factories. Capacity utilization is at 67%, 15% below normal. Since consumers are not likely to pick up where they left off before the recession, we will see more stores, malls, distribution centers and factories close. Joseph Schumpter called this “creative destruction”.

This means that the consumer discretionary sector will be affected the most. This will also affect the financial sector as consumers borrow less. We already see this as demand for loans from consumers is falling even further. Those in Congress do not seem to understand that falling demand for loans means banks will loan less. In addition, many of the loans secured by assets that contribute to the excess capacity will put added pressure on the banks resulting in higher loan losses. Couple this with the growing corporate mortgage problem and the financial sector will go from one bad problem to another.

As companies realize they must close more facilities, they will shut down those less productive. The facilities left will produce more with less. In fact, we can expect to see further investment in new facilities and technologies to improve productivity even more. This will be a positive for the technology and industrial sectors.

Next, spending by the government on various stimulus programs will add to the demand for materials like copper, steel, aluminum, and advanced materials like titanium. This demand will be worldwide and is will cause prices for these materials to rise over time. The materials sector will benefit, possibly significantly.

Finally, we come to the energy sector. Demand for energy will increase including oil and coal. As the demand for oil increases, so will the price. We could see significant price increases once again. Such increases will harm the recovery, though the stocks of the companies will benefit.

President Obama’s renewable energy initiatives are the wild card in whether energy will offer great investing opportunities. The government is driving the movement with substantial subsidies. If renewable energy cannot become economically self sufficient, it will be a drag on the economy affecting all sectors. Spain has been leading the world in going green. Every green job created in eight years by the Spanish government came at the expense of 2.2 regular jobs lost, according to economics professor Gabriel Calzada at Madrid’s Juan Carlos University. He found only one in 10 new jobs became permanent. Calzada has concluded the U.S. would lose nine existing jobs for every four green jobs created, even without considering regular jobs that could have been created had the money been diverted. If even partially true, this indicates the U.S. economy could face further difficult times.

On the other hand, we could see some surprising innovation as well. For example, a company has developed an electric drive train for SUVs. The one they have installed on a Hummer H3 gets 100 miles per gallon. By the way, they are not associated with any car company. Energy and transportation offer significant opportunities for entrepreneurs who have good ideas that they can develop and sell.

The energy sector will do well in a recovery, though efforts by the administration and the Congress to tax these companies could cause investors some pause. However, for the economy to recover it needs access to a reasonably priced source of energy.

The Bottom Line

Once the economy begins to recover, the consumer will not be a driving force behind its growth. Rather, we are likely to see the efforts to create a new industrial base through upgrades in productivity and innovation as the important drivers. Investors should look to the technology, materials and industrial sectors as the best places to invest. We will see volatility in the consumer discretionary, energy and financial sectors as they encounter the underlying changes in the economy. While companies within these sectors might offer opportunities, investors should tread carefully.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

Copyright © 2009 Hans Wagner

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