Wednesday, August 18, 2010

Tracking the Recovery: Not All News Is Bad

With the momentum of the economic recovery having slowed visibly since late spring, the spotlight has remained consistently on the overall dispiriting tone of the various economic reports. The bond market's rally, the latest leg of which was fueled by the Fed's decision to re-invest the proceeds of its maturing MBS securities in Treasuries, has been based on the premise that the cooling of economic activity can be appreciable. Inevitably, some errand, but misguided, predictions of a "double dip" scenario have emerged as well.

In that environment, with the market focused almost single-mindedly on the downshifting in the pace of economic growth, it is easy to miss some low-key positive signals suggesting that things may actually be stabilizing. Two such pieces of information have, in fact, emerged since the beginning of the week that portend constructively for the underlying trajectory of the recovery.

The first such report was the Fed's Senior Loan Officers Survey conducted in July that showed that "on net, banks had eased standards and terms over the previous three months on loans in some categories". The survey included 57 domestic banks and 23 U.S. branches and agencies of foreign banks. In a key part of its summary conclusions, the report states that "Domestic survey respondents reported having eased standards and most terms of C&I loans to firms of all sizes, a move that continues a modest unwinding of the widespread tightening that occurred over the past few years. Moreover, this is the first survey that has shown an easing of standards on C&I loans to small firms since late 2006".

This is a potentially very significant shift taking place on the bank lending standards front that may start removing one of the major roadblocks for the fledgling economic recovery. Inasmuch as the survey also found that most of that improvement is concentrated at large domestic banks, versus smaller banks or U.S. branches of foreign institutions, its importance cannot be underestimated for its likely impact on both consumer and capital spending- and, by extension, the overall economic recovery- over the coming quarters.

Granted, that actual lending activity will naturally be a function of demand for such credit in the first place, and the survey found little change on that side of the equation in the latest period- presumably a reflection of lack of confidence of the business sector in the trajectory of the economic recovery. Differently put, easing of credit standards by banks is a necessary but not sufficient condition for robust business expansion plans and household spending. However, it represents an undoubtedly crucial positive development, following an approximately 3 1/2-year period during which the tightening of bank lending standards had become an albatross around the economy's neck.

The second encouraging report this week was the sharp increase in July's industrial production (+1.0%), which included a 1.1% surge in manufacturing output. While it is true that the latter benefited greatly from a 14.5% spike in vehicle production (largely the result of the industry's decision not to proceed with the seasonal shutdowns in July for retooling), the real value of the reports lies elsewhere.

Output of business equipment, a key category in manufacturing, rose an impressive 1.8% last month, following solid gains in the prior four months. Such strength demonstrates that there is still decent momentum left in manufacturing, despite the waning inventory cycle dynamic. The implication here is that the strong comeback of capital spending in the first half of the year (17% annualized in Q2, following a 7.8% increase in Q1) appears to be pushing ahead in Q3, representing one of the key pillars of growth for the recovery in the coming quarters.

Anthony Karydakis