Andrew S. Grove, former chief executive officer of Intel and author of “Only the Paranoid Survive,” defines a strategic inflection point as “a time in the life of a business when its fundamentals are about to change. That change can mean an opportunity to rise to new heights. But it may just as likely signal the beginning of the end…they are full-scale changes in the way business is conducted … strategic inflection points are about fundamental change in any business.”

Today, the global economy is at an inflection point not only for the challenge of generating growth, but for larger structural shifts in how global economies and financial markets will recover and transition to a new normal. In recent weeks, economic data and earnings reports from large global companies like Intel have shifted the risks of the global economy from a bias toward the downside to a more balanced risk assessment.

Minutes from the June Federal Open Market Committee (FOMC) meeting indicate that the Fed has raised its outlook for growth for the remainder of 2009 and into 2010. Many notable market and economic strategists believe the economy bottomed out in June and that July will represent the first month of recovery.¹ For the first time in two years, the Organization for Economic Cooperation and Development (OECD) has revised its growth projections upward.² Significant upside changes to economic forecasts may very well signal a pending recovery.

However, in our first commentary of the year we noted how consensus was wrong leading into the worst recession in the post-WWII era. Even in the aftermath of the near collapse of Bear Stearns in March 2008, consensus estimates put the odds of a recession in the second half of 2008 at about 50 percent. In fact, U.S. GDP fell 6.3% quarter over quarter in the fourth quarter of 2008, the worst result since 1981. (Fig. 1.)

Any use of economic forecasts should be supported by sound evidence. Analyst forecasts are not the only means of assessing the economy’s potential. Market prices and trends reflect real investor expectations and there is strong evidence that improved forecasts by economists are based on recent market action. While often misguided, consensus can be a positive development to the extent that market participants perceive a general improvement in economic conditions coming off of a severe recession. We look for perception to be supported by economic evidence.

Borrowing from Andrew Grove’s concept of a strategic inflection point, the current global economic environment may be in the midst of its own inflection point this quarter. Below we examine world GDP growth, the inventory cycle, and consumer sentiment in an attempt to assess the current inflection point and the viability of renewed optimistic economic forecasts.

Inflection point for global GDP

Prior to the Great Recession of 2008, there was a seismic shift in global output. The emergence of a global consumer class in many developing nations has had a profound impact on global growth prospects and the allocation of resources. According to a Northwestern Mutual study³, developed economies account for 74% of global GDP, but emerging economies account for 58% of global GDP growth. (Fig. 2.) According to the World Bank, the share of international trade in emerging economies has grown from 35% in 1980 to 57% in 2007.

While the current recession has been widely attributed to the bursting of housing and debt bubbles, commodity related sectors represented perhaps the most overbought and expensive of the investable asset classes.

While the decline in developed market growth has occurred with a high degree of harmonization, the global recovery among emerging economies is much less synchronized to developed nations. Emerging economies have also been the beneficiary of massive government stimulus, including direct government outlays and state-sponsored investment. Demand has picked up significantly, especially in China. The infrastructure demand in China alone has helped provide a boost to commodity prices off of the bear market lows. As a result, leading indicators and industrial production in China, for example, have led the U.S. and Eurozone by a few months.

Leading indicators tend to be more anticipatory in nature. They often provide a preview of future economic activity. Because leading indicators are designed to reflect the early stages of production and investment, they generally reflect early changes in economic conditions. (Fig. 3.)

Economic activity involves not only interaction between consumers, business and government, but also between and among global entities and individuals. And it is the global economies, particularly emerging economies, that may drive global GDP in the coming years. Upward revisions for global growth are being driven by more optimistic forecasts for demand among consumers and producers in China and India. Just as the current global recession demolished the emerging markets “decoupling” theory, a quicker and more robust upturn within emerging economies may signal better prospects ahead for developing nations, albeit at a more moderate pace.

Inventory cycles

Business investment fell markedly at the end of 2008 and the beginning of this year due to output contraction, declining corporate profits and a lack of credit. Concurrently, businesses aggressively depleted inventories or allowed inventories to run off. According to OECD, the inventory adjustment in first quarter accounted for nearly one-half of the fall in OECD GDP.

Inventory levels provide insight into the nature of business cycles. Inventories are better at predicting growth because they reflect tangible and measurable demand. The need to restock inventory adds directly to companies top line sales growth. Inventories in U.S. business fell 1% in May, representing the ninth straight month of decline. In fact, inventory reduction in the first quarter was the largest on record. (Fig. 4.)

Manufacturers’ inventories contracted in June as the Inventories Index registered 30.8%, 2.1 percentage points lower than May’s reading of 32.9%. An Inventories Index greater than 42.6% over time is generally consistent with expansion. As the recession continues, producers have slashed inventories to better align with decreased sales demand causing a negative effect on growth. The inventory drag hit the first quarter of this year particularly hard.

This run-off in inventories is unsustainable over the long term. According to minutes from the June 24 meeting of The Federal Reserve, “some participants noted that, as this process continues, increases in sales will have to be met by increases in production, which would, in turn, support growth in hours worked and eventually in investment outlays.” The Institute for Supply Management presents a similar view, “aggressive inventory reduction continues and indications are that the de-stocking cycle is at or near the end in most industries.”

Carrying inventory results in significant costs to a company. The company must carry the cost of capital, overhead, insurance, employee salaries and benefits, and even information technology costs. Partly as a reaction to the economic downturn and partly as a proactive management tool, companies slashed inventories in anticipation of a sharp decline or even complete severing of demand.

When companies eliminate or exhaust their supply of goods, production increases must follow. To the extent that government stimulus spending is effectively released into the economy, demand is created for the production of goods. Factories start up again and worker furloughs expire. Even a slight moderation in the inventory adjustment can generate a positive effect on growth.

When inventories start accumulating again, it means that companies are entering into production in order to meet actual or perceived demand. The resulting effects can be infectious.

When overall consumption stabilizes or recovers moderately, inventory channels that had been dramatically depleted begin to fill up and approach more normalized levels. Anticipation of a stronger second half of the year will set off an inventory build. Management comments for second quarter earnings have revealed that many firms are currently holding inventory levels slightly lower than their comfort level. In fact, due to surprise demand in the second quarter, Intel depleted inventory when it was expecting to build it. Depleting inventory due to stronger than expected demand, rather than anticipation of low demand, is a positive indicator for the economy.

Manufacturing

Historically, the manufacturing sector of the economy tends to adjust earlier than the service sector, but with more volatility in between cycles. Typically, manufacturing composites tend to lead recessions by more than two months.

According to the Institute for Supply Management (ISM), economic activity in the manufacturing sector failed to grow in June for the seventeenth consecutive month. Manufacturing contracted at a slower rate in June as the Purchasing Manager’s Index (PMI) registered 44.8%, two percentage points higher than the 42.8% reported in May. (Fig. 5.)

ISM states that a reading above 50% indicates that the manufacturing economy is generally expanding; below 50% indicates that it is generally contracting. When assessing the relationship to GDP, ISM finds that a reading greater than 41 indicates an expanding GDP. Perhaps more important is the general direction of month-to-month changes.

Consumer sentiment

With the exception of the 1974-1975 recession, a bottoming out of consumer sentiment has on average led the end of recessionary periods by two months. (Fig. 6.) The University Of Michigan Survey of Consumer Confidence Sentiment Index rose for four consecutive months from March to June 2009 then unexpectedly dropped six points in July, prompting concerns that the past performance represented a false start.

Leading indicators are useful in spotting potential economic growth trends, however unless the consumer feels meaningful improvement in their own economic situation confidence decreases, resulting in a further retrenchment in spending.

Confidence is important to the equity markets. According to ISI, the correlation between consumer confidence and the S&P 500 has been 77% over the past 11 months.

The back-up in consumer confidence puts the notions of second derivative economic data and more moderately-paced decline into perspective. A decline in confidence may simply reflect that the economy is still weak on an absolute basis. Furthermore, a sudden drop in the index level implies a disconnect between consumers and economic forecasters regarding the outlook going forward.

Consumer sentiment historically does not correlate strongly with consumer spending, and therefore the predictive value of the index is questionable at best. As we have discussed on numerous occasions, sentiment plays a significant role in the equity markets.

What to watch for

Investors and economists are scrutinizing all economic data for signs of stabilization or deceleration in the rate of decline. We have identified three useful, although certainly not all-inclusive, economic indicators: Leading Economic Indicators (LEI), inventories and consumer sentiment. Indicator readings do not follow linear paths, but we can use them as tools to help us form opinions regarding anticipated recessions and recoveries. In fact, according to strategist Ned Davis, each of these indicators has either led or was coincident with economic recovery in all recessionary periods since the Second World War.

Where are we headed?

A pervasive improvement in growth forecasts is beneficial to the economy, the stock markets and aggregate wealth. However, the economy is still very weak on an absolute basis and is, as repeatedly demonstrated over the past 18 months, vulnerable to further adverse shocks. The recovery is still very likely to be slow and painful, with significant dangers lurking under the renewed sense of optimism.

Labor market conditions are still very poor. Unemployment is high and could go higher. And, cumulative household wealth has declined precipitously. These are all conditions that weigh heavily on consumer spending. The recession could officially end this quarter, but a sizeable segment of the population may not feel or perceive any inkling of economic expansion. Underlying all this is an economy that, in the words of Martin Wolf, is “underpinned by massive explicit and implicit taxpayer support. The probability of mischief down the road is close to 100 percent.”⁴

The dollar has depreciated substantially, and according to the Fed, represents “a renewed sense of optimism about global growth prospects, leading investors to shift away from safe-haven assets in the United States to riskier assets elsewhere.”

We are not trying to be cynics. In fact, we welcome the optimism of improved growth forecasts. A healthy dose of consumer and equity market sentiment has been essential in unwinding the vicious negative feedback loop prevalent in the global economy over the past 18 months. We have attempted to check sentiment against concurrent and leading indicators and encourage investors and economic observers to continue to maintain reasonable testing going forward.

In other words, monitor economic news for divergences between improved and optimistic expectations and the realistic assessment of current and potential economic conditions. The economic and equity markets may be vulnerable to the risk that expectations move too far ahead of reality. After the economy officially comes out of recession, will consumers allow their collective confidence to be adversely impacted by the massive wealth destruction that has occurred over the past 18 months? What is the consumers’ capacity and willingness to take on more debt? Or will the household deleveraging continue over a longer course and incrementally drag down GDP?

The global and U.S. economies are showing signs of improvement and we may experience positive GDP growth as early as the current quarter. But the global economy is still fragile, and we have argued consistently that the road back to a more stable economic state will be protracted and jagged.

Whatever the outcome, it is important for investors to have a framework grounded in reality and to take action based on where the economy and markets stand, and not solely on economic forecasts. Being grounded in actual outcomes increases the likelihood that investors can accept whatever happens next, even if they are unfavorably disposed to the outcome. As individuals, we cannot prevent future shocks, but maintaining reasonable expectations can lessen the impact and surprise factor.

¹ According to Ned Davis Research, their proprietary Economic Timing Model “bottomed in November, and has historically led the end of the recession by 4.5 months ... We believe the economy bottomed in June and that July will be the first month of recovery.” Daily Economic Commentary, July 20, 2009.
² OECD Economic Outlook, Volume 209/ 1, No. 85, June 2009.
³ July 2009
⁴ Wolf, Martin. “After the Storm Comes a Hard Climb.” Financial Times, July 14, 2009.