It was the strongest storm to strike the U.S. in decades and the costliest in monetary losses and damages. September marks the anniversary of, no not the Great Recession of 2007-2009, but the 20th anniversary of Hurricane Hugo which struck the eastern United States in 1989, with South Carolina bearing the brunt of the storm.

Storm surge flooding and waves wiped out nearly 28 miles of dunes and beaches on the barrier islands of Folly Island, Isle of Palms and Sullivan’s Island. Homes and buildings without the initial protection of the dunes were hit the hardest. One has to wonder then how well insulated our financial markets and domestic economy could be with the likes of AIG, Lehman Brothers and Bear Stearns—loaded with excessive leverage—standing in front of a financial tsunami?

After the clean-up in the ensuing months and years, a transformation took place on these islands that some residents referred to as the “Hugo effect.” The islands transformed from working class neighborhoods and local vacation spots to million dollar beach front homes and upscale resorts. In a way, these islands transitioned into a new normal, one that while causing some dislocations in the old economy, eventually led to a period of investment demand and growth.

GDP data released on July 31 showed a 1% decline from the previous quarter, compared with a consensus forecast of -1.5% and the previous first quarter decline of 6.4% (revised down from -5.5%). (Fig. 1.) On a year-over-year basis, GDP declined a record 3.9%. Over the past month, economic commentators and media outlets have been proclaiming that an economic recovery is not only imminent, but underway. The Federal Reserve Board’s statement after its August 12 meeting declared that “economic activity is leveling out.” And, according to the International Monetary Fund (IMF), the global economy is beginning to recover from the worst recession since World War II.

Now that consensus deems the recovery to occur in the current quarter, the dialogue has shifted from when recovery will occur to how it will and what the lasting effects will be. Two of the more common descriptions include alphabet shaped recoveries (“V”, “W”, “U” and “L”) for the how and the phrase “new normal” for the what.

Discussions about the letter shape of recoveries simply refer to how a graph of GDP growth might look throughout the economic cycle. A new normal, according the investment manager PIMCO “reflects a growing realization that some of the recent abrupt changes to markets, households, institutions, and government policies are unlikely to be reversed in the next few years. Global growth will be subdued for awhile and unemployment high; a heavy hand of government will be evident in several sectors.”1 Oliver Blanchard, chief economist for the IMF, stated that “the recession has left ‘deep scars’ likely to affect consumers and businesses for years.”

The duration of any pending recovery and the lasting impact of the recession are still unknown and under considerable debate. Our objective is not to take a position on the possible “shape” of the potential economic recovery. Rather, we seek to assess what components of the economy are likely to influence the strength, sustainability and duration of a recovery. Over the last month, a number of economic reports have been released that will over time shed more light on the recovery, but currently are subject to interpretation. These include corporate profits, employment, retail sales and consumer credit.

Corporate profits

At the time of this writing approximately 90% of S&P 500 companies had reported second quarter profits with an aggregate surprise of earnings above consensus estimates close to 11%, one of the highest quarterly earnings surprises on record. (Fig. 2.) While the earnings estimates certainly overshot to the downside, the positive earnings quarter helped support the equity market’s recovery off of March lows, which is important because the equity markets almost always recover before the economy does.

Slowing growth concurrent with rising unemployment is common in recessionary environments and the recent productivity report revealed that compensation per hour for the second quarter was the weakest in 14 years, having increased 1.3% year-over-year. While this is obviously negative for American households, it is positive for corporate profitability.

Increased production will help lift corporate profits from current levels in the second half of the year, with automobiles potentially leading the way as a result of the Cash for Clunkers program. While there is a strong relationship between nominal GDP growth and corporate earnings growth over long periods of time, given earlier and stronger industrial and materials related demand from emerging economies, there is a strong possibility that S&P 500 earnings will outpace GDP expansion over the short term.

Proponents of a stronger and sustainable recovery argue that corporate cost cutting has paid off as shown by the better-than-expected second quarter profits of U.S. companies. In other words, while second quarter earnings still came in negative on an absolute basis, they surprised analysts on the upside. Moreover, earnings revisions have moved higher as economic conditions have shown signs of improving which should be viewed as a positive development.

Sure, earnings relative to expectations are driven almost exclusively by cost reductions, but cost cutting almost always leads sales growth out of recessions. You have to start somewhere. However, should corporate profits miss expectations and fall short in revenue growth, both the equity markets and economic recovery will be in jeopardy.

At this juncture, we are at a crossroad where the Bears are focused on cost cutting (e.g. job cuts) and the Bulls are focused on the pressing need for inventory re-stocking. We must stay tuned to see what the future holds.

Employment

Market participants have been eagerly waiting for the job loss trend to break through the -300,000 barrier, following the -500,000 and -400,000 barriers. Nonfarm payrolls contracted by 247,000 in July, the fewest number of job losses since August 2008. The latest report is dismal when compared with the 40-year average gain of 126,000 jobs per month. When compared with the employment environment since November of 2007, the most recent data suggests a further moderation in the trend of job losses. Payroll reports generally serve as lagging indicators, signaling the worst of the recession may be over and the recovery process in the economy, not necessarily the job market, is underway.

The unemployment rate also declined slightly from 9.5% to 9.4%, the biggest drop since September 2006. This small improvement in unemployment was driven by fewer job cuts and workers dropping out of the labor force. Despite this improvement, the average number of weeks of unemployment has spiked dramatically to 25.1 weeks, up from 16 weeks in March 2008, which represents the 20-year average duration of unemployment. (Fig. 3.) One out of every three unemployed workers has been out of a job for more than six months.

Recent productivity reports are also a disadvantage from the perspective of the unemployed. Gains in productivity and a record average duration of unemployment do not bode well for job seekers. Unfortunately, the faster the increase in productivity, the more moderate the job recovery can be. Over the long run, there is a positive relationship between GDP growth and employment growth. If the magnitude of the recession has caused employers to overshoot cost-cutting, there could be upside surprises in the labor markets.

While private sector hours have dropped, productivity has increased helping boost corporate profits. Furthermore, the surge in ISM Manufacturing means production is ramping up and that may signal the bottoming of payroll reductions. Significant increases in production may require re-hiring, which will also be boosted by government infrastructure spending.

Consumer credit

The year-over-year percent change in outstanding consumer credit fell 2.8% in June, the biggest drop on record since the inception of the Federal Reserve’s monthly tracking dating back to 1943. (Fig. 4.) Historically consumer credit has often served as a barometer for consumer activity, since consumer spending accounts for 60% to 70% of GDP. Consumer credit typically represents credit taken out for purchases other than homes.

Proponents of a “W” shaped recovery point to the above as evidence that the markets have run ahead of themselves in discounting an economic recovery. The markets will correct upon any sign consumers cannot help sustain the economic recovery through spending. Consumers are still fixing balance sheets and labor markets are not improving leading to a continued drag on the economy. Growth is being artificially manufactured by government stimulus and low rates which is unsustainable over the longer-term. The underlying current from the severe contraction in credit will remain with the economy for a long period.

Retail sales

July’s retail sales report disappointed the markets. Total sales fell 0.1% versus expectations of an increase of 0.8%. Excluding autos, retail sales declined 0.6%. (Fig. 5.) The report signaled that the weak labor markets and muted income growth continue to weigh heavily on consumption. It seems almost silly to think that steep job losses and massive wealth destruction would not continue to weigh on retail sales.

Critics argue that because real consumer spending has not yet turned up, businesses cannot realize improving sales (i.e. top-line growth) unless consumers start spending.

What to watch for

Last month we reviewed the inventory cycle and manufacturing, concluding that even in the absence of increased consumer spending manufacturing was poised to increase. We advised readers to watch for continued strength in the trend of the ISM Manufacturing index, even if the absolute reading is low by historical standards. (Fig. 6.) We likewise recommend taking the same approach for the economic data discussed this month. Pay particular attention to the employment data, as employment is typically the last economic indicator to turn positive. A strong reversal in job losses would signal that the economic recovery has some strength.

Where are we headed?

The issue should not be trying to assign a letter or symbol to the interpretation of a likely economic recovery. Rather, the focus should be on assessing whether or not the forces that caused the economic downturn are more powerful than those forces trying to prop up a recovery?

There is likely to be a cyclical rebound over the next few quarters driven by factors that do not require early consumer participation, including inventory restocking, manufacturing production and the continued impact of government stimulus and monetary policy. However, beyond a short-term rebound the consumer will have to step in to help sustain the recovery. There is widespread debate on whether the consumer can accomplish this, and we are too early in the cycle to really know for sure.

The range of possible outcomes from the current state is perhaps wider than after any recessionary period since the 1930s. A Bloomberg survey for third quarter 2009 GDP ranges from -3.3% on the low end to 4.7% on the high end, an extremely high range of 8.0%. All forecasters are calling for positive growth of 2.3% for 2010 GDP, with a low of 0.5% and a high of 4.0%, a range of 3.5%.

As we have advised throughout the course of this recession, it is best not to get caught up in extreme interpretations of the improvement in economic fundamentals. There may be too many downward pressures that put the high forecasts at risk, and likewise, there are probably too many upside risks to assign a high probability to the worst 2009 forecasted outcomes.

Over the past few months the recovery in economic data has been faster than the markets anticipated and this is demonstrated in part by the significant rally in global risky assets. While a rapid return to sustainable growth is not impossible, there are a number of factors that may reduce the probability of it occurring, including but not limited to, unemployment, consumer spending, a weak housing market, and continued deleveraging among households and corporations. Growth could be positive for a sustained period, but at the same time advance below long-run trends.

Hurricane Hugo led to a massive rebuilding effort that did in fact change certain areas of the region. In some areas, the aftermath initiated a renewal, as communities rebuilt, invested and attracted outside investors and aspiring home owners. This dramatically changed the economic dynamic with both positive and negative implications, depending on your point of view.

Damage to buildings and property and the ensuing rebuilding needs are well documented in the aftermath of any major storm. One lesser known and considerable impact of Hugo was the immense amount of trash and debris the storm caused. According to South Carolina state officials, the debris generated by Hugo shortened the lifespan of South Carolina’s sanitary landfills by seven years. In a way, the economy is currently picking up the debris caused by a massive super-cycle of debt, leverage and risky investments. We have argued in previous commentaries that at some point the excessive debt and leverage in the economy had to unwind. To the extent the recession moves this process forward at a much quicker and painful clip, then a “new normal” is not necessarily negative. We do not know where the next Isle of Palms will be, but we are confident it will happen somewhere.