A 10.2% unemployment rate is nothing if not grim news. But it begs the question – What does it mean for business activity going forward? Unfortunately, there is a deep divergence of opinion on the answer to this important question. In one corner, we have the “Lagging Indicator” crowd – those that believe – as the namesake suggests – that unemployment is a lagging indicator and therefore not a meaningful predictor of where the economy might be headed. In other corner, we have the “Coincident Indicator” crowd – those that essentially believe that in a credit induced contraction – like this camp would argue we are currently experiencing – that the unemployment rate is a quite reliable – and in this case grim – predictor of economic activity over the near to medium term.
The Lagging Indicator theory suggests that in a typical business cycle that unemployment is obviously one of the last economic statistics to turn positive. Why after all would businesses turn first towards increased hiring to meet growing demand when other cheaper options – like increasing work hours for example – are typically available? The answer of course is that businesses would indeed tend to opt for the cheaper option. And, as it happens, the Coincident Indicator crowd generally agrees with this assessment.
So where’s the beef? The “beef” – as it were – effectively turns on the question of which type of downturn is occurring – a typical business cycle or a downturn induced by credit contraction?
A typical business cycle is generally characterized by continuing strong underlying fundamentals – competitiveness, good demand growth expectations, productivity gains and the like. But a period preceded by excess production and investment in capacity. So the resulting excess inventories and production capacity requires rebalancing – a little time to be absorbed by the economy. During such rebalancing periods, businesses often shed some workers for a period – until demand has a chance to catch up.
A credit contraction induced downturn is generally characterized by consumers and businesses having taken on too much debt in the previous period – generally in amounts that exceeded their income growth potential. And when credit growth subsides, they find that a greater portion of their income must now devoted to servicing those debt balances – thereby not being available to direct towards the key drivers of GDP growth – those being consumption and/or investment. In short, the credit contraction theory essentially argues that excessive debt has weakened the underlying fundamentals.
Although few can credibly argue that there is not an element of credit contraction associated with our current downturn, there remains widespread debate on the continuing strength – or lack thereof – of the underlying fundamentals.
In such an environment Bulls and Bears can point to the same event and credibly reach two nearly polar opposite conclusions. Take Warren Buffet’s recent bid for Burlington Northern (railroad) for example. Bulls point out that arguably the greatest investor of the modern era has seen fit to plunk down $34 billion (the largest ever acquisition by Berkshire by factor of two) as a “Bet on America”. Bears say it is nothing more than a terrifically shrewd bet on the long term price of energy (since rail transportation becomes increasingly competitive compared to truck transportation as fuel prices increase) and perhaps a back door bet on international demand for coal (since Burlington derives a majority of its marginal income from shipping coal from U.S. heartland to the west coast for export – mostly to Asia).
So the debate rages onward. But what does it all mean for our clients – the small and medium sized businesses at the heart of our economy? On the one hand, we can’t say with any conviction which argument seems better – our crystal ball is no better than others in the end. On the other hand, however, the buzzword that strikes us as quite sensible in this environment is “prudence”. Managing towards preservation of capital (i.e. keeping operating costs down) and maintaining liquidity (i.e. making sure that borrowing capacity is maintained or increased) seems to us to be a mantra with little downside risks. No one ever went broker after all – to paraphrase Mr. Buffet – by being profitable and having access to a stable source of funding.