Evolution or Revolution?

The title of this Outlook, “The Future of Investing,” is a theme that will take the evolving years to resolve, let alone the next few days. Still, PIMCO is an organization that loves a challenge. All of us here today would agree that the answer to both questions will be highly dependent on the evolution of the global economy, and when it comes to those questions PIMCO has excelled because of its long-term secular outlook. It has paid dividends for our clients for over 30 years and it should do so now as well. The fact is, that the future of investing will depend on the long-term future of the global economy – its nominal growth rate and the distribution of that growth between public and private interests. And so we should start at the beginning, or perhaps at the top, of our top-down process – the future of the global economy.

 I. Future of the Global Economy

The future of the global economy will likely be dominated by delevering, deglobalization, and reregulating, yet if so, it is important to state at the outset that we do not envision a mean reversion, cyclically oriented future, but instead a new world where players assume different roles, and models relying on bell-shaped/thin-tailed outcomes based on historical data are less relevant. Historical models look backward while modern-day finance is being fast forwarded and reconstituted almost as we speak.

 1) Delevering – The prior half-century of leveraging and the development of the amorphous shadow banking system was growth positive. Major G-10 economies became dominated by asset prices and asset-backed lending most clearly evidenced in housing markets. Excess consumption was promoted, and investment based on that consumption followed in turn. Savings rates in many countries including Japan, the U.K., and the U.S. fell towards zero as the reliance on rainy day thrift faded. Deleveraging of business and household balance sheets now means those trends must reverse, and as they do, growth itself will slow, bolstered primarily by government spending as opposed to the animal spirits of the private sector.

 This topic is one which literally could take hours to discuss, and at PIMCO forums and Investment Committee meetings, it does. There are those of us here as well as highly respected economists outside of PIMCO who would suggest destruction as opposed to slow growth, and they may have a minority, but not insignificant, case. Much depends on the effectiveness of policy responses and the simplistic answer to a simplistic question. Can global financial markets and the global economy heal by pouring lighter fluid on an already raging fire? Can too much debt be cured by the issuance of even more debt? Must the debt supercycle come to an end by crashing and burning or does the world keep breathing with a whimper instead of a bang? We shall see, but there is a near certain probability that the financially based global economy of the past half-century will not return, nor will we experience the steroid driven growth excesses that it facilitated.

 2) Deglobalization – Lost in the wondrous descriptions of finance-dominated, Bretton Woods-initiated, global growth has been the adrenaline push provided by global trade and indeed portfolio diversification into a multitude of markets – developed or developing. Yet historians point out that globalization is not an irreversible phenomenon – witness the aftermath of WWI and nearly three decades of implosion. Now the beginning signs of trade barriers – “Buy American” and “British jobs for British workers” among them – as well as government support of locally domiciled corporations (banks and autos) suggest an inward orientation that is less growth positive. Additionally, “financial mercantilism” is an added threat – a phenomenon that speaks to growing pressure on banks to retreat from international business and concentrate on domestic markets.

 3) Reregulation – Academics, politicians, investors, central bankers and everyday citizens are questioning the economic philosophy that idolized free markets and their ability to self-regulate. The belief in uncapped and unregulated incentives producing unlimited upside but nearly always cushioned downside losses is fading. While Sarbanes-Oxley was a well publicized but relatively toothless response to the dot-com bust of nearly a decade past, today’s politicians have gained the upper hand, driven by a citizenry that has recognized the unbalanced, disproportionate distribution of incomes. The efficient market thesis, so prevalent in academic theory and market modeling is now in retreat, and perhaps rightly so. In its place, we will experience less efficient but hopefully less volatile economies and markets – monitored and controlled by government regulation. Executive compensation, of course, is just the poster child. Government ownership and control of vital financial and manufacturing institutions will politely be described as “industrial based” policy and “burden sharing,” but we should have no doubt that we will move significantly away from the free market model that has dominated capitalistic countries for the past 25 years.

 With the top-down framework for future global economic growth in place, let’s take a look at PIMCO’s outlook for the future of investing – evolution or revolution.

 II. The Future of Investing

Whether evolution or revolution it is important to recognize that the aftermath of an economic and investment bubble transitioning from levering to delevering, globalization to deglobalization and lax regulation to reregulation leads to an across-the-board rise in risk premiums, higher volatility and therefore lower asset prices for a majority of asset classes. The journey to a new stasis is a destructive one insofar as it affects previously assumed wealth. Rough estimates suggest that as much as 40% of global wealth has been destroyed since the beginning of this delevering process. In essence, asset prices, which are really only the discounted future value of wealth creation, go down – not only because that wealth creation slows down but because it becomes more uncertain. In such an environment, equity interests in the form of stocks, real estate or even high yield bonds become re-rated. Those who believe that capitalism is and will remain a going concern and that risk taking – over the long run – will be rewarded, must recognize that those rewards spring from beginning prices and valuations that correctly anticipate the global economy’s future growth path and volatility. In terms of that old maxim “buy low – sell high,” this means at the minimum that an investor during this period of re-rating must “buy low.”

 In turn, investor preferences towards risk taking, even when correctly calculated and modeled must be considered. Peter Bernstein has for several years counseled that policy portfolios structured for the long run and based on historical return statistics should be reconsidered. The standard pension or foundation approaches to policy portfolios are being challenged, he asserts, and PIMCO agrees. Stocks for the long run? Home prices that cannot go down? The inevitable levering of asset structures to double or quadruple returns relative to risk-free assets? These historical axioms must now be questioned. In fact, as of March 2009, the superiority of risk-asset returns are not what many assume them to be. For the past 10, 25, and 40 years, for example, total returns from bonds have exceeded those for common stocks.1 Home prices have declined a staggering 30% since their peak in late 2006, and have barely kept up with inflation for the last century according to Case-Shiller statistics. Commercial real estate when ultimately mark-to-market over the next several years will likely show similar results. In short, our stereotyped conceptions of what makes money are being challenged. As Bernstein says, there is no predestined rate of return. And a PIMCO corollary would counsel that future rates of return will be dependent on the beginning price and future growth rates and risk preferences that cannot necessarily be derived from historical models. Government policies will also play an important role, especially insofar as they impact long-standing property rights and capital structures. What I have previously described as a CQ – a common sense quotient – may take precedence over IQ and quantitative analysis in future years. How much of a benefit, for instance, did the renowned risk modeling of some of our major competitors produce over the past several years in terms of their bond funds and derivative-related products as compared to PIMCO’s? We invite comparison, not only of our own risk models, but our collective common sense quotient.

 What then does common sense tell us about future asset returns? Let’s revisit our previous conclusions on the developing environment for some clues. They include: delevering, deglobalization, reregulation leading to slow global growth, a heightened risk aversion, a distrust of conventional investment model portfolios, and a greater emphasis on surviving as opposed to thriving. If valid, then an investor or an investment committee would likely stress the bird in the hand – as opposed to the one in the bush; stable and secure income – as opposed to uncertain capital gains; a government-regulated utility model – as opposed to innovative yet risky venture capital investments. At current price levels, to cite one example, the current income from corporate bonds is higher and certainly more secure than the dividend income from stocks.2 A return to an era reminiscent of the first half of the 20th century is not unimaginable where stocks were viewed as subordinated income producers with yields exceeding their senior bond companions on the liability ladder.

 But let me not go too far in suggesting that asset classes near the perimeter of risk have no future. They do if only because they eventually will be priced right. In fact, PIMCO intends to participate in the management of many of them, and as argued previously should be well and healthily positioned to do so. Our recent launch of a global multi-asset fund featuring tail-risk protection is just one example. The potential participation in TALF and other government-sponsored levered structures is another. Still, the tide seems to be going out and as Buffet suggests, all swimmers are being exposed, swimming suits or bare-bottomed naked.

 There are a host of investment implications that one can subjectively conclude from this outgoing tide, although they have not been officially endorsed by our upcoming secular forum. It seems to me, though, that one has only to ask what investments were positively affected by the previous long-term cycle of levering, deregulation, and globalization in order to imagine which ones will do poorly as the trends reverse. A short list might read as follows:

 (1) The Dollar – As the center of structured finance and the shadow banking system, the dollar was bolstered as it sold paper to the rest of the world. To date, its recent strength seems counterintuitive. Weakness may more accurately describe its future.

 (2) Credit – Lax regulation and increasing leverage squeezed risk premiums and spreads to historically overvalued levels. We are now moving in full reverse.

 (3) Equity – In addition to the previous conclusions, it is evident in retrospect that narrow risk premiums in credit markets facilitated narrow equity premiums in stocks if only because they seemed cheap by comparison and allowed corporations to borrow cheaply and buy back their own stock.

 (4) Emerging Market Globalization and lax lending standards re-rated emerging and developing country financial markets to unrealistic levels. Eastern Europe is likely the first to fall.

 Many of these trends, of course, have now reversed course, direction, and magnitude, and there will come a point where those low and lower prices, as well as the potential for successful policy healing, will favor what is now in disfavor. For now, however, let it be simplistically said that the trend is your friend and that the ad hoc, disjointed and anemic policy responses of government appear to be too little, too late. Investors should therefore favor stable income as opposed to speculative growth or the subordinate liability structures of most private market balance sheets. Shake hands with the government is and has been our motto although the contractual certainty of a government handshake may now be questioned in an increasingly number of marginal areas.

 Another way to summarize our caution would be to quote a recent comment by Barton Biggs. “I am a child of the bull market,” he said which upon further elaboration meant that he bought on cyclical dips with the expectation of riding mean reversion to an upward sloping trend line of prosperity and ultimately higher peaks. In a sense, we are all children of the bull market, although some of us are more mature than others – a bull market of free-enterprise productivity and innovation, yes, but one fostered by a bull market in leverage, deregulation and globalization that proved unsustainable in its excesses. We now must view ourselves as chastened adults, forced into acknowledging a new reality that is dependent upon bear-market delevering and debt liquidation to deliver us to our new and ultimate restructured destination – wherever it lies. Thus, while historians might describe these years as an evolution, for those of us living it day-by-day it most assuredly has the feel of a revolution. Much like Irving Fisher’s “permanently higher plateau” of prosperity that was quickly turned on its head in 1929, those who would forecast a “permanently lower valley” of despair might similarly be off the mark. Yet there should be no doubt that the bull markets as we’ve known them are over and that the revolution is on. Investing is no longer child’s play.

Bill Gross, CIO PIMCO
 

Improvement in the U.S. economy, whenever it comes, will be much weaker than recoveries from previous downturns, the founder of giant bond-fund manager Pacific Investment Management Co. said Friday.

Bill Gross, who is also Pimco’s co-chief investment officer, told CNBC that anyone expecting a robust uptick on the back of consumer spending ought to brace for a “new normal that in no way resembles past experience.”

“Those who would look for bottoms in the economy or the stock market, I think, are really focusing on the wrong thing, because that implies that we’re going to return to what is a normal stasis,” he said.

The “new normal” will likely see U.S. unemployment — now at a quarter-century high of 8.5% — reach 10% before it retreats to 8%, not 4%, Gross said. The economy, he added, will bottom before starting to grow at a modest 1% to 2%, not the 3%-4% of historical norms.

“We’re evolving into a post-levered financial economy which will witness intense regulation and a redistribution of profits and wealth, most importantly, to previously disadvantaged groups,” he said.

Gross said he believes the U.S. will show signs of recovery starting in the second half of this year, with the key driver being government stimulus spending.

Dow Jones Newswires

WASHINGTON — The U.S. continued to shed jobs at an unrelenting clip in March, pushing total losses since the recession started 16 months ago past five million.

The figures, which included another sharp rise in the unemployment rate to a 25-year high, are a sober reality check on the economy after some mildly encouraging news on housing, automobiles and manufacturing.

The risk is that if job losses continue at their recent pace, nervous consumers will be less likely to commit to the types of big-ticket items that usually propel recoveries, stamping out a recovery before it takes hold.

Nonfarm payrolls plunged 663,000 in March, the U.S. Labor Department said Friday, largely matching Wall Street expectations, according to a Dow Jones Newswires survey. However, January was revised to show a steeper loss of 741,000.

January’s decline is the third-largest on record. However, the other two — a 834,000 decline in 1949 and a nearly two million plunge in 1945 — were driven by one-time events including a large coal and steel strike and by the end of World War II.

The economy has shed 5.1 million jobs since the recession started in December 2007, with over two million of those losses occurring in the last three months alone.

“These declines have been widespread across industry sectors, but particularly sharp in manufacturing, construction, and temporary help services,” said Keith Hall, Commissioner of the Bureau of Labor Statistics.

Layoffs announcements continued last month across sectors including: United Technologies Corp. (UTX); General Dynamics Corp. (GD); National Semiconductor Corp. (NSM); and Wal-Mart Stores Inc. (WMT).

The unemployment rate, which is calculated using a survey of households as opposed to companies, jumped 0.4 percentage point to 8.5%, the highest since November 1983. In its latest report on the U.S. economy, the Organization for Economic Cooperation and Development said it expects the jobless rate to reach 10.5% by the end of next year.

By broader measures, the labor market is already there, and then some. When marginally attached and involuntary part-time workers are included, the rate of unemployed or underemployed workers hit 15.6% last month, up from 14.8% in February and more than six percentage points higher than it was one year ago.

Average hourly earnings increased a modest $0.03, or 0.2%, to $18.50. That was up just 3.4% from one year ago, a sign that inflation isn’t a threat.

To be sure, the severe first-quarter payroll drop doesn’t mean the economy can’t find its footing later this year, since employment has lagged the last couple of recoveries. Indeed, consumer spending — which accounts for about 70% of gross domestic product — likely expanded last quarter despite the loss of two-million-plus jobs.

But if that pace doesn’t decelerate noticeably by the middle of the year, then hopes for even a modest recovery this year would increasingly look out of reach.

According to Friday’s report, hiring last month in goods-producing industries fell by 305,000. Within this group, manufacturing firms cut 161,000 jobs, bringing the total since the recession began to 1.5 million.

Construction employment was down 126,000 last month.

Service-sector employment plunged 358,000. Business and professional services companies shed 133,000 jobs, the fifth-straight six-figure loss, and financial-sector payrolls were down 43,000.

Retail trade cut 47,800 jobs, while leisure and hospitality businesses shed 40,000 as households cut back on discretionary spending. Temporary employment, a leading indicator of future job prospects, fell by more than 70,000.

As has been the case throughout much of the recession, the sole bright spot among private sector industries was health care, which tends to be more labor intensive than manufacturing and other services. Health care payrolls rose 13,500.

The government shed 5,000 jobs last month due to cutbacks in state and local payrolls.

The average workweek slid 0.1 percentage point to 33.2 hours. A separate index of aggregate weekly hours fell one percentage point to 100.9.

The Federal Reserve ramped up its efforts to resuscitate the sagging economy, saying it would purchase up to $300 billion of long-term U.S. Treasury securities in the next few months and hundreds of billions of dollars more in mortgage-backed securities.

By buying long-term government bonds and mortgage-backed securities, officials hope to push up their prices and bring down their yields, and thereby energize the economy. Interest rates on many corporate bonds and consumer loans are benchmarked to U.S. Treasury debt.

The move was a bold statement of force from the central bank, which during months of internal debate on the issue had been hesitant to begin buying long-term government bonds as the Bank of England recently began to do.

The Fed action underscores the central bank’s ability to move aggressively to combat the financial crisis without any action by Congress, an important attribute at a time when the political firestorm ignited by bonuses made to employees of American International Group Inc. (AIG). Other rescue efforts has made Congress hostile to approve any more taxpayer money.

Prices on U.S. Treasury bonds soared on the news and the yield fell sharply. Yields on 10-year treasury notes dropped, stock prices rose sharply and the dollar sank.

The Fed’s steps came against a gloomy economic backdrop. “Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending,” the Fed said in a statement after its two-day meeting. “Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession.”

The Federal Open Market Committee, the Fed’s policy-making arm, voted 10-0 to hold the target federal-funds rate for interbank lending in a range between zero and 0.25% and to continue using credit programs financed by an expansion of the Fed’s balance sheet to stabilize markets. Richmond Fed President Jeffrey Lacker, who dissented in January, went along this time. He had wanted the Fed to focus on Treasury purchases as opposed to targeting its lending on various corners of the credit markets. The discount rate that the Fed charges on direct loans to banks was unchanged at 0.5%.

With rates near zero, the Fed is now essentially printing money to increase the supply of credit in the economy.

The Fed said it will buy up to $300 billion in long-term Treasurys over next six months. The purchases of mortgage-backed securities guaranteed by Fannie Mae (FNM) and Freddie Mac (FRE) will push the maximum to $1.25 trillion, up from the previous $750 billion. The Fed also said it would increase the size of its potential purchases of the mortgage giants’ debt to $200 billion from $100 billion.

The Fed’s strategy appears to be to double down on the programs that it thinks work. In addition to commercial paper and money market mutual fund facilities, which appear to have stabilized those sectors, Bernanke has repeatedly highlighted the decline in mortgage rates in response to the agency and mortgage-backed securities facilities, calling it one of the “green shoots’ evident in some markets.

By expanding its securities purchase programs, the Fed also is effectively ramping up efforts they can control. The commercial paper program and a new consumer lending program that commences Thursday are driven by how much demand there is in the markets.

Demand has waned for the commercial paper program in recent weeks, a sign that the market is returning to health. Meantime, the new consumer lending program the Term Asset Backed Securities Loan Facility, or TALF, has gotten off to a slow start.

The U.S. economy is expected by economists to decline at an annual rate of 5% or more in the current quarter. It plunged at a 6.2% rate in the fourth quarter of 2008, the steepest in a quarter century. The economy is now shedding more than 650,000 jobs a month, pushing the unemployment rate to 25-year highs. One nugget of good news is that consumer-spending figures signaled some stabilization since the start of the year.

By Jon Hilsenrath andBrian Blackstone
Of THE WALL STREET JOURNAL

 Corporate dividends were once sacred, but no longer. As the economy declines, so have the regular cash payouts that both companies and stockholders considered untouchable. Some of the biggest names in U.S. business have cut or eliminated dividends — choosing not to share the wealth either because they need the money now or think they will later.

Last year was the worst ever for dividend reductions among Standard & Poor’s 500 stock-index companies. In the final three months of 2008 alone, $15.9 billion worth of S&P 500 dividend payouts were whisked off the table.

That quarterly record has already been eclipsed in the first two months of 2009 with more than $30 billion in dividends wiped out, most notably General Electric Co.’s (GE) move late last month to slash its quarterly distribution by more than two-thirds.

For investors who depend on dividend income, or who expected the cash would cushion the bear-market’s blows, the setback has been sobering. The cuts have been particularly unkind to shareholders of dividend-focused mutual-funds and exchange-traded funds who’ve suffered losses in both take-home yield and investment returns.

“Dividend investors have now joined the rest of investors in looking for safer harbors, and there are not many out there,” said Howard Silverblatt, senior index analyst at Standard & Poor’s Inc.

Big Payers Cutback

The comedown is especially hard for dividend cutters that not long ago were considered highly predictable payers — so-called dividend aristocrats — such as Bank of America Corp. (BAC), Pfizer Inc. (PFE) and GE.

Dividend investing itself also has been tarnished. Dividend growers historically have been defensive stalwarts, outperforming less-generous corporate rivals and the U.S. market as a whole through good times and bad, and with less risk.

S&P 500 companies that raised dividends gained 8.8% on average annually between January 1972 and last November, according to Ned Davis Research Inc. Index members that cut dividends or paid no dividends finished the period with essentially flat returns.

Still, shareholders who temper their expectations can find cash-rich companies that are increasing dividends. The battered financial-services sector is being necessarily frugal, but some commodity-related and consumer-staples companies have breathing room.

Recently, for example, agricultural bellwethers Archer-Daniels Midland Co. (ADM) and Monsanto Co. (MON), along with soft-drink giant Coca-Cola Co. (KO), retailer Wal-Mart Stores Inc. (WMT) and paper-goods supplier Kimberly-Clark Corp. (KMB) boosted payouts.

“Dividends are an endangered species, but nowhere near extinct,” Silverblatt said. “You’ve got to do a lot more homework. Pick the company first, the dividend second. A high yield won’t do you any good if the company can’t sustain it.”

Against this grim backdrop, managers of funds that focus on dividend-payers are facing the most challenging conditions many have ever experienced.

“Clearly this environment has created some stress,” said Don Taylor, lead manager of Franklin Rising Dividends Fund (FRDPX). He screens for companies that have raised dividends in at least eight of the last 10 years, and then chooses only those whose dividends have doubled over a decade.

“A lot of companies that previously met the rising-dividend screen no longer do,” he added.

Some managers are tightening the screws. Judith Saryan, who oversees the Eaton Vance Dividend Builder (EVTMX) and Dividend Income (EDIAX) funds, is analyzing corporate financials for signs of cash shortfalls.

“You want to avoid companies paying the highest yield because they’re the ones that are most at risk,” she said. “Even a very good company that needs to access the credit market might raise a red flag.”

Financial-services companies comprise the bulk of distressed dividend payers, and these high-yielding stocks often show up in the equity-income fund category, which has been broadsided as a result.

Roam The Market For Payers

“Equity-income is under a cloud because of the feeling that these companies are not secure, their finances are eroding, and they probably would cut the dividend,” said Mark Salzinger, editor of the No-Load Fund Investor newsletter.

Salzinger recommends vehicles that roam the broad market for dividend growers, such as the mostly large-cap Vanguard Dividend Growth Fund (VDIGX). An ETF sibling, Vanguard Dividend Appreciation (VIG), also highlights dividend standouts but sports a much different portfolio.

Other proven dividend-oriented stock funds, in addition to the Franklin and Eaton Vance portfolios, include T. Rowe Price Dividend Growth Fund (PRDGX) and Alpine Dynamic Dividend Fund (ADVDX).

Choices among ETFs include: PowerShares Dividend Achievers (PFM), WisdomTree Large Cap Dividend (DLN), SPDR S&P Dividend (SDY), and the largest of the group, iShares Dow Jones Select Dividend Index (DVY).

In the search for dividends, remember that high quality, not high yield, counts most in this market.

“You really need companies that have the most quality balance sheets you can possibly find,” Salzinger said. “A good dividend-growth fund would invest across industries in stocks that yield between 1% and 3% and have the capacity to increase those dividends over time.”

By Jonathan Burton

WASHINGTON — The U.S. recession was far more severe at the end of 2008 than first reported because companies cut supplies to adjust for falling spending by consumers and businesses at home and abroad.

Gross domestic product decreased at a seasonally adjusted 6.2% annual rate October through December compared to the prior quarter, the Commerce Department said Friday in a new, revised estimate of fourth-quarter GDP.

The 6.2% tumble followed a 0.5% decline in the third quarter and meant the worst quarterly showing for GDP in nearly 27 years — since a 6.4% plunge during first-quarter 1982 GDP.

GDP is a measure of all goods and services produced in the economy. The 6.2% decrease in fourth-quarter GDP surprised Wall Street. Economists surveyed by Dow Jones Newswires forecast the revision would show a smaller, 5.4% decrease.

Stephen Stanley, an analyst for RBS Greenwich Capital, had a name for the fourth quarter: “an economic washout.”

“And conditions do not appear to have gotten any better in the first quarter,” he said.

The Obama administration, in its first month in office, pushed through a Congress with a Democratic majority an enormous package of stimulus for the slumping economy. But the relief isn’t seen kicking in for a while.

“The recently enacted $787 billion stimulus package will have virtually no impact on growth in the first half of this year, but will help to turn the economy around by the second half,” wrote Nariman Behravesh, an economist for IHS Global Insight. “Even then, the best we can hope for is an average growth rate of around 0% in the third and fourth quarters -with a small contraction in Q3 followed by weak positive growth in Q4.”

The National Association of Business Economics sees a 5.0% contraction in first-quarter GDP and a 1.7% drop in the second quarter. The latest survey of the group’s forecasters was released Monday; 47 of them were polled Jan. 29 to Feb. 12. They see a modest upturn in the second half of 2009, a sub-par increase of 1.6%. For 2010, growth is projected at 3.1%.

The economy is so bad, inflation isn’t a concern any more, suggests data issued not even a year since soaring oil prices were rattling nerves all over the land. Deflation is now a worry. A gauge within the GDP data, the price index for personal consumption expenditures, decreased 5.0%. The PCE price gauge excluding food and energy increased 0.8%; Federal Reserve officials define their statutory goal of price stability as inflation of 1.5% to 2%.

The government revision issued Friday lowered GDP to a 6.2% decline from an originally estimated 3.8% fall. The adjustment reflects revisions to inventory investment, exports and consumer spending.

The report showed businesses inventories shrank $19.9 billion in the fourth quarter, instead of rising by $6.2 billion as Commerce originally estimated. Third-quarter inventories fell by $29.6 billion in the third quarter.

Falling prices — oil is a good example — likely contributed to the fourth-quarter drop in inventories. But companies also likely liquidated stocks of goods to adjust for retreating demand amid the recession, which began in December 2007. Since then, 3.6 million jobs have vanished.

The inventory revision in Friday’s report was good and bad. Bad, because the $19.9 billion drop meant inventories added a mere 0.16 of a percentage point to GDP in the fourth quarter, instead of adding 1.32 percentage points as reported originally. But the drop also suggests there is less of an inventory overhang, a bit of good news. Still, inventory-to-sales ratios have gone up, an unwelcome sign. Excess inventory will have to be worked off, and that signals production cuts, which, in turn, could mean layoffs and further impair the economy. Experts see a large drawdown of stockpiles during the first half of 2009 and expect a big drop in GDP during the current, first quarter.

“The drop in inventories means there is less of an inventory rundown ahead, other things equal, but the effect is marginal,” said Ian Shepherdson, an analyst at High Frequency Economics. “Everything else looks grim and we think (the first quarter) will not be much better.”

Trade took a bite out of the economy in the fourth quarter, the data revisions revealed. U.S. imports fell 16.0% instead of 15.7% as originally reported. Exports were revised down, dropping 23.6% instead of falling 19.7%. Trade reduced GDP by 0.46 of a percentage point in the fourth quarter. Originally, trade was seen adding 0.09 of a percentage point to GDP.

Businesses decreased spending more than previously thought. Outlays fell by 21.1% October through December, lower than the originally estimated 19.1% decrease. Business spending fell 1.7% in the third quarter. Fourth-quarter investment in structures decreased 5.9%. Equipment and software plunged 28.8%.

Fourth-quarter spending by consumers tumbled 4.3%, down from a previously reported 3.5% decrease and below the third quarter’s 3.8% decline. Consumer spending accounts for about 70% of economic activity. It cut 3.01 percentage points out of GDP in the fourth quarter, instead of the tamer reduction of 2.47 percentage points initially thought.

A separate report Friday showed consumer sentiment fell in February. The Reuters/University of Michigan final sentiment reading stood at 56.3; it was 61.2 in January. “Consumers are clearly very worried about the economy,” Insight Economics analyst Steven Wood said.

The sick housing sector undercut GDP sharply. Residential fixed investment decreased by 22.2% in the fourth quarter, a smaller drop than the originally estimated 23.6% but bigger than a third-quarter spending drop of 16.0%.

The sector became overbuilt in a boom that turned bust in a big way. Receding demand pushed up supplies of unsold homes, forcing down prices and undercutting sales further. Many home builders have thrown in the towel. Home construction in January was 56.2% below the pace a year earlier.

Real final sales of domestic product, which is GDP less the change in private inventories, decreased by 6.4% in the fourth quarter, a revision down from an originally estimated 5.1% decrease. Third-quarter sales fell by 1.3%.

Federal government spending investment increased by 6.7% in the fourth quarter, a bigger climb than the originally estimated 5.8% increase. Third-quarter spending rose by 13.8%. State and local government outlays fell 1.4% in the fourth quarter.
By Jeff Bater
Of DOW JONES NEWSWIRES

 WASHINGTON — U.S. employment plunged in January by a three-decade high, a government report showed, bringing total job losses since the recession started in December 2007 to 3.6 million.

Half of those losses occurred in the last three months alone, and the stepped-up pace of layoffs in recent months suggests no end in sight to the economic downturn.

The report, which included another sharp rise in the unemployment rate to a 16-year high, upped the heat on U.S. lawmakers to enact a large fiscal stimulus package.

Nonfarm payrolls, which are calculated by a survey of establishments, tumbled 598,000 in January, the U.S. Labor Department said Friday, the most since December 1974 and well above the 525,000 drop Wall Street economists in a Dow Jones Newswires survey expected. December was revised to show an even steeper decline of 577,000.

The government included revisions for all of 2008, which showed the U.S. lost about 3 million jobs last year, roughly 400,000 more than first thought. In the 12 months through January, the economy shed more jobs over that timeframe since the government started compiling those figures in 1939.

“Job losses in January were large and widespread across the major industry sectors,” said Keith Hall, commissioner of the Bureau of Labor Statistics. Mirroring the government data, a Who’s Who from Corporate America including Caterpillar Inc. (CAT), Home Depot Inc. (HD), Black & Decker Corp. (BDK) and Microsoft Corp. (MSFT) all announced layoffs in January.

The unemployment rate, which is calculated using a survey of households, jumped 0.4 percentage point to 7.6%, the highest since September 1992. Employment in the household survey plummeted by more than 1.2 million. Some economists think the jobless rate may hit 9% in coming months.

“It is an unmitigated disaster,” said Chris Rupkey, economist at Bank of Tokyo-Mitsubishi. “The scary thing is that there is no end to the soaring jobless rate in sight.”

Indeed, by some broader measures labor-market conditions are even worse than the main numbers suggest. When marginally attached and involuntary part-time workers are included, the rate of unemployed or underemployed workers actually reached 13.9% last month, up almost five percentage points from a year earlier. The employment-to-population ratio was the lowest since 1986.

According to Wachovia Chief Economist John Silvia, job losses have already outpaced those of the 1982 downturn. That recession is considered by many to be among the worst since World War II.

With no more room to lower official interest rates, which are near zero, Fed policymakers now have to rely on quantitative easing through the Fed’s balance sheet to pump money into the financial system. Officials will likely face more pressure to widen their efforts to perhaps even include purchases of longer-term Treasury securities.

Average hourly earnings increased a modest $0.05, or 0.3%, to $18.46. That was up 3.9% from one year ago.

Friday’s numbers, along with grim automobile and retailer sales reports, suggest that the economy hasn’t stabilized after the fourth quarter’s 3.8% slide in gross domestic product, which was the steepest since 1982.

According to Friday’s report, hiring last month in goods-producing industries plunged by over 300,000. Within this group, manufacturing firms cut 207,000 jobs, the most since the 1982 recession, with losses concentrated in fabricated metals and motor vehicles and parts.

Construction employment was down by 111,000.

Service-sector employment tumbled 279,000. Business and professional services companies shed 121,000 jobs, the third-straight six-figure loss, and financial-sector payrolls were down 42,000.

Retail trade cut over 45,000 jobs, the 12th-straight loss, while leisure and hospitality businesses shed 28,000, as households curtail nonessential spending.

Temporary employment, which economists consider a leading indicator of future job prospects, fell by more than 76,000.

Among the sole bright spots were health care and education, which tend to be more labor intensive and less productive than manufacturing and other services. Employment in those sectors together rose 54,000.

The government added 6,000 jobs.

The average workweek was unchanged at 33.3 hours. However, a separate index of aggregate weekly hours fell 0.7 points to 102.6.

By Brian Blackstone
Of DOW JONES NEWSWIRES

WASHINGTON — The final employment report for 2008 closed the books on a miserable year for U.S. workers with payrolls plunging last month by more than half a million, pushing the unemployment rate to a 16-year high of more than 7%.

The economy lost 2.6 million jobs last year, the most since Harry Truman was president in 1945, though the labor force was much smaller then. Nearly 2 million of those losses were in the last four months of 2008 alone, a sign that the recession accelerated as the financial crisis intensified and should drag on well into the new year.

The figures will likely put pressure on Federal Reserve officials to expand already aggressive quantitative easing steps in which cash is essentially created and pumped into the economy, and gives backing to those calling for large-scale fiscal stimulus.

Nonfarm payrolls, which are calculated by a survey of establishments, tumbled 524,000 in December, the U.S. Labor Department said Friday, the 12th-straight decline and in line with the 525,000 drop Wall Street economists in a Dow Jones Newswires survey expected. November was revised to show an even steeper decline of 584,000, the most since 1974, and October was also worse than first thought.

The pullback was broad-based among manufacturing, construction and most service industries. Companies across a variety of sectors, including AT&T Inc. (T), DuPont Co. (DD) and Bank of America Corp. (BAC), all announced job cuts last month. That trend continued into this year with Alcoa Inc. (AA), EMC Corp. (EMC), Walgreen Co. (WAG) among others announcing cuts in January.

Meanwhile, the unemployment rate, which is calculated using a separate survey of households, jumped 0.4 percentage point to 7.2%, the highest since January 1993. Economists think the jobless rate, which was just 5% as recently as April, will hit 8% or higher in coming months.

“At this pace, the unemployment rate could well test double digits later this year, and certainly looks well on course to do so during 2010 at the latest,” said ING Bank economist Rob Carnell, in a research note.

Indeed, according to the minutes of the Fed’s December meeting released Tuesday, its staff economists expect the unemployment rate to rise “significantly” into 2010.

By some broader measures, labor-market conditions are even worse than the main numbers suggest. When marginally attached and involuntary part-time workers are included, the rate of unemployed or underemployed workers reached 13.5% last month, up almost six percentage points from a year earlier.

With the Fed having already lowered official interest rates to near zero last month, officials will have to rely on quantitative easing through the Fed’s balance sheet to pump money into the financial system, and officials will likely face more pressure to widen their efforts.

Average hourly earnings increased $0.05, or 0.3%, to $18.36. That was up just 3.7% from a year earlier, suggesting wage inflation remains under wraps.

Friday’s numbers, along with weak automobile and retailer sales reports for December, suggest that after contracting just 0.5% at an annual rate in the third quarter, gross domestic product probably plunged 5% or more in the fourth quarter, which would be the steepest decline since the early 1980s.

Many economists expect U.S. GDP to contract again this quarter, albeit at a softer pace, and stall or contract next quarter as well.

Against that backdrop, expect another 1.5 million job losses at least by the middle of the year, said Harm Bandholz, economist at UniCredit Markets and Investment Banking.

According to Friday’s report, employment last month in goods-producing industries plunged by just over 250,000. Within this group, manufacturing firms cut 149,000 jobs, with motor vehicles and auto parts makers accounting for 21,000 job losses.

Construction employment was down by 101,000 last month and has fallen almost 900,000 since peaking in September 2006.

Service-sector employment tumbled 273,000. Labor-intensive services make up the vast majority of employment and usually cushion downturns. Yet business and professional services companies shed 113,000 jobs, the second-straight six-figure loss, and financial-sector payrolls were down 14,000.

Retail trade cut over 66,000 jobs, reflecting the bleak holiday shopping season. Leisure and hospitality businesses, meanwhile, shed 22,000 jobs as households rein in non-essential spending.

Temporary employment, which economists consider a leading indicator of future job prospects, fell by more than 80,000.

Among the sole bright spots were health care and education, which tend to be more labor intensive and less productive than manufacturing and other services. Employment in those sectors together rose 45,000.

The government added 7,000 jobs.

The average workweek fell 0.2 hour to 33.3 hours. A separate index of aggregate weekly hours fell 1.2 points to 103.5.

In another worrying sign, business wholesale inventories decreased in November by 0.6% compared with the prior month, the Commerce Department said, as sales plunged a record 7.1%. Automotive inventories increased 1.2% as sales fell 10.6%, suggesting that people afraid for their jobs aren’t making big purchases.

According to Insight Economics analyst Steven Wood, inventories should depress GDP in both the fourth quarter and first quarter.

By Brian Blackstone
Of DOW JONES NEWSWIRES

WASHINGTON — U.S. Federal Reserve officials on Tuesday slashed official interest rates to an historic low range to combat a deepening recession and signaled they will keep rates “exceptionally low” for some time amid rapidly waning price pressures.

Officials also signaled a new phase for policy in which lending programs financed by the Fed’s ballooning balance sheet, a process known as quantitative easing, replace the federal funds rate as the Fed’s primary policy tool.

The Federal Open Market Committee voted unanimously to reduce the target fed funds rate for interbank lending from 1% to a range of zero to 0.25%, the lowest since the Fed started publishing the funds target in 1990. The market-determined effective fed funds rate already has already hit record lows in recent weeks.

Economists had expected a smaller cut of just 0.5 percentage point, and hadn’t envisioned the Fed setting a range.

“The Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time,” the Fed said, adding it will “employ all available tools” to promote growth and maintain price stability.

The Fed has used a variety of operating targets through the decades, including the discount rate and monetary aggregates.

The Fed also lowered the discount rate paid by commercial and investment banks for Fed loans by 0.75 percentage point to 0.5%.

In a statement, the FOMC said its focus “will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level.”

Ben Bernanke tipped the shift toward quantitative easing — in which cash is essentially created and used to finance lending facilities — earlier this month. He said that while the Fed’s ability to use interest rates to support the economy “is obviously limited” with rates so low, the “second arrow in the Federal Reserve’s quiver — the provision of liquidity — remains effective.”

Even President-elect Barack Obama on Tuesday said “we are running out of the traditional ammunition that’s used in a recession, which is to lower interest rates, they’re getting to be about as low as they can go.”

The Fed already has nontraditional initiatives in place to support lending to commercial and investment banks, provide U.S. dollar funding overseas and stabilize commercial paper and money market mutual funds. The Fed recently started purchasing agency debt and has announced plans to purchase hundreds of billions of dollars of agency-backed mortgage backed securities and consumer-linked asset backed securities.

In Tuesday’s statement, the Fed also said it is “evaluating the potential benefits of purchasing longer-term Treasury securities.”

When loans to Bear Stearns and American International Group are included, the Fed’s balance sheet now tops $2.2 trillion, more than double where it was when Lehman Brothers collapsed in mid September.

Meanwhile, the drumbeat of economic news worsened considerably between the late October and December FOMC meetings, highlighting the need for more stimulus. Consumer spending got off to a horrible start in the fourth quarter, and the economy lost more than 500,000 jobs in November alone, a total that could be matched or exceeded this month.

On Dec. 1 the National Bureau of Economic Research, the semi-official arbiter of recession, declared that the U.S. has been in a recession since last December. And it appears to be getting worse. Wall Street economists expect U.S. gross domestic product to plunge as much as 6% at an annual rate or even more this quarter. Some are penciling in another steep drop for the first quarter of 2009.

“The outlook for economic activity has weakened further,” the Fed said, noting weak labor markets and declining consumer spending, production and investment.

That weakness, coupled with a steep declines in energy prices, has not only brought inflation rates down sharply but also fanned some fears of outright deflation — which is a sustained, economy-wide decline in prices that cripples consumer and business spending. In its worst form, deflation is associated with Japan’s deep recession earlier this decade as well as the Great Depression.

According to November consumer price data released Tuesday, annual U.S. inflation is now running just 1.1%, matching its lowest rate since 1965. If December data come in soft as expected, the annual rate could approach zero.

“Inflationary pressures have diminished appreciably,” the Fed said, citing lower energy prices and the weak economy.

Still, Fed officials didn’t go as far as they did in 2003, when they referred in policy statements to the risk of an “unwelcome fall” in inflation.

Officials have good reason to avoid such language for now. Outside of energy and energy-dependent sectors, prices are still rising albeit at a slower pace then they were a few months ago.

And the Fed’s deflation fears in 2003 and 2004 appear in hindsight to have been overblown and may even have contributed to ultra-low interest rates that fueled the housing bubble.

By Brian Blackstone andMaya Jackson Randall
Of DOW JONES NEWSWIRES

The percentage of U.S. mortgage holders who were behind in their payments soared to a record 6.99% of loans outstanding in the third quarter, the Mortgage Bankers Association said Friday, and the number of mortgages somewhere in the foreclosure process was also at a new high.

But the number of mortgages on which foreclosure proceedings was started actually fell slightly during the third quarter compared with the second quarter, according to the Mortgage Bankers Association’s quarterly delinquency survey. But that doesn’t necessarily indicate a slowdown in foreclosures, said Jay Brinkmann, MBA’s chief economist.

“An initial look at the number of foreclosure starts would seem to indicate at least a leveling off of foreclosures,” Brinkmann said. “These numbers, however, are being influenced by several factors including various moratoria on foreclosure filings and by mortgage companies holding loans in the 90-plus-day bucket during the modification and workout process.”

“Evidence of this can be seen in the large increase in loans 90 days or more past due but not yet in foreclosure. This rate jumped by 45 basis points, the highest increase in this category ever recorded in the MBA survey and far above the average 4 basis point jump we would expect to see,” he added.

Mortgages entering the foreclosure process fell to 1.07%, from 1.08% in the second quarter but were up from 0.78% a year ago. The delinquency rate for mortgage loans on one- to four-unit properties was 6.99% of all loans outstanding at the end of the third quarter. That’s up from 6.41% at the end of the second quarter and 5.59% a year ago, according to the survey.

“There are some good reasons, in a sense, why that number might go up,” Brinkmann said, during a phone interview. As mortgage lenders and servicers try and work with borrowers, constructing repayment plans and modifying loan terms, those borrowers will remain classified as delinquent until they can show they can make payments on time, he said.

The percentage of loans somewhere in the foreclosure process also rose in the third quarter to 2.97%, up from 2.75% in the second quarter and 1.69% a year ago, and a new record.

But some of the reasons why people are struggling to make their mortgage payments are shifting, Brinkmann said.

In past quarters, California and Florida have had some of the highest foreclosure start numbers, and much of that had to do with a combination of too many houses, speculation and weak underwriting, he said. Now, those states are dealing with job losses.

“Economic fundamentals are now deteriorating in California and Florida. Over the past year, Florida led the nation in job losses at 156,200, with California losing 101,300, as compared with Michigan job losses at 71,200 and Ohio at 17,300,” he said in the release.

Subprime mortgages continued to perform poorly, with more than 19.5% of those loans seriously delinquent in the third quarter, meaning homeowners were more than 30 days past due on payments.

Amy Hoak: Dow Jones News