7/23/2009
By Carlos Guillen, Semiconductor Analyst

As it is widely known, increasing levels of unemployment tend to be the by-products of recessionary macroeconomic conditions. If we look back at the last couple of recessions, we can actually observe the time delay between the end of a recession and peak unemployment rates. For instance, the recession of the early 80s, which was mainly caused by sharply increasing oil prices around the world, ended in November 1982, but the unemployment rate remained at above 9% for one extra year. The recession of the early 90s, which was partially caused by the start of the Gulf War and by the resulting 1990 spike in the price of oil, ended in March 1991; however, the unemployment rate continued increasing to 7.50% in 1992. The recession caused by the dot-com bubble in the early 2000s ended in November 2001, but yet the unemployment rate continued rising for two years, reaching 5.99% in 2003. However, the current recession that we are experiencing is different than the typical recessions just mentioned. This recession is the result of massive leverage in the housing, financial, corporate, and public sectors. Unemployment in June reached 9.51% and will most probably top 10% towards the end of this year. Given these conditions, we contend that unemployment may have a feedback effect on gross domestic product (GDP) and that it may likely act as a leading indicator, putting pressure on consumption and attenuating growth in the long term.

While the unemployment rate in June totaled 9.51%, increasing from 9.36% in May, the actual situation is actually more severe than this. If we add to the unemployment figure "part time for economic reasons" of 9.0 million and "marginally attached to the labor force" of 2.2 million, we calculate an unemployment rate of 16.5%. Moreover, we must also consider that total labor income is also significantly weakening. Labor income is defined as the product of labor units, hours of labor, and average wages. As we all know, labor units have been decreasing, but making the situation worse is that in an effort to spread the pain, companies have been reducing hours and average wages, basically reducing total labor income.

One of the feedback effects of this drop in labor income is that it will significantly reduce consumer confidence and, as a result, consumption. As it stands, consumer confidence in July took a turn for the worse, decreasing to 64.6 from the 70.8 level posted in June and landing below the Street's expectation of 70.0. It is clear that consumer confidence has been negatively affected by the continuing rise of unemployment as well as by the rapid rise in fuel prices.

In looking at retail sales, we can observe that, despite modest sequential gains, these sales are still significantly lower year over year, down 8.49% in June. What is currently happening is that consumers are changing their spending habits, buying less and saving more of their disposable income.

In fact, despite government efforts to stimulate the economy by providing tax rebates, consumers are becoming even more worried about their jobs, income, and overall debt levels. Many homeowners have taken massive hits to their net worth as home values have plummeted, and now they can't use their homes as ATMs as they once did. Consequently, consumers have no choice but to save more and consume less. As we can observe in the chart below, the personal savings rate has been rapidly rising on a month-to-month basis since late 2008, and in May 2009 this figure clocked in at 6.93%, representing the highest savings rate since December 1993 when the savings rate was 7.63%.

Another major risk associated with the ramping unemployment rate is that if it rises well above 10%, many banks will find themselves under water as delinquency rates will also increase, putting the entire banking system under great pressure once again. As it stands, delinquency rates on real estate loans as well as on credit cards have been rising quite rapidly. The most recent stress tests that were performed to 19 major banking institutions used an unemployment rate of 10.3% as a worst case scenario. However, the probability of surpassing this worst case level of unemployment is increasing.

Elevated and prolonged levels of unemployment will also continue to extend the length of time it will take for the housing market to reach a firm bottom. As more and more people lose their jobs, or as labor income continues to weaken, the likelihood of not being able to service mortgage payments will certainly increase, causing foreclosures to increase and housing average prices to decline further. As it stands, according to the Case-Shiller index, the average home price has already dropped more than 32% from its peak reached in July of 2006, and on a year-over-year basis, home prices have fallen over 18%. Given that we expect the unemployment rate to peak well above 10% in 2010, we see home prices dropping further, as many homeowners will likely end up having negative equity in their home investments and will see the option to abandon their payment responsibility as a more attractive alternative.

In sum, given the current magnitude and uptrend of the unemployment rate, we believe that it would be more appropriate to view this metric as a leading indicator instead of a lagging one, at least until the macro-economic fundamentals normalize. Consequently, we believe that the rising unemployment rate will deteriorate consumer confidence, reduce labor income, exacerbate the housing market, endanger the banking system, and attenuate consumer spending. All of this, of course, will put great pressure on GDP for quite some time.

Carlos Guillen
Wall Street Strategies

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