Kiplinger Letter 5-15-09

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1729 H St. NW, Washington, DC 20006-3938 • kiplingerbiz.com • Vol. 86, No. 20

Dear Client: It’s true, the banking sector is recovering. Investors are no longer pummeling share prices. Government stress tests revealed a badly damaged but viable cadre of big banks, shoring up confidence. Some banks…notably Goldman Sachs…even plan to repay federal government rescue funds shortly. Still, there’s a long, bumpy road ahead. Scores of banks remain doomed to fail… At least 60 more, mostly smalls, this year. About three dozen have already succumbed in 2009. Across the Sun Belt and in hard-hit industrial states such as Ohio and Mich., tanking home mortgages combined with rising joblessness spell more trouble. Commercial real estate woes will take a toll as well. Cracks in these loans are just appearing... leases aren’t renewed when tenants go belly-up or seek out cheaper digs to survive the recession. Commercial mortgages account for 23% of assets of banks under $100 billion vs. 7% for bigger ones. And higher FDIC assessments will sting, taking a bite out of banks’ precious capital cushions.
BANK BUSINESS

Washington, May 15, 2009

ECONOMIC FORECASTS
GDP growth
-2.7% in ‘09, contraction

Interest rates
Prime at 3.25% in ‘09, 10-year T-notes yielding 3.25%

Inflation
Steady for a couple of months

Unemployment
Peaking at about 10% in early ‘10

Crude oil
About $53/bbl. by July or so

Housing sales
Up a bit in the second half of ‘09

Retail sales growth
A drop of over 1% in ‘09

Trade deficit
Falling to $497 billion in ‘09 Complete economic outlook at kiplingerbiz.com/outlooks

NEW

Big banks will have to sell their way out of trouble, shedding ancillary lines to salvage their core business. Bank of America plans to put First Republic Bank on the auction block, as well as Columbia Asset Management and BofA’s stake in a Chinese bank. Regions Financial and Fifth Third Bank will slim down as well. Also…a scramble for new profit centers to replace securitization markets, which contributed 10%-15% to revenue just a few years ago but add only 3%-5% now. In 2006, total value of issues hit $2.3 trillion. So far this year…a paltry $89 billion. Some banks are finding rays of sunshine through the clouds, though. Great growth opportunities for those strong enough to take advantage. Look for U.S. Bancorp, JPMorgan Chase, Wells Fargo, Goldman Sachs and others to snap up bargain priced units that generate deposits and fees. Among smaller banks, jittery customers are flooding those perceived as stable with deposits. And those banks are luring top-notch loan officers and commercial business from troubled rivals, including bigger banks. La.’s MidSouth Bank, for example, is aggressively marketing in an effort to pluck customers from Regions Financial, which needs to raise capital. Sustained industry growth is a few years off and depends on the economy. Indeed, the availability of credit will return faster than demand for it. Already some more-aggressive banks are eager to lend but are finding few qualified… and interested…borrowers. Most banks won’t be able to grow their way out of the hole they’re in until business spending picks up…probably around the middle of next year. By 2011…a healthier, but chastened and more conservative, bank industry.
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May 15, 2009

Companies haven’t finished liquidating inventories, despite the big drop in the first quarter…a $100-billion cut in the value of products and materials that businesses have on hand. Firms still have plenty to burn off in coming months. At the wholesale level, for example, the ratio of inventory to sales is down only slightly from Jan., despite seven months of liquidation. Sales have dropped nearly as swiftly. For the rest of the year, look for quarterly cuts of $50 billion to $80 billion. The good news: Such steep plunges typically come late in recessions. Measured as a percentage of GDP, the first quarter’s 0.9% decline was about the same as the steepest inventory cutbacks seen late in the 1982, 1991 and 2001 recessions.
THE ECONOMY

Consumer spending isn’t seeing a bump from tax cuts…the roughly $10 a week that began to show up in March paychecks from lower income tax withholding. Continued layoffs and rising unemployment are offsetting any benefits, pushing retail sales lower in April. The 0.5% decline, which doesn’t include auto sales, follows a 1.2% drop in March but surprising increases in January and February. Thus…little help for GDP in the second quarter. Odds are consumer spending will be flat at best, with a seasonal uptick in gasoline prices an additional dampener. By the second half of the year…slightly better. Spending should grow 1% to 2%. Where is the extra money going? Savings. And paying off accumulated debt. That’s good news for long-term U.S. economic health. But it adds to the pain now. So the lipstick index is a dud. Lipstick sales aren’t rising this recession, as a cosmetics giant famously noted they do in periods of economic downturns. The theory: In tough times, women turn to simple, relatively cheap luxuries. But maybe mascara’s a better guide. Turns out that although lipstick sales are off this year, eye makeup is flying off shelves. Mass merchandisers’ sales of mascara, eye shadow, pencils and the like are up nearly 9% so far this year. It’s not department stores that are benefiting, but drugstores, mass sellers and specialty makeup stores that offer lower cost versions of the little indulgences. Businesses, both small and large, have scant ability to raise prices. That’s reflected in the latest Consumer Price Index report, unchanged for April. Food prices show a decline, and gasoline prices didn’t rise as much as expected. Some increases, in rents and medical care, are enough to dispel deflation worries. One product price sure to climb sharply in coming years, though: Autos. With sales likely to remain well below the 16-million mark in coming years, the high volume, low margin sales model employed by carmakers will bite the dust. Both Detroit and foreign brand car companies will slap much higher sticker prices on cars and trucks starting in 2011 or so, once the economy is in full swing again. The biggest hikes will come on smaller cars. The average cost of compacts such as the Honda Civic, Chevy Aveo and Ford Focus will go from about $18,000 today to $25,000 by mid-decade. Automakers will have little choice but to raise the price of smaller cars as environmental and energy policies squeeze production of big SUVs and sedans plus pickup trucks. The bigger vehicles typically have fat profit margins.
AUTO INDUSTRY

Meanwhile, a cash-for-clunkers plan in the works won’t rev up sales much… spurring 500,000 or so purchases a year, about half the goal set by the White House and supporters in Congress. Billed as a way both to generate economic activity and to clean up the environment, the plan is to give vouchers for as much as $4500 to consumers who dump old gas-guzzlers and buy qualifying new cars. The problem: Most consumers driving a clunker couldn’t swing a new car even with the feds’ help. The swapped out car can’t be sold or traded, so the deal makes sense only for junkers. The vouchers will mostly accelerate sales that would’ve been made anyway, just as Detroit incentives did in spring and summer 2005. Come fall, sales tanked.
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May 15, 2009

THE WORLD

Pakistan’s campaign against the Taliban won’t show results till summer. There’s not much cause for optimism. Pakistan’s army is still geared to conventional warfare against India rather than dealing with internal insurgents. A transition won’t come easily, and U.S. financial assistance will take time to bear fruit. Plus Islamabad is wary of appearing to do Washington’s bidding. Moreover, driving the Taliban out of the Swat Valley will be a temporary reprieve unless the local government is strengthened and an effective police force built. Chaos in Pakistan’s northwest frontier threatens the U.S. in Afghanistan, providing the Taliban a safe haven and a choke hold on America’s supply route.

The U.S. trade deficit will narrow by more than 25% this year. But that’s not good news. Although the trade gap will shrink to $497 billion in 2009…just 3.6% of GDP, the lowest since 2001…it’s not due to growing exports. Collapsing world demand and tight world credit actually spell a 16% dive in them. Imports are in a steeper slide than exports, shedding 19% this year as businesses and individual consumers hunker down and slash their spending. And any benefit to long-term interest rates from the contraction of the trade deficit will be erased by expansion of the federal budget deficit. Plus the gap will widen again as the U.S. pulls out of recession ahead of other economies, boosting imports.
TRADE

There’s a surprise in Obama’s 2011 tax proposals for some upper incomers: A tax cut. That’s right…some folks who now fall in the 33% tax bracket would find themselves in an expanded 28% bracket. As a result, married couples with taxable income between about $210,000 and $263,000 and singles with income between about $170,000 and $223,000 would pay less tax. Those with incomes above those levels would pay more, with marginal rates jumping from 33% to 36% and from 35% to 39.6%. Maximum savings: $1000 for both singles and couples.
TAXES

Among the White House’s proposed tax changes for businesses: Making employers offer payroll deduction IRAs if no other retirement plan is in place, the firm has 10 or more employees and has been around at least two years. Employers wouldn’t have to make contributions, would have no fiduciary liability for the accounts and no responsibility for investing their employees’ funds. Removing the option to value inventory at the lower of cost or market price. Requiring first-in, first-out inventory valuations, but spreading the tax bill incurred when switching from last-in, first-out valuations over a period of eight years. As the Obama Justice Department steps up its antitrust activities… Who’s liable to be on its radar screen or tagged by competitors for scrutiny? High tech candidates Google, IBM, Dell, Intel, Microsoft, Verizon, Alcatel-Lucent and Oracle, of course. All are industry giants that have engaged in market behavior that has raised eyebrows. Other possible targets: Military contractor Halliburton. DuPont. Agribusiness giant Archer Daniels Midland. And toolmaker Stanley Works. The regulatory shift flashes a green light for smaller firms to file complaints.
REG WATCH

Local, state and federal officials are racing to prepare for swine flu next fall. Congress will pump nearly $2 billion more into emergency preparedness: Stockpiling additional antiviral medications plus masks, respirators, gowns, gloves and other medical supplies. Beefing up disease detection and surveillance capabilities at the Centers for Disease Control and Prevention. And supplementing the budgets of state & local preparedness and response programs hit hard by recession cutbacks. It’ll take four to six months to get a vaccine ready, and because the virus is new to humans, people may need two shots, plus a regular seasonal flu vaccination.
HEALTH ALERT

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May 15, 2009

Employers are likely to cut more deeply into health care coverage in 2010. They’re getting walloped by higher expenses when they can least afford it. Workers afraid of losing jobs often use more benefits while they still have insurance. That’s happening now and will push costs up about 7.5% this year instead of 6%. Look for more companies to embrace consumer directed health plans, which cost firms about $6000 per worker vs. $7800 for a preferred provider plan. CDHPs combine high deductible insurance with tax advantaged savings accounts. 25% of large companies offer CDHPs now, usually as one of several options. 14% of smalls offer them, usually as the only option. About 60% of firms with CDHPs make a contribution to the workers’ accounts. Deductibles average about $2100.
HEALTH CARE

Obama’s push for a health care overhaul is picking up lots of steam. The recent offer from providers to slow the growth in health costs is a step forward. The industry is also buying a seat at the table, acknowledging that a bill is likely. But there’s a long way to go. Cutting costs is just one of Obama’s goals, and the industry’s offer is both vague and insufficient to finance universal coverage. Congress is looking at other ways to pay for extending insurance to all. Gaining momentum: Taxing a portion of health benefits for some workers… those with “Cadillac” plans paid for by employers. Those benefits aren’t taxed today. There’s no talk, though, of taking away the tax-exempt status of employer payments. The dire report on Medicare will also light a fire under health care reform. Restraining cost growth is critical to Medicare’s future, as well as an essential element of Obama’s proposals. The Medicare fund for hospital care, known as Part A, is on course to go broke in 2017, two years earlier than expected because continued high unemployment means fewer workers paying taxes into the fund. Look for Congress to buy some time: Lower payments to private Medicare Advantage plans. Take an ax to home health services. Lop payments to skilled nursing facilities. But all are short-term fixes. Long term, tougher decisions must be made: Higher taxes, cuts in benefits or more means testing so more-affluent seniors have to pay a bigger share. Yet another commission to repair both Medicare and Social Security… in much the same boat. Starting in 2016, annual payouts will exceed funds coming in, and Uncle Sam will need to cut benefits or dip into the trust fund. Problem is, the fund is full of government IOUs. Getting cash will mean raising taxes or increasing debt. Congress would rather tackle Medicare and Social Security on its own. But if it can’t, a blue-ribbon panel with a legislative guarantee is a good bet. It could be set up next year, with orders to report back after the 2010 elections. Congress would have to accept or reject the recommendation in toto…no changes. That’s the same system used with success to determine which military bases to close. Yours very truly,

May 15, 2009

THE KIPLINGER WASHINGTON EDITORS

P.S. Want to sell your business but finding it tough during the recession? Let us give you a hand. Join us May 28 for a 90-minute interactive audio conference. Register today by visiting www.krm.com/kiplinger or by calling 800-775-7654.

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