Surging SKUs Could Skew Economic Outlook

February 1, 2010

As the U.S. economy continues to languish in the trough of the current recession, analysts are busy attempting to identify the factors that will lead to recovery. The chicken vs. egg conundrum applies: which will come first, jobs or consumer spending? With promising signals emerging from the business sector, namely inventory replenishment, we continue the search for other clues to recovery by comparing current economic conditions to those present during the last recession in 2001.

YOY Growth Rates: Personal Consumption vs. Business Investment

After spending heavily in the late 1990s to adapt to newly emerging technologies in the areas of telecom, internet, and business software, and to prepare for the predicted snafu of Y2K, U.S. businesses began to curtail their expenditures and investments in 2000. Many believe this dramatic reduction in spending by the business sector was the main culprit leading us into the recession of 2001. However, despite significant slowdowns in business expenditures and investments, U.S. consumers were still spending freely throughout the recession as consumer expenditure showed positive year-over-year growth.

What was the source of such consumer optimism?

In response to overall slowdowns in commerce led by decreases in corporate spending as well as concerns over deeper slowdowns caused by the 9/11 terrorist attack, the U.S. Federal Reserve slashed its discount rate to below 1%. The Fed also engaged in a monetary policy of quantitative easing to provide credit and liquidity needed to boost the economy. Given the circumstances, this was the most effective policy choice at the time, but many believe the Fed kept interest rates artificially low for too long, leading to inflation of various asset classes — including housing.

For the majority of Americans, their home is the single largest tangible asset on their household balance sheets. Encouraged by rising home values, U.S. consumers engaged in leveraging of their balance sheets — via home refinancing and home equity lines of credit — to tap their newfound (and, in many cases, illusory) wealth, and they continued to make discretionary purchases. With personal consumption comprising approximately 65% to 75% of U.S. GDP, this segment of our economy helped lead us out of the last recession.

Fast-forward to 2010: who or which sector of our economy will lead us out of the current economic slowdown? This recession was much more painful than the last as not only did the business sector experience a deeper contraction, but personal consumption expenditure also showed negative year-over-year growth for the first time since 1991. Last year’s quantitative easing redux did not work its magic on consumers as it did the last time. With our economy continuing to shed jobs — 85,000 job losses in December 2009 — there seems to be no end in sight.

Despite the gloom, some encouraging signs have emerged, and surprisingly, these signs are coming from the business sector of our economy. During 2008 and 2009, fearing for the worst, U.S. businesses not only downsized their payrolls, but also slashed their inventories and halted purchasing as they anticipated one of the worst recessions in recent memory. However, with the unprecedented fiscal and monetary stimulus initiatives of central governments around the world, companies must now begin restocking their inventories in anticipation of returning demand. The dramatic upswing in the Purchasing Manager Index over the past year seems to support this thesis, having now reached a reading of over 50, a leading indicator of near-to-intermediate term economic expansion.

Business Inventory Levels YOY and Purchasing Managers Index

Restocking of business inventories will provide the economy with the initial stimulus to at least stabilize our economy. But how far can our economy get without consumer participation in the recovery? Past recessions have shown that companies emerge from recessions with greater efficiency and higher worker productivity, allowing them to produce more with less and, consequently, to delay hiring new employees as the economy begins to recover. Only when future demand is clearly visible will businesses resume hiring. This explains why unemployment rates are unreliable predictors of economic recovery and are widely viewed as lagging indicators.¹

Although it is premature to declare the economy fully recovered based upon a mere few promising signs coming out of business sectors, we may be nearing a turning point. If job reports continue to show improvement followed by declines in unemployment, this should confirm strengthening of our economy. However, businesses replenishing their SKUs can only buttress the economy for so long. What remains to be seen is whether current economic conditions will bring about a just-intime conversion of inventory to cash, or whether lean consumer spending will continue to constrain recovery.

¹ Some academic research has suggested that unemployment tends to be a coincident indicator. Indeed, Saturna Capital analysts compared lagged market returns and unemployment to current market returns and unemployment and found a higher correlation coefficient than with the lagged data.

Important Disclaimers and Disclosures

This report is intended only for the information of the reader, and is not to be used for or considered as an offer or the solicitation of an offer to sell or buy any securities or other financial instruments of any kind, including without limitation, any mutual fund or other product offered, sponsored, created, or managed by Saturna Capital Corporation or its subsidiaries or affiliates ("Saturna"). This report is not intended for distribution to, or use by, any person or entity who is a citizen or resident of, or located in, any locality, state, country, or other jurisdiction in which such distribution, publication, availability, or use would be contrary to law or regulation or which would subject Saturna to any registration or licensing requirement within such jurisdiction.

This document should not be considered as providing investment advice or services, or any service offered by Saturna. Saturna may not have taken any steps to ensure that the securities referred to in this report are suitable for any particular investor. Saturna will not treat recipients as its customers by virtue of their reading or receiving the report.

Nothing in this report constitutes investment, legal, accounting or tax advice or a representation that any investment or strategy is suitable or appropriate to a particular investor’s circumstances or otherwise constitutes a personal recommendation to any investor. Saturna does not offer advice on the tax consequences of any investment.

All material presented in this report, unless specifically indicated otherwise, is under copyright to Saturna. None of the material, nor its content, nor any copy of it, may be altered in any way, transmitted to, copied or distributed to any other party, without the prior express written permission of Saturna. Unless otherwise indicated, all trademarks, service marks and logos used in this report are trademarks or service marks of Saturna.

The information in this report was obtained from sources Saturna believes to be reliable and Saturna believes the information and opinions in the material are accurate and complete as of the date of this material. However, information and opinions contained herein will change over time and without notice. Saturna has no obligation to update or amend any information or opinions at any time. Saturna makes no representations as to the accuracy or completeness of this material, nor does it have any responsibility to ensure that any other materials, including any containing materially different information, are brought to the attention of any recipient of this report.

Under no circumstances shall Saturna, its employees, or any affiliate, be responsible for any investment decision by any recipient. This material is distributed on condition that it will not form the sole basis for any investment decision by any recipient. Any recipient who is not a market professional or institutional investor should seek the advice of an independent financial advisor prior to taking any investment based on this report or for any necessary explanation of its contents.

Saturna does not provide tax, legal or accounting advice. Investors should consult their own tax, legal and accounting advisers before engaging in any transaction. In compliance with IRS requirements, recipients are notified that any discussion of U.S. federal tax issues contained or referred to herein is not intended or written to be used for the purpose of (A) avoiding penalties that may be imposed under the Internal Revenue Code; nor (B) promoting, marketing or recommending to another party any transaction or matter discussed herein.

Past performance does not imply or guarantee future performance, and no representation or warranty, express or implied is made regarding future performance. The price, and value of, and income from, any of the securities or financial instruments mentioned in this report can fall as well as rise. The value of foreign securities and financial instruments is subject to exchange rate fluctuation that may have a positive or adverse effect on the price or income of such securities or financial instruments. Investors in securities such as ADRs — the values of which are influenced by currency volatility — effectively assume this risk.

To obtain more detailed information, including investment objectives, risks, expenses and charges and the current prospectuses, please visit Documents & Forms or call 1-800-SATURNA. Please read the prospectuses carefully before you invest or send money. Distributor Saturna Brokerage Services, Member FINRA / SIPC.