By Don Miller
Associate Editor
Money Morning

It’s no secret that government spending has been fueling much of the growth in the $14.2 trillion U.S. economy. And if consumers aren’t ready for the handoff when that stimulus spending winds down – and they certainly don’t appear to be – it will be up to the U.S. business sector to carry the ball.

And it’s not at all clear that Corporate America is ready, willing or able to fulfill that role.

For one thing, companies just aren’t hiring en masse. That means the current economic rebound is actually a “jobless recovery,” and could be vulnerable to unforeseen shocks, San Francisco Fed President Janet Yellen told an audience during a speech in Phoenix, Ariz, earlier this month.

“Unemployment could stay high for several years to come,” Yellen said during the speech that was given less than a week after the U.S. Federal Reserve left interest rates unchanged at near zero. “High unemployment, weak job growth and paltry wage increases are a recipe for sluggish consumer spending growth and a tepid recovery.”

U.S. Businesses Throttle Back on Spending Plans

Even though a recently released government report showed that the U.S. economy grew at a 3.5% annual rate in the third quarter, 75% of economists polled in a separate survey concluded that the gross domestic product (GDP) number will be revised downward in the future. The key reason for that belief: The U.S. unemployment rate is expected to keep rising in the new year, heightening the prospects of a jobless recovery.

Small businesses, which employ more than half of all private-sector workers – and which have generated 64% of all new jobs over the past 15 years – are not even close to picking up the slack.

In fact, 16% of small-business owners surveyed by the National Federation of Independent Business said they are planning to cut jobs in the next three months – nearly double the number of those planning to add jobs.

“The ‘job generating machine’ is still in reverse,” the federation said.

A survey of 1,537 chief financial officers in the latest Duke University/CFO Magazine Global Business Outlook Survey showed that most large U.S. companies do not plan to increase capital spending in the near future.

Furthermore, 56% of U.S. companies say they are still being adversely affected by credit-market conditions. Among those negatively affected, two-thirds say the cost of credit is their biggest problem, and half say credit is simply less available. That can’t help but stifle GDP growth.

“For full economic recovery we need to see capital spending increase by double digits, rather than simply treading water as we’re seeing now,” said John Graham, a finance professor at The Fuqua School of Business who is also the director of the CFO Magazine survey.

Most firms will take several years to return to pre-recession employment levels and some expect to operate with permanently reduced workforces. Unemployment could reach 10.5% before leveling off in the third quarter of 2010, further crimping consumer spending.

“We’ll see a steeper decline in investment and business structures and a little less growth in residential investment,” said Randell Moore, editor of the Blue Chip Economic Indicatorsnewsletter.

Money Morning’s Outlook: U.S. businesses – big and small – have embraced a leaner, lower-cost mindset that leaves firms reluctant to hire and reticent about making capital investments other than those that can’t be avoided. That will prolong the jobless recovery, and result in lower contributions to U.S. GDP growth by both consumers and businesses. But there is a benefit. With this newfound frugality, companies should be able to maintain – or even boost – profitability, even during a sluggish revenue environment. That, in turn, could be good for U.S. stock prices, and for the ongoing stock-market rebound.

Unemployment Handcuffs the Fed

In an effort to get the economy on its feet, the government so far has put up at least $3.27 trillion in stimulus programs, including the American Recovery and Reinvestment Act and the Troubled Asset Relief Program (TARP).

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According to Standard & Poor’s Inc. (NYSE: MHP), only about a third of the $787 billion stimulus package has hit the U.S. economy. Most of the infrastructure spending is just getting started now after being delayed by both the political and bidding processes.

Additionally, the Federal Reserve since last March has kept the benchmark Federal Funds rate for overnight lending to banks at between zero and 0.25%. More recently, the Fed has promised to keep rates “exceptionally low” for “an extended period.”

The unemployment rate has never peaked inside a recession and the Fed has never raised interest rates while unemployment was still rising. That means that all signs point to the central bank continuing its current lending programs until unemployment starts to subside.

Despite the U.S. dollar’s decline and the recent surge in the price of oil, gold and other commodities, the fear of inflation is probably unwarranted, U.S. Federal Reserve Chairman Ben Bernanke and other policymakers contend.

Economists who subscribe to this viewpoint say that inflation is currently at acceptable levels and overcapacity will continue to cast a long shadow over the housing and labor markets. Some believe we might even see deflation within the next 18 months.

Just yesterday (Tuesday), in fact, the Labor Department reported that “core” producer prices – which exclude such volatile items as food and energy – posted an unexpected moderate decline for October. The 0.6% decrease for October followed a 0.1% decrease in September. That surprised economists, who had been expecting core prices to increase 0.1%.

However, overall producer prices increased 0.3% in October after an unrevised 0.6% drop in September. Big jumps in food and energy prices powered the increase. Energy prices soared 1.6% in October after falling 2.4% in September, while food prices also rose 1.6%, after a 0.1% decline the month before.

“Core producer price inflation accelerated above 4.5% during the boom in the latter part of the previous cycle, but plunged during the recession,” FTN Financial Group Chief Economist Chris Low said in an interview with RTTNews. “Core producer prices tend to bottom a year or two after recessions, so there is still disinflation to come at the wholesale level.”

But there’s another school of thought – one that says that the policies now being followed will fan the flames of inflation and cause an inflationary conflagration the likes of which the country hasn’t seen since the 1970s and early 1980s. If that inflationary escalation comes while unemployment remains high it could turn into “stagflation,” a culprit that’s hard to vanquish once it’s gone to ground.

A report on consumer prices will be released today (Wednesday). Economists expect overall consumer prices to increase 0.2%, with “core” consumer prices rising 0.1%.

Regardless of what school of thought you subscribe to, look for the government to keep the pedal to the metal. The Fed won’t hike rates before late 2010, most likely after the mid-term elections. And while talk of a “second stimulus” is surfacing once again, it’s also possible that any additional spending programs will be put on the back burner by the burgeoning $2 trillion deficit, which is approaching 10% of GDP.

Money Morning’s Outlook: Fed policymakers are in a tough spot: Raise rates too soon and they choke off the recovery; wait too long to boost borrowing costs and they’ve spawned potentially ruinous inflation – and possibly even stagflation. Investors will need to spend some serious time watching the Fed in the New Year, while closely tracking such statistics as unemployment and commodity prices.

[Editor's Note: Part I of Money Morning's U.S. economic analysis of what's to come in 2010 appeared yesterday (Tuesday). To read that story, please click here. Part I focused on the overall outlook for growth in the New Year and examined how the "jobless recovery" would impact consumer spending.]

News & Related Story Links:

• Money Morning:
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• Reuters:
  Stronger U.S. GDP Seen in 2010: Survey.
• Los Angeles Times:
  Obama to hold job forum in December
• Money Morning:
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• MarketWatch:
  Small-business owners skeptical of recovery
  
• CFO Survey:
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• MSN.COM:
  What comes after 10% unemployment?
  
• Reuters:
  U.S. jobless rate to peak at 10.5 pct, Fed on hold – poll
  
• MarketWatch:
  Fed’s Yellen see signs of jobless recovery
  
• Standard & Poors:
  U.S. Economic Forecast: Panic Is Being Replaced By Fear.
• Knowledge@W.P. Carey:
  2010 Economic Forecast: Don’t Hold Your Breath
  
• Naroff Economic Advisors:
  Monthly Economic Review.
• 401K.fidelity.com:
  The Road Map to Recovery: Leading Economic Indicators.
• Duke University Fuqua School of Business:
  Official Web Site.
• Money Morning Week Ahead Column:
  Is a Second U.S. Stimulus Package Headed Our Way?
  
• Wikipedia:
  Federal Funds Rate.
• RTT News:
  Core Producer Prices Show Unexpected Decrease In October.

By Don Miller
Associate Editor
Money Morning

Historically, the U.S. stock market has been one of the key leading indicators of a U.S. economic rebound.

With the Standard & Poor’s 500 Index up more than 60% from its March lows – and the Dow Jones Industrial Average up nearly 40% – prognosticators are finally confident that the U.S. economy will dodge the “double-dip” recession that has been the focus of much fear since the Bush and Obama administrations launched their financial counterattacks on the worst financial crisis since the Great Depression.

But those same forecasters are reluctant to forecast a sharp economic rebound for 2010. In fact, as opposed to a classic “V-shaped” economic recovery that would accelerate as the year goes on, many economists are predicting that the rate of growth will slow as the New Year unfolds.

Forecasts from Standard & Poor’s Inc. (NYSE: MHP) and Goldman Sachs Group Inc. (NYSE: GS) illustrate this outlook. S&P recently projected average GDP growth of 1.6% for all of 2010, while top Goldman Sachs economists expect to see the U.S. growth rate decline from 3% early in the year to 1.75% by the fourth quarter.

“We don’t expect a V-shaped recovery; in fact we think that 2010 is going to be a bit slower in terms of annualized GDP growth than the second half of 2009,” Goldman Sachs Chief U.S. Economist Jan Hatzius said during a recent speech in New York City.

For analysts and economists who play the forecasting game, 2010 promises to be one of the toughest challenges in decades.

Unemployment has pierced the psychologically daunting 10% level, placing U.S. joblessness at its highest level in a quarter century. Serious questions remain about the strength of the country’s banking and financial systems. The U.S. dollar is under siege and inflationary concerns are at their highest levels in years. There’s massive uncertainty about the nation’s residential and commercial real estate markets. And even the stock-market rebound – one of the strongest in history – is considered suspect by some analysts: They worry that federal stimulus money and the U.S. Federal Reserve’s “zero-interest-rate policy” has forced bearish investors to become reluctant bulls.

Among the difficulties would-be forecasters currently face economists face is the fact that 4% of the economic growth in recent months is attributable to temporary factors, most notably the replenishing of inventories and government fiscal stimulus, Goldman’s Hatzius said. Those factors are likely to diminish by the second half of 2010, due to high unemployment, budget-conscious consumers, and overcapacity in the manufacturing sector and housing markets.
Despite these obvious difficulties, the outlook for 2010 is far from dismal. Among the bright spots:

• The stimulus seems to be having its intended effect – one reason the odds of a double-dip recession remain remote.
• The U.S. housing market – a crucial element of the consumer sector – is showing signs of bottoming out.
• The weak U.S. dollar is making U.S. exports highly competitive, giving a much-needed boost to American manufacturers.
• With their reluctance to hire, businesses are clearly operating in a highly cost-conscious zone – a reality that could bode well for corporate profits, and for stock prices.
• And the overall outlook for the U.S. economy is much better than it was a year or 18 months ago, and actually continues to improve – albeit slowly – a reality that can feed on itself to further bolster growth.

In this leadoff story in Money Morning’s Third Annual “Outlook” forecasting series, we’ll take a look at overall expectations for the U.S. economy for the New Year, will consider four key challenges, and will give you our take on each one. The areas that we’ll explore will include:

• Economic expectations and the odds of a double-dip downturn.
• The odds for maintaining growth with a “jobless recovery.”
• The outlook for business investment and spending.
• And the risks and rewards of current central bank policies.

Let’s take a look …

Handicapping U.S. Growth in 2010

A new survey concluded that top economic forecasters have grown in confidence that the U.S. recovery is sustainable. But those analysts also expect that growth will fall short of the typical post-recession rebound, the Blue Chip Economic Indicators newsletter reported in its November issue.

The U.S. economy should expand 2.7% next year, the consensus estimate of 52 economists polled by the newsletter. That’s an upward revision from the consensus prediction of 2.5% made just one month before.

“The major uncertainty surrounding the outlook for growth next year involves the degree to which private demand accelerates as the positive contributions to GDP from reduced business inventory liquidation and fiscal stimulus play out,” the newsletter said.

Those factors alone pose some significant challenges to a robust rebound. Add in the near-certainty that this recovery will be a jobless one – as well as the fact that most economists believe that U.S. growth will slow, and not accelerate – as 2010 progresses, and it might be overly optimistic to expect a growth rate of 2.7%, which is how well the economic often performs even during healthy periods.

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Money Morning Chief Investment Strategist Keith Fitz-Gerald is forecasting growth of, at best, 2.0% in 2010, a key reason he continues to tell investors to look abroad for some of the most-profitable investment plays.

The U.S. economy “will be lucky to do 2.0% ” next year, Fitz-Gerald said. “The economy faces some very difficult challenges. There’s a slight chance – depending on what happens with some outside factors – that the U.S. could do 2.5%, but I really doubt it. China could actually pull us along [to higher-than-expected growth], but those are some long odds.”

That’s not to say that 2.0% growth is bad news. That’s more than enough to negate the odds of a double-dip recession. Indeed, after reviewing U.S. economic history all the way back to the 1850s, Deutsche Bank AG (NYSE: DB) economists recently found that double-dip recessions are exceedingly rare.

And Money Morning Contributing Writer Jon Markman notes that when these double-dip downturns do occur, they happen under circumstances quite different from the ones that we face today. Reprised recessions usually occur in concert with a fight against inflation.

“A repeat of the 1980s just isn’t in the cards,” Markman said.

Money Morning’s Outlook: Overall, the likelihood is that the U.S. economy will experience slow GDP growth. In terms of the average growth rate for the year, investors are most likely looking at a range of 1.0% to 2.0% for all of 2010, as a protracted jobless recovery extends the housing and banking crisis, puts a damper on wages, reduces consumption. And that growth rate will decelerate as the year progresses, meaning that it’s measure investors should watch closely.

U.S. Joblessness Will Stifle Consumer Spending

As we’ve all learned as far back as Econ 101, the U.S. marketplace is chiefly consumer driven. Historically, consumer spending spurred 60% of U.S. growth. In recent years, that number has surged as high as 70%. Given the U.S. economy’s avowed consumer focus – coupled with the near-certainty that we’re facing a jobless recovery – investors who are hoping for stronger-than-expected growth would best keep the champagne on ice, according to economist Joel Naroff.

“We need households to become a little more confident and businesses to start thinking about tomorrow so we can transition out of the government- and Fed-supported economy into a private-sector recovery,” Naroff, president of the Holland, PA-based Naroff Economic Advisors, said in a note to investors.

To that end, Naroff is concerned about the effect a jobless recovery could have on consumer spending.

“Can consumers save the day? Only if incomes grow solidly and that is not going to happen … businesses have some room to expand without hiring lots of new employees,” Naroff noted. “It could take four to five years for the unemployment rate to get back to full employment. There is little reason to expect that happy times are here again.”
The U.S. unemployment rate in October pierced the psychologically important 10% barrier for the first time since 1983, as employers made deeper-than-predicted payroll cuts.

It’s no surprise, then, that U.S. consumers in September cut their spending for the first time in five months, reducing their outlays for products and services by a hefty 0.5%.

Only one other time since World War II has the unemployment rate topped 10% – between September 1982 and June 1983. It hit 10.1% in September 1982, moving up from 9.8% the month before.

The economy, as measured by gross domestic product (GDP), was basically flat in summer 1982. But the economy at that time was actually getting ready to recover.

Then the economy began to surge in early 1983, fueled by tax cuts and, more importantly, substantial interest-rate cuts by the Federal Reserve. By the end of 1983, the unemployment rate was down to 8.3% and dropped to 7.3% in 1984 and 7.0% in 1985.

But that was then and this is now.

Although the official unemployment rate hit 10.2% last month, the employment outlook is actually much worse: If you factor in part-time workers who’d prefer a full-time position, and people who want work but have given up looking, the “real” unemployment rate is actually a record-high 17.5%.

That means that more than 16 million people are now out of work, compared to 6 million in 1982. In July – the last month the government released statistics – there were more than six officially unemployed persons for every job opening. Historically, the ratio is closer to 2-to-1.

What’s worse is that productivity is increasing as employers are successfully getting their existing staff to produce more in fewer hours – making it less likely they will start hiring.

Any improvements will come slowly. In the Blue Chip Economic IndicatorsNovember issue, 52% of the economists surveyed said the unemployment rate won’t fall back below the 7.0% level on a sustained basis until the second half of 2013 – and it may take longer than that.

Money Morning’s Outlook: The recession may technically have ended, but for the millions of unemployed workers the hard times are far from over. Given that almost one-fifth of the U.S. work force is unemployed or underemployed, don’t expect consumers to step up and step in if stimulus spending falls short, or ends. The upshot is that, from this vantage point, GDP growth for the New Year is likely to be severely constrained.

[Editor's Note: Part II of Money Morning's U.S. economic outlook story will appear tomorrow (Wednesday). Part II will focus on business spending and the U.S. Federal Reserve.]

News & Related Story Links:

• Money Morning:
  Jobless Recovery Category
• Reuters:
  Stronger U.S. GDP Seen in 2010: Survey.
• Los Angeles Times:
  Obama to hold job forum in December
• Money Morning:
  Unemployment Rate Cracks Double-Digit Barrier at 10.2%, Boosting the Odds of a “Jobless Recovery”
• MarketWatch:
  Small-business owners skeptical of recovery
• CFO Survey:
  CFO optimism improves, but employment outlook is bleak
• MSN.COM:
  What comes after 10% unemployment?
• Reuters:
  U.S. jobless rate to peak at 10.5 pct, Fed on hold – poll
• MarketWatch:
  Fed’s Yellen see signs of jobless recovery
• Standard & Poor’s:
  U.S. Economic Forecast: Panic Is Being Replaced By Fear.
• Knowledge@W.P. Carey:
  2010 Economic Forecast: Don’t Hold Your Breath
• Naroff Economic Advisors:
  Monthly Economic Review.
• 401K.fidelity.com:
  The Road Map to Recovery: Leading Economic Indicators.
• Duke University Fuqua School of Business:
  Official Web Site.
• Money Morning Week Ahead Column:
  Is a Second U.S. Stimulus Package Headed Our Way?

Kraft Foods Inc. (NYSE: KFT) yesterday (Monday) refused to sweeten its $16.4 billion offer for Cadbury PLC (ADR NYSE: CDY).

Instead, the North American food giant repeated the terms of its original offer, which Cadbury rejected two months ago. Kraft will now put its bid directly to Cadbury shareholders, setting the stage for a battle that could last months.

Cadbury swiftly rejected the bid, saying the offer is now worth less than the initial proposal, which had already undervalued the company.  Kraft’s bid is now worth 4% less than the original offer, and 6% below the current stock price, because Kraft shares have lost some of their value.

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When Cadbury rejected the initial offer in September, the company said it preferred to remain independent, and called the original proposal from Kraft Chairman and Chief Executive Officer Irene Rosenfeld an “unappealing prospect” from a “low-growth” conglomerate.

The formal bid values Cadbury shares at $16.44 billion (9.8 billion pounds) or 713 pence a share, compared with $17.0 billion (10.2 billion pounds) or 745 pence a share, at the time of Kraft’s September offer.

“I’m not sure what kind of appetite Cadbury holders have to hold on while these two slug it out for the next six months,” William Hobbs, who helps manage $224 billion in assets, including Cadbury stock, at Barclays Wealth in London told Bloomberg News. “Anything under 800 pence is still a pretty chunky discount to what we could get.”

The deal would make Kraft, the maker of Oreos and Ritz crackers, the world’s largest confectioner, surpassing privately owned Mars Inc.  Acquiring Cadbury, the London-based maker of Dairy Milk chocolate, would give Kraft entry into untapped emerging markets and shore up its brands in the United Kingdom.  The merger would be the largest cross-border acquisition of the year.

Kraft’s bid for Cadbury had been expected after the U.K. Takeover Panel ruled that Kraft either had to make a formal bid by 12 :00pm Eastern Standard Time Monday, or refrain from any other overtures for six months.  Kraft now has 28 days to mail the official offer documents to Cadbury shareholders, which triggers a 60-day bid time limit according to U.K. rules.

Kraft’s Rosenfeld has dug in her heels on the price, repeatedly insisting she won’t overpay for Cadbury.  Conversely, Cadbury’s CEO Todd Stitzer has stated that a deal with Kraft makes no strategic sense and likes Cadbury’s prospects better as an independent entity.

“Kraft’s offer does not come remotely close to reflecting the true value of our company, and involves the unattractive prospect of the absorption of Cadbury into a low-growth conglomerate business model,” Cadbury’s Carr told Reuters.

Most analysts seem to agree with Carr’s assessment and think Rosenfield will eventually have to increase its bid in order to finalize a deal.

“There’s a good chance they (Kraft) will have to increase this a little bit. I still think the cash side is likely where they have the opportunity to make it more attractive to Cadbury shareholders,” Matt Arnold at Edward Jones told Reuters.

This is not likely to be the final offer from Kraft, a source familiar with the situation told Reuters.

“This just starts a new clock ticking. Today’s announcement is just the beginning of a new phase,” the source said.

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Welcome to the jobless recovery.

The U.S. unemployment rate zoomed to an unexpected 10.2% in October, piercing the double-digit barrier for the first time in 26 years as employers continued to slash payrolls even as the nation’s economy continues to improve.

The jobless rate pierced the psychologically important 10% barrier for the first time since 1983, as employers made deeper-than-predicted payroll cuts. In fact, the number of unemployed Americans grew by 190,000 last month, the Labor Department said Friday.

Economists had predicted job losses would reach 175,000, and that the unemployment rate would reach 9.9%, according to a survey of economists conducted by Bloomberg News. The unemployment rate was 9.8% in September.

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“The rise in the unemployment rate is very ugly,” Ethan Harris, chief U.S. economist at Bank of America Merrill Lynch (NYSE: BAC), said in an interview with Bloomberg Television in New York. “This is a big backward step to get this high of an unemployment number this early in the recovery.”

Including part-time workers who’d prefer a full-time position – and people who want work but who have given up looking – unemployment levels reached a record 17.5% in October, up from 17% in September. That’s almost one-fifth of the U.S. work force.

The uptick in joblessness comes just after the U.S. economy delivered better-than-expected growth in the third quarter. On Oct. 29, the U.S. Commerce Department said that gross domestic product (GDP) in the world’s largest economy grew 3.5% during that three-month stretch. That was slightly better than the 3.2% that economists were expecting.

October marked the 22nd consecutive month that payrolls have declined, which means that a total of 8.2 million people have been thrown out of work since the recession began in December 2007. A total of 15.7 million Americans are now out of work, the Labor Department report said.

One glimmer of hope was that payrolls in August and September were revised higher by 91,000 jobs.  Additionally, the pace of layoffs has slowed sharply from early this year, when nearly 750,000 jobs were lost in January.

Even though the economy grew by 3.5% in the third quarter, the rebound is predicted by some economists to be a “jobless recovery,” making it especially difficult on Americans who are already out of work.

“The unemployment rate of 10.2% is problematic because it gives a sense of urgency to Washington, D.C. Washington will be looking for any increase in stimulus,” Tom Sowanick, co-president and chief investment officer at OmniVest Group LLC told Reuters.

The weak labor market and anemic wage growth are expected to keep inflation in check   for some time, giving the U.S. Federal Reserve free rein to maintain supportive policies.

The central bank on Wednesday said the economy will continue to be sluggish as it held overnight interest rates near zero and reiterated a pledge to keep borrowing costs low for an “extended period.”

The labor market is being closely watched for signs of whether the economic recovery that started in the third quarter can be sustained without government support.

President Barack Obama has said job creation is a critical piece of any economic recovery, and the Fed has hinted that economic growth by itself won’t be enough to raise borrowing costs.

The jobless rate is “the dominant variable driving changes in the fed funds” rate, and the central bank “has never raised rates with unemployment rising.” economist Joseph LaVorgna of Deutsche Bank Securities Inc. (NYSE: DB) wrote in a client note that was obtained by Bloomberg.

Some companies are laying off workers as concerns grow that consumer spending will dry up as government-assistance programs run out. Johnson & Johnson (NYSE: JNJ), the world’s largest health-products company announced last week it will shed as many as 7,000 workers, potentially reducing its payrolls by 7%

In October, job losses were across almost all sectors. Manufacturing employment fell 61,000, construction payrolls dropped 62,000, and the services sector cut 61,000 workers. Education and health services bucked the trend by adding 45,000 jobs. Government employment was flat.

The worsening unemployment picture could cause problems for Democrats who control Congress as they face congressional elections in November 2010.

This week, voters in Virginia and New Jersey showed their displeasure over the weak economy by ousting two Democratic governors in New Jersey and Virginia. According to election polls, the economy and unemployment were the most important issues, Bloomberg reported.

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Productivity at U.S. businesses blew away forecasts in the third quarter and initial unemployment claims dropped to a 10-month low last week the Labor Department said Thursday.  The reports raised hopes that the labor market may be starting to bottom.

The news sent the stock markets soaring as the Dow Jones Industrial Average rose 204.05 points, or 2.08%%, to close at 10,006.19, while the Standard & Poor’s 500 Index popped 20.13 points, or 1.92%, to close at 1,066.63 and the Nasdaq Composite Index gained 49.8 points, or 2.42%, to close at 2,105.32.

Business productivity rose a higher-than-expected 9.5%, its fastest pace in six years, as companies squeezed more output from fewer workers. A survey of analysts by Reuters had projected productivity, or output per hour per worker, to rise at a 6.4% rate in the third quarter.

Productivity data “has indicated resilience and growth, though it also has a negative connotation of more being done with fewer workers,” Peter Kenny, managing director, Knight Equity Markets in Jersey City, New Jersey told Reuters. “Expect unemployment to creep up as productivity does.”

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But other analysts think businesses have cut to the bone already and, combined with an economy showing new evidence of growth in the third quarter, companies will now be forced to hire workers to replenish inventories.

“The combination of very a powerful productivity gain and low labor costs … keeps inflation at bay. This reinforces the Fed’s ability to stay on the sidelines for an ‘extended’ period.’” Richard DeKaser, president, Woodley Park Research in Washington told Reuters.

The central bank on Wednesday expressed optimism an economic recovery was underway and policymakers voted to keep the target federal-funds rate for inter-bank lending at a record-low range of zero to 0.25%.

Initial claims for jobless benefits decreased by 20,000 to 512,000 in the week ended Oct. 31, the lowest level since early January, the Labor Department reported. The previous week’s level was revised to 532,000.

Economists surveyed by Dow Jones Newswires had projected a drop of only 5,000 claims.

More significantly, the four-week moving average for new claims fell 3,000 to 523,750 last week, declining for the ninth week in a row, indicating the labor market may be stabilizing. The four-week moving average is seen by economists as a more accurate gauge because it evens out week-to-week volatility in the data.

“Over the past two weeks, initial jobless claims were somewhat disappointing,” Barclays Capital economist Michelle Meyer told The Wall Street Journal. “But the four-week moving average has actually still improved.”

However, October unemployment figures today (Friday) are expected to show that the U.S. unemployment rate soared above 10% in October, even as the pace of layoffs slowed. The national unemployment rate hit 9.8% in September.

Analysts have forecast that payrolls fell 175,000 in October, compared with a decline of 263,000 in September.

After the worst recession in 70 years, fixing the labor market is critical to a sustained economic recovery.  Wide-spread unemployment is putting a chill on consumer spending, responsible for 70% of all economic activity.

The economy grew in the third quarter for the first time in more than a year, mostly on the back of government stimulus programs. But keeping economic growth on track will eventually mean weaning the economy off government stimulus.

“We need households to become a little more confident and businesses to start thinking about tomorrow so we can transition out of the government and Fed supported economy into a private sector recovery,” said Joel Narnoff, President of Holland, Pennsylvania- based Naroff Economic Advisors, in a note to investors.

News & Related Story Links:

• Reuters:
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General Motors Co. (OTC: MTLQQ) stunned European government and labor leaders yesterday (Wednesday) when it backed out of a deal to sell a majority stake in its Opel and Vauxhall brands to car-parts supplier Magna International Inc. (NYSE: MGA).

GM may now be forced to spend billions to restructure the money-losing business itself as German and Russian leaders threatened to withdraw their governments’ support in protest.

The u-turn will leave GM with control of Opel’s small car designs, including its proprietary electric vehicle technology, which is an important part of its plan to deal with more stringent U.S. fuel-economy standards.

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GM’s decision to keep Opel makes sense in view of the U.S. carmaker’s significant progress since it filed Chapter 11 bankruptcy last June, analysts said.

After the U.S. government took a 60% stake in GM in July, it emerged debt-free from bankruptcy and its domestic car sales have risen, climbing 4.7% in October.

“Strategically, it makes sense to keep a maker of small vehicles that can quickly be sold in the U.S.,” Xerfi analyst Guillaume Mouren told Reuters.

But the about face is also extremely risky, because it’s angered many overseas government and labor union leaders. GM is counting on European loan guarantees for the majority of the financing it needs to overhaul Opel. But those guarantees were based on GM maintaining European car factories.

Labor leader Klaus Franz took hundreds of millions in labor concessions off the table yesterday – concessions that were agreed to on condition that Opel was bought by Magna, the Canadian company long favored by Berlin and Moscow as buyer-of-choice.

“General Motors’ behavior toward workers is completely unacceptable,” German Economy Minister Rainer Bruederle told reporters after hearing GM’s news.

Germany is home to half of Opel’s 50,000 workers.

Labor leaders were planning protests across Europe on Thursday as Franz said workers would no longer tolerate GM’s “blackmail” of European governments and staff.

The question for GM now is how it will finance its plan to restructure Opel. Germany, Britain, Spain and Belgium were originally expected to provide about $6.6 billion (4.5 billion euros) in aid to rescue Opel and Vauxhall.  GM said it expected restructuring on its own would cost about $4.4 billion (3 billion euros).

Amid the political rancor, GM may be forced to return by the end of November the balance it owes on a $2.2 billion (1.5 billion euro) bridge loan it took from Berlin to keep Opel out of GM’s bankruptcy filing earlier this year.

The repayment looms over GM even though German officials had said they would provide support for restructuring Opel no matter what route GM chose for the restructuring.

The decision to keep control of Opel and Vauxhall was made at a board meeting Tuesday after the company’s directors rejected a plan submitted by Chief Executive Officer Fritz Henderson, who had spent months negotiating the Magna agreement, according to The Wall Street Journal.

GM’s change of direction reflects the newly appointed board of directors’ increasing confidence about its business outlook as well as the direction of its aggressive new chairman, Edward E. Whitacre Jr., the former CEO at AT&T Corp. (NYSE: T).

Whitacre, the U.S. government’s hand-picked man for the job, has told GM executives to concentrate on expanding its market, not shrinking it, The Journal reported.

News & Related Story Links:

• Reuters:
  GM’s U-turn on Opel sale angers Germany, Russia
• Reuters:
  Deep GM revamp of Opel vital for company, market
• The Wall Street Journal:
  GM Throws Opel Deal Into Reverse

In its continuing efforts to nurture the fragile economic recovery, the U.S. Federal Reserve is widely expected to leave interest rates at record lows when it concludes its meeting today (Wednesday).

However, observers will be closely examining the details of the language in the statement of the Federal Open Market Committee (FOMC) meeting for hints as to when it plans to change monetary policy.

The overwhelming consensus is that the Fed will hold the federal funds rate steady at near-zero until the second half of next year. But that assumes the economic growth will stay in line with the Fed’s current forecast – a weak recovery with subdued inflation and slow growth.

The real internal debate between Fed Chairman Ben Bernanke and his colleagues is likely to focus on how to signal a change in stance to investors, businesses and everyday Americans when it anticipates raising rates.

Change to Two Phrases Will Signal Policy Reversal

The key language most analysts will focus on is the Fed’s promise to keep rates “exceptionally low” for “an extended period.” Bernanke has been using those two phrases since March, and an Oct. 23 report in the Financial Times set off a firestorm when it suggested that the Fed was considering scrapping them. Any changes to those words in the FOMC statement could blow up the bond markets, according to some analysts.

“Suggestions that the Fed might fiddle with the ‘extended period’ text of its statement are worrying,” analysts at ING Groep NV (NYSE ADR: ING) told the FT. “This phrase is dynamite – and should be handled only with extreme caution, better not at all in our opinion.”

Other analysts say the central bankers know the dangers involved and will avoid any changes for now.

“We don’t expect them to move away from the extended-period language,” Dean Maki, chief U.S. economist at Barclays Capital Inc. (NYSE ADR: BCS), in New York told MarketWatch.com.

But whatever they decide, most analysts feel the debate is likely to stay internal for now and say it’s highly unlikely the Fed will make any fundamental changes.

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“I think they will stick with interest rates in the zero to quarter-point range and will mention that economic conditions are better, but still justify rates at low levels for an extended period,” David Jones of DMJ Advisors said.

Factors in the Fed’s Decision

Price pressures and unemployment will be the two key factors in the Fed’s policy decisions.

As of September, inflation was subdued, while the unemployment rate surged to a 16-year high of 9.8% – suggesting any move toward a reversal in policy would be premature.

“The facts on the ground – high unemployment, low inflation, no net private-sector job creation – suggest to us that it is inconceivable that policy will actually change on Nov. 4,” Credit Suisse Group AG (ADR NYSE: CS) said in a report to clients.

Consumer prices rose just 0.2% in September, an indication that inflationary pressures remain mild. And even though energy prices have increased since the last meeting – and are likely seen by some Fed governors as a risk – core inflation is trending down, having slipped 1.5% in the past 12 months.

Meanwhile, three years of declining home values, stagnant wages, and the unfavorable labor market has dampened consumers’ appetite to spend.

U.S. consumers curtailed spending in September for the first time in five months. And that decline in consumer spending – which accounts for almost 70% of all U.S. economic activity – is increasing fears that consumers will pull back this winter as the government’s spending programs run out of funding.

And with a “jobless recovery” on the horizon, the labor market could be too weak to support domestic demand, leading to concerns the economy’s nascent recovery could stumble once the government support wanes.

That’s why Federal Reserve Bank of St. Louis President James Bullard said in an interview with Bloomberg Radio that job growth was a top priority.

“You want some jobs growth and unemployment coming down,” Bullard said. “That is a prerequisite” for an increase in interest rates.

Some analysts expect it to peak at 10.5% next summer.

Coping with a Collapse in Commercial Real Estate

The labor market has stolen the spotlight in recent months, but there is still a large amount of uncertainty in the banking sector, which continues to suffer from tight credit, a spate of foreclosures and potential losses in commercial real estate (CRE).

Commercial property values in the U.S. have plummeted 36% since peaking in 2007, and the commercial real estate market is unlikely to recover before 2012, according to the quarterly PricewaterhouseCoopers Korpacz Real Estate Investor Survey, released in September.

Federal Reserve Associate Director of Banking Supervision and Regulation Jon Greenlee said in testimony before Congress this week that those large regional and community banking firms building up “unprecedented concentrations of CRE loans” will be particularly affected by emerging conditions in real estate markets.

Roughly $530 billion in mortgage-backed securities are due for refinancing between now and 2011, according to property researcher Foresight Analytics LLC, which estimates that the U.S. banking sector could incur as much as $250 billion in commercial real estate losses – enough to cause a as many as 700 banks to fail, in that time.

The Federal Deposit Insurance Corporation’s (FDIC) “problem list,” or banks that run a higher risk of failure, grew to 416 in the second quarter, up from 305 in the first quarter. That’s the highest number since the second quarter of 1994, when there were 434 banks on the list.

Greenlee says that prices for commercial properties would probably fall further and that many institutions would benefit from portfolio level stress testing, improved management information systems, and more robust appraisal practices, Reuters reported.

Another dark cloud appeared on the CRE market last week when the Fed threw out five commercial market bonds that were pledged as collateral for taxpayer loans to purchase debt.

In an effort to clean up bank balance sheets and encourage new lending, the Fed opened its Term Asset-Backed Securities Loan Facility (TALF) to so-called legacy commercial-mortgage bonds. TALF attracts buyers by pumping up returns with low-cost Fed loans. Bonds deemed too risky are rejected.

The rejections came as a surprise, and may limit future demand under the program.

“The Fed/collateral monitor is more concerned with credit risk than many expected,” Barclays analysts led by Aaron Bryson in New York, wrote in a note obtained by Bloomberg News.

News & Related Story Links:

• Financial Times:
  Fed weighs its words on ending near-zero interest rate
• Ameritrade:
  No winks or nods about rate hikes this week
• Money Morning:
  U.S. Economic Growth Surprises in the Third Quarter
• Money Morning:
  Drop in Consumer Spending Could Spell Trouble for Economic Recovery
• Money Morning:
  Jobless Recovery Category
• Money Morning:
  Ford Reports $997 Million Profit as Manufacturing Heats Up
• Reuters:
  What the Fed is considering at its November meeting
• Forbes:
  Fed Official Says Fed Focused on CRE Loan Exposure
• Bloomberg News:
  Commercial Real Estate Debt Spreads Rise as Fed Rejects Bonds

Ford Motor Co. (NYSE: F), the only major U.S. automaker to avoid bankruptcy in 2009, said yesterday (Monday) that an aggressive cost-cutting campaign, improved earnings at its financing arm and market-share gains in North America resulted in a $997 million third-quarter profit – its first operating profit since early 2008.

Ford has now been profitable for two consecutive quarters, a first for Chief
Executive Officer Alan Mulally, who kept Ford out of bankruptcy as General
Motors Co. (OTC: MTLQQ) and Chrysler Group LLC reorganized under
Chapter 11 protection earlier this year.

Ford handily beat the 20 cents a share loss projected by 11 analysts surveyed
by Bloomberg News, reporting a quarterly pretax profit of $1.1 billion, or 26 cents a share on an adjusted basis, compared with a year-earlier loss of $3 billion, or $1.32 a share.

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The back-to-back quarterly profit is the first real evidence that Ford may
have completed a turnaround and will meet its goal of turning a full-year profit in 2011.

“Ford is a company that’s well into a turnaround,” Bernie McGinn,
president of McGinn Investment Management of Alexandria, Virginia, told
Bloomberg. “They did it by themselves and
didn’t take government money. That gives people a good gut feeling and they’re being rewarded for that.”

Ford lopped off $4.6 billion in costs in the first three quarters and expects
to eliminate a total of $5 billion in costs this year.

The company also reported positive automotive cash flow of $1.3 billion after it burned through $1 billion in cash in the second quarter.  By comparison, Ford burned $7.7 billion in cash in last year’s third quarter.

Fitch Ratings raised its outlook on Ford and its finance arm to positive from
stable, citing progress on its cost-cutting program, a reduction in output to
match demand and a decrease in buyer incentives.

Ford’s share of its primary U.S. market increased to 15.8% for the first
nine months, compared with 14.8% from a year earlier, according to Autodata Corp.

“We now expect to return to a strong profit in 2011 and positive cash
flow,” Chief Financial Officer Lewis Booth told reporters. “There
are still some headwinds, particularly economic headwinds. What happens in the balance of the year will be a good economic indicator.”

Those headwinds include $26.9 billion in debt. After another $7 billion to $8
billion is added by payments made to the United Auto Workers (UAW) retirement fund, Ford’s debt load will be larger than that of its restructured
rivals.

Additionally, rank and file union members in the UAW formally rejected a
contract with a host of cost-cutting concessions on Monday.  Meanwhile, the company remains in talks to sell its Volvo unit to China’s Geely Automobile Holdings Ltd.

Ford’s announcement amplified a report from the Institute of Supply
Management (ISM) that a key index of U.S. manufacturing activity jumped in
October, reaching its highest level since the spring of 2006.

“This is another clear sign the recession is over, and the recovery has begun,” Adam York, an economist at Wells Fargo & Co. (NYSE: WFC) told CNNMoney.com.

Tempe, Ariz.-based ISM reported its national survey of purchasing managers in the manufacturing field increased to 55.7 in October, versus consensus
estimates of 53 by analysts compiled by Briefing.com. It was the highest
reading since April 2006 when the index registered 56.

Index readings above 50 signal growth while levels below 50 indicate
contraction.

The index first went positive in August after 18 months of contraction.
It has now has held above the 50 level for three months in a row.

“The jump in the index was driven by production and employment,”
Norbert Ore, chair of the ISM’s manufacturing business survey committee told CNNMoney.com. “Overall, it appears that inventories are balanced and that manufacturing is in a sustainable recovery mode.”

News and Related Story Links:

• CNNMoney.com:
  Manufacturing at a 3-1/2 year high
  
• Bloomberg:
  Ford Earns $997 Million With Better Prices for Its New Vehicles
• Money Morning:
  Ford Inches Closer to Volvo Sale,
  Profitability

U.S. consumers curtailed spending in September for the first time in five months the government reported on Friday.  Combined with a weak report on consumer sentiment, it increased fears the economic recovery could falter as government stimulus spending winds down, sending the stock market into a downward spiral.

The news sent the Dow Jones Industrial Average plummeting by 294.85 points, or 2.51%, on Friday to close at 9,712.73.  Meanwhile, the Standard & Poor’s 500 Index fell by 29.93 points, or 2.81%, to close at 1,036.18 and the Nasdaq Composite Index plunged 52.44 points, or 2.5% to close at 2,045.11.

The Commerce Department said purchases fell by 0.5%, after gaining 1.4% in August, matching the median estimate of economists surveyed by Bloomberg News. But consumers continued to increase their savings even as their incomes dropped.

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The Reuters/University of Michigan’s consumer sentiment index rose to 70.6 in late October, up from 69.4 earlier in the month. However, that’s still down from September’s reading of 73.5.

“Consumers were more optimistic about prospects for the national economy, inflation, and the unemployment rate, although most consumers thought their own finances would remain problematic for some time,” said Richard Curtin, the director of the survey.

Stagnant wages and mounting concern over surging unemployment are increasing fears that consumers will pull back this winter as the government’s spending programs run out of funding.

“The consumer went out spending in August, but once that incentive was taken away they didn’t have the same reason to spend as much,” Jonathan Basile, an economist at Credit Suisse Group AG (NYSE ADR: CS) in New York told Bloomberg. “Consumers are going to be selective and not necessarily aggressive going into the holiday season.”

Consumer spending, which accounts for almost 70% of all U.S. economic activity, got a shot in the arm in the third quarter from the popular Car Allowance Rebate System (CARS), better known as the “cash for clunkers” program, which offered discounts on some new automobile purchases.

Government data on Thursday showed the economy grew at a 3.5% annual rate in the third quarter, probably ending the recession that began in December 2007. Consumer spending for the July-Sept. quarter actually gained 3.4%, thanks in large part to cash for clunkers, which ended in August.

But with a “jobless recovery” on the horizon, the labor market could be too weak to support domestic demand, leading to concerns the economy’s nascent recovery could stumble once the government support wanes.

Wages and salaries fell 0.2% after a 0.2% gain the prior month and employment costs in the United States rose 0.4% in the third quarter.  While wages and salaries from year-ago levels increased by 1.5%, it was the smallest increase since 1982, when record keeping began.

“The issue of poor labor income remains quite front and center,” Pierre Ellis, senior economist at Decision Economics in New York told Reuters. “The ability to finance consumer spending growth will come down to improvement in the labor market.”

And even though incomes dropped, Americans increased savings, further raising concerns about consumer confidence. Savings increased to an annual rate of $355.6 billion, pushing the savings rate up to 3.3% last month from 2.8% in August.

“It sets up a very weak fourth quarter for consumption. It might be around flat to up 1% annualized in the fourth quarter,” Ian Morris, chief economist at HSBC Securities in New York told Reuters. “But if inventories add and you get some rise in business investment, you could get a much more decent fourth-quarter (GDP gain) of around 3%.”

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• Bloomberg News:
  Consumer Spending in U.S. Declined in September
• Thomson Reuters:
  Recession Ends, but Recovery Will be Hampered By Weak Consumer Finances
• Money Morning:
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• Money Morning:
  Jobless Recovery Category
• Reuters:
  Consumer spending falls as sentiment sours

The House Financial Services Committee and the U.S. Treasury Department have released a draft version of legislation designed to address systemic risk and the issue of “too big to fail” institutions.

The proposed bill, spearheaded by U.S. Rep. Barney Frank, D-MA, the House’s Financial Services Committee chairman, aims prevent big bailouts after the government last year spent over $200 billion to rescue American International Group Inc. (NYSE: AIG), Citigroup (NYSE: C) and Bank of America Corp.(NYSE: BAC)

Facing a room packed with Wall Street bankers and dealmakers, Treasury Secretary Timothy Geithner said they could not look America in the eye and argue that financial regulation is ready to protect the fragile financial system, Reuters reported.

Calling efforts to bring reform to the system a “war”, he told the Securities Industry and Financial Markets Association annual meeting in New York that the government must respond by adding new regulations and strengthening old ones.

"It’s a war of necessity, not a war of choice," he told the gathering. "And it’s a just war."

The bill would grant the Federal Reserve, the Federal Deposit Insurance Corp. (FDIC) and a new systemic risk regulatory council the power to monitor and address risks to economic stability posed by shaky financial holding companies.

Key parts of the proposal would require financial firms with more than $10 billion in assets to pay for the unwinding of a collapsed competitor, and force at-risk companies to sell or transfer assets or stop certain activities if the central bank determined there could be a "threat to the safety and soundness of such company or to the financial stability of the United States," The Wall Street Journal reported. 

In addition, the proposal would set up a council of regulators to monitor potential threats to financial markets, abolish the Office of Thrift Supervision, make companies liable for part of the assets they securitize, and under certain circumstances, allow the Fed to force a financial company into bankruptcy, The Journal reported.

The draft legislation plugs a regulatory hole, missing until now, by giving the administration the legal authority, to take over a failing financial firm such as Lehman Brothers, which went bankrupt in 2008.

Even though Geithner and others have been pushing for the authority since last year, U.S. Rep. Jeb Hensarling, R-TX, remains skeptical.

"Based upon what I’ve heard [Rep. Frank] say in the past, I’m still fearful that the plan will de facto designate certain firms as being systemically risky, which is a precursor to a taxpayer bailout," he told The Journal.

Geithner will testify on the proposals in Congress tomorrow (Thursday).

News and Related Story Links:

• Reuters:
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• The Wall Street Journal:
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