Third Quarter September 26, 2015

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The waiting game continues

The Federal Open Market Committee (FOMC) announced earlier this month that it will leave its federal funds rate target at its current level of near zero for now. I was not surprised based on recent comments from policymakers but I was still disappointed. According to the FOMC statement following its policy meeting, they were concerned about recent international and financial developments restraining economic activity rather than any hard evidence that the U.S. economic expansion was being derailed. In fact, with the U.S. economy operating at or very near full employment and with inflation risk still subdued, I thought they missed an opportunity to start normalizing interest rates without creating a huge financial backlash. Also, the FOMC essentially added a new twist to its policy reaction function, thus raising the question of what it will take to convince the FOMC to retreat from a policy stance that seems more appropriate for an economy in the depth of a financial crisis than in the seventh year of an expansion.

  • The apparent concerns of the FOMC were the international economic slowdown, commodity price deflation, and financial market volatility. With regard to the international economy, the only new development on that front since the last policy meeting in July was China devaluing its currency and defending stock prices with outright purchases of Chinese equities. These actions raised fear that the economic slowdown in China was even more pronounced than initially estimated and that it would have an even more dramatic adverse effect on the U.S. economy.

  • I contend that the extent of the slowdown of the China economy should not have been surprising to anyone, nor the policy responses taken. After all, China is still a controlled economy. But more importantly, I contend that the deflationary concerns being assigned to the slowdown (even by the FOMC) may prove to be dramatically overstated. Recall that the slowdown in China is likely due to less productivity improvement combined with a declining labor force. The policy responses by China, I think, only exacerbates the productivity slowdown.

  • Recall that in any economy, there are two components of real growth; more hours worked and more output per hour worked. Hours worked increase largely by hiring more workers. In China, hours worked are at best likely to remain flat due to the declining labor force. I do not mean a slower growing labor force, like the U.S., but a labor force that is actually shrinking—fewer people available to work. That being said, the labor force in China is still huge and offers plenty of opportunity to improve productivity by shifting rural workers to more productive urban jobs. However, the easy gains in this regard have been achieved. As China attempts to make its economy more dependent on personal consumption and less dependent on exports, gains in output per hour will likely suffer somewhat. A key factor in this transition to a more consumer oriented economy will be the growth in consumer services. However, services tend to be more labor intensive (less productive) than goods production, suggesting that as personal consumption increases in importance, productivity gains will slow.

  • If the labor force is shrinking and labor productivity growth is slowing, then it should be no surprise that China's real gross domestic product (GDP) growth slows as well. A more realistic sustainable growth rate for China over the longer run is closer to 5 percent than to 10 percent. But for the second largest economy in the world, 5 percent still is not bad.

  • Commodity price deflation in the past has proven to be temporary and generally followed by a period of commodity price inflation. This is just another way of saying that commodity prices are very volatile and seldom an indicator of underlying inflation risk. A more appropriate measure is some measure of consumer prices excluding food and energy. For example, the consumer price index (CPI) less food and energy in August was up 1.8 percent from a year ago and much closer to the FOMC's inflation target. By the way, the FOMC noted in its statement that inflation is "anticipated to remain near its recent low level in the near term but … to rise gradually toward 2 percent over the medium term."

  • A significant factor in the commodity price deflation of late has been energy, which has seen a dramatic drop in prices over the last year. However, as illustrated in Chart 1, this component of the CPI is extremely volatile and, if history is any guide, is unlikely to continue declining forever. Without the downward drag on the overall CPI from energy, the core measure suggests that it is likely to move higher over time. I suspect that the increase may be even more pronounced than most economic commentators currently expect.

chart 1

  • With regard to financial market volatility, the FOMC itself seems to be a major factor. After all, the ongoing uncertainty associated with waiting for the Federal Reserve to finally hike rates has made investors nervous. I actually think that if the FOMC raised its federal funds rate target, it would reduce rather than increase concerns about the U.S. economic outlook. That being said, the FOMC may be a bit disingenuous to say it is concerned about equity prices going down when it did nothing to stem skyrocketing stock prices earlier.

  • The FOMC needs to focus on the fundamentals of the U.S. economy rather than the global stock market. I understand the easing bias of monetary policy in a low inflation environment but I also fear that under current conditions this bias is overdone. A 1.5 percent federal funds rate with core inflation running at about 1.6 to 1.8 percent, depending on the measure used, still suggests a negative real rate of interest.

Exactly how would the economic slowdown in China spillover to the U.S. economy and in turn increase the risk of a recession? This is the question being asked by investors at the moment. Those concerned about this spillover effect point to the stronger dollar, falling commodity prices and the sharp correction in global equity markets as evidence of the contagion and why the Federal Reserve should wait to make any change in policy. I disagree. Although a stronger dollar may have an adverse effect on manufacturing (the net effect is much smaller than the stronger dollar alone would suggest) and lower crude oil prices may have an adverse effect on the domestic energy sector in the near term, these effects could be more than offset by a solid gain in consumer spending. By the way, I am convinced that if we are truly in a proverbial "liquidity trap," low interest rates do nothing to bolster activity if no one wants to borrow. In fact, higher interest rates and the interest income that they might generate could do more to boost spending than lower rates. And as ironic as it may sound, the threat of higher rates may encourage more consumers to initiate debt-financed spending decisions.

  • It seems that the bulk of the feared adverse effect on the U.S. economy will come through a stronger dollar. Recall that it was only about a year ago that investors were concerned about dollar weakness. As shown in Chart 2, the trade-weighted dollar index against major currencies has jumped over the last year to a level well above its 40-year trend but is still well below the previous peak in the dollar.

chart 2

  • The implication for the U.S. economy is that the trade sector will be a drag on growth in the near term. If this is the case, it is not yet evident in the data. After detracting nearly 2.0 percentage points from real GDP growth in the first quarter, real net exports actuallycontributed 0.2 percentage point to real GDP growth in the second quarter. But more importantly, real net exports are on track to contribute (albeit very slightly) to real GDP growth again in the third quarter.

  • I often hear commentators refer to other episodes of international financial crises, such as the 1994 Mexican peso crisis, the 1997 Asian financial crisis or the 1998 Argentina crisis, as examples of how the current problems could be a drag on the U.S. economy. However, I see nothing in the U.S. economic data to suggest that any of these crises had a significant adverse effect. In fact, the stronger dollar gave consumers the real purchasing power to increase spending more than enough to offset the drag from net exports; in all cases, the U.S. economy rallied rather than sank.

  • One impact of a stronger dollar that needs to be considered is that not only do the cost of finished imports decline but the costs of imported intermediate goods (parts and materials) for final assembly and processing in the U.S. decline as well. In this latter case, if the cost of the intermediate goods exceed the value added in the U.S., then the cost of production could actually fall, allowing U.S. companies to offset some, if not all, of the strong-dollar effect by lowering U.S. dollar prices on exported product without adversely affecting wages or profit margins.

  • Indeed, slower growth abroad may hamper U.S. business operations there but the bulk of any hit to corporate profits likely will come from the translation of foreign currency into the stronger dollar; that is, it now takes more of the foreign currency to buy a U.S. dollar. On the other hand, it now takes fewer dollars to buy foreign.

  • On the negative side of the data, industrial production has been hampered somewhat by the stronger dollar, but also by the bad weather earlier in the year and the plunge in crude oil prices. But again, I view the adverse effects of the latter two factors to be temporary and the former factor to be less severe than many fear. As such, I suspect that industrial output will improve over the remainder of this year, but probably not as robustly as it did earlier in the current expansion. This is another reason why consumer spending, especially on services, will become increasingly important to the pace of the expansion over the remainder of 2015.

Despite the new concerns about the U.S. economy highlighted in the recent FOMC statement, the forecast for 2015 is little changed from June. Indeed, the only meaningful change is that the trajectory for short-term interest rates has been shifted outward once again thanks to the FOMC's decision to maintain "the current 0 to ¼ percent target range for the federal funds rate."

  • The expansion continues at a slower pace than many market participants hoped but fast enough to push the unemployment rate even lower. Indeed, the current level of unemployment suggests that any excess capacity still available in the labor market is small and likely to be absorbed rapidly. The implications over the forecast horizon are that consumer prices will be pressured upward, wage gains will accelerate, corporate profit growth will slow, and interest rates will trend higher. However, the exact timing of such outcomes remain unclear. Although I have been saying this for over a year (and I have been wrong) I expect that it will be sooner rather than later.

  • Since the June forecast, not only did the Bureau of Economic Analysis revise its estimate of real gross domestic product (GDP) in the first quarter to show a small gain rather than a small decline, it also revised sharply upward its estimate of real GDP growth in the second quarter. As a result, the U.S. economy grew at a 2.2 percent annual rate in the first half of this year, which is about twice as fast as shown in the June forecast. Given the stronger performance now estimated for the first half, less is needed in the second half to sustain the expansion at an above-trend pace for all of 2015. For the second half of this year, real GDP is now expected to average about 2.6 percent growth at an annual rate rather than the 3.5 percent pace shown in the June forecast. Nevertheless, 2.6 percent still would be more than enough to eliminate my estimate of the output gap (excess capacity) by yearend.

  • The major source of real GDP growth in the second half remains real personal consumption expenditures, led by increased spending on services. Consumers are expected to sustain spending on goods, but the foreign exchange strength of the U.S. dollar is likely to cause more of that spending to be on imported goods rather than domestically produced goods. For this reason, I now expect net exports to be a larger drag on real GDP growth over the remainder of the year than expected earlier.

  • Real disposable income grew at a 2.6 percent annual rate in the first half of the year, compared to real personal consumption expenditures growth of 2.5 percent. As such, it appears that the pent-up demand that might have developed in the first quarter was satisfied in the second quarter. Hence, going forward, spending gains may only keep pace with income gains. In this regard, real disposable personal income in July was already up 2.0 percent at an annual rate from the second-quarter average, and given the job and wage gains reported for August, it looks like real disposable income could climb even faster in the third quarter. My expectation is that real disposable income growth will average 3.0 percent or so for the second half of this year. But rather than income growth being an upper bound on consumer spending, I contend that it more likely represents the lower bound. Household balance sheets, despite the recent stock market correction, still look very solid and provide ample opportunity for consumers to increase borrowing, which I expect they will. For this reason, do not be surprised if real consumption expenditures increase faster than real income in the second half of the year.

  • New home construction, and to a lesser extent home improvement, should push residential investment higher in the second half as well. This too should help fuel some borrowing by consumers to finance purchases. After all, consumers are unlikely to spend on renovations unless they feel better about owning a home and are more confident that they have some home equity again. As shown in Chart 3, home equity has not quite recovered completely from the housing crisis of 2007-8 but it has clearly returned to a level more in line with the longer-term trend in home equity.

chart 3

  • On the other hand, nonresidential fixed investment is expected to remain sloppy, especially with regard to equipment spending in the wake of a substantially stronger dollar and slower global growth.

  • Real government spending on goods and services, which jumped in the second quarter, is not expected to be much of a factor in driving real GDP growth one way or another over the remainder of the year. In particular, the surge in real spending by state and local governments in the second quarter (up 4.3 percent at an annual rate) is unlikely to be repeated in the second half. However, spending at the federal level is likely to accelerate some from its average pace in the first half of only 0.5 percent at an annual rate. Although I do not anticipate a federal government shutdown at the end of this month due to the failure by Congress to agree on a budget, it remains a possibility. Any shutdown could have an adverse impact on real GDP growth in the third quarter if it is allowed to persist for more than a few weeks.

  • The one area that seems positioned to have a very pronounced adverse effect on real GDP growth in the near term is the change in business inventories, which is at a relatively high level by historical standards and unlikely to be sustained. The question is not whether inventory accumulation slows but rather whether real final demand growth will accelerate sufficiently to offset it. Although I do expect final sales growth to be solid, I doubt it will be enough to prevent the change in inventories from detracting somewhat from overall economic growth in the second half. That is why I now expect real GDP growth to slow to 3.0 percent in the third quarter from 3.7 percent in the second quarter.

  • Despite the anticipated slowdown in third-quarter real GDP growth, it still will be strong enough to push the civilian unemployment rate even lower over the remainder of the year. In June, the forecast was for the unemployment rate to average 5.2 percent in the third quarter. Based on the first two months of data, the average is 5.2 percent (5.3 percent in July and 5.1 percent in August). There is nothing in the more recent data to make me change my mind. And for the fourth quarter, I continue to expect the unemployment rate to fall to an average of 5.0 percent, which by nearly everyone's definition is considered full employment.

  • As shown in Chart 4, there are other measures of unemployment that appear less favorable and are often referenced by commentators as more appropriate as a gauge of labor market conditions. I disagree—I contend that the information about the labor market captured by these other measures is no different than the headline statistic. First, the alternative measures move roughly in line with the official measure. Second, the alternative measures are relatively new compared to the official statistic and only include two recessions, the extremely mild 2001 recession and the extremely severe 2008-9 recession.

chart 4

  • As such, do not be surprised if upward pressure on consumer prices start to surface before yearend. Such a development would not only lead to a less accommodative monetary policy by the Federal Reserve but the perception by market participants that the Fed will need to raise rates far more to curb inflation risks than the consensus at the moment. In this case, interest rates across all maturities would rise initially. Not until market participants were convinced that the Fed had move enough would longer-term interest rates start to drift lower again. This would most likely produce the inverted yield curve necessary for a recession but not sufficient. For the most part, I expect this yield curve action to occur in 2016 rather than this year.

Economic conditions still favor risk, but investors should be more selective about the risk taken than they might have been earlier in the current business cycle. In particular, operating profits are now expected to register a small decline this year compared to a small gain expected earlier, owing in large part to a much stronger than expected foreignexchange value of the dollar. In this case, it is the large multi-nationals that will suffer most, both in terms of domestically produced goods sold abroad as well as the dollar effect on earnings from slowing overseas operations. I suspect it will be more the latter than the former.

  • The U.S. economy is expected to put in a solid performance in 2015, including solid real output growth, more jobs, lower unemployment, and still benign inflation.

  • The recent stock market correction has gotten everyone's attention, especially since it has been so long in coming. I still expect the stock market to move higher on average over the remainder of this year, but not until investors are convinced that the slowdown in China will have little net impact on the U.S. economy. It has been my experience that the U.S. economy benefits from financial and economic crises elsewhere, in large part because of the perception of the U.S. as a safe haven. Of course, if the crisis originates in the U.S., the rest of the world generally feels our pain.

  • Treasury bond yields remain low by historical standards, while credit spreads have widened out somewhat. Apparently, the concern that the U.S. economy is heading for a dramatic slowdown owing to the international developments has caused bond investors to elevate their assessment of potential default. Again, I think it is too soon to be concerned about credit problems, except maybe in one-off cases.

  • I still expect the FOMC to raise its federal funds rate target before yearend. Here again there is considerable uncertainty plaguing financial markets, although maybe not as much as there was before Fed Chair Janet Yellen's recent speech identifying herself as one of the members of the FOMC who favor a rate hike this year. However, the debate about the timing of the Fed's first move will be replaced by the debate about how aggressive the Fed will be about raising rates once it starts. With regard to the first part of the debate, I still expect the Fed's initial rate hike to come sooner rather than later. With regard to the second part of the debate, I think the data will force the Fed to be more aggressive about normalizing interest rates than most now anticipate.

Daniel E. Laufenberg, Ph.D. dan@laufenbergquarterly.com

LQ Economic Forecast Third Quarter 2015

blue bar spacerAppendix: Laufenberg Quarterly forecast at a glance blue bar chzrt 1 - 4

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Forecast Details

Statistics highlighted in bold have changed substantially from the previous forecast. f—forecast

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The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.


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