February 2012invisible

Laufenberg Economic Quarterly

Daniel E. Laufenberg, Ph.D.
Economist

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.

Executive Summary - Feeling better, but still worried

  • In November 2011, the concern of the consensus was that the U.S. economy was gathering gloom, led by a contagious debt debacle in Europe. Given the more favorable U.S. economic releases the last few months, the consensus now has substantially reduced the recession risk for U.S. economy. In other words, the question now is not whether the expansion continues, but at what pace.

  • Admittedly, I was too optimistic a year ago about real gross domestic product (GDP) growth in 2011, in large part because of unexpected natural and government budget disasters. Now, some are concerned that I may be too optimistic again in 2012.

  • On balance, the U.S. economy finished 2011 stronger than it started. Real GDP grew at an annual rate of 2.3 percent in the second half of the year, compared with an annualized gain of only 0.8 percent in the first half. It may not be stellar but it was an improvement.
    The outlook for 2012 is for solid real growth, still relatively mild inflation, a declining unemployment rate, unusually low interest rates, and good earnings growth. This has not changed from my November report. The keys to the outlook are consumer spending, business fixed investment and housing, all of which are expected to improve this year versus last year.

  • Consumer spending, especially spending on services, should accelerate some over the four quarters of 2012 compared with the growth rate over the four quarters of 2011, reflecting solid income growth and the end to deleveraging by households.

  • Business fixed investment is expected to accelerate slightly over the four quarters of 2012, as spending on both equipment and structures turn up. Record corporate profits and solid aggregate demand will drive businesses to add capacity in the months ahead. Finally, residential investment starts to improve in a more meaningful way in 2012, as pent up demand for housing finally spills over into new construction.

  • I continue to expect the Fed to raise short-term rates earlier than its recent commitment of 2014. At the moment, my best guess is early next year. Under this scenario, equities and high-yield bonds are still preferred over high-grade bonds.

Forecast at a glance

chzrt 1, Chart 2

chart 3, Chart 4

 

Forecast details

Forecast Details

Feeling better, but still worried

Financial markets, which only a few months ago were concerned about the U.S. economy falling into a recession, now seem to be convinced that the economy will continue to expand but at a relatively “sluggish” pace. This change was triggered in large part by a surprisingly strong January employment report. Nevertheless, the ongoing political haggling in Europe continues to weigh on financial markets and the consensus outlook for the U.S. economy. Although a mild recession in Europe, which is the most likely scenario, will provide a headwind for the U.S. economy, it will not dampen the pace of real growth as much as most now fear. As a result, the Laufenberg Quarterly (LQ) forecast for 2012 is little changed, including solid real growth, low inflation, less unemployment, good corporate earnings growth, and still low interest rates.

Real growth in 2012 will be led by a uptick in consumer spending once again. Many economists disagree. They contend that real growth in the U.S. must come from someplace other than the consumer sector, because consumers have neither the income nor the credit available to spend. I believe that they are grossly underestimating the propensity of U.S. consumers to spend. More jobs will provide more income, which in turn will provide the ability to borrow. The difference now versus a few years ago is that consumer credit rather than mortgage credit will be used to finance big-ticket items; that is, a home-equity line of credit is not an option if there is insufficient equity in the house. For this reason, many economists contend that house prices need to recover before consumer spending growth can be sustained. I disagree. I think a job matters more than higher house prices when it comes to consumer spending; that is, the income effect is far more important than the wealth effect.

Also helping consumers in 2012 is the likelihood that inflation will remain relatively tame, allowing real incomes to improve markedly. Unfortunately, this will be disguised somewhat by huge swings in energy prices. Nevertheless, any sharp moves in energy prices—up or down—most likely will prove temporary. The LQ forecast shows the refiners’ price of imported oil averaging $104.8 a barrel for all of 2012, which is about 4.0 percent higher than the $100.8 average price for all of last year. However, the price of crude oil in the fourth quarter of 2012 is expected to average $104.5 a barrel, which is actually lower than the $106.3 average for the fourth quarter of 2011. Recall that inflation is not the level of prices but the rate of change in those prices. On a fourth quarter-to fourth-quarter basis, overall consumer price inflation is expected to be 2.1 percent in 2012, down from 3.3 percent in 2011, while core consumer price inflation is expected to be 2.1 percent in 2012 as well, little changed from the level of core inflation in 2011.

The employment picture has improved considerably since November of last year. Although many were surprised by this, clients of the LQ were not. This improvement was anticipated in the LQ forecast and explained in considerable detail in an essay on the LQ website.1 The LQ argument was that the labor force participation rate, which had been trending lower for several years, would remain low rather than rebound sharply as many economists suggested. Changing demographics, in particular the aging population, were a key factor. Revised data for 2011 that reflect the results of Census 2010 provide further support for the LQ view. Hence, the outlook for employment remains favorable—the unemployment rate is expected to drop further this year and next, even though payroll job gains are not as stellar as in the past. According to the LQ forecast, the civilian unemployment rate will be very close to 7.5 percent by the end of 2012, down from 8.5 percent in December 2011.

Corporate profits should continue to drift higher in 2012, assuring investors that the profit gains of 2011 will be sustained. This, combined with the anticipated acceleration in real GDP growth, should help propel stock prices higher on average over the remainder of this year. Europe will be a headwind for corporate profits but not the hurricane that many seem to expect.

Bond prices seem less likely to move higher. Indeed, the best bond investors can hope for in 2012 is that it will be a coupon clipping year, but even that may be too optimistic. The good news is that inflation should not be a problem this year or most of next year, which means that the Federal Reserve will see little need to abandon its very accommodative policy stance anytime soon. And as long as the Fed is convinced it is safe to remain accommodative, I doubt that bond investors will want to “fight the Fed” on this score. As such, in the bond portion of a portfolio, the better place to be under these circumstances is riskier bonds that are not yet priced for a sustained economic expansion, in terms of both interest rate risk as well as credit risk.

Q4: Good growth but some question its quality

According to the Bureau of Economic Analysis, real GDP grew at a 2.8 percent annual rate in the fourth quarter of 2011, following a gain of only 1.8 percent in the previous quarter and 0.8 percent in the first half. Although a good performance, it fell short of my expectation as well as the consensus estimate just before the GDP data were released. The disappointment was in real final sales, which increased a scant 0.8 percent at an annual rate in the fourth quarter, following a gain of 3.2 percent in the third quarter.

This disappointment was led by an unexpected decline in government spending in the fourth quarter. The LQ forecast was expecting government spending to be flat in the fourth quarter. Instead, real government spending plunged 4.6 percent at an annual rate and detracted a whopping 0.9 percentage point from real GDP growth. The decline reflected a sharp drop in defense spending at the federal level (down 12.5 percent at an annual rate) as well as a meaningful drop in spending at the state and local government level (down 2.6 percent at an annual rate). Federal nondefense spending actually increased 4.2 percent in the fourth quarter, the first quarterly gain of the year.

The other major disappointment to real final sales in the fourth quarter was a much slower-than-expected gain in nonresidential fixed investment. There was considerable talk about businesses accelerating the timing of some fix investments into 2011 to take advantage of the 100 percent bonus depreciation provision that expired at the end of 2011. However, the placed-in-service deadline to qualify for 100 percent bonus deprecation was extended through December 31, 2012 for certain assets that have longer production periods; including transportation equipment and aircraft. The 50 percent bonus depreciation rules return in 2012 for eligible assets placed in service during the year. The placed-in-service deadline is extended to December 31, 2013 for certain assets that have longer production periods.

Given the much slower-than-expected gain in real final sales, the bulk of the increase in real GDP in the fourth quarter was due to inventory accumulation. The question then is whether the inventory build in the fourth quarter was planned. If it was, then more inventory accumulation is a reasonable expectation. If not, then it suggests that inventories are excessive and need to be reduced. In this case, just a slowdown in inventory accumulation would be a drag on real growth in the first quarter of 2012.

The best way to assess whether the build in inventories in the fourth quarter was planned is to take a look at the inventories-to-sales ratio to see if it spiked higher. As seen in Chart 1, this was not the case. From all indications, the level of business inventories is very much in line with sales. Indeed, despite the jump in inventories in the fourth quarter of 2011, it was far from excessive; indeed, the ratio of inventory to sales for total businesses was near a record low in the fourth quarter. Just to maintain this ratio at its current level, inventories must increase $1.25 for every $1.00 in sales. And given what I expect sales to do in 2012, any drag on growth from slower inventory accumulation will be transient.

The bottom line is that business inventories are certainly not a problem given the level of sales. As such, any drag on real GDP growth from a smaller change in inventories would be temporary. In fact, it could be safe to argue that the boost to fourth-quarter real GDP growth from the change in inventories was payback for the sizable drag from the change in inventories in the third quarter.

Labor market recovery continues, albeit slowly

The labor market continued to improve in January according to the Bureau of Labor Statistics, which reported that the unemployment rate fell to 8.3 percent, its lowest level in nearly three years, but still well above its low at the end of the previous expansion (see Chart 2). This was a much better outcome than the consensus was expecting. Indeed, many were concerned that the unemployment rate would rebound owing to the reentry of the many people who left the labor force in recent years. That is, the labor force participation rate, which had been declining, was expected to rebound. Such a rebound in the labor force participation rate did not occur. In fact, updated population estimates using the results from the Census 2010 increased the civilian population in December 2011 by 1.51 million, the civilian labor force by 0.26 million, employment by 0.22 million, and persons not in the labor force by 1.25 million.

chart 2

As a result, the participation rate in January at 63.7 percent actually was reduced by 0.3 percentage point by the population adjustments. This reduction was because the population increase was primarily among persons 55 and older and, to a lesser degree, persons 16 to 24 years of age. Both these groups have lower levels of labor force participation than the general population.2 Although there will be a point when many of the younger persons who left the labor force for economic reasons will return, many of the older persons who are no longer in the labor force most likely will not return. As such, I am confident that the unemployment rate will continue to trend lower over the next year or two, probably more so than the consensus expects.

Of course, sustained improvement in the labor market requires job growth. In the household survey, employed persons in January increased a whopping 847 thousand from a month earlier and a solid 2.3 million from January 2011. This is a very volatile series from month to month but it tends to follow the establishment survey data over the longer term. In this regard, nonfarm payroll employment in January was up 243 thousand from December and up 1.95 million from January 2011. The January payroll jobs gain in the private sector was even more pronounced, up 257 thousand from December and up 2.2 million from January 2011. In 2012, payroll jobs are likely to increase at least this much, if not more.

Jobs and income will be the keys in 2012

With regard to personal incomes, the bulk of the gain will come from wages and salaries (see Chart 3). In particular, as nominal wages continue to move higher in 2012, consumer purchasing power will be enhanced. Many analysts were concerned about the slower growth in personal income through most of 2011, but upon closer inspection, it was not wages and salaries that caused the slowdown. Over the twelve months ending in December 2010, wages and salaries increased 3.2 percent, while over the twelve months ending in December 2011, wages and salaries climbed 3.8 percent. The difference was that inflation in 2010 was far less than in 2011, which in turn put a damper on real income growth last year. I contend that the wages and salaries component of income will continue to accelerate in 2012, reflecting a moderate gain in average hourly wages and another solid gain in jobs. In addition, inflation will remain tame enough to provide a boost to consumers’ purchasing power as well.

chart 3

On the other hand, interest income, which has been trending downward for over a year now, most likely will not be much help to personal income growth in 2012. As shown in Chart 4, there is recent evidence that this decline in interest income has slowed, suggesting that its slide may be near an end. Also, in Chart 4, it is evident that rental income and dividend income have been on the rise.3 Both should continue to improve in 2012, albeit at a less generous pace than in recent years. Rents are rising as households shift away from home ownership to renting. Dividends are rising again in response to investors stretching for return—moving away from interest earning assets toward dividend paying assets.

In addition, I contend that the deleveraging of the household sector may be over. According to the Federal Reserve Board, consumer credit in the fourth quarter of 2011 increased at a seasonally adjusted annual rate of $185.6 billion, following an average gain of about $40 billion for the prior three quarters.

More importantly, the pay down of mortgage credit by households, which was estimated at $181.4 billion in the third quarter by the FRB, most likely slowed a bit in the fourth quarter, resulting in total household debt to increase for the first time in over three years. Of course, the ability of consumers to use home-equity lines of credit is very limited given that owners’ equity in household real estate at the end of the third quarter of 2011 was less than half of what it was at the end of 2006. Also, with interest rates so low, non-revolving (not credit card) consumer credit is a reasonable alternative to home-equity lines of credit. In addition, the tax deductibility of home mortgage interest is less valuable when returns on less risky investments, both real and financial, are expected to be low.

Some economists contend that the consumer cannot recover until house prices recover. I disagree because the income effect on spending is far more important than the wealth effect. For example, in a year, consumers spend nearly 94 percent of their income but only about 3 percent of any increase in wealth. Hence, an increase in income is far more important than an increase in wealth. These propensities to spend are not the same for all income groups, but it does give us a clue as to how essential house prices are to consumer spending. In other words, a recovery in house prices is not necessary for consumer spending to recover, but it would make it easier. Given the lingering problems in housing, it looks like the recovery in consumer spending will be done the hard way.

Inflation remains low-for now!

The inflation outlook for 2012 remains essentially the same as it was in November 2011; that is, the overall consumer price index is expected to increase 2.1 percent over the four quarters of this year, following an advance of 3.3 percent over the four quarters of last year. Moreover, core consumer price index, which excludes the volatile food and energy price components, is expected to increase 2.1 percent this year as well, following an advance of 2.2 percent in 2011. Although I remain convinced that inflation will become problematic for the economy at some point, there is still too much slack in the U.S. economy for it to happen this year.

The LQ outlook assumes that energy prices will be volatile again this year, but the swings will be offsetting over the course of the year. Obviously, recent events in Iran have sparked concern that the flow of crude oil from the Middle East could be interrupted, albeit temporarily, causing the recent spike in energy prices. If these higher prices are sustained for an extended period such that they start to be incorporated in non-energy consumer prices, then they could become problematic. That is not my forecast. As such, any temporary spike in prices will result in a temporary loss of purchasing power. This will be viewed by consumers as a transitory loss of income. And just as transitory income is not spent but saved, a transitory loss of income will lower saving rather than spending. Indeed, there is nothing shocking about higher energy prices at this stage of the business cycle, unless it is perceived as permanent.

The January CPI report, which showed an advance of 0.2 percent in overall consumer prices on a seasonally adjusted basis, was roughly in line with the LQ forecast of 2.1 percent for all of 2012. On a not seasonally adjusted basis, prices were up 0.4 percent, which may help explain why some people contend that the government’s statistic understates inflation. For that reason, it may be more appropriate to think in terms of the change in prices from a year ago on a not seasonally adjusted basis.

As shown in Chart 5, the percent change in the overall CPI from a year ago trended higher over the first eight months of 2011 before rolling over later in the year. Obviously, energy prices had a lot to do with this trajectory because the percent change in the core CPI from a year ago edged higher throughout the year from 1.0 percent in January 2011 to 2.3 percent in January 2012.

The bottom line is that the quarterly trajectory of the overall inflation forecast most likely will be wrong, but that the direction and the average for all of 2012 will be close. The reason is that I am far less confident about forecasting crude oil prices on a quarterly basis than I am about forecasting the average energy inflation for all of 2012. The political events in Iran seem to fly in the face of demand and supply fundamentals. The politics suggest higher prices, while the fundamentals suggest lower prices. My experience is that eventually fundamentals dominate, but it also is very uncertain how long it will take. One thing for sure, higher crude oil prices will accelerate the switch from gasoline or diesel to natural gas or electric vehicles. After all, consumers and truckers are in a much better place today to make that switch than they were even a year ago.

Chart 5

chart 6

A peek at 2013

In this LQ, I offer up my first peek at the U.S. economic outlook for 2013. For the most part, it is a continuation of developments in 2012. In particular, the economic expansion is expected to continue, albeit at a slightly slower pace than in 2012. Consumer spending, which is expected to start 2013 strong, should slow markedly in the second half. A substantial slowdown in real disposable income growth late next year could cause consumers some problems. Housing is expected to continue to improve throughout the year, in part because it will be starting the year at such a low level. Business fixed investment will slow down somewhat in 2013, as manufacturing output growth slows. Government spending should remain neutral throughout 2013, assuming that the federal government does not make any meaningful cuts to defense spending and government employment improves a bit with the economy.

Somewhat higher inflation in late 2013, combined with efforts by the Federal Reserve to fight inflation, will put downward pressure on growth in the second half of the year. Major tax reform and federal spending cuts most likely would not be implemented until later in the year, regardless of the outcome of the 2012 election. On the other hand, what will be included in tax reform and the extent of any spending cuts probably will depend on the outcome.

When the Fed fights inflation, it means that interest rates rise. I doubt that the Fed will wait until the end of 2014 before it starts to tighten monetary policy, but then my forecast for 2012 and the first half of 2013 is more optimistic than the consensus at the moment. That being said, there are a host of issues that could provide a meaningful headwind for the U.S. economic expansion this year, as well as next. In particular, there will be considerable discussion about fiscal drag on the economy coming from higher taxes or meaningful cuts in spending in an effort to reduce the U.S. federal deficit. Regulation will continue to reinvent itself as new rules are interpreted and new regulators find their niche.

Corporate earnings should continue to rise, reflecting the combination of still good real growth and some pricing power. Nevertheless, the quality of the earnings will be questioned. Under this scenario, before the end of 2013, equities and high yield corporate bonds will start to look expensive, while Treasury bonds may start to look cheap. The timing of these things is still very unclear.

Investment implications

I continue to believe that the economic and financial fundamentals in the U.S. are positive and, more importantly, improving. For that reason, my investment implications are little changed once again. Although I was wrong about equities being the best performing financial asset last year (bonds outperformed almost across the board), I still think equities will be the best for all of 2012 and most likely for most of 2013 as well. The economy should continue to expand at a reasonable pace, which I define as 3.0 percent or more, and inflation should be subdued, although not as subdued as the Fed seems to expect. For this reason, I maintain my view that longer-term Treasury yields will start to head higher later this year in anticipation of the Fed raising its target on short-term interest rates sometime in 2013.

In 2012, the challenges to investors will not disappear but they may be less pronounced or less frequent. Indeed, higher interest rates in 2012 will actually be considered a good thing for the economy primarily because they will reflect higher inflation expectations more so than unusually high credit risk. If the Fed looks to be ahead of the inflation curve, financial markets will react favorably. Not until the Fed is viewed as behind the curve will investors get jittery.

In this regard, I continue to dislike long bonds of any kind but especially Treasury longer-term notes and bonds with exceptionally low coupons. As I noted before, investors seem to feel safe from interest-rate risk because they think the Federal Reserve will provide advance warning of higher rates. I think they will be sadly disappointed. The Fed may warn them but by then it will be too late. Indeed, because corporate earnings should remain solid and economic fundamentals should continue to improve, high-yield corporate bonds and many municipal bonds seem more attractive than U.S. Treasuries for now.

______________________________

1. See Daniel. E. Laufenberg, “Is the Great American Jobs Machine Finally Broken?” Perspectives, Laufenberg Quarterly, laufenbergquarterly.com, December 3, 2011.

2. For more details about the impact of demographics on the labor force participation rate, see Daniel E. Laufenberg, “Is the Great American Jobs Machine Finally Broken?” Perspectives, Laufenberg Quarterly, laufenbergquarterly.com, December 3, 2011.

3. The spike in dividend income in late 2004 was due to the special dividend paid by Microsoft of $32 billion, which at an annual rate was worth $128 billion. The bulk of this special dividend went to individuals rather than institutions.

______________________________

 

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.


ECONOMIC COMMENTARY
Mid-term updates to the Quarterly Reports

ARCHIVES OF LAUFENBERG QUARTERLY ECONOMIC REPORTS

November 2009 - LEQ (PDF)
February 2010 - LEQ
May 2010 - LEQ

August 2010 -LEQ
November 2010 - LEQ
February 2011 - LEQ
May 2011 - LEQ
August 2011 - LEQ
November 2011 - LEQ


 

HOMEABOUTCOMMENTARY FORECASTspacerPERSPECTIVESLINKS