March 2013

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 - Expecting more than most

  • Weak economic growth at the end of last year was due to special factors, including a sharp drop in federal defense spending and a larger-than-expected slowdown in inventory accumulation. Neither is expected to be a meaningful drag for all of 2013.

  • Although fiscal policy continues to be the focus of most discussions about the near-term outlook for the U.S. economy, it seems a bit exaggerated. Clearly both the sequestration already in place and the upcoming deadline for the current continuing resolution later this month will be disruptive to the economy in the near term but neither is expected to have any long-term impact.

  • The debt ceiling deadline, which is May 1 of this year, could be a different matter. Failure to avert that deadline could be far more problematic for government operations and the economy, especially in the near term but also longer-term. For that reason, I expect the debt ceiling legislation necessary to allow the government to continue to borrow will be enacted between now and then, probably closer to then.

  • Actually, many analysts were already concerned about the outlook for the economy, especially for consumer spending, because of the tax increases implemented in early January. Although there is some justification for this anxiety, it should not be overstated. The consumer data for January was very positive, while the limited information on the consumer so far for February is mixed.

  • A few minor changes have been made to the Laufenberg Quarterly (LQ) outlook for 2013; for the most part, it now looks like a tale of two halves—a slower start but a better finish. Despite the early hurdles for the economy, it still is expected to grow at a faster pace this year than last. At the moment, the LQ growth forecast for 2013 is ahead of the consensus as well. Also, inflation is expected to remain benign this year, allowing the Fed to maintain its current policy stance longer

  • The LQ economic outlook for 2014 is more in line with the consensus, as the expansion is expected to accelerate once again. Another recession is still expected, just not as soon as suggested earlier. Apparently one of the benefits of sluggishly paced recoveries is that they do not burn out as quickly as the fast-starting kind.

Forecast at a glance

chzrt 1 - 4

Forecast details

Forecast Details

Expecting more than most

The perceptions of a sudden loss of momentum in the U.S. economy at the end of last year have been wildly exaggerated. Part of the explanation is, of course, that there never was much momentum to be lost. Perhaps the best illustration of this point is the gross domestic product (GDP) statistics released recently. Headlines proclaimed the loss of momentum signified by the sluggish 0.1 percent growth estimated for the fourth quarter. Strictly speaking, this was correct, since 0.1 percent is perceptibly more sluggish than the (upwardly revised) 3.1 percent growth rate for the third quarter. However, the comparison is badly flawed because the transitory factors that lifted the third-quarter growth rate artificially, simultaneously depressed the fourth-quarter growth rate. During the four quarters of 2012, real GDP grew a mediocre 1.6 percent. Viewed from this perspective, the growth rate expected for the first quarter of 2013 should be more of the same. The issue is not that the U.S. economy’s performance can be described as “slowmotion,” but that it continues to do so into the fourth year of the current economic expansion.

Nevertheless, it is clear that many analysts continue to have trouble coming to grips with such sluggish growth—which is perhaps not surprising since the recovery has been the most sluggish on record. In any event there is a clear tendency to paint the outlook in more dramatic colors. The economy must either stage a traditional recovery, with strong growth, or else it must be sliding into another recession. For many, there simply are no other alternatives, and perceptions jump back and forth rather violently in reaction to incoming data that never quite conforms to either extreme. In this sense, the economic reality is vastly more boring than the perceptions of it are.

The labor market would seem to provide the major exception to this generalization. On balance, the unemployment rate has trended downward so far during the current expansion at a surprisingly solid pace. In the absence of more payroll employment, many analysts are convinced that at least some of the decline in the unemployment rate reflected statistical distortions. That may be the case if the downward trend was a recent phenomenon but the unemployment rate has fallen 2.2 percentage points over the last three years, albeit from a relatively high level. It may be that an improving labor market in the wake of sluggish GDP growth is all part of the same changing demographics story.

Another aspect of the recovery that seems to be inconsistent with the sluggish growth rate is the solid gain in corporate earnings over the last three years. Operating earnings for the S&P 500 stock index on a trailing twelve month basis have climbed at a 37 percent annual rate from its low in the third quarter of 2009, despite a lull last year. Last year’s slowdown was not a major surprise to the Laufenberg Quarterly forecast, even though the extent of the slowdown was more than anticipated. The good news is that operating earnings growth is expected to reaccelerate again in 2013, but only at about a 7.0 percent pace. Productivity gains will help but the bulk of the improvement will be from revenue growth as pent-up demand is finally unleashed.

Final sales: Private versus total

The key to the outlook will be real final sales growth. But intensified pessimism regarding the near-term prospects for sales has carried into 2013, and any number of analysts have shaved—or in some cases, slashed—their forecasts of real final sales growth and in turn real GDP. In contrast, the Laufenberg Quarterly (LQ) forecast continues to look for a slight acceleration in real GDP growth this year to a pace of 2.5 percent from 1.6 percent in 2012.

The concerns are not by any means unjustified, but in this instance they appear to be exaggerated. For most pessimists the standout source of anxiety is the consumer. This is understandable. Consumer spending power most likely has been dinged somewhat by the recent increase in taxes, especially the end of the payroll tax holiday. However, this hit should not be very extensive. After all, real personal consumption expenditures in January 2013 were already at a level that was 1.7 percent at an annual rate above the fourth-quarter average. The implication is that consumer spending had some momentum going into the current quarter.

Based on the limited data that we have for February, it is unclear whether consumer spending will build on this momentum. The only data available that might give us a clue are light-vehicle sales and consumer confidence. In both cases, the reports were constructive for consumer spending in February. Although some large department stores reported some sluggishness in February sales, it may not be as widespread as many fear. Of course, the sequestration could be a negative for sales in March, causing the first quarter to end on a weaker note. But this too may prove temporary. For now, the LQ forecast shows real consumer spending growth at a 1.8 percent annual rate in the first quarter but 2.4 percent for all of 2013.

In addition, the manufacturing sector has shown more vitality recently—at least where output is concerned—than is generally realized. Although the Federal Reserve’s index of factory output declined in January, it still was at a level that was 3.6 percent at an annual rate above the fourth-quarter average. In addition, shipments of nondefense capital goods in January (which are input into the GDP statistics) were up a whopping 7.2 percent in January from the fourth-quarter average. Of course, the monthly shipments data are notoriously volatile, but momentum of this magnitude suggests that the manufacturing sector is likely to contribute to first-quarter growth. In February, the Institute for Supply Management's manufacturing index climbed to a reading of 54.2 percent from 53.1 percent in January. The overall index was above the consensus of 52.5 percent and above the 50 percent break-even level for the third consecutive month. The February new orders component was particularly strong, climbing to 57.8 percent from January's 53.3 percent.

In the same regard, residential investment is likely to contribute to growth again in the first quarter and for all of 2013, owing to the recent upturn in housing starts. Although starts slipped a bit in January, it was after a sharp climb in the preceding few months. In fact, the average number of housing starts at an annual rate was at 744 thousand in the third quarter, followed by a jump to 900 thousand in the fourth quarter. Indeed, the pace of starts climbed to nearly a million units in December before trailing off to 890 thousand in January. This is still a very low level given the pace of household formation and the pent-up demand for housing. The surprise in 2013 may be that housing recovers even faster than currently shown in the LQ forecast. Regardless of the pace, residential investment is expected to provide a boost to real growth after years of being a drag.

On the other hand, international trade is expected to be a mild drag in 2013, as imports outpace exports once again. While net exports actually added 0.25 percentage point to real GDP growth in the fourth quarter, this is unlikely to continue in 2013. Weak economies around the world will put some downward pressure on U.S. exports this year. Typically during slowdowns like the ones in Europe and Japan, businesses use it to improve productivity, part of which requires some investment in plant and equipment. This should help mitigate the weakness in U.S. exports. On the import side, a rebound in consumer spending over the remainder of this year should boost imports to some extent. Of course, the offset here is that as the labor market improves, incomes rise, and household wealth advances, so too will consumer spending on services. Hence, the bulk of the expected gain in consumer spending this year should be on services rather than goods.

An interesting aspect of the GDP data in 2012 is that real final sales in the private sector (excluding government expenditures) grew a moderate 2.4 percent over the four quarters of 2012. This compares to total final sales growth of 2.0 percent over the same period. Moreover, as shown in Chart 1, private real final sales growth exceeded total final sales growth in ten of the last twelve quarters, including a huge gap in the fourth quarter of last year.

chart 1

The difference between private and total final sales is government consumption and investment spending. This sector has been a bit of a paradox in the current recovery, in that federal as well as state and local expenditures have been a drag on real growth for most of the recovery. As shown in Chart 2, typically when one government sector is a drag on growth, the other sector provides somewhat of an offset. Not this time. Although this has happened before, briefly in the late 1970s, the drag from both government sectors this time is far more substantial and has lasted much longer than in the 1970s.

State and local government spending traditionally has had a strongly procyclical bias, as strong growth of revenues early in the business cycle would engender accelerated spending late in the expansion, followed by a sharp retrenchment as revenues deteriorated in recession. Although state and local governments experienced the downside in spending, it did not participate in the upside to the same extent as in the past. In fact, state and local spending has been a drag on real GDP growth nearly every quarter since the recovery began. The exception was the third quarter of 2012, which also represented the first quarter of the current fiscal year for most states, as well as the quarter prior to the presidential election. For both reasons, it should not be a surprise that spending increased.

chart 2

With the sequester, which requires mandatory cuts to federally sponsored programs, now in effect, it is likely that state and local governments will feel the pain of smaller federal payments. As such, state and local spending most likely will continue to be a drag on growth at least through the end of this fiscal year. In other words, any contribution to real GDP growth this year probably will not occur until the second half at the earliest. Of course, the sequestration could change, and probably will.

Federal spending also has had a negative effect on growth in each of the last two years, detracting about a quarter of a percentage point in 2011 and about a fifth of a percentage point in 2012. With sequestration and the $85 billion cut in federal discretionary spending required over the last seven months of this fiscal year (ending Sept. 30), it is unlikely that federal government spending will change direction anytime soon.

Meaningful inventory correction in Q4

The change in business inventories detracted a 1.3 percentage points from real GDP growth in the fourth quarter of last year, following a contribution of 0.7 percentage point in the third quarter (see Chart 3). In other words, a drag on real growth in the fourth quarter in large part was built into by the strength of the third quarter. But the extent of the inventory correction in the fourth quarter surprised most everyone. Recall that late last year, there was considerable anxiety being expressed by business leaders about the “fiscal cliff.” One apparent response by business managers to the fiscal cliff uncertainty would be to dramatically slow the pace of inventory accumulation. It appears that is precisely what happened.

chart 3

Of course, it is unrealistic to expect the change in inventories to continue to be a drag on real GDP growth in early 2013. After all, the ratio of inventories-to-final sales has fallen steadily over the last 15 years from 2.68 in the first quarter of 1998 to 2.31 in the fourth quarter of 2012. Although possible, a further decline in this ratio is not expected. The implication is that the change in inventories on average will keep pace with final sales growth, which means that there is very little room for inventories to add or detract from real GDP growth on average over the forecast horizon. Indeed, if I am wrong, it seems that the risk is to the upside more so than the downside on this matter.

Jobs pave the way to sustainability

Jobs are not always necessary to get the recovery going but they are generally necessary for the recovery to sustain itself. The current business cycle has reached the point where the sustainability of the expansion will depend on jobs. And the LQ forecast expects that sufficient job growth will occur to do so. In Chart 4, the change in payroll employment over the trailing twelve months is plotted from January 2000 to the present. This period includes two recessions, the very mild recession of 2001 and the very severe recession of 2007-2009 (shaded areas). As shown in both cases, job growth was at best a coincident indicator of the onset of the recession, if not a lagging indicator. Prior to the start of the 2001 recession, payroll jobs were still up nearly 3 million from a year earlier and this yearly change in employment remained positive throughout the relative short and mild 2001 recession. It wasn’t until the recovery was well underway that the change in jobs from a year earlier turned negative, and it remained in negative territory for over two years. Indeed, the worst job loss was over a year after the recovery began. Yet the economy continued to recover, albeit at a “slow-motion” pace. It was not until the start of the third year of the recovery that the change in payroll employment from a year ago turned positive. In other words, it was not strong growth in payroll jobs that got the recovery started but job growth apparently was necessary for the recovery to survive as long as it did.

chart 4

The change in payroll employment experience during the recession of 2007- 2009 was a bit different, especially in degree and timing. For example, the slowdown in employment gains occurred much closer to the onset of the recession in December 2007, the employment change fell into negative territory shortly after the recession began, and there were far more jobs lost in that downturn than in the previous one. In fact, by the end of the last recession, payroll jobs were down 6.8 million from a year earlier, compared with the 2.0 million jobs lost at the trough of the previous jobs cycle.

On the other hand, there were a few similarities. For example, the change in jobs from a year ago in the current jobs cycle was in negative territory for over two years, which was very similar in duration to the previous jobs cycle. Again, jobs continued to decline well after the recovery was underway and did not turn positive until over a year into the recovery. Yet, the economic recovery continued as it did in the previous expansion. The current business cycle is now at the point where jobs are necessary to sustain growth. The LQ forecast expects job growth to be strong enough to get it done. After what may have been a fiscal policy induced slowdown in jobs near the end of 2012, the change in nonfarm payroll employment is expected to reaccelerate. At the moment, the forecast anticipates payroll employment will be up about 2.5 million over twelve months of 2013. The bulk of the jobs gained this year most likely will be in the private sector. The assumption is that the federal government will get its act together and finally settle on a deficit reduction plan and that municipal governments will have sufficient revenue in fiscal year 2014 to actually start to add jobs once again. Fiscal year 2014 for most states begins July 1 of this year. This means that if there are any government sector job growth, it will not be until late this year.

Fiscal policy deadlines

Self-imposed deadlines on fiscal policy seem to be the rage in recent years, in large part because of the dysfunctional nature of the current budget process. I contend that we are becoming increasingly jaded by the threat associated with a deadline because they have occurred so often. For example, 2011 was a year in which a series of deadlines threatened government shutdowns, including the threat of a partial government shutdown during budget talks in the spring, the debt ceiling debate over the summer and the budget talks in the fall. In 2011 alone, there were five continuing resolutions. A continuing resolution is used to provide temporary funding for the government when appropriation bills are not passed before the new fiscal year begins. Sometimes the continuing resolution is extended multiple times, while sometimes there is a longer-term continuing resolution. Moreover, continuing resolutions often just continue the funding levels and programs from the prior year.

The situation did not change in 2012, but the threat of a shutdown was not quite as frequent. Prior to the start of fiscal year 2013 (Oct. 1, 2012), Congress failed to act on appropriations, so they agreed to delay the budget debate until after the election and passed a continuing resolution, signed by President Obama on Oct. 1, 2012, that allowed the government to continue to operate until March 27, 2013. In the midst of this continuing resolution, however, the repeal of the Bush tax cuts at the end of 2012, which already had been given a two-year reprieve in 2010 with the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act, as well as the sequestration that would go into effect at the end of 2012 in the absence of a budget, had to be dealt with. Once again, a last minute deal was struck to postpone the sequestration until March 1, 2013, to allow most (but not all) of the Bush tax cuts to remain permanent and to end the payroll tax holiday. Finally, the government was due to hit its debt limit once again in February, but it too was delayed until May.

The point is that self-imposed deadlines abound, but they are generally avoided by enacting a continuing resolution or raising the debt ceiling. In both cases, Congress is simply imposing another deadline at a future date. This is not the way budget policy should be done. The one consolation is that the continuing resolutions may have helped total government outlays to remain in check in recent years (see Chart 5). This may not be the most efficient way to bring down the budget deficit but unfortunately it may be the only way given the inability of the current government to compromise.

Sequestration is an even more inefficient way to reduce deficits. But that is exactly what we now have. The March 1 deadline for sequestration was not averted with a last minute deal. As a result, discretionary spending by the federal government is scheduled to be cut across-the-board by $85 billion over the remainder of the current fiscal year. The size of the automatic cuts looks trivial compared with the $3.7 trillion federal budget—only about 2.3 percent. It seems like 2.3 percent of savings could be found without inflicting harm. But that 2.3 percent is applied to only a part of the budget, and the smaller part at that. And seven months, not 12, remain in this fiscal year to make the cuts. With little discretion about trimming areas such as aviation and food safety, layoffs and furloughs will interrupt services vital to the economy and public health. However, the reality is not so immediate or dramatic. The damage will accumulate in less visible ways, as irrational reductions in public spending impede economic growth and job creation; reduce investments in education, infrastructure and scientific research; and further disrupt the routines of a modern democracy. The longer the sequester remains in place, the more harm it will inflict.

chart 5

For that reason, I doubt that it will remain in place very long. The LQ forecast assumes that sequestration remains in effect for no more than a few weeks. After all, the next deadline is the expiration of the current continuing resolution on March 27. That will provide politicians another opportunity to reach a deal. The likely outcome is another deadline, which may or may not coincide with the May 1 deadline on the debt ceiling. In other words, this is far from the last word on the federal budget and fiscal policy.

The bottom line is that the near-term economic outlook will depend on how long the sequestration remains in effect, what happens to the continuing resolution scheduled to expire on March 27, and what happens to the debt ceiling on May 1. If recent history is a guide, it is a good bet that all of these deadlines are simply replaced with other deadlines. As such, self-imposed deadlines most likely will continue to be an important part of the budget process. Unfortunately, they seem to do very little to resolve the budget problem. Instead, they make tax and spending policies even more confusing, frustrating, and inefficient.

A first glance at 2014

In this issue of the LQ, I attempt to extend the forecast through 2014. My first take on the outlook for next year is that the expansion will remain intact, but that inflation will become a bit less benign. This should finally push the Federal Reserve to pull back on some of the monetary stimulus that they have implemented over the last several years.

In particular, the unemployment rate in 2014 is expected to drift below 6.5 percent, which happens to be the level that the Fed said would get them to do less. Indeed, by the end of 2014, the LQ forecast expects the unemployment rate to be near 6.0 percent. Although this is still above what most economists considered full employment, it will be moving in a direction that will start to generate some cost pressures for firms. Moreover, the assumption for fiscal policy in 2014 is that many of the major budget issues will have been resolved, including budget appropriations for fiscal year 2014 and the debt ceiling. This should be a small net positive for the economy, given that at least some of the uncertainty about fiscal policy will be reduced. That does not mean that continuing resolutions will not be used. After all, continuing resolutions have been part of the budget process for 135 years and there is nothing to suggest that will change.

In 2014, the LQ forecast shows operating profits for the S&P 500 companies increasing less than 4 percent, following an expected gain of about 7.0 percent this year. A stronger economy and a small degree of pricing power will help drive earnings higher next year, despite the increased likelihood that profit margins could be under some pressure from higher costs, especially labor costs.

Investment implications

Based on the LQ forecast, credit risk is still favored over interest rate risk. This means that investors should overweight equities and underweight bonds. And in bond portfolios, short-duration, high-yield bonds are preferred over long-duration, low-yield bonds. This is a bit of a contrarian view because there are still plenty of reasons for investors to be cautious toward risk. But when most investors are fearful of risk, it is typically a good time to own it. That certainly has been the case for nearly the last four years. That being said, it is probably a good time to be more selective about when to take more risk. The best time is when the market pulls back somewhat, as volatility is expected to rise. Contrary to recent advertisements, this is not the time to jump back into the market if you have been on the sidelines since the last recession. I contend that the time to get back into the market was probably when most were rushing to get out. Be careful not to get sucked in at or close to historically high prices.

It is increasingly clear that the Fed is in no hurry to raise short-term interest rates. However, as inflation and inflation expectations start to drift higher, as I expect they will at some point, bond investors most likely will not wait. I now expect the Fed to keep its current policy intact through the middle of next year. Of course, by the time the Fed gets around to doing something, the bond market will be ahead of the game.

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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.


ECONOMIC COMMENTARY
Mid-term updates to the Quarterly Reports

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