August 2011invisible

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

  • Political economy can be defined as the social science that deals with political science and economics as a unified subject; the study of the interrelationships between political and economic processes. Unfortunately, the political side of this interrelationship in the U.S. apparently is not to the liking of Standard and Poor’s (S&P) at the moment. However, when is the political process in the U.S., which is never pretty, to their liking? I disagree with their decision in large part because I disagree with the rational for it.

  • The first half of 2011 was much weaker than expected thanks to a sharp drop in government spending owing to local government budget pressures and to a sluggish consumer sector owing to higher prices. Both may prove to be temporary. Unfortunately, the much anticipated upturn in service spending by consumers may be delayed a bit by the recent stock market correction but not canceled as others have suggested.

  • The outlook for the second half is far more favorable for growth, despite all the noise around the U.S. downgrade by S&P. The last time the federal government was engaged in a seriously divisive partisan budget and debt limit debate was in 1995. The similarity in the pattern of economic growth so far during the current debate and what transpired during the 1995 debate is quite uncanny.

  • Obviously, there are plenty of things that could make it different this time. Nevertheless, the July data reported so far seem to favor a reacceleration in real growth in the second half of 2011, much like it did in the second half of 1995. These include motor-vehicle sales, jobs, hours worked, chain store sales, and even the Institute of Supply Management manufacturing index that seemed to trigger the stock market correction.

  • At this point of the expansion, equities and high-yield bonds are still preferred over high-grade bonds. Now even more after S&P downgraded the U.S. government’s debt. That being said, it was a bit counterintuitive that federal government debt actually rallied on the news. I think I have an explanation.

Forecast at a glance

chzrt 1

chart 2

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chart 4

Forecast details

Forecast Details

Downgrading the U.S. political economy

Despite numerous headwinds so far this year, the outlook for the U.S. economy in the second half of 2011 and for all of 2012 has changed very little from the May 2011 issue of the Laufenberg Economic Quarterly. In particular, I expect real gross domestic product (GDP) to grow in excess of 3.0 percent at an annual rate on average for the next six quarters. Please note that I said “on average” because the quarterly pattern most likely will not be as even as shown in the forecast. It will be this growth that is expected to boost employment and push the unemployment rate downward to about 7.0 percent by the end of 2012.

That being said, the downward revision to real GDP growth in the first quarter of 2011 to 0.4 percent at an annual rate and the slower-than-expected 1.3 percent advance estimate of real growth in the second quarter reported by the Bureau of Economic Analysis require a downward adjust to real growth for all of 2011. This adjustment suggests that the unemployment rate, although still expected to decline over the next six quarters, may be slower to do so than shown in the May forecast.

Moreover, the Federal Reserve now is expected not to raise short-term interest rates until early next year. In their statement following the August policy meeting, the Fed said “economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” The key phrase is “exceptionally low.” It does not necessarily mean that the federal funds rate will remain at 0.25 percent through mid-2013.

The headwinds facing the U.S. economy in the first half of the year included sharply higher oil prices, government spending cuts, sovereign debt concerns in Europe, and parts shortages owing to the earthquake in Japan. The good news is that oil prices have retreated substantially from their highs earlier this year, many state governments have resolved their budget issues for now, and much of Japan’s production is back on line. Unfortunately, many headwinds remain, including the ongoing political noise about federal budget and debt issues, the implications of the unprecedented downgrade of the long-term sovereign credit rating of the U.S., the downward revised trajectory of real GDP over the last three years, and the renewed concern of the sustainability of the European Union. Although these issues are significant in their own right, any adverse effect on the U.S. economy’s performance over the next year or two is expected to be very small. They are more likely to encourage financial market volatility than economic consequences.

Nevertheless, the trend in financial markets eventually should reflect the economic fundamentals, which seem to be improving in my view. I base this assessment primarily on expectations but also on the economic data reported so far for July, including motor-vehicle sales, chain store sales, initial unemployment claims, payroll jobs, and yes even the Institute for Supply Management (ISM) manufacturing index that seemed to spark the recent sell-off in equity markets.

Political noise

One headwind that continues to haunt financial markets is the very partisan budget debate that has occurred at all levels of government. And while the debate was not confined to Washington, that is where it seemed to be the loudest. Recall that several state governments also were dealing with budget deficits, but the difference is that most states are required to balance their operating budgets—they cannot borrow to finance operations but they can borrow for capital expenditures. The federal government does not distinguish between operating and capital budgets. For budget accounting purposes at the federal level, all spending is treated the same.

Some politicians and political observers suggest that the federal government should be held to the same standard as state and local governments when it comes to balancing the budget. They favor passing a constitutional amendment to that effect. But what would this amendment look like? Would it require that only the operating budget balance, as states are required to do, or would it require that the unified budget balance? And would the requirement apply to annual or biannual budgets? Also, who is to decide what to include in the operating budget? Would all defense spending, even spending on airplanes and ships, be in the capital budget? Indeed, the only borrowing allowed at the federal level under such an amendment may be for expenditures associated with infrastructure and military equipment.

Experience at the state level has shown that under such circumstances, politicians attempt to push as much government spending into the capital budget as possible. The state of Minnesota provides a good example of that. After an extremely partisan debate on how to balance its budget over the next two years, which by the way resulted in the state government shutting down for nearly three weeks in July, the two sides reached an agreement. An important part of the budget agreement was to borrow and use future revenue paid to the state from the settlement with tobacco companies to pay for it, which for budget accounting purposes is part of the capital budget. In other words, having a legal requirement to balance the budget will not eliminate politically charged budgeting decisions.

Another aspect of this debate is that we have been here before. The last time the federal government engaged in a bitterly partisan debate over deficits and debt was in 1995, when Bill Clinton was in the White House and Newt Gingrich was Speaker of the House. Many of the same issues were debated then as now. In fact, the federal government was partially shut down for a few days in November 1995 and again for a few days at the end of December into January 1996. The federal government did not lose its AAA rating but there was plenty of talk about it.

So what happened to the U.S. economy during the 1995 budget debate? As shown in Chart 1, real GDP grew 4.1 percent over the four quarters of 1994, slowed to less than 1.0 percent in the first half of 1995 and then reaccelerated to about 3.0 percent over the second half of 1995. Over the four quarters of 1996, real GDP grew nearly 4.5 percent.

If we superimpose the pattern of real GDP growth over the four quarters of 2010 and the first half of 2011 on the same chart (Chart 1), it seems to follow a very similar pattern. The difference is that real GDP grew 3.1 percent over the four quarters of 2010 but also slowed to an average pace of less than 1.0 percent for the first half of 2011. My expectation is that real GDP growth reaccelerates again in the second half of 2011 to an average pace not too different from the average pace in the second half of 1995. I believe this not because I think 2011 is similar to 1995 because it is not. There are numerous differences between the two periods. But these differences do not always preclude history from repeating itself. And while the trajectory going forward may not match the 1995-96 experience precisely, the general direction seems like a good bet to me.

chart 1

Unprecedented downgrade of long-term sovereign credit rating on the U.S.

Another headwind facing the U.S. economy, which seems highly correlated with the prior headwind, is the unprecedented downgrade of the U.S. sovereign credit rating by Standard and Poor’s (S&P). Apparently S&P considers the political economy at the moment to be worthy of a downgrade, with an emphasis on “political.”1 In particular, S&P lowered their long-term sovereign credit rating on the U.S. to “AA+” from “AAA” but affirmed their “A-1+” short-term rating. Moreover, S&P removed both the short- and long-term ratings from CreditWatch negative, but with negative implications on the long-term rating.

The rationale given by S&P for the downgrade was that the fiscal plan recently enacted “fell short of what, in their view, would be necessary to stabilize the government’s medium-term debt dynamics. More broadly, the downgrade reflects [their] view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges.” I contend that American policymaking and political institutions have always been unpredictable during the process but seem to reach the right decision eventually.

If that is the case, then the prices on long-term Treasury debt should drop in response to that news. They did not. In fact, prices (yields) on long-term Treasury debt have increased (declined) since the S&P announced its downgrade. Clearly global investors do not agree with S&P—or do they? Why would anyone be willing to buy a 10-year Treasury note yielding 2.15 percent? The answer is not what S&P says or whether they think the U.S. government can make good on its debt. I think the answer is the Federal Reserve. Quantitative easing has made it easier for investors to buy Treasury notes and bonds because they are convinced that the Fed will not leave bond investors hanging when prices (yields) start to drift lower (higher). The problem will be that when the Fed opens that door, everyone will try to rush through it at the same time. Of course, some investors will get trampled in the process. For now, however, who cares. For now, investors are convinced that Treasury note and bond prices can only go up. Haven’t we been down this road before?

Of course, the equity market wants the same deal; indeed, they expect it. Every time the stock market falls, talking heads in the financial media want the Federal Reserve to bail them out with another round of quantitative easing (QE). The last round was QE2. Goldman Sachs reportedly expects the Fed to engage in QE3 this fall. I hope it does not happen. I didn’t like QE1 or QE2, so I am certain I will not like QE3.2

In addition, I feel that S&P was far too political in its assessment of the outlook, especially their reference to specific policy steps. For example, S&P threatens that unless “the recommendations of the Congressional Joint Select Committee on Deficit Reduction--independently or coupled with other initiatives, such as the lapsing of the 2001 and 2003 tax cuts for high earners--lead to fiscal consolidation measures beyond the minimum mandated, and we believe they are likely to slow the deterioration of the government's debt dynamics,” a further downgrade to the long-term rating of the U.S. is likely. I think it was totally inappropriate for S&P to even mention a specific policy prescription in its assessment. The only thing they should consider is the U.S. government’s ability to service its debt, both in the short- and long-run, and not refer to specific policies to maintain that ability. Policy prescriptions are the responsibility of policymakers and not credit-rating agencies.

In terms of the consequences of the downgrade on the economy, there is very little if any short-term effect expected. This is evident in the fact that my outlook for the U.S. economy has changed very little. In the medium- to long-term, the downgrade could be more of a factor. In particular, when interest rates start to drift higher, and they will at some point, the downgrade may result in Treasury yields increasing more than they would otherwise. For this reason, I believe the Federal Reserve, when it does decide to raise rates, will be even more gradual about it now than they might have been before the downgrade.

Downward revision to the level of real GDP over the last three years

Recently the Bureau of Economic Analysis released its revised estimates of real GDP for the last three year. As shown in Chart 2, the revised trajectory of real GDP (the solid line) was lower than that previously estimated (the dashed line). This was clearly a disappointment to some and a concern to many. The disappointment was that the recession was even more severe than originally estimated and that the recovery has been less robust. Indeed, one result was that real GDP, which had been estimated to have recovered all that was lost during the recession, has not recovered completely just yet. But it is very close and should meet that condition this quarter, if not by an upward revision to second-quarter real GDP growth later this month.

The concern is that the U.S. economy is more vulnerable to a double-dip recession given the lower trajectory of real growth coming out of the last recession. The argument seems to be that with the very sloppy start to 2011, the economic recovery is vulnerable to a shock of some sort. After all, real growth in the first two quarters of 2011 was only slightly better than zero and a shock of some sort could send us down once again.

chart 2

I disagree. The U.S. economy hit a soft patch due to a variety of factors, most of which were out of our control. Those headwinds have waned. The headwinds going forward are in large part self-imposed and more subject to change.

European Union survival revisited

Finally, the budget debacle in Greece, and concern that other European Union member countries will soon face similar problems, have weighed heavily on global financial markets. Indeed, some are concerned that the U.S. is heading toward a similar crisis, which may explain why U.S. financial markets react so aggressively to renewed concerns about Greece. However, I contend that Greece is the euro’s problem and not the dollar’s problem. As such, it is a test of Europe’s resolve to remain united under a single currency, because unfortunately that is essentially the only way Europe is united. That may be the problem.

When the European Monetary Union was established, many argued that it would be tested by the independent fiscal policies of the member countries. The issue was that there was no enforcement mechanism in place to limit fiscal excesses. That concern is now real and the options available to deal with the problem are not very pleasant for Greece or any other member country that may slip into the same situation. Germany and France can serve as the financial backstop for only so long. Greece and others must take matters into their own hands if the Union is to survive. And the only option for survival is a major self-imposed austerity program that reduces Greece’s deficits and stabilizes its government debt burden.

In the absence of such program, the Union does not survive; either Greece decides to leave the European Union in the hope that it can depreciate its own currency rather than its economy or Germany and France decide to call it quits because they no longer want or can afford to be the fiscal “white knight” for all the other European member countries. Regardless of the option followed (survival or not), Greece will continue to be in recession. Once markets understand that, then maybe debt issues in Greece will stop being such a surprise every time it is revisited.

A good start to the third quarter

July data reported so far seem to indicate a reacceleration in real growth in the third quarter of 2011 and possibly the second half, much like it did in the second half of 1995. These include motor-vehicle sales, jobs, chain store sales, and even the Institute of Supply Management manufacturing index that seemed to trigger the stock market correction.

First, light motor-vehicle sales rebounded in July to 12.2 million units at a seasonally adjusted annual rate, up from the anemic 11.6 million in June. Although unit sales in July were only slightly above the average level of sales in the second quarter, it bodes well for sales over the next few months given the more recent plunge in oil prices and production of Japanese automakers back on line.

Second, the July employment report, especially the increase in private nonfarm employment, surprised to the upside. According the Bureau of Labor Statistics, private employment jumped 158 thousand, suggesting that businesses were hiring more aggressively last month than they had been in each of the prior two months. Moreover, initial claims for unemployment insurance have trended slightly lower in recent weeks and job openings have trended higher, both of which suggest more employment gains over the next month or so.

Third, chain store sales were much better than expected, suggesting that the core component of retail sales, especially after adjusting for inflation, will be up markedly in July. It appears that consumers were starting to spend again before the sharp decline in the stock market over the last week. I think consumers will continue to increase spending, but the pace of that increase will depend on whether the stock market remains depressed for a bit or recovers quickly. I expect the market to recover rather quickly—I still anticipate the S&P 500 hitting 1300 sometime in October. This has been my call since last October. Ironically, it was considered too low a month ago, but now many consider it too high.

Finally, the Institute of Supply Management (ISM) reported that the manufacturing index fell to 50.9 percent in July from 55.3 percent in June. Such a reading suggests that manufactured output grew at a slower pace in July than it did in June, but it still grew. Recall that this is a diffusion index, where a reading above 50 percent indicates that the manufacturing sector is expanding. What is even more interesting is that according to the ISM, “if the PMI for July (50.9 percent) is annualized, it corresponds to a 2.9 percent increase in real GDP annually.”

The bottom line is that the high frequency economic data reported so far for the month of July, and now even initial unemployment claims for early August, continue to favor a stronger economy in the third quarter and probably beyond. As such, I have not extrapolated the soft patch of the first half of 2011 into the second half of the year. Rather I am convinced that the economy will do much better in the second half, despite all the political noise both here and abroad.

What did the Fed mean?

The statement released following the meeting of the Federal Open Market Committee (FOMC) was initially greeted by financial markets as unfavorable. I had a somewhat different reaction to the FOMC’s statement.

First, the FOMC noted that indicators “suggest a deterioration in overall labor market conditions in recent months, and the unemployment rate has moved up.” That was essentially the Fed reiterating the soft patch in the first half of the year, it was not a forecast of labor market conditions. In fact, in July, the unemployment rate slipped lower, the gain in private nonfarm payroll employment surprised to the upside, and initial claims for unemployment insurance have edged downward. I contend that the more recent indicators suggest a mild improvement in overall labor market conditions.

Second, the FOMC noted that “[t]emporary factors, including the damping effect of higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan, appear to account for only some of the recent weakness in economic activity.” Consumer spending added a scant 0.75 of a percentage point to the average annual rate of real GDP growth in the first half of 2011, including motor-vehicle sales detracting about 0.1 of a percentage point from overall GDP growth. In other words, the FOMC was absolute correct in its assessment of the first-half slowdown, but it was conspicuously incomplete. The FOMC forgot to mention the plunge in government spending in the first half of 2011, which detracted another 0.75 of a percentage point from real growth. The good news is that most of the downward adjustments to state and local government spending to balance their previous fiscal budgets ending July 1. As such, even the government spending effect may prove to be temporary.

Third, the FOMC “now expects a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting and anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate.” I would argue that the FOMC’s outlook has not changed as dramatically as many market commentators suggested. In fact, I would say that the FOMC forecast, as presented in its statement, is not that different from mine.

Fourth, the FOMC stated what everyone knew—that the “downside risks to the economic outlook have increased.” Clearly, the risk of the economy slipping into a recession has increased, but it is not the most likely scenario. I would assign a probably of a recession at 25 percent, up from 10 percent a month ago. It certainly is not 50 percent as suggested by some very prominent economists, which only made market participants more fearful.

Finally, the FOMC set a new precedent by stating “that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” This is the first time that the FOMC has set a specific date for a change in policy. However, I question whether investors are interpreting this comment correctly. The key phrase in my view is “exceptionally low levels.” The FOMC did not say historically low levels, which would imply that the nominal rate of the federal funds rate remain at zero until mid-2013. I think that the phrase “exceptionally low levels” is a relative statement and not an absolute statement. If the real economy is growing at 3 percent and inflation is tracking at 2.5 percent, a federal funds rate of 2.0 percent is still an exceptionally low level.

Investment implications

Since I did not anticipate equity markets reacting as violently to political noise as they did, I felt impelled to reassess my investment implications. My conclusion is that the recent move in equities is noise and that the economic and financial fundamentals in the U.S. are still positive and, more importantly, improving. For that reason, the investment implication with regard to equities is little changed from last time. I still think equities will be the best performing financial asset for all of 2011 and certainly the best performing asset between now and the end of the year.

As I noted last time, “I continue to believe that this year will prove to be very challenging for investors.” That is still the case but for somewhat different reasons. In May, I said that “credit risk will not be as much of an issue, although concern about the credit rating of the U.S. government and some municipal general obligations may surface at times this year.” Although I expected the topic to be revived from time to time, I did not expect the credit rating for the U.S. to actually be downgraded. One reason is that in the short-term, it changes nothing other than create a great deal of renewed uncertainty in global financial markets. But that too will pass. I believe that the impact of the downgrade will be felt more in the longer-term than over the next year.

I did not like the 10-year U.S. Treasury note at 3.0 percent so I certainly do not like it at 2.2 percent. Investors who feel safe from interest rate risk because they think the Federal Reserve will warn them when rates are going higher may 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 seem to be improving again, I continue to favor high-yield corporate bonds and many municipal revenue bonds more so than U.S. Treasuries.

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1. The political economy can be defined as the social science that deals with political science and economics as a unified subject; the study of the interrelationships between political and economic processes.

2. For a discussion of whether we have become addicted to quantitative easing, see Daniel E. Laufenberg, Laufenberg Economic Quarterly, "The current expansion: Sustainable but uneven," November 2010. pp. 11-12.

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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

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


INDEX TO CURRENT EDITION

Executive Summary

Forecast at a Glance

Downgrading the U.S. Political Economy

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INDEX TO CURRENT EDITION

Executive Summary

Forecast at a Glance

Downgrading the U.S. Political Economy

~ ~ ~ ~

 

INDEX TO CURRENT EDITION

Executive Summary

Forecast at a Glance

Downgrading the U.S. Political Economy

~ ~ ~ ~

 

 

 

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