August 2012

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 - A few revisions following a Q2 stumble

  • The U.S. economy may have taken one on the chin in the second quarter, but it was not knocked out by any stretch of the imagination. In particular, the concern expressed by many that the U.S. economy is on the brink of another recession is premature. There will be another recession but its start actually may have been delayed by the slower-than-expected pace of the recovery so far.

  • The primary concerns seem to be the spill-over effects of the ongoing debt debacle in Europe, as well as the so-called “fiscal cliff” anticipated to occur here when many of the Bush-era tax cuts expire at the end of this year. Although both may detract from U.S. economic growth at times over the next two years, I doubt either will be meaningful. Indeed, there is a chance that these events will be a net positive for the U.S. economy in the longer term.

  • In view of the disappointing second quarter, the LQ growth forecast for 2012 has been revised downward but not as much as the consensus. Moreover, the forecast continues to include relatively mild inflation, a falling unemployment rate, a slight upturn in long-term interest rates and good corporate earnings growth, despite the many perceived headwinds facing the U.S. economy.

  • The key to the LQ’s more optimistic forecast is further improvement in real final sales growth, led by solid gains in consumer spending, a less negative government sector and a boost in housing. Business fixed investment should follow suit.

  • Unit labor costs registered a relatively large gain in the first half of the year (3.6 percent at an annual rate), despite an elevated unemployment rate. The acceleration in such costs was due to compensation increasing faster than productivity—the former increased at a 4.2 percent pace at an annual rate in the first half, while the latter edged up a mere 0.5 percent. The implications are for stronger second half consumer spending, but less robust corporate profit growth.

  • I continue to expect the Fed to raise short-term rates earlier than its commitment of 2014. At the moment, my best guess is early 2013.

  • S&P 500 operating earnings per share for all of 2012 and 2013 have been revised downward, but still remain well above $100 a share each year.

Forecast at a glance

chzrt 1 - 4

Forecast details

Forecast Details

A few revisions following a Q2 stumble

My near-term outlook for the U.S. economy has been revised downward somewhat in view of the less than stellar economic releases since the May issue of the Laufenberg Quarterly (LQ) was published. In particular, it looks as if the manufacturing sector slowed down from its earlier pace now that business inventories apparently have been restored to a level more consistent with sales, real consumer spending growth has not kept pace with real income growth, and the government sector continued to be a drag on growth. This bad news notwithstanding, the U.S. economy is not going over a cliff—fiscal or otherwise—anytime soon. Housing is starting to show some improvement, business spending on equipment and software seems to be holding up, consumers continue to acquire the wherewithal to spend, unit labor costs still favor solid earnings growth, and the government sector will not be a drag on the economy forever.

As a result, real gross domestic product (GDP), which grew at a mere 1.5 percent annual rate in the first quarter, is likely to accelerate somewhat over the remainder of the year. Unfortunately, the pace so far in the first half—especially in the second quarter—has fallen short of what was shown in the May forecast, resulting in a less robust U.S. economy for all of 2012. That being said, inflation is still expected to be relatively tame, the unemployment rate will continue to drift lower, and corporate earnings should remain solid. The numerous headwinds in place, including the European debt “crisis” and the potential “fiscal cliff” at the end of this year, will detract some from the U.S. economy temporarily but will not derail the expansion.

The other side of this scenario is that the slower-than-expected growth in the first half most likely will delay the bottlenecks that will lead to the next recession. As such, my forecast for 2013 is actually better than it was in May. Real GDP now is expected to grow 2.7 percent over the four quarters of next year, following an expected gain of 2.3 percent this year. Inflation will accelerate a bit next year, owing to large swings in energy and food prices. Stronger growth and slightly higher inflation will increase the likelihood that the Federal Reserve will shift to a less accommodative policy stance sooner than currently advertised.

Despite some minor changes to the economic forecast, the investment implications are little changed from the last LQ. Indeed, the risk-on trade continues to be preferred, suggesting that portfolios remain overweight equities. Also, I continue to dislike buying long bonds of any kind at the moment, but this is especially true of longer-term Treasury obligations. As I noted several times before, investors seem to feel safe from interest-rate risk because they think the Federal Reserve will provide advance warning of higher rates. They most likely will be sadly disappointed. The Fed may warn us of when they are likely to raise rates, but by then the longer end of the bond market will have already figured it out. Also, credit spreads have narrowed recently to the point where the exposure to interest-rate risk outweighs the credit premium investors are being paid to buy riskier bonds at this time. That being said, if you own them, hold on to them for now because the coupons you are getting on bonds purchased at par or less most likely are higher than the yield currently being offered.

Second-quarter stumble

According to the Bureau of Economic Analysis’ advance estimate, real GDP expanded 1.5 percent in the second quarter, which was well below the 3.0 percent pace projected in the May LQ. The sources of this disappointment were primarily consumer expenditures and government spending (see Chart 1).

chart 1

Real personal consumption expenditures (PCE) were the biggest disappointment, growing a mere 1.5 percent at an annual rate in the second quarter, following a downward revised gain of 2.4 percent in the previous quarter. In the May LQ, I had projected real PCE to grow at a 2.5 percent pace in the second quarter. Much of the shortfall was due to spending on durable goods, which fell 1.1 percent in the second quarter, following a gain of 11.5 percent in the first quarter and 13.9 percent in the fourth quarter of 2011. With regard to the outlook for real PCE, the second quarter ended on a very weak note. Indeed, the June level of real PCE was at a level that was below the second-quarter average. The implication is that real PCE will need some solid monthly gains from July through September to match the LQ forecast for the third quarter. So far, the only things we know about July are light-vehicle unit sales and retail sales. Both suggest that consumers were back spending but not at a stellar pace.

Moreover, real government spending on consumption and investment declined 1.4 percent at an annual rate in the second quarter, marking the eighth consecutive quarterly decline. Once again, spending at all levels of government contributed to the decline, with federal government spending slipping 0.4 percent and state and local government spending falling 2.1 percent. Together they detracted 0.3 percentage point from real GDP growth in the second quarter. Recall that government spending as defined in GDP does not include transfer payments, such as Social Security, Medicare or unemployment benefits, paid by the various levels of government. For the most part, government spending includes what is typically referred to as discretionary spending. I doubt that discretionary government spending will decline much longer, especially at the federal level in a presidential election year.

Business fixed investment in the second quarter was not as robust as anticipated in the May LQ (5.3 percent increase versus a forecast of 8.7 percent), but it followed a much stronger first quarter than reported originally. According to benchmark revisions from the Bureau of Economic Analysis, real business fixed investment in the first quarter was revised upward to show a gain of 7.5 percent at an annual rate from 3.1 percent. Indeed, the advance estimate for the first quarter as reported in the May LQ showed a decline of 2.1 percent. Indeed, the average gain in business fixed investment for the first half of 2012 was 6.4 percent versus the May estimate of 3.3 percent. With regard to the outlook, the Federal Reserve announced that factory output of business equipment in June was already up 4.3 percent at an annual rate above the second-quarter average, suggesting that the production of such equipment had considerable momentum at the end of that last quarter. This could translate into more business investment on equipment, but it also could mean more exports or more inventories. Regardless of where it falls, it favors acceleration in real GDP growth in the third quarter.

Also, residential fixed investment did not contribute as much to growth in the second quarter as expected in May, but it still made a solid contribution. Residential investment rose 9.7 percent versus an expected gain of 17.4 percent. Housing should continue to improve, given that housing affordability is at a record high and household demographics are starting to put some strain on the available housing stock.

As expected, net exports detracted a bit from real GDP growth in the second quarter, as the gain in imports exceeded the gain in exports. More recent trade data suggests that this may change in the revised second-quarter data and that net exports are less likely to be a substantial drag on real GDP growth in the current quarter. Nevertheless, given the stronger dollar and slower growth elsewhere in the world, net exports most likely will be a drag on real GDP growth in the U.S. over the remainder of the year but probably not as much of a drag as many seem to fear.

On balance, I continue to expect real GDP to deliver solid growth over the four quarters of 2012 and again in 2013, led by solid gains in consumer spending, good business fixed investment, better housing data, and less drag from the government sector. The implication is that I doubt that the numerous headwinds for the U.S. economy frequently discussed in the financial media will be as problematic for the U.S. economy as many commentators and analysts contend.

Consumers remain the key

Although real PCE growth was disappointing in the second quarter, I remain convinced that it will do better over the remainder of 2012 despite the ongoing headwinds of bad debt and higher taxes. For the most part, the bad debt this time is someplace other than in the U.S. and higher taxes will not alter consumer behavior very much since lower taxes did very little in the first place. Lower taxes boost consumer spending if consumers perceive the tax cuts to be permanent. This perception is more likely if the tax cuts are combined with at least a commitment to reduce government budget deficits. When taxes are reduced at the same time that government entitlement programs are being expanded, there is little credibility that the tax cuts are permanent. In addition, sunset provisions on tax changes simply enhance this feeling. This is important because spending decisions by consumers are influenced considerably by expectations. Typically when consumers have income, they spend it. But this is only if the income is expected to continue.

So far this year, real disposable personal income, which is personal income after taxes and adjusted for inflation, has increased at a solid 3.3 percent annual rate, thanks to a sharp upward revision to income in the first quarter. Yet, real consumer spending has increased at a more conservative 2.0 percent pace in the first half. For the most part, the quarterly percent changes in income and spending tend to be volatile. The year-ago percent change may provide a clearer picture of the underlying trends in each. On this basis, real disposable personal income was up a mere 1.3 percent in the second quarter, whereas real PCE was up 1.9 percent. This offers a less favorable interpretation of the wherewithal of consumers to spend than the first-half data alone.

The softer data over the last year notwithstanding, the recent strength in real disposable personal income and the prospect of more to follow suggests that real income growth from a year earlier is bound to accelerate by yearend. In particular, I expect job growth to remain strong enough to push the unemployment rate lower over the next several months. This, combined with further wage gains, should be enough to sustain solid income growth in the second half of 2012 and into 2013. Needless to say, the quarterly gains in both income and spending most likely will continue to be very uneven, but the upward trajectory seems clear.

Unit labor costs are starting to stir

Unit labor costs in the nonfarm business sector increased 3.6 percent at an annual rate in the first half of 2012, far more than anticipated given the still elevated rate of unemployment. Such a large gain in costs seems out of step with so much excess capacity still available. Or maybe there is less excess capacity than currently measured by the unemployment rate. After all, one of the issues frequently mentioned in employer surveys is the lack of skilled workers to fill many open positions.

Also over the first half of 2012, compensation per hour rose 4.2 percent at an annual rate (5.1 percent in the first quarter and 3.3 percent in the second quarter), following a gain of 2.0 percent over the four quarters of 2011. Faster compensation gains, led by strong increases in wages and salaries, bode well for income and in turn second-half consumer spending once some of the uncertainty abates.1 Apparently, employers were induced to increase hourly compensation of employees in the first half of the year to attract the talent they needed. This tends to support the notion that the “output gap” may not be as large as the unemployment rate may suggest.

Moreover, total hours worked in the nonfarm business sector increased 1.8 percent at an annual rate in the first half, while real output increased an average of 2.4 percent. It is interesting to note that real output in the nonfarm business sector grew faster than the 1.7 percent gain in real GDP over the same period. This helps confirm the fact that the government sector has been a drag on the economy recently.

Unit labor costs in the nonfarm business sector rose 1.7 percent at an annual rate in the second quarter, following a gain of 5.6 percent in the first quarter. Needless to say, the quarterly changes are volatile. Like many economic statistics, the percent change from a year ago probably offers a better read to the underlying trend. On this score, unit labor costs are up a mere 0.8 percent, far less than the 1.8 percent increase in prices. Moreover, given the forecast for productivity and compensation growth over the remainder of the year, unit labor costs most likely will subside a bit in the second half but still finish the year up 2.5 percent from a year ago. This compares with a gain of 1.4 percent over the four quarters of 2011.

The implications of an acceleration in unit labor costs for corporate profits is less encouraging all else the same. However, all else will not be the same. There is a good chance that productivity will improve over the remainder of the year, in association with stronger economic growth. Also, the strong increases in hourly compensation in the first half will likely subside a bit in the second half, as employment picks up somewhat. Finally, there is a greater opportunity for pricing to accelerate somewhat as well. In other words, any gain in compensation will increasingly be paid for with stronger productivity and to a far lesser degree pricing. Under these circumstances, unit labor costs should rise but not to the point where they would threaten corporate profit growth in a meaningful way. That being said, I have lowered my forecast of S&P 500 operating earnings per share to $101.8 for all of 2012 and to $107.9 for all of 2013.

International outlook

I need to qualify any discussion I have about the international outlook in that I am neither familiar with the nuances of institutional arrangements overseas nor do I have access to the international economic and financial data necessary to do a more detailed analysis. That being said, I tend to fancy myself as a good international economist, not because of my training in graduate school necessarily but my experience as special assistant to Governor Henry Wallich, member of the Federal Reserve Board (FRB), for nearly two years. Prior to becoming a member of the FRB, Governor Wallich was a professor of international economics at Yale University and one of three authors of a weekly column in Business Week. The other two authors were Milton Friedman and Paul Samuelson. One of his many responsibilities at the Fed was to represent the FRB at all international economic and central bank meetings. Upon his return from his trips overseas to attend such meetings, he would give his assistant a list of questions that he wanted answered. It was not unusual for this list to be extensive. I would attempt to answer the domestic questions but I relied on the staff of the international finance division of the Federal Reserve Board for the answers to international questions. In the process of finding those answers, I learned a lot of international economics.

Over the years, I have use that experience and knowledge to fine-tune my forecast of the U.S. economy. After all, we are constantly reminded by the financial media that what happens elsewhere matters here and vice versa. But we must also be careful not to think that everything that happens over there has an equal impact here.

Along this line, there is one thing that I have learned over the years that may help us assess the current debt crisis in Europe. That is, when the debt crisis occurs in the U.S., there is no way to avoid a deep and prolonged recession. The Great Depression and the more recent Great Recession are examples of this. On the other hand, when the debt crisis occurs elsewhere, it is far less painful to the U.S. and in some cases actually provides some stimulus to the U.S. The debt crises in South America and Southeast Asia in the 1990s provide examples of how a strong dollar, low domestic inflation and low interest rates resulting from the debt crises elsewhere actually helped boost the U.S. economy. Of course, many argue that a debt crisis in Europe is different. In some ways it is but in many other ways it is not. In particular, the debt crisis in Europe probably will not be the threat to the U.S. economic expansion that many suggest. On the other hand, with interest rates already very low, it is unlikely to provide much of a boost either. The end result is that the U.S. economy continues to expand, just not as fast as it typically does.

During the second quarter, when the European debt crisis was heating up again, the foreign exchange value of the dollar rallied, inflation slowed, and longer-term interest rates fell. Although there may have been some relief from inflation, interest rates were already at very low levels, which meant that there was not as much room for lower rates to drive economic activity as they might have in the past.

That being said, Europe is in a recession but is not likely to remain there much longer. I believe the stock market in Europe is suggesting just that—European stock markets have increased for eleven consecutive weeks. Greece notwithstanding, I expect the European economy to start recovering before yearend. As a result, the marginal propensity to consume probably will start to increase, as consumers become more confident about the current situation. This would more likely be enhanced if there was a moratorium on the U.S. fiscal cliff.

The other part of the world that seems to be a concern at the moment is the economic slowdown underway in China. It may be that China is in a growth recession, given that its growth rate has slowed so dramatically from the torrid double-digit pace of a year earlier. And a growth recession in China may feel miserable in China but it may also provide a few buying opportunities for the U.S., as well as an opportunity to negotiate a more level playing field in global markets. As I have noted on several occasions in the past, the only way China becomes the largest economy in the world, surpassing the U.S. in the role, is if they make major legal, financial, and even political changes along the way. Communism and the formal planning that goes with it will only take China so far. At some point, they need to establish property rights in China, they must deal with all the bad loans still being carried by banks, they must allow their currency to convert, and they need to provide more political freedom and choice if they want to have the economic flexibility necessary to respond to a rapidly changing world.

Without these changes, in my view, it would be no surprise that the trend rate of economic growth in China slows. After all, government sponsored construction projects cannot continue forever without some underlying demand for the infrastructure being built. Markets and not governments need to play a bigger role in investment decisions. Remember that Japan was the envy of the world not that long ago because large trade surpluses provided them with the wherewithal to boost domestic spending. China seems to be heading in the same direction, with many of the same symptoms, including a substantial amount of nonperforming loans on bank balance sheets, a currency that was slow to appreciate, an aging population, and very limited domestically-owned natural resources.

Finally, I sometimes question referring to the second largest economy in the world as “developing.” After all, in terms of real gross domestic product, the most comprehensive measure of economic performance, China is second only to the U.S. That being said, China’s immense population still makes GDP per capita look skimpy by comparison with the developed economies and even a few other developing economies. In this regard, with China’s population of 1.3 billion, there is clear potential for China to become the largest economy in the world, as it most likely was many centuries ago. I expect China to continue to grow, but not at a double digit pace. Exactly how fast it will grow over the next decade will depend on whether it implements some of the reforms needed to make it a less rigid economy. Too many rules and too many plans can sap the economy of its creative energy. In fact, I suggest that U.S. policymakers exercise the same caution. They too should be careful not to make the U.S. economy too rigid. If the U.S. wants to compete in global markets, it needs innovation to drive it. A rigid U.S. economy would postpone, if not prevent, such innovation from happening here.

Monetary policy watch

Following its recent policy meeting, the Federal Reserve’s Open Market Committee announced that it would keep policy where it was, but that it would monitor the data carefully. This seems to be the only somewhat meaningful change in the most recent FOMC statement. In June, the FOMC noted that it “was prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.” In the August statement, the FOMC said that the “Committee will closely monitor incoming information on economic and financial developments as needed to promote a stronger economic recovery…in a context of price stability.” Contrary to many other interpretations of the difference, I interpret it to mean that the Fed is less likely to take action now than in June without statistical evidence to warrant such a move.

Historically, the fact that it is a presidential election year does not affect shifts in monetary policy. Over the last thirteen presidential election years, the Fed has raised interest rates six times and lowered rates seven times, with 2008 breaking the tie with an easing move. That being said, the Fed has been careful not to act too close to the election if they can possibly avoid it. I contend that we are getting too close to the election for the Fed to act. Of course, there is always the possibility that the Fed waits until after the election to do another round of quantitative easing (so-called QE3). I doubt they will feel the need if the economy is living up to my expectations as well as theirs.

The FOMC outlook for the U.S. is moderate economic growth over the coming quarters followed by a very gradual acceleration, a slow but steady decline in the unemployment rate to a level closer to full employment, and a level of inflation consistent with relatively stable prices.

I continue to believe that the Fed will not feel the need to do QE3, nor do I think they should. Financial markets have become addicted to quantitative easing, which was one of my fears when these programs were first suggested. That is, every time the stock market goes into a slump, market participants expect the Fed to come to their rescue. The risk is that they once again get their wish in the short-run, only to be smacked with much higher inflation in the long run. In this regard, the Fed assures us over and over again that they know how to fight inflation, so we should not worry about it. I was on the staff of the Federal Reserve Board in the 1970s and 1980s and saw firsthand how the Fed fights inflation. I agree, they know how to win the inflation war, but the battles are very, very ugly and extremely expensive. The hope is that they do not allow the inflation fiend out of the bottle in the first place. Unfortunately, I worry that they are already flirting with that one.

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1 For a discussion of the determinants of consumer spending, see Daniel E. Laufenberg, “Factors that drive consumer spending,” Perspectives, laufenbergquarterly.com.

 

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

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