September 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 - A few minor changes to the near-term outlook

  • In the June issue, I argued that if "it works, don't fix it". The reason was that at the time the Laufenberg Quarterly forecast seemed to be working. However, after a series of downward revisions to the pace of real growth in the first quarter by the Bureau of Economic Analysis, as well as a less robust consumer sector in the second quarter than anticipated earlier, a few aspects of the forecast were in need of repair. As such, real growth is now expected to be a tad slower in 2013 than shown in the previous forecast. In addition, the long anticipated backup in interest rates apparently has arrived.

  • Most of the downward adjustment to real gross domestic product (GDP) growth for all of 2013 is due to a less optimistic view of consumer spending. But it is not all aspects of consumer spending that are to blame. Spending on goods has continued to register solid gains, but spending on services has not. This has continued longer than I originally expected.

  • Comprehensive revisions to real GDP from 1929 through the first quarter of 2013 published by the Bureau of Economic Analysis late last month included definitional changes, one of which was the introduction of the intellectual property products category to business fixed investment. This change alone added markedly to the levels of nominal and real GDP in recent years but had very little impact on their average growth rates.

  • The Federal Reserve now enters unchartered waters as it faces the task of backing away from quantitative easing. Some minor dislocations are possible as the Fed makes its exit. In addition, the reported departure of Fed Chairman Ben Bernanke (probably in January 2014) could add to what likely will be an already elevated level of nervousness in financial markets.

  • Also, fiscal policymakers still have several important issues to resolve before yearend, including raising the debt ceiling and enacting a budget for the new fiscal year. Both are likely to generate very contentious negotiations, reviving at least the threat of a government shutdown.

  • The risk-on trade is still in play but from a contrarian viewpoint it will become increasingly difficult to maintain. Indeed, if some decide to reduce the credit risk in their portfolio now, it will be easier to take on interest rate risk with the 10-year Treasury yield at 2.9 percent than it was when this yield was below 2 percent.

Forecast at a glance

chzrt 1 - 4

Forecast details

Forecast Details

A few minor changes to the near-term outlook

In the June issue, I suggested that if "it works, don't fix it". The reason was that at the time the Laufenberg Quarterly (LQ) forecast seemed to be working. However, after a series of revisions to the historical data by the Bureau of Economic Analysis (BEA), some aspects of it now seem to be in need of repair. In particular, the rate of real growth for all of 2013 has been lowered regardless of how it is measured; that is, real gross domestic product (GDP) is now expected to grow 1.6 percent on a year-over-year basis and 2.1 percent on a fourth-quarter-to-fourth quarter basis versus 2.1 percent and 2.5 percent, respectively, in the June forecast.

Most of the downward adjustment to real GDP growth this year was due to a now sloppy first quarter. Recall that initially (and as shown in the June forecast) the BEA reported that real GDP in the first quarter of 2013 grew 2.4 percent at an annual rate. Now the BEA estimates first-quarter growth at 1.1 percent, reflecting sizable downward revisions to personal consumption expenditures (a gain of 2.3 percent versus 3.4 percent), nonresidential fixed investment (down 4.6 percent rather than up 2.2 percent), and real exports (a decline of 1.3 percent versus a gain of 0.8 percent) from the initial release in June. It is difficult to point to one thing as the culprit, but the federal tax hike at the start of this year probably was part of the story. After all, real disposable income plunged at an annual rate of 8.2 percent in the first quarter of this year after surging at a 9.0 percent pace in the fourth quarter of 2012. Anticipation of higher tax rates at the start of the year accelerated income growth in the fourth quarter, followed by the expected retrenchment in the first. In the second quarter, real disposable income increased at a 3.4 percent annual rate, providing consumers with the wherewithal to increase spending at a solid pace. I expect this situation to continue to improve over the remainder of this year.

In the second quarter, the Bureau of Economic Analysis' initial estimate of real GDP growth was slightly below the June forecast, while the revised estimate is now slightly above it. Although the most recent estimate of 1.9 percent real final sales growth for the second quarter is very close to the 2.0 percent pace anticipated in the previous forecast, businesses accumulated more inventories than I had expected. This marked the second consecutive quarter in which inventory building contributed to growth.  On balance, it is unrealistic to expect the change in inventories to continue to contribute to growth over the remainder of the year. Hence, it is essential that real final sales gain momentum for the expansion to be sustained. I expect that they will but to a lesser degree than in June.

Many analysts have expressed concern about the apparent discrepancy between the sluggish growth of real GDP and the more solid gains in payroll employment. Some argued that it was due to part-time jobs representing a larger share of all new jobs. However, that conclusion is not supported by the data. According to the household survey data reported by the Bureau of Labor Statistics, part-time jobs' share of all jobs was little changed over the last year—that is, 17.80 percent in July 2013 versus 17.83 percent in July 2012. Of course, according to the establishment survey, temporary employees gained share of the total—1.98 percent in July 2013 versus 1.88 percent in July 2012. But temporary does not always mean part-time. Many temporary jobs are full-time. Another possibility is that either jobs get revised downward to match real GDP growth or real GDP growth gets revised upward to match jobs. At the moment, I am leaning more toward the latter outcome.

Of course, the price effect from a stronger dollar encourages U.S. firms and consumers to import more, which could lead to further deterioration in net exports. However, imported goods have to go somewhere—either consumed, invested, or added to inventories, most of which represent final goods and are included in GDP. On the other hand, a stronger dollar could make U.S. manufacturers less price competitive overseas, causing them to either shift production over there, find ways to cut prices in dollar terms or to scale back production. On balance, as long as the U.S. can continue to grow exports, the trade sector will not be a substantial source of weakness, but this is certainly a risk to the outlook. This may be most evident in the nondefense capital goods orders and shipments data in recent months, which show a meaningful slowdown in both categories. This does not bode well for exports, as well as domestic fixed business investment, in the third quarter. The expectation is that any near-term dollar strength is temporary and that the dollar will give back some of its gains before yearend, which should help limit the downside risk to the outlook.

Headline inflation, which was tame in the first quarter, was very subdued in the second quarter. However, this could change somewhat in the second half, as higher energy prices, as well as upward pressure on core prices (excluding the more volatile components of food and energy), push overall inflation moderately higher. The bulk of the pickup in core prices is likely to be in services.

Fiscal policy has the potential to be disruptive to the economy and financial markets. In particular, the debt ceiling must be dealt with by policymakers over the next few months as the extraordinary measures taken by the Treasury to provide temporary headroom under the limit play out. According to Treasury Secretary Lew latest comments, the U.S. government will be forced to shut down in mid-October if the debt ceiling is not raised by then. The partisan follies likely to occur in connection with this issue could be disturbing to markets, and in turn have a temporary adverse effect on the economy. At the moment, investors seem to expect that there will be a happier resolution of the upcoming partisan fiscal conflict, just as there was at the start of the year to avoid the widely dreaded fiscal cliff. Once again, investors have not panic, at least not yet.

Unfortunately, the debt ceiling is only one of several fiscal policy deadlines before yearend. It is very likely that the debt ceiling debate will occur in conjunction with the budget debate for fiscal 2014, including the future of ObamaCare. If recent history is a guide, the most likely outcome will be another continuing resolution, which will allow the government to continue to operate under current appropriations temporarily. This will help push the budget debate to mid-October, the same time the debt ceiling needs to be resolved. In her Wall Street Journal column recently, Kimberley Strassel notes that Republicans might adopt a "delay" rather than a "defund" strategy on Obamacare. In the former, they would "use one of this fall's legislative fights to impose a one-year delay of ObamaCare's individual mandate, exchange subsidies and taxes." However, neither side seems too excited about a government shutdown, which may facilitate a compromise of some sort. Apparently that is what investors are expecting.

One factor that might help drive a compromise is higher interest rates. After all, the burden of servicing the huge level of federal debt outstanding has actually come down in recent years, making it easier for policymakers to pile on more. Of course, this would change if interest rates were higher. With the Federal Reserve talking about tapering, this backup in rates seems to be underway.

Although talk is cheap, I still expect the Fed to scale back its quantitative easing this year, possibly as soon as the next policy meeting in September. This should cause longer term interest rates at least to remain at their currently higher levels, despite keeping short-term interest rates near zero for now. My guess is that the stock market corrects on such a change, reflecting many investors' concerns that the economy would stumble without extensive quantitative easing. However, once it is clear that the Fed will not derail the expansion, at least not yet, the stock market should rebound rather quickly. After all, much of the Reserve Bank credit extended since the previous recession never found its way into the economy—most of it ended up on deposit at the Fed. As such, removing it may not be as problematic for the economy as many now seem to fear.

Nevertheless, it is important to note that the current expansion is in its fifth year, which is near the average length of expansions since World War II. For that reason alone, the risks to the expansion are probably greater now than at any time in the last four years although still not enough to derail the expansion anytime soon. It is my experience that expansions end due to some excessive behavior—they do not die of old age, they are killed. The only thing that looks excessive at the moment is monetary policy, which of course will be viewed as a positive until it is not. Low interest rates benefit borrowers who have access to the loan market—so-called cheap money. On the other hand, low interest rates represent a challenge to investors looking for income. The only way to get a better return is to take on more risk, such as credit risk or market risk.

One thing to keep in mind is something that I heard Neal Soss, Chief Economist for Credit Suisse, say a long time ago, "If you are looking for the next financial crisis, just follow the debt." In that regard, the fastest growing segment of debt outstanding in the U.S. at the moment is Treasury debt, with corporate debt a close second. Under such circumstances, my concern would be an inflation-induced recession more so than a housing bubble bursting. Such a recession would be the proverbial "double whammy" to bond investors, as interest rates rose because of higher inflation expectations as well as increased credit risk. That is not in my forecast at the moment, but it is certainly something to keep in mind.

Of course, the response of many of my golfing partners to such a concern is that "inflation is dead." After all, every country in the world has manufacturing capabilities, which means that companies can keep prices down by shifting production to the lower cost country. I contend that the opportunities to make such a shift are far more limited today than they were ten years ago. At some point, labor costs rise even for low-cost producers, removing the competitive price advantage of one country over another. Hence, if demand continues to grow, prices will rise as well, regardless of where the goods are produced.

Changes to the outlook

The near-term forecast has been revised to show slightly less real growth and somewhat higher interest rates than shown in the June forecast. The outlook for inflation, unemployment, the foreign exchange value of the dollar and S&P 500 operating earnings are little changed.

Less robust real consumer spending is the primary factor behind the outlook for less real GDP growth over the remainder of 2013. But it is not all aspects of consumer spending that are to blame. That is, spending on goods jumped a very respectable 3.4 percent in the second quarter, following gains of 3.7 percent in each of the preceding three quarters. The surprise once again was in service spending, which only grew 0.9 percent at an annual rate after accelerating slightly to 1.5 percent in the first quarter. But this is not new. As shown in Chart 1, real consumer spending on services has been a disappointment for most of the current business cycle, starting with a meaningful decline during the last recession, followed by a less than stellar cyclical rebound and the slowdown more recently. I still expect consumer spending on services to rebound on average but not as soon or as dramatically as I had originally expected. As such, the LQ forecast of real personal consumption expenditures has been scaled back a tad. Over the four quarters of 2013, real personal consumption expenditures now are expected to increase 2.3 percent rather than 2.9 percent in the previous forecast.

chart 1

Given that consumer spending is roughly 70 percent of GDP, any weakness in such spending tends to have a similar effect on overall GDP growth. For that reason, the LQ forecast has lowered its estimate of real GDP growth for 2013 as well—to 2.3 percent from 2.5 percent in the June forecast. More importantly, other components of real GDP, such as government spending and net exports, will provide very little if any offset to a less robust consumer in the near term. The only hope is that fixed investment picks up substantially. Although possible, that seems unlikely in the near term as well. That being said, the LQ forecast for real GDP growth in 2014 has not been revised.

Government spending continued to be a drag on real growth in the second quarter. As shown in Chart 2, real government spending growth has retreated once again in recent quarters after showing some earlier signs of a recovery. Unfortunately, the near-term outlook for government spending, both at the federal and state levels, does not look markedly better. There is a chance that the percent change from a year ago will find its way back to zero over the next few quarters, but probably not much higher. A host of factors likely will contribute to this scenario, including the pending need for a higher debt ceiling, the growing probability of another continuing resolution, and the lingering effects of sequestration. And while state and local government budgets have improved, much of that improvement will be used to make good on all the outlays they postponed during the budget crunch. It may be another year of steady revenue growth before state and local governments can seriously consider bumping up spending on infrastructure or employment.

chart 2

Moreover, net exports are expected to continue to detract from overall real GDP as imports outpace exports. The former will reflect the expected upturn in consumer spending and the stronger dollar. The latter will reflect the expected improvement in economic growth outside of the U.S. in the months ahead. At some point in the next few months, I would expect the dollar to retrench somewhat, putting pressure on imports. At that point, the drag on growth from net exports likely will ease somewhat.

Finally, fixed investment in the second quarter did not live up to earlier expectation, as housing contributed less and business fixed investment plunged. More importantly, both have gotten off to a shaky start in the third quarter. The good news is that there still is time for both to show improvement, and I think they will. Notwithstanding this anticipated improvement, both are now expected to contribute less to real GDP growth in the second half, especially the third quarter, than shown in the June forecast.

In particular, housing starts in July were at a pace slightly better than the 872 thousand units at an annual rate in the second quarter, but still down from the first-quarter pace of 957 thousand units. Also, new orders for nondefense capital goods excluding aircraft plunged 3.3 percent in July to a level that was already nearly 7.0 percent at an annual rate below the level of such bookings in the second quarter. Although I expect August and September to show improvement, the contribution to real GDP growth is unlikely to equal my earlier assessment.

Also, with the recent backup in longer-term interest rates, the outlook for interest rates has been revised back to an earlier version. That is, in the December 2012 forecast, I was forecasting the 10-year Treasury yield to average 2.5 percent in the fourth quarter of this year and the 5-year Treasury yield to average 1.5 percent. At the moment, the 10-year is 2.8 percent and the 5-year is at 1.6 percent. Although previous forecasts had interest rates increasing in 2013, Fed guidance earlier this year caused me to postpone it. More importantly, the recent backup in rates is expected to be sustained on average through 2014.

Comprehensive revisions to GDP

Comprehensive revisions, which are carried out about every five years, are an important part of the Bureau of Economic Analysis' attempt to improve and modernize its GDP report to keep pace with the ever-changing U.S. economy. These revisions typically can be classified as either definitional or statistical. As shown in Table 1, there were four major definitional changes to the data in this round; capitalization of research and development, capitalization of entertainment, literary, and artistic originals, expanded set of ownership transfer costs for residential fixed assets, and accrual accounting for defined benefit pension plans. For example, the level of current-dollar GDP for 2012 was revised up $559.8 billion, with $526.0 billion of it due to definitional changes and the bulk of that due to the new treatment of expenditures for research and development by business, government and nonprofit institutions serving households as fixed investment.

table1

As part of the definitional changes to GDP, a new category of business fixed investment had been created to incorporate the capitalization of R&D and ELAO. This new category is intellectual property products (IPP), which includes the two items above as well as software expenditures. In the past, business equipment and software were included in one category. As a result, business fixed investment now has three major categories— equipment, structures and IPP. This addition has added markedly to the levels of GDP but has had very little impact on the average growth rates. Needless to say, most of the relative performance of IPP was due to the surge in expenditures in software during the tech boom and the run-up to Y2K. As such, it was already included in GDP prior to this year's comprehensive revisions.

Finally, IPP investment is less cyclical than equipment investment, falling less in recessions but expanding less in expansions (see Chart 3). One interesting feature of the relationship between these two components is that IPP investment grows faster than equipment investment, the U.S. economy appears to be either coming out of a previous recession or approaching the start of the next one. In the second quarter, real business investment on IPP grew faster from a year earlier than investment on equipment for the time since the second half of 2009, which was very early in the expansion phase of the current business cycle. Of course, like any component of GDP, it is subject to considerable revision before finalized.

chart 3

Another definitional change that added somewhat to the level of GDP in recent years is the expanded set of ownership transfer costs of residential assets. Under the old definition, only brokers' commissions on the sale of a house were capitalized. Under the new treatment, all of the non-financial ownership transfer costs, such as title insurance, title, abstract, and attorney fees, are recognized as capital investment and are depreciated over the typical holding period of the asset. This change is designed to improve the estimates of residential fixed investment, rental income of persons, and consumption of fixed capital. As a result of this new treatment, both gross private residential fixed investment in structures and GDP have increased by the amount of the newly capitalized acquisition and disposal costs. As shown in Table 1, these costs added about $42 billion in 2012.

The last definition change listed in Table 1 is "accrual accounting for defined benefit pension plans. Employer-sponsored retirement plans are either defined contribution plans or defined benefit plans. Each is exactly what it is called—the former provide benefits during retirement based on the amount of money that has accumulated in an employee's account, while the latter provide benefits during retirement based on length of service and average pay. To fund benefits to retirees, defined benefit plans primarily rely on contributions from employers and employees, as well as interest and dividend income earned on the financial assets held by the plan.

In the past, the transactions of defined benefit pension plans were recorded on a cash accounting basis. Now the transactions are recorded on an accrual accounting basis. Such a change will better align pension-related compensation with the timing of when employees earned the benefit rather than when employers make sporadic cash payments to the plans. The impact on GDP is positive because government consumption expenditures are measured using input costs, and the upward revision to state and local government spending (actuarial contributions exceed actual contributions) is partly offset by a downward revision to federal government spending (actual contributions exceed actuarial contributions).

One interesting development seen in Table 1 is that the contribution to GDP from this item is on a downward trend. This trend should continue as state and local government defined benefit pension plans continue to be phased out in favor of defined contribution pension plans. Another side effect of adopting the accrual treatment of defined benefit pension plans is that it accounted for most of the revisions to the personal saving rate, which was revised up for 1929-2007, down for 2008, and up for 2009-2012. It should be no surprise that disposable personal income was revised up for all years, except 2008, as well, reflecting the contribution to income from switching to accrual accounting of defined benefit pension plans.

Statistical changes introduced new and improved methodologies and newly available source data to the process of measuring GDP, including improved methods for computing financial services provided by commercial banks to establish a more accurate picture of banking output. Although there are several aspects of the new methods for computing of banking output, the most meaningful may be the new treatment of losses due to borrower defaults. A portion of the interest that banks charge on loans is used to cover losses of principal due to borrower defaults and is not used to cover production costs. As a result, that portion of the interest payments should not be included as part of banking output. As shown in Table 1, this item actually lowered the level of GDP in 2012 by about $50 billion. For all the details of the definitional and statistical changes, see BEA's Web site at http://www.bea.gov/national/pdf/NIPA%202013%20RevisionTable.pdf.

The bottom line is that the level of GDP is substantially higher as a result of the comprehensive revisions of 2013, but without changing broad economic trends or the general patterns of U.S. business cycles. For that reason, the near-term changes to the LQ forecast were due to the revision to first-quarter GDP growth more so than to the comprehensive revisions back to 1929.

Risks to the forecast

As usual, there is a long list of risks to the forecast. Indeed, it is often easier to be pessimistic about the outlook than optimistic, especially with the U.S. economy still struggling to recover from a serious recession. This is exactly what we have been doing for nearly the past four years—struggling to recover. But the struggle seems to be more than just gaining back the output lost during the recession, because we did that a long time ago. The concern seems to be that we have not returned to the growth rates of old. The difficulty may be that a return to the average growth rate of old is an unreasonable expectation, given the demographics of the U.S. and the reduced prospect of a major productivity improving innovation in the next few years. At the moment, the big story is the domestic oil industry, which really doesn't improve productivity as much as national security. And as we have discovered once again, a political crisis in the Middle-East, even if we no longer rely as heavily on them for our crude oil, creates uncertainty in global crude oil markets and causes crude oil prices to rise.

A guest on a major financial news network noted recently that the risks to financial markets and the U.S. economy in September are the limit on federal debt outstanding, the Federal Reserve's likely tapering of quantitative easing, and Syria. Although I agree that these are near-term downside risks, I would also throw in (maybe as back burner issues) Europe, China, hurricane season, job growth and corporate earnings.

The interesting thing is that fiscal follies with regard to the debt ceiling are a near certainty, the Fed tapering before yearend is very likely, and a military strike on Syria by the U.S. appears increasingly likely. I wish I could say differently, but at the moment I cannot. How disruptive will they be to the economy? I contend that failure to deal with the federal debt limit on a timely basis has the potential to be most disruptive, with military action in Syria second and tapering by the Fed a distant third.

Despite this long list of issues, I remain optimistic that the U.S. economy will continue to grow, albeit slower than many might have hoped but fast enough for the unemployment rate to continue to fall. More recent high frequency data seem to confirm this view. One example is the Quarterly Services Survey recently released by the Census Bureau, which reported stronger results in many service categories than assumed in the source data used to generate the latest estimate of second-quarter GDP. In fact, it may be that in the final revision to second-quarter GDP scheduled for later this month, consumer spending on services was not quite as sloppy as currently estimated by the BEA. Another example of a more upbeat statistic was the Institute for Supply Management index for manufacturing, which jumped to its highest reading since early 2011. And even more recently, light vehicle sales in August rose to over 16 million units at a seasonally adjusted rate, the fastest sales pace in six years.

Implications of tapering by the Fed

As noted above, tapering of quantitative easing (QE) by the Federal Reserve is considered a downside risk to the forecast. While I do expect tapering to cause some temporary disruptions to financial markets, I am less concerned about its impact on the real economy. After all, longer-term interest rates have already backed up from their levels in May, suggesting that investors are increasingly convinced that it is time for the Fed to start backing away from its extremely accommodative policy stance. This is because the U.S. economy for the most part is displaying signs that the current expansion will continue. Of course, some might argue that the expansion would be short-lived if not for the Fed continuing its aggressively accommodative policy.

Clearly, I think the current expansion can survive a less accommodative Fed. Indeed, it could be that the economy would do better if the Fed appeared to be less concerned about the outlook. Under such circumstances, banks may be more willing to lend and bank customers may be more willing to borrow. A measured hike in longer term interest rates might accomplish both—lenders get more spread and borrowers rush in to lock in a loan before rates rise further.

Recall that higher interest rates are usually considered from the borrower's perspective—that is, higher interest rates means higher borrowing costs, limiting the demand for new loans. Very seldom are higher interest rates discussed from the saver's perspective. With the boomers retiring or trying to retire, investment income is increasingly important to this rapidly growing segment of the population. In this regard, the yield on the 10-year Treasury note has increased to 2.94 percent recently from 1.78 percent at the end of last year, which is on track to deliver a total loss for all of 2013 of over 6 percent. Of course, this is painful for those who own 10-year Treasury notes, but it also represents a better buying opportunity for those who are searching for interest income, as well as an opportunity to ride down the still very steep yield curve. That is, a 10-year note purchased two years ago with a 2 percent coupon is now an 8-year note with a 2 percent coupon.

I continue to believe that the economic data will provide the Fed the excuse it needs to start tapering before the end of this year. I also believe that the Fed will need to exit the QE strategy completely before it starts to raise its federal funds rate target. That too will be gradual, as long as the Fed does not wait too long to do so. The concern is that the Fed will miss the mark—either start tapering too soon or wait too long. I think the greater risk is that the Fed waits too long. After all, this is the politically easier option. Congress never likes it when the Fed is raising rates, especially in an election year. And 2014 will be an election year.

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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

August 2011 - LEQ

November 2011 - LEQ

February 2012 - LEQ

May 2012 - LEQ
August 2012 - LEQ
December 2012 - LEQ
March 2013 - LEQ
June 2013 - LEQ


 

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