September 2014

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.

blue barExecutive Summary - Making sense of the numbers blue bar

  • The Laufenberg Quarterly forecast is little changed for the remainder of 2014 despite the weather-related problems at the start. This forecast includes a mild acceleration on average in real gross domestic product (GDP) growth, a slight uptick in core consumer price inflation, meaningful improvement in labor market conditions, and mildly higher interest rates across the entire maturity spectrum.

  • The snapback of real GDP growth to 4.2 percent at an annual rate in the second quarter tends to support the contention that the weather was the key factor behind the shocking decline in real GDP in first quarter. In the second quarter, both final sales and the change in inventories contributed to GDP growth, more than reversing the drag on growth from both components in the first quarter.

  • Although the overall growth rate for second-quarter real GDP performed in line, consumer spending growth was less than expected. Two possible explanations are that consumers are still unwilling to open their purses or that there is nothing in their purses to spend. Although the latter may have been part of the reason for the slow start to the current expansion, it seems to be less of an issue more recently.

  • According to revised data from the Bureau of Economic Analysis, real GDP growth was even slower in 2011 and 2012 than estimated earlier, but somewhat stronger in 2013. As a result, the level of real GDP at the end of 2013 is little different from where it was prior to the revision, just the path to that point has changed.

  • Despite the “slow-motion” average growth rate so far during the current expansion, the unemployment rate in August was 6.1 percent, down from 7.2 percent a year earlier and from 9.5 percent in July 2009 when the current expansion began. The implication is that conditions in the labor market are improving more than payroll job growth alone would suggest.

  • In this regard, some contend that the unemployment rate is meaningless in the current expansion because it is being driven lower in large part by people leaving the labor force rather than new jobs. I disagree. In fact, the unemployment rate most likely is the more important statistic in determining the pace of wage gains in the near future.

  • The Fed is running out of excuses to justify its slow exit from aggressive accommodation. Earlier it was a still high unemployment rate, now it seems to be housing. Indeed, it may be that the Fed has already overstayed its easy policy stance and be forced to respond more aggressively than most market participants now expect.

blue barForecast at a glance
blue bar chzrt 1 - 4

Forecast details blue bar

Forecast Details

blue bar Making sense of the numbersblue bar

Again this quarter, the Laufenberg Quarterly (LQ) forecast remains essentially unchanged, as the “slow-motion” expansion scenario continues to draw support from the great majority of incoming statistical reports. The sharp increase in second-quarter real gross domestic product (GDP) following the weather-induced decline in the first quarter, along with the benchmark revisions to real GDP over the last few years, have clinched the slow-motion growth scenario of the current expansion. Contrary to the generally accepted view, a slow-motion expansion is not unusual. The U.S. economy has experienced such a scenario in each of the previous two expansions. The difference this time is that the slow-motion pace has persisted much longer; that is, growth has been slow for five years rather than only about two. According to the latest data from the Bureau of Economic Analysis (BEA), real GDP has grown at an average annual rate of 2.2 percent for the first five years of the current expansion, which is obviously slower than the 3.0 percent average annual pace for the first five years of the previous expansion, the 3.9 percent average annual pace for the first five years of the 1990s expansion, or the 5.0 percent average annual rate for the first five years of the 1980s expansion. As things now stand, the current expansion has been the slowest paced on record.

Yet, despite the unusual sluggishness in real GDP growth, the labor market has improved substantially during the current expansion, highlighted by the steady decline in the civilian unemployment rate from 10.0 percent in October 2009 to 6.1 percent in August of this year. This compares most closely to the drop in the unemployment rate during the first five years of the 1980s expansion, when it fell from its cyclical peak of 10.8 percent in October 1981 to 5.8 percent in October 1986. But recall that real GDP grew much faster during the first five years of the 1980s expansion than it has over the last five years. The labor market improved in each of the two more recent expansions as well but not to the same degree in large part because the unemployment rate peaked at a much lower level.

Of course, there is still considerable debate about the current health of the labor market. Most would agree that the unemployment rate, although lower than it was roughly five years ago, is still too high when compared to its low of the previous expansion. However, when compared to its historical average, it seems to be close to normal. For example, from January 1948 to the present, the median civilian unemployment rate was 5.6 percent and the average was 5.8 percent, which is not that different from its most recent reading. Indeed, the LQ forecast anticipates the unemployment rate falling to 5.8 percent by the end of this year and to about 5.0 percent by the end of 2015.

In summary, the average pace of the current expansion has been sluggish when compared to the average pace of previous expansions but still fast enough to push the unemployment rate lower. This aspect of the LQ forecast has not changed in five years, in large part because it has been correct. Not only has the unemployment rate fallen during the current expansion, it has done so roughly in line with its decline in previous expansions. As such, the U.S. economy has absorbed most of the excess capacity made available by the last recession. This is far different than the generally accepted view that considerable excess capacity still exists, citing the declining labor force participation rate rather than more jobs as the key factor behind the decline in the unemployment rate. After all, the people leaving the labor force could reenter, putting upward pressure on unemployment once again. The question is why workers left the labor force and how likely are they to return. In seems reasonable to expect discouraged workers and students, who left the labor force, to be more likely to return than retirees. Some economists contend that most of the labor force dropouts were discouraged and represent a large army of unemployed not captured in the traditional measure of unemployment. Proponents of this view argue that the U.S. economy will struggle to absorb this army of unemployed once they decide to return. I disagree. I contend that most dropouts do so by choice—either to attend school or to retire. I also believe that this difference may be setting the stage for more robust growth ahead, as employers increasingly will be forced to raise wages to entice workers to remain in the labor force. Obviously, a major factor behind this more optimistic scenario is stronger growth, led by more consumer spending.

Waiting on the consumer to do more

At the time the June issue of this report was published, real personal consumption expenditures (PCE) in the first quarter were estimated by the Bureau of Economic Analysis (BEA) to have increased at an annual rate of 3.1 percent, owing to strong gains in spending on housing and healthcare services. However, the sharp increase in spending on healthcare seemed at odds with the harsh weather effects on most other market based categories of consumer spending and was difficult to explain. Since then, the BEA has revised downward its estimate of first-quarter real PCE to a mere 1.2 percent, reflecting primarily a dramatic downward revision to spending on healthcare; that is, rather than a gain of 9.1 percent at an annual rate, healthcare spending declined 1.4 percent. Obviously, this substantial downward revision to first-quarter real PCE was a huge factor in the downward revision to first-quarter real GDP growth.

But also as outlined in the June issue, if the severe winter weather was a drag on real GDP growth in the first quarter, then a return to more normal weather was expected to promote a sharp rebound in real GDP growth in the second quarter. For the most part, that is precisely what happened given that second-quarter real GDP is now estimated to have grown at a very solid 4.2 percent annual rate. Nevertheless, the rebound in consumer spending failed to live up to my expectation, especially given the added weakness in the first quarter. Although this was somewhat frustrating, it was not surprising. After all, sluggish real PCE growth has been the key reason the current expansion has been so slow. So why has real PCE growth been sluggish for so long? The answer to that question may help us better anticipate, as well as better understand, the economic outlook.

I suspect that several factors have contributed to consumers’ ongoing cautiousness. For example, consumers are reluctant or unable to borrow to finance spending to the same extent that they did prior to the 2008 financial crisis, especially the use of home mortgage credit. This is illustrated somewhat in Chart 1, which plots the total level of household mortgage debt outstanding against the level of household net equity in the houses they own. Twenty-five years ago, I worked with a fixed-income portfolio manager who believed that whenever two lines crossed, it was important. In that regard, when the two lines in Chart 1 crossed in the fourth quarter of 2007, for the first time on record, it may have been a harbinger of things to come.

Prior to 2008, the net equity in housing consistently exceeded total mortgage debt, although the positive gap began to narrow as early as 2006 when house prices started to decline. In fact, by the fourth quarter of 2007, home equity fell below mortgage debt outstanding for the first time on record, which interestingly coincided with the onset of the previous recession. More importantly, this plunge in home equity may have contributed to the severity of the 2007-2009 recession, as well as the delay in the recovery. That is, it denied many households the flexibility and mobility needed to soften the impact of the recession. If that is so, then the fact that the two lines have crossed again more recently, with the total level of home equity once again rising above household mortgage debt outstanding, could be a harbinger of future events as well. In other words, households once again may have sufficient equity in their houses to rely on it to finance consumer spending.

The one area of consumer spending that has not disappointed so far during the current expansion has been new motor-vehicle sales. In August, vehicle sales totaled 17.5 million units at a seasonally adjusted annual rate, the strongest performance since 2006. One reason for this is that the financing for vehicle purchases is readily available and offered on very attractive terms. As such, 85 percent of all new car purchases in the second quarter were financed, which was up slightly from the same period a year earlier. Clearly, consumers have not needed home equity to buy a new vehicle but that may not be true of other purchases that were financed with mortgage debt in the past. This void may have been even more of a drag on consumer spending in recent years given the banks’ cautiousness about mortgage lending owing to the changing regulatory environment since the 2008 financial crisis.

chart 1

The obvious question is whether households will ever increase mortgage debt again. Based on the relationship in Chart 1, it seems to be a reasonable bet that it will and probably sooner rather than later. In other words, homeowners have the opportunity to borrow against their houses once again. Whether they do will depend on whether they qualify for a loan. Certainly, the old days of “no document loans” has been replaced with “all document loans,” which means that borrowers will need income to borrow money.

Being unable to satisfy the new and improved means test has been another factor contributing to consumer cautiousness. In particular, the percent change in “economic” income adjusted for inflation (real personal income less transfer payments) has been very uneven the last few years in large part due to the enactment of the American Taxpayer Relief Act of 2012 (see Chart 2). This tax legislation was promoted as the resolution to earlier tax changes that were scheduled to expire at the end of 2012. In response to the higher tax rates anticipated in 2013, flexible income payments were paid in the fourth quarter of 2012 rather than in the first quarter of 2013, causing fourth-quarter 2012 real income growth to surge 14.5 percent at an annual rate and 6.3 percent from a year earlier. The payback was in the first quarter of 2013, when real income plunged 11.9 percent at an annual rate, and again in the fourth quarter of 2013 when real income fell 1.4 percent on a year-ago basis. Recall that this income measure is before taxes and excludes all transfer payments, such as Social Security, Medicare, unemployment benefits, and net private transfers. As such, it is a better measure of personal income earned from services provided.

chart 2

For the most part, I am confident that real income growth will be a bit more stable over the next year or so barring any disruptions to before-tax income due to major changes to the personal tax code. Of course, not everyone would agree. In particular, there has been a great deal written in recent years about the slack in the labor market and its impact on income. I think the most difficult thing for most investors to accept is that the U.S. economy cannot sustain 4.0 percent growth any more. In fact, the sustained rate of growth for the U.S. economy now may be closer to 2.0 percent. The U.S. economy can still grow faster than 2.0 percent, and I expect it will, but not for an extended period without the economy overheating. And the labor market has a great deal to do with it.

Part of the labor market slack story has been the steady decline in the laborforce participation rate; that is, a smaller share of the civilian population is participating in the labor market—either already employed or looking for employment. As shown in Chart 3, the percent of the working age population not in the labor force is higher now than it was in the mid-1990s but not as high as it was in the mid-1970s. In other words, as a percent of the working age population, the large number of people out of the labor force is not unusual. Of course, some would argue that the more interesting aspects of the series shown in Chart 3 are in the details. Unfortunately, the details are not available prior to 1994. But one could speculate about the earlier period. In particular, the mid-1970s was when the bulk of the baby-boom generation were still in school rather than looking for a job. As this demographic bubble entered their working years, the percentage of the population not in the labor force fell. Of course, this downward trend was aided by the increased participation of women in the labor force during this period.

chart 3

More recently, detailed data is available to help us assess the cause of the upward trend in labor force dropouts, which as a percent of the population has increased 4.2 percentage points to 37.0 percent over the 20 years ending in August 2014. Some contend that it reflects the growing army of discouraged workers who have given up looking for a job. Others argue that it reflects the growing number of boomers retiring. In fact, based on my analysis of the detailed data, it seems to be the young and the old that have dropped out. In August 2014, 44 percent of the younger segment of the population (aged 16 to 24 years) had dropped out of the labor force, up markedly from the 29 percent who had dropped out of the labor force in August 1994. However, this age group represented a smaller segment of the total population in 2014 than it did in 1994, which is why they only contributed 2.0 percentage points to the increase in the ratio shown in Chart 3 over the same period. Obviously some of the young people who left the work force recently were discouraged, but most left to attend school. According to the Institute of Education Sciences, the percentage of the population aged 20-24 years attending college jumped to 40 percent in 2012 from 32 percent in 2000. One could argue based on this statistic that school enrollment may have had much to do with the sharp rise in the share of younger people not in the labor force over the last 20 years.

The oldest segment of the population (aged 65 years and older) was less likely to drop out--82 percent in 2014 versus 88 percent in 1994—but represented a larger share of the population. As such, they still accounted for a percentage point of the 4.2 percentagepoint increase in the share of the population not in the labor force. A similar scenario could be told for those aged 55 to 64 years, who accounted for another 1.2 percentage points of the gain. In other words, those aged 55 years and older accounted for more than half of the increase in the dropout rate over the last 20 years. Were they discouraged or did they retire? Although probably both, I contend that retirement was the primary reason.

By the way, in August 1994, people aged 16 to 24 years outnumbered those aged 65 years and older by nearly 5 percent. In August 2014, people aged 65 years and older outnumbered those aged 16-24 years by a whopping 20 percent. This alone should have a somewhat damping effect on the pace of spending growth, given that the life-cycle hypothesis of consumer spending suggests that older folks are more likely looking to downsize than upsize.

Another concern of many has been the sluggishness of hourly wage gains so far during the current expansion when compared to previous expansions. There is little doubt that hourly wage gains have fallen dramatically short of what they were in the start of the sixth year of previous expansions that lasted that long (see the solid blue line in Chart 4). But that too may be about to change. After all, dropouts may not drop out if they are incented to stay. The implication is that the year-over-year growth rate in average hourly earnings has not yet peaked for this business cycle. Whether it will get as high as it was in each of the three prior expansions is unclear but it most likely will move higher from where it is today, which in turn should bode well for consumer income and spending in the months ahead.

 chart 4

Moreover, as shown in Chart 4, consumer price inflation as measured by the PCE price index has remained relatively benign except for the spike in early 2011 reflecting the collapse of Libyan crude oil production during that nation’s revolution. The price refiners paid for crude oil rose from an average of $78 a barrel in the second half of 2010 to $101 a barrel in the first half of 2011, which resulted in a spike in overall consumer inflation. This inflation spike obviously eroded real purchasing power given that consumer prices increased faster than wages in2011. Since then, inflation has settled down to a more benign level. More importantly, it is still low enough that real average hourly earnings are positive. More recently, oil prices have fallen considerably from their highs earlier in the year, which combined with further wage gains, should boost consumer purchasing power over the remainder of the year.

So why do people feel less confident about the current expansion? I suspect that it has a lot to do with the data shown in Chart 5. In particular, the sizable gap that was created between real disposable personal income and real personal income less transfer receipts during the last recession, which has been very slow to narrow. From the end of 2007 to mid-2009, real disposable personal income grew 1.1 percent at an annual rate, while real personal income less transfer receipts declined a whopping 4.0 percent at an annual rate. That is, all of the modest gain in real disposable income during the recession was due the combination of a sharp rise in transfer receipts and lower personal income taxes. Recall that transfer receipts include income payments to persons for which no current services are performed, as well as net insurance settlements. For the most part, it reflects the sum of all government social benefits. So far in this expansion, real disposable income has grown at a meager average annual rate of 1.6 percent, while real personal income less transfer receipts has grown at a more robust 2.4 percent annual rate. Apparently the surge in transfer receipts, as well as the cuts in personal income taxes, during the last recession were unsustainable, which is just another reason why real disposable income growth over the first five years of the current expansion has been so slow for so long.

chart 5

The bottom line is that, as shown in the LQ forecast, more is expected from consumer spending over the next year due to the end of the deleveraging by households, higher asset prices, further tightening of labor markets, and solid gains in real wages. The first two should boost the wealth effect on spending, while the latter two should boost the income effect. In addition, we should see an end to the push for higher taxes and for further cuts in transfer receipts for now. As can be seen in Chart 5, real personal consumption expenditures tend to track real disposable personal income growth more so than real personal income less transfer receipts. The fundamentals for real disposable personal income while far from exciting, are fully capable of sustaining a reasonable pace of expansion in the months ahead, which should in turn translate into a similar scenario for real personal consumption expenditures.

The Fed—less acceleration but still cruising

According to the July 30th press release following the Federal Reserve’s last “Committee” meeting, the Fed will continue to maintain its very accommodative policy stance for a “considerable time.” Like it has in recent policy meetings, the Fed decided to ease up a bit on the accelerator but appears to be in no hurry to apply the brakes. In this regard, the Committee noted that it “continues to anticipate, based on its assessment of current economic factors, that it likely will be appropriate to maintain the current target range for the federal funds rate (0 to ¼ percent) for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.”

Despite the Fed being comfortable about its rate policy, the Committee decided that there had been sufficient improvement in the broad economy for it to make a further measured reduction in the pace of its asset purchases. The Committee reduced its net purchases of agency mortgage-backed securities to $10 billion per month from $15 billion and its net purchases of longer-term Treasury securities to $15 billion per month from $20 billion. At this pace, it will be another two to three policy meetings before the asset purchase program ends. However, the Fed is quick to remind us that the “pace of the asset purchases are not on a preset course.” Based on my assessment of labor market conditions improving substantially over the next year, as well as the possibility that inflation expectations becoming a bit unanchored late next year, I expect the Fed to move sooner rather than later. Indeed, market participants may force the Fed to bump up short rates soon after its asset purchases end by pushing longer-term interest rates even higher than most now anticipate.

As noted earlier, while the economy has sustained a modest growth pace for an extended period, there are good reasons for thinking that growth will accelerate somewhat in coming months, regardless of the near-term course of Fed policy. Certainly the surge in vehicle sales in August and the solid gains in the Institute of Supply Management’s indexes for manufacturing and non-manufacturing, though hardly decisive, lend support to this view. However, the surprisingly sluggish gain in payroll employment does give policymakers reason to pause. Once again, I contend that payroll employment is less important in the current demographic environment as an indicator of future economic strength. Indeed, a more telling labor market statistic may be that there were 4.67 million job openings in June 2014 (the most recent data available), which is a record high for this series and in a market where new job growth has been disappointing. Unfortunately, new hires have not recovered so dramatically or completely as job openings, as the spread between hires and openings narrowed to its lowest level on record. It seems that the jobs are there, but employers are having a difficult time finding qualified candidates at the current wage paid. This is another reason why I expect wage growth to accelerate in the months ahead. At that time, inflation expectations, which seems to be a key factor in the Fed’s policy decisions, is likely to push higher as well.

Investment implications

My views on financial markets have not changed. I continue to favor equities over fixed income, although expectations of future returns continue to be adjusted downward. And I continue to favor riskier assets, although risk spreads generally have narrowed considerably in recent years. Indeed, in some cases investors are no longer paid for the risk they are asked to take. For that reason, both the stock and bond markets have become “pickers” markets in my view.

If you want to own fixed-income assets, then short-duration, high-yield obligations seem better than long-duration, high-quality bonds. This is based on the expectation of higher interest rates, something I have been anticipating incorrectly for some time. More importantly, the higher rates initially will be in response to an improving economy and the increased prospect of the Fed raising short-term interest rates, which may have an initial adverse effect on the stock market, and riskier assets in general, but this concern will pass. In fact, after this initial response, market participants will view a less accommodative monetary policy as good for risk because the Fed will be working to prevent the economy from overheating.

At some point in the distant future, however, market participants will perceive the Fed to have gone too far, in which case longer-term interest rates will start to fall, the yield curve will invert, credit spreads will begin to widen and riskier assets will underperform. Nevertheless, such an interest rate scenario, if it does occur, most likely will do so well beyond the current forecast horizon.

______________________________

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
September 2013 - LEQ
November 2013 - LEQ
March 2014 - LEQ
June 2014 - LEQ


 

HOMEABOUTCOMMENTARY FORECASTspacerPERSPECTIVESLINKS