December 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 - As good as it gets? blue bar

  • Following a miserable first quarter, U.S. real gross domestic product (GDP) growth rebounded substantially, averaging 4.25 percent at an annual rate for the second and third quarters according to the latest estimates. Just as the weather-induced slump in the first quarter was more severe than expected, the rebound owing to a return to normal weather was stronger than expected. Although the pace of real GDP growth in the fourth quarter should be okay, it most likely will fall short of the preceding two quarters.

  • For all of 2014, real GDP growth most likely will be less than the Laufenberg Quarterly (LQ) forecast at the start of the year, reflecting the shockingly weak first quarter but also the more difficult comparison due to the upward revision to real GDP at the end of 2013 as reported in the annual benchmark revisions. Interestingly, the plunge in the unemployment rate and the still benign consumer price inflation so far in 2014 are very much in line with the earlier LQ forecast. The more recent plunge in crude oil prices was not. Nevertheless, crude oil prices are very volatile and as such could rebound just as quickly as they dropped. Indeed, contrary to the generally accepted view at the moment, I contend that the process to accomplish this retracement is already underway.

  • The U.S. economy is expected to perform well in 2015, even to the point of reviving the sound bite “Goldilocks” to describe it. Next year, real output growth is expected to be solid, the unemployment rate should continue to drift lower, inflation is expected to accelerate a bit as the year unfolds, interest rates should move slightly higher in the process, and wages will finally see stronger gains. Corporate profits are expected to grow but in response to higher volumes and not wider profit margins. Enjoy it while it last because it may be as good as it gets for this business cycle.

  • Over the years, I have noted on several occasions that “expansions do not die of old age, they die of shock.” There is no reason to expect anything different this time. The problem is identifying the “shock” that will kill the expansion. As Neal Soss, chief economist for Credit Suisse, once told me, “if you are looking for the next economic problem, follow the debt.” The last time it was mortgage debt, which policymakers, investors and home owners viewed as a good thing until it wasn’t. What will it be this time?

  • In this regard, the current monetizing of the Federal debt is viewed by many as a good thing, as evident by the positive reaction in financial markets to quantitative easing. But as we know from the past, too much of a good thing can be trouble. The question is knowing when it becomes too much. The Fed seems confident that it will know.

blue barForecast at a glance blue bar chzrt 1 - 4

Forecast details blue bar

Forecast Details

blue bar As good as it gets?blue bar

The term “Goldilocks” is very likely to be used increasingly as the sound bite to describe the U.S. economy in the months ahead given the current momentum in the U.S. economy and where it seems to be headed. The Goldilocks theme is that everything is “just right”, including solid real output growth, a relatively low unemployment rate, decent payroll job growth, more wage gains, a low inflation rate, asset price appreciation, strong corporate profits and low interest rates. Although many of these factors are already in place, most economists still question their sustainability. That may be changing. For example, at the moment, the consensus forecast for next year is very encouraging, assuming the weather cooperates this time. While the Laufenberg Quarterly (LQ) forecast for 2015 is encouraging as well under the same weather assumption, it is slightly less optimistic about real growth, inflation and interest rates and more optimistic about unemployment than the consensus.

Nevertheless, there still will be plenty to worry about, as we will be reminded from time to time in the months ahead. For example, financial or economic crises elsewhere are always possible, with special emphasis on Europe and China. Also, bouts of political unrest, both here and abroad, could threaten the Goldilocks outlook. And, of course, a fiscal meltdown or a monetary misstep could derail Goldilocks over the next year or so. Despite these concerns, the LQ forecast puts a very low probability on any of these risks becoming significant in 2015.

In that regard, we do expect Congress to do what is necessary to avoid shutting down the government in 2015. Whether it involves an official budget deal is unclear even though the House seems to be moving in that direction. The more likely scenario is another resolution that will allow the government to continue to fund its expenditures at least through fiscal year 2015. Moreover, the LQ forecast expects the Federal Reserve to start normalizing interest rates next year. In fact, the LQ expects the Fed to start sooner rather than later and to be more aggressive about it than most. However, the LQ also expects the Fed to successfully explain what it is doing and why, which should minimize the adverse effect of higher short-term interest rates on financial markets and the economy.

The year in review

As noted in the LQ forecast in March, the softness in the first-quarter economic data likely had been due to the “unusually harsh winter weather rather than a deterioration in the economy’s fundamentals”, suggesting “a snap back in economic activity once the weather simply [returned] to normal.”1 This is precisely what happened but to a different degree than expected at the time. In particular, the weakness in the first quarter was far more pronounced than initially anticipated, which in turn led to a much stronger rebound in the following two quarters than expected.

Despite the stellar bounce in recent quarters, real gross domestic product (GDP) growth for all of 2014 will come up short of the earlier forecast for two reasons. The obvious reason is that some of the decline in economic activity in the first quarter apparently was lost forever. But the other less obvious reason is that the estimate of real GDP for the fourth quarter of 2013 had been revised substantially higher in the benchmark revisions in July of this year, making it more difficult to obtain the 3.1 percent fourth-quarter to fourthquarter growth rate shown in the March forecast. Indeed, with one more quarter of data to be reported, it now looks as if this measure of 2014 real GDP growth will be closer to two percent than the March forecast of three percent.

An interesting aspect of slower than expected growth is that the unemployment rate in 2014 has already fallen further than shown in our better-than-consensus forecast in March. We expected the civilian unemployment rate to average 6.1 percent in the fourth quarter of 2014, down from the 7.0 percent average in the fourth quarter of 2013. With one more month of data to be reported, the unemployment rate in the current quarter is on track to average 5.8 percent.

Inflation may turn out to be in line with the March forecast as well. In particular, in the March forecast, the overall consumer price index (CPI) was expected to be up 1.9 percent over the four quarters of 2014 and the core CPI was expected to be up 1.8 percent. At the moment, with two more months of data to be reported and despite the recent plunge in crude oil prices, it looks as if both will be close.

In addition, corporate profits seem to be on track to perform about as expected. In the March forecast, S&P 500 operating earnings were projected to total $114 a share for all of 2014. It now looks as if it will be $117. Although slightly higher than the earlier estimate, corporate profits clearly are higher than $107 a share for all of 2013.

The one area where the March forecast was too high was interest rates. In March, the LQ forecast had the 10-year Treasury yield averaging 3.1 percent for all of 2014. It now looks as if it will be more like 2.5 percent. The same could be said about all interest rates, except for the 5-year Treasury yield. The March forecast was for this rate to average 1.7 percent for all of this year. It is on track to average 1.6 percent, hardly a significant difference.

In 2014, the U.S. economy performed about as the LQ forecast projected at the start of the year, as most of the surprises apparently were offsetting or temporary. The conclusion is that the improved economic fundamentals in place at the start of 2014 carried the day. More importantly, it seems that the fundamentals continued to improve during the year, creating considerable positive momentum at the end that is expected to carry over into 2015.

A “Goldilocks” economy in the year ahead

According to the LQ forecast, the U.S. economy most likely will deliver above trend growth in the first half of next year followed by about trend growth in the second half. The consumer will be the driver of this outcome, as higher incomes and positive wealth effects are expected to boost spending early, while a slight pickup in consumer price inflation and milder higher interest rates damp spending growth a bit in the second half.

Personal income gains should be solid over the next few quarters, led by strong job growth and higher hourly earnings. For example, the employment report for November suggests that personal income in the current quarter is on track to increase about 5.0 percent at an annual rate, led by solid gains in the wages and salaries component of income. With inflation expected to remain relatively benign, given the plunge in crude oil prices, real personal income should improve markedly, providing consumers with the wherewithal to increase spending going into next year. And I expect they will.

Moreover, the wealth effect, especially in housing, has rebounded considerably in recent years (see Chart 1). It seems that owners’ real estate equity as a percentage of the market value of real estate has rebounded to 53 percent, up from 37 percent in early 2009 but still not back to its average of 60 percent for the 16 years prior to 2007. In addition, the stock market has recovered dramatically in recent years, with several segments reaching record highs. Renewed stock market wealth, combined with the rebound in real estate equity, should encourage consumers to spend more at the margin. Recall that when consumers have added wealth, they are more likely to save less and borrow more, especially if interest rates remain low.

chart 1

Of course, this cannot go on forever. As the year unfolds, inflation is expected to accelerate slightly and interest rates are expected to rise. Neither will be enough to derail the expansion in 2015 but they could slow down the pace of spending a bit later in the year. In fact, increasingly the focus will shift to how more inflation and higher interest rates are good for the economy rather than bad. We have been there before. And under such circumstances in the past, the Fed has been forced to push short-term interest rates much higher than most expected, but not immediately. The Fed tends to be very gradual at first. Hence, the Fed tightening, which likely will start sometime next year, most likely does not become problematic until 2016 at the earliest. In the meantime, it appears that Goldilocks will hang around for most—if not all—of 2015.

Finally, as noted above, there seems to be very little appetite in Washington to shut the government down this week over the budget for the current fiscal year, which ends on September 30, 2015. Recall that the federal government at the moment is operating on a continuing resolution that was enacted last September that provided funding through today (December 11). This means that something has to happen soon. On December 9th the House Appropriations Committee unveiled a fiscal year 2015 Omnibus Appropriations bill, which is legislation that will provide discretionary funding for the vast majority of the federal government for the current fiscal year. The House is expected to approve the bill today but would give the Senate only hours to pass the bill before funding runs out. As such, the House will be forced to pass a short-term funding bill to provide the Senate time to debate the much larger Omnibus Appropriations bill. Just how short-term is unclear but the consensus is days and not months.

Of course, there is more fiscal drama possible in 2015. In particular, the federal debt ceiling will have to be raised again next year. Although the government's current borrowing limit expires on March 15, the Treasury's ability to use its so-called "extraordinary measures" most likely will extend this deadline into June. The timing notwithstanding, the debt ceiling will have to be raised at some point in the current fiscal year and has been demonstrated in the past it is never easy for Congress regardless of what else is happening. The LQ forecast assumes that the debt ceiling will be raised but not without a lot of partisan rhetoric.

Paved with good intentions

With the emphasis on a Goldilocks economy next year, it seems ridiculous to discuss the potential downside at this time. However, I think it is important not to be taken in by the irrational exuberance that is likely to be associated with Goldilocks. After all, the road to all recessions are paved with good intentions.

The perennial plan is to never have another recession but unfortunately that is not the way it works. Business cycles have not been repealed. It is usually when most think they have been repealed that we get into trouble. Recessions may not be necessary to counter excesses and greed, but for now they seem to be the only means. This is because in large part we wait too long to do anything to derail what at the time looks like a good thing. As such, we end up doing too much or going too far. After all, as I have noted on numerous occasions in the past, expansions do not die of old age, they die of shock. Stephen K. McNees, a former Boston Fed Economist, also noted over twenty years ago, long before the "great" recession of 2008, that "virtually all recessions have occurred around the time of some highly distinctive, not purely economic event such as a war, a massive change in the price of imported oil, a major strike, or wage, price, and credit controls." And they "almost always come as a surprise even though they seem easy to 'explain' after the fact."2 But in every case, it has been a substantial retrenchment by the consumer that has led the downturns. From that perspective, the next shocking event that results in a recession will be something that derails consumer spending once again.

One of the reasons expansion die of shock is because whatever it is that shocks us most likely was not considered a bad thing until it was. At the moment, I increasingly hear policymakers refer to a little inflation as a good thing, especially if the trade-off is lower unemployment and higher wages. I actually remember in the 1960s when the common refrain was that a little inflation is okay. The problem is timing policy to promote only a little of anything. Our track record in this regard is not very encouraging.

By the way, not all recession are as severe as the last one. In fact, I claim that the next recession will look mild relative to the "great" recession in terms of output and jobs lost, but equally severe in terms of the financial market's reaction. With interest rates as low as they are, it will not take much of a boost to deliver a knockout punch to economy.

Do I know what the shock will be? I do not. If I did, then it would not be shocking. One thing I do know is that after the fact, we once again will be scratching our heads wondering why we didn't see it coming.

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. Indeed, a lot of the good economic news anticipated next year may already be priced in the market, or will be soon. For that reason, it may be a good time to start moving to a more defensive equity position.

If you own fixed-income assets, then short-duration, high-yield obligations are preferred over long-duration, high-quality bonds. This is based on the expectation of higher interest rates, something I have been anticipating incorrectly for a long 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 perceived as working to prevent the economy from overheating. This perspective is expected to remain in place at least through the end of next year.

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1 See Daniel. E. Laufenberg, Laufenberg Economic Quarterly, March 2014, p. 1.

2 Stephen K. McNees, "The 1990-91 Recession in Historical Perspective," New England Economic Review, January/February 1992, p. 3.

The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.


ECONOMIC COMMENTARY Mid-term updates to the Quarterly Reports

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