Economic Commentaries

23

In her Congressional testimony Fed Chair Yellen professed optimism that the economy is rebounding from the weakness induced by harsh winter weather. But let’s face some facts. If there were no rebound the economy would be in a full-fledged recession and monetary policy would be under serious critical review. So it is not whether there is a rebound, it is really an issue of the quality and magnitude of the rebound.

First quarter preliminary GDP was reported at 0.1% with inflation running at a 1.4% rate for a nominal growth rate of 1.5%. (Extracting the surge in health care spending and utility outlays, real GDP would have contracted by 1% annually). Leaving aside the distinct possibility of a downward revision to the first quarter report, if inflation holds steady at 1.4% this spring and real growth rebounds to a 3% rate, nominal GDP growth in the first half would be 2.9% or more than 1% below the rise for 2013 and significantly below the Fed’s full year forecast for this year.

So far the spring rebound appears underwhelming. For example, vehicle sales slumped in this year’s first two months, but the selling rate rebounded in March-April as the weather normalized. But the four month average is only 15.7 million or about 4% below the rate in last year’s second half. Similar disappointing performance is evident in housing demand. Indeed builders like Lennar and Hovnanian are finally voicing concern over the weakness of demand, and companies like Trulia and Realogy are now expressing similar concerns.

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18

Real GDP growth was about 1% annually in the first quarter while inflation was about 1% as well. This is well below consensus forecasts at the start of the year and it can be attributed in part to harsh winter weather. Activity declined in January and February but as the weather normalized in March there was improvement.

The pick-up was most noteworthy in the labor market report for March which showed a steady rise in payrolls and a healthy rebound in hours worked. Also according to the ISM, production rebounded in March. But this is not to suggest that weather was the only restraint on business activity. Indeed, the March rebound merely brought activity back to the norm of the last six months with no indication of the acceleration that has been widely expected. And because GDP growth was much weaker than hours worked in the first quarter, productivity slumped. (This may be an aberration but it bears watching).

We continue to believe more fundamental constraints are in play. Mortgage demand remains weak from a combination of reduced affordability and tough loan standards. Vehicle demand, while strong in March, has been flat over the last nine months despite increased price discounting. Vehicle loans get longer and longer, indicating that sellers are reaching down the affordability ladder to find buyers. A positive is that the household saving rate is neutral. But income growth remains weak amidst stagnant wage growth; cash flows are being crimped by a collapse in mortgage refinancing; prices for necessities are rising and home price inflation is easing. Finally, there is capital investment, which was supposed to be a source of strength this year. But as yet there is no such indication as policy uncertainties prevail and business revenue growth remains elusive.

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Posted in: General
01

Economic activity indicators were universally weak in the December-February period. Harsh winter weather is only partially to blame in our view. So while some rebound may be expected as weather conditions normalize, underlying growth seems stuck in the same 2% mode that has characterized this recovery. Even assuming a rebound in March, the first quarter’s real GDP rate will probably be around 1.5% at best, following last year’s final quarter pace of 2.4%.

Economic growth was set to slow in our view regardless of weather. Approximately 55 tax preferences expired at year end including full expensing of capital equipment. Emergency jobless benefits expired at year end. The Affordable Care Act’s botched implementation and ill-conceived provisions have hurt job prospects and is looking increasingly expensive. And of course those affected by the 2013 personal income tax increase will soon have to pay the bill. Thus, there is more fiscal drag hitting the economy than many had envisioned without any offsetting improvement in the fundamentals of the economy.

Indeed, inventories rose unintentionally in last year’s second half and are now being worked off. Vehicle sales appear toppy in our view as pent up demand is being satiated with buyers lengthening the maturity of car loans. Housing demand has yet to revive from last summer’s interest rate spike because investor demand is waning and first time buyers are scarce because of stiffening loan requirements, worsening affordability, and mediocre job and income prospects. Business investment is failing to lift off because spending was pushed into 2013 by policy uncertainties; revenues growth remains weak, economic conditions abroad appear iffy; and financing costs have turned up when adjusted for a complete absence of inflation.

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31

The past year was another one of sub-par growth and low inflation, but with a moderate rise in market interest rates. The former may be attributable to continued deleveraging, over regulation, policy uncertainty, and the drag from business and household tax increases. With all these roadblocks, it is a testimony to the economy’s underlying resiliency that it managed respectable growth.

But in the face of sub-par growth and low inflation long term interest rates rose as the Federal Reserve initially created unnecessary uncertainty by failing to adequately explain how it would extract itself from asset purchases. As a result, amidst too low inflation long term interest rates went from negative to positive in inflation-adjusted terms and the interest rate yield curve steepened.

A positive development in 2013 was the seeming end of the global economic emergency. The euro zone began to stabilize by spring and a modest recovery seems to be taking root. Japan has shown signs of life for the first time in over a decade. And China’s economy proved more resilient than many have suspected.

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22

Delayed by the government shutdown, the Commerce Department reported this past week that real GDP grew 2.8% in the summer and that inflation was at a 1.9% rate. A surge of inventory investment boosted growth as final sales rose at only a 2% rate. Consumption and investment were especially weak while residential investment was strong.

Activity in September, the quarter’s final month, was especially soft for final demand and this spilled into October. The back to school selling season failed to materialize for retailers; motor vehicle sales dropped for a second month; and housing demand faltered despite a relapse in mortgage rates. Household demand is continuing to suffer from an absence of income growth. In the third quarter wage and salary income rose by only 0.5%. And in October hourly earnings rose only 2.2% year on year. Thankfully food and energy prices are easing so as to free up what little discretionary income exists.

Given this demand weakness we suspect retailers will be quite cautious in building inventory and in hiring workers for the coming holiday season. Thus, whatever boost inventory investment provided to the third quarter is likely to be taken back in the current quarter. The upshot is that while quarterly patterns can show deviations, the underlying trend of weak growth remains in place.

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27

The Federal Reserve's open market committee is soon to meet amidst widespread expectations that the FOMC will agree to reduce the size of its asset purchase program. The only question seems to be by how much. Consensus expectations are currently for about $10-$20 billion with no guarantee that furthers reductions will occur in the future.

There is no question but that the Fed is seeking a graceful exit strategy from its asset purchase program. Chairman Bernanke was the architect of the program and as he prepares to step aside, he would like to begin winding it down before he leaves. There is also considerable research within the Fed that questions the effectiveness of the program. Additionally many argue that the program has created market distortions. Also, given the degree to which the Federal budget deficit is falling, the Fed's purchases of some $40 billion treasuries per month is drying up the supply of new issuance. Finally, both the financial markets and Wall Street analysts have basically given the Fed the green light to proceed.

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22

At the start of the spring quarter we forecast about a 2.5% rise in nominal GDP with real growth about 1.5% and inflation at about 1% annually. While this forecast was initially viewed as pessimistic it now appears optimistic as nominal GDP appears to be about 2%, evenly split between growth and inflation. Jobs growth accelerated in the quarter but productivity declined. Residential investment continued as a positive for growth, but consumption, capital investment, and government were drags.

We think this same sectoral performance will remain pretty much in place through the second half. Our overall forecast is still for about 2.5% to 3% nominal GDP growth for the second half, which would now actually be an improvement from the first half, but below the Federal Reserve's official forecast. At this stage our view for 2014 is for more of the same.

Two big questions overhang our outlook. The first is the role and impact of government policy. The Affordable Care Act still appears operative for later this year and by all accounts it will boost the aggregate health insurance burden while reducing job growth from what it would have been. Nonetheless, with the timetable for the employer mandate being pushed back, some shift from part-time to full time employment may be a consequence.

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26

Since the beginning of this year global equity markets have risen steadily while sovereign fixed income markets have held roughly steady. This is despite the fact that if anything global economic growth is shaping up as weaker than generally expected while inflation is collapsing worldwide.

The reality of subdued growth and negligible inflation has led global Central Banks to aggressively ease credit, flooding the world with liquidity. We think the out performance of equities reflects this liquidity infusion and a seeming blind faith on the part of investors that central banks will indeed succeed in reviving the global economy. This faith is reflected in consensus economic forecasts which are for a meaningful reacceleration of economic growth in the year's second half.

Whether or not this faith is justified or the piper will be paid with a sharp equity correction and interest rate drop remains to be seen. But no matter the outcome at least one thing seems pretty certain to us and that is that inflation is cooked and commodity markets will continue losing appeal.

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12

Belatedly ECB head Mario Draghi reduced the benchmark interest rate in May and allowed for even more action if needed, including taking the deposit rate below zero and perhaps buying low quality loans directly from European banks. Meanwhile, at its FOMC meeting Federal Reserve officials suggested a flexible approach to its asset purchase program, allowing that it could even increase the size of its purchases if deemed necessary.

Other Central Banks have since followed the lead of the U.S. and Europe with their stimuli of lowering interest rates. And of course the Bank of Japan is sticking with its own aggressive easing program. Equity markets worldwide have been cheering this latest liquidity injection while bond markets hang tough in the face of decreased sovereign debt supply and diminishing inflation expectations.

Why have Central Banks become bolder, especially in the face of an improved labor market in the U.S., evidence of more lenient lending standards among U.S. banks, and even a smattering of some relatively upbeat economic data reports in Asia and Europe? One reason is that labor markets worldwide remain fundamentally weak. While the jobless rate has fallen to 7.5% in the U.S. a portion of this can be attributed to increased part time work and decreased labor force participation. Euro zone unemployment is at a new record high above 13% and in the periphery it is twice this level.

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15

The Federal Reserve has clearly enunciated its guideposts for the beginning of a change in its open ended asset purchase program. A 6.5% jobless rate and a 2.5% inflation rate are the thresholds, and progress toward these goals is captivating the imagination of financial markets. Of the two benchmarks analysts have been intensely focused on the labor market because the jobless rate has fallen more quickly than many including the Federal Reserve had forecast and because trends in jobless claims have been toward improvement.

Focus on the jobless rate is not without caveats, though, of which Federal Reserve officials are well aware. An important reason for the decline in the jobless rate over the past few years has been a downtrend in the labor force participation rate. And if this were to continue the jobless rate could fall without an underlying improvement in the labor market. A shift from full time to part time employment has a similar effect. And this could become important since the Affordable Care Act is giving employers an incentive to adjust hours worked. Meanwhile, in the public sector the sequester is causing workers to be furloughed rather than be dismissed.

The Congressional Budget Office is estimating that approximately 700K jobs will be lost because of the sequester. Furloughs probably make this an overstatement but even if the estimate is half right it will impose an upward bias on jobless claims in coming weeks and a downward bias on payrolls. Meanwhile, the economy's overall momentum may be about to slow as inventory rebuilding is completed. Finally the spring is a seasonally strong period for hiring so any drag on hiring would exaggerate the weakness.

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