Economic Commentaries

26

Recent Economic Commentaries noted that the third calendar quarter's rise in business activity would top expectations, but that it would not be sustained. In fact, upon revision real GDP growth was pushed up from 2% to 2.7% annually. This was primarily due to outsized increases in public spending and private sector inventory investment. In coming months as these excesses are corrected, they will join with fundamental weaknesses in consumption and investment to push down the growth rate of overall business activity.

Super storm Sandy and worries over potential tax law changes and public sequestration threats make it difficult to decipher the economy's true course. But when the economy is operating at stall speed, which is where it has been, there is little margin for error. Indeed, we think real GDP growth could fall below 1% annually in the current quarter and remain at this rate into next year.

Consumption and investment trends are concerning. Overall spending fell in September; retail sales were weak in October; and chain store sales were poor in November despite an early start to the holiday shopping season. The storm bears some responsibility, and some recovery in spending should soon begin in its aftermath. But aside from the storm inflation adjusted income growth has declined in recent months and the household saving rate has declined to a depressed 3.4% in November despite weak spending patterns. Cash infusions from mortgage refinancing are slowing as well although some offset should accrue from big year end dividend payments and capital gains realizations.

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Posted in: General
15

Economic activity continues to flounder worldwide. Europe is in a recession and Asia, particularly Japan and Chine, is bordering on recession. While we think the U.S. will continue to skirt an actual downturn, the odds of avoiding one are continuing to shrink in our view. For now though, we expect real GDP growth in the second half to come in at about 1%-1.5% annually.

Despite the proximity of the election and the Federal Reserve's traditional reluctance to enter the political fray, the Fed acted decisively at its last meeting by extending its extended period language of low rates while also implementing a new open ended bond buying program. If nothing else this is testimony to the Fed's concern that the U.S. and the global economy is unhealthy, a concern that is being echoed by Central Banks worldwide.

With the Fed having acted, focus will now turn to the Presidential election and the looming fiscal cliff. The general consensus is that there will be some compromise to extend current law and modify spending cuts until a lasting formulation for fiscal discipline can be negotiated by the new President and Congress.

The consensus forecast for economic activity is for a reacceleration of growth and profits in 2013 premised on a fiscal compromise and the recent actions of the Federal Reserve. We hope this materializes but we have major doubts. Indeed, extracting from the fiscal cliff there could well be about $200-$300 billion of fiscal drag hitting the economy in the new year. Both the payroll tax cut and emergency jobless benefits are set to expire at year end, and there does not appear to be any appetite to extend them. Additionally high income earners will be hit with a 3.8% tax on investment income, a 0.9% tax on wage and salary income, and a Medicare surtax to pay for the health care law.

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Posted in: General
06

In recent weeks we revised our range for GDP growth from 1.5%-2.0% to 1% - 2% annually. It appears that growth in the spring quarter will be at the lower end of this range. We always thought the earlier consensus expectation of 2% -2.5% growth was too optimistic, and similarly we think a recession forecast at this juncture is too premature. However, in our view the risks continue to be on the downside and the prospect of an outright decline in business activity is a toss-up.

Guarded optimism is warranted for three reasons in our view. First, it appears that a nascent recovery in residential construction is building some momentum. Homebuilder confidence rose sharply in June as did buyer traffic. And this was during a month when the weather was very hot and consumer confidence was very cold.

Affordability, evidence of home price stability, rising rents, and an improving supply-demand balance are key drivers. Housing starts rose nicely in the spring quarter and residential construction is becoming a key contributor to the paltry economic growth that exists. In line with this, while June was the weakest month of the spring quarter for the overall economy, real earnings actually rose. This was because of declining inflation and not wage increases, but you take whatever you can get. The rise in real earnings was complemented by a rise in the saving rate, so the hope is that these can buffer consumption in coming months. Maybe the back to school selling season will be better than expected.

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Posted in: General
29

In our Economic Commentary dated May 8, 2011 we warned that budget discipline is a two edged sword. However laudable deficit reduction may be in the long run, the short term fiscal drag effect on the macro economy can not be minimized. This why we have consistently said that there is no easy way out of the fiscal mess in which we find ourselves.

The two edged sword is evident in the most recent GDP report wherein the economy's 2.2% growth rate was held back by a 3% contraction in government outlays. This reflected reduced defense outlays as well as a 6.4% drop in public construction over the past six months. It also shows up in employment where public sector job losses amount to 600K workers over the past year. Outside this country the U.K.'s drive for budget discipline has resulted in a double dip recession. And in the periphery of Europe the drive for budget austerity is resulting in depression like conditions.

So far there is a lot of pain and no gain. Indeed, there is as yet no sign of an improvement in economic circumstances in Europe. And in this country if our forecast of 1.5% to 2% GDP growth for the remainder of this year is realized, employment growth will slow, household and business angst will rise, the budget deficit will worsen, and the nation's debt ceiling will be exceeded. Is there any good news in all this bad news? In the short rum economic lethargy and over-production is beginning to weigh on commodity prices and inflation. Weakening energy and food prices will relieve some of the downward pressure on disposable that is being wrought by the continued absence of wage growth. This will hopefully enable households to rebuild depleted savings without inordinate pain. Additionally there is increasing attention to Bernanke's fiscal cliff and our fiscal train wreck such that perhaps Washington's nitwits may be forced to address the issue sooner rather than later.

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Posted in: General
15

Economic growth was at a 3% annual rate late last year, but it slowed to about a 2% rate in this year's first quarter. What's more, the economy's momentum seems to have flagged as the quarter progressed. Home sales were relatively weak in February and durables manufacturers could not recoup orders that were lost in January. Regional purchasing managers indexes were uniformly weaker than generally expected in March. And for many regions activity growth slowed relative to February. Finally, the downward momentum that jobless claims had established leveled in March.

This record is consistent with our view in that we have thought activity was being artificially boosted by this year's non-winter winter, and that there would be a spring-time pay back. The degree of pay back may now be very dependent on price trends for necessities, particularly gasoline. Prices are already at a level that is negatively affecting behavior. IF the gasoline price remains at this level or rises further, consumer spending will be adversely affected. Indeed, this would be beyond the negative headwinds emanating from high debt, low savings, depressed home prices, and weak wage growth.

Conditions are not positive elsewhere in the world. Europe is clearly in recession, and now sovereign debt issues are creeping back into financial markets. China's economy is slowing at best, and this is beginning to weigh on commodity exporters like Australia, Europe, and Japan. Meanwhile, Japanese consumers are facing a sales tax increase this spring just as the economy is emerging from recession. For those with a bad memory, the last time this was tried was in the mid 1990s and it smothered an emerging recovery in Japan.

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Posted in: General
24

In late 2009 we conducted an in-depth study of the fiscal condition of the United States. We found it rather terrifying and we concluded that the country was about to end an era of twelve digit budget deficits (multi billions) and begin an era of thirteen digit budget deficits (trillions). The consequences of this would be to severely limit the government's options to fight the business cycle and ultimately to severely constrain its preeminence as a world power.

Since that analysis the U.S. economy has embarked on an economic recovery that has been sub-par by the standards of post World War II business cycles. Indeed growth was only about 2% in 2010-2011 and worse, nominal growth was below 4%. To some observers this record is akin to a depression, exposing the impotence of monetary and fiscal policy to revive the economy. To others it is a failure of fiscal stimulus to be sufficiently large to lift the economy out of its funk.

In either case the result is that through 2012 the federal government will have run a fourth consecutive year in which the budget deficit exceeds $1 trillion. In this period federal spending has climbed to roughly 25% of GDP versus its post war norm of about 20%. Federal revenue has fallen to about 15% of GDP versus its post war norm of about 18%. Despite this dismal record a recent CBS/N.Y. Times poll showed a drop in those surveyed expressing a concern about the federal budget deficit. Nevertheless the deficit is commanding the attention of aspirants for the Republican nomination, castigating its size and the recklessness of federal spending. So the budget deficit will undoubtedly be a topic for debate in the approaching election campaign. But in the meanwhile the President has seemingly responded to the most recent polls by offering a budget for fiscal 2013 and beyond that does little to address the structural ills that are imperiling the U.S. fiscal condition.

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Posted in: General
21

With an eye toward fiscal discipline, last year the President formed a bi-partisan deficit reduction commission. Last December the commission presented a broad outline to achieve fiscal discipline, with its centerpiece being broad based tax reform that would enhance revenue, and large scale spending restraint. Aside from the usual partisan attacks a major criticism that was leveled at the commission report was that it sidestepped recommendations to confront the rising cost of health care. And it postponed tough decisions on the entitlements of Social Security and Medicare to beyond 2040. Two members of the commission namely Congressman and House Budget Chair Paul Ryan and Democrat Alice Rivlin followed up on the fiscal commission’s report by tackling both health care and entitlements.

The fiscal 2011 deficit will exceed $1.5 trillion and the President’s budget forecasts another year of a thirteen digit deficit in 2012 after which the deficit path declines as shown in the accompanying table. The two documents named above provided a template for debate and action, but the President’s budget document essentially ignored their recommendations. The President’s budget does not offer any tax reform. On the contrary it assumes an increase in taxes on the highest income earners beginning in 2013 when the recent lame duck Congress’ extension of the Bush era tax rates are set to expire.

On the expenditure side the President’s budget trims defense and non-security discretionary spending from the high base line established in 2010-2011. Thus, federal spending would decline from over 25% of GDP to about 23% in 2012. It then stabilizes in this area until 2016 when it begins rising again. Meanwhile, interest on the federal debt is forecast to rise from about 1.5% of GDP to about 3.5% of GDP by 2020. As a percent of GDP publicly held debt would climb to nearly 80% of GDP by late this decade.

These future costs may seem daunting, but just as important as the result are the assumptions on which they are derived. The budget assumes that the decade is free of business recessions. Economic growth is forecast to exceed 4% per year in the 2012-2104 period despite presumed tax increases. It also assumes that inflation adjusted wages and salaries will rise by about 4% per year even while joblessness remains high. After 2015 growth averages nearly 3% per year. The budget assumes that interest rates on the ten year Treasury note remain low. Finally, and perhaps in a nod to those who argue that excessive debt eventually eats into national security and thus affects a country’s standing in the world, the budget projects that defense falls to only 2.7% of GDP by 2021 or less than half the post World War II peacetime rate.

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Posted in: General
09

Any period’s valuation of equities is determined by corporate profits and the multiple the market is willing to place on those profits. Macro economists typically take a top down approach to estimating profits. Determinants are typically GDP, labor cost, and inflation. Market strategists typically adopt a bottom up estimate of profits by aggregating views of industry analysts.

A much less precise exercise is involved in determining the market multiple. Assumptions of the multiple for any given year typically relate to the position of the market relative to the business cycle. Other inputs tend toward a dividend/discount model, interest rate assumptions, and the degree to which investors are under or over exposed to equities.

In this note we take a more rigorous approach toward estimating the market’s multiple. There is more than 50 years of data on the price to earnings multiple of the S&P 500. The S&P 500 is widely regarded as the best single gauge of the large capitalization U.S. equities market since the index was first published in 1957. The index includes 500 leading companies in leading industries of the U.S. economy, capturing 75% coverage of U.S. equities. Published data on the earnings of the S&P 500 are available from 1960 forward.

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Posted in: General
30

The government reported that real GDP rose at a 3.2% annual rate in last year’s final quarter while final demand was a much faster 7.1% rate. Consumer spending and a narrower trade deficit paced the advance, while business investment growth slowed and government outlays contracted, particularly at the state and local level. For the full year real GDP growth was 2.9%; inflation was 1.3%; and the jobless rate averaged 9.6%.

For the current year analysts are more upbeat in suggesting faster economic growth, but only halting progress in reducing joblessness. The Federal Reserve is continuing to do its level best to support this outcome and make it even better. At this past week’s FOMC meeting the Federal Reserve acknowledged that the economic climate is showing some improvement, but that low inflation and unacceptably high unemployment will cause it to remain very accommodative for an extended period. Analysts typically interpret extended period to mean at least six months. We interpret it to mean considerably longer.

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Posted in: General
19

2010 was the year of the Federal Reserve as the Chairman appeared on the air waves, undertook massive unconventional asset purchases, and stirred emotions of supporters and detractors. We think 2011 will be the year of the government as budgets at the federal, state, and local levels will stir acrimonious debate.

It is important to remember that while the agreement to extend current tax rates removes a cloud of uncertainty for a few years, it does not represent new economic stimulus. Moreover, while the payroll tax holiday and full cash expensing for business equipment is new stimulus, they are temporary as both extend for only one year. Meanwhile, a portion of the payroll tax holiday is offset by the expiration of the Making Work Pay credit from the prior stimulus program. And other stimuli from the 2009 “Recovery Act” fade away in the coming year.

On balance we calculate only about $60-$90 billion of net new stimulus from this agreement in 2011 which is a lot less than government provided in 2010. The economy will thus be more dependent on private sector growth going forward. And within the private sector demand will be all important as the inventory cycle is mature and will provide less punch to the production process.

Upon examining the condition of the private sector there are both positives and negatives. Household finances are in better shape than at any time in the past two years. The saving rate is up; debt relative to income is down somewhat; and wealth has recovered somewhat with improving equity markets. Corporate balance sheets are in great shape, and full cash expensing in 2011 should provide some boost to capital spending. Meanwhile, financial institutions are seeing fewer loan delinquencies and they are beginning to expand credit. Finally, even though China and selected emerging economies are snugging credit, economic growth should remain firm.

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Posted in: General
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