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Market Update -- Economic Chartbook

August 27, 2010

Written by Jane Caron, CFA, Chief Economic Strategist

Economic Outlook:

• The old economics adage—one bad data point is an outlier, two are a coincidence and three are a trend—has forced economists across the board to downgrade their GDP forecasts for the second half of 2010 and 2011. We joined our brethren and cut our 2010 GDP forecast to 2.7% from 3% and our 2011 forecast to 2.2% from 2.5%.
• The recovery was developing nicely in our opinion until a series of mini-shocks caused market participants to retrench. Importantly, the economy has the necessary ingredients—strong corporate cash flows; adequate household income; low interest rates; improving credit access; improved balance sheets; and plenty of pent-up demand—to expand at a 3% or faster pace. The missing leavening ingredient is confidence.
  
• Real consumption growth increased at a modest 2% annualized rate during the first half of 2010, and it appears to be on track to rise by a 1.5–2% rate during the second half of the year. To get consumers to loosen their purse strings, employment growth will have to improve. Indeed, employment growth is the elixir that will treat all economic ills.
  
• The problem is that potential employers with the wherewithal to increase hiring are too uncertain about future developments to do so, while other employers willing to take the risk have limited or no access to credit. The Fed is seeking to address the credit problem, but Congress is exacerbating the confidence problem by failing to provide clarity about future regulatory and taxation policies.
  
• Subpar employment growth is likely to leave the unemployment rate elevated this year and next, and we envision that it will still be above 8.5% by the end of 2011. Thus, job creation will remain a political hot button and could result in additional, job-related stimulus despite newly discovered fiscal rectitude.
• The federal budget deficit is likely to be near 9% of GDP this year, and it could still be near 6% of GDP by 2012. While we believe Congress will need to seriously address the structural budget problem, it must be careful about how and when it does this. Destroying the recovery by tightening prematurely will only exacerbate the problem. We would like to see most of the Bush tax cuts and the make-work-pay tax credit extended. We believe any fiscal easing, however, must be accompanied by realistic plans for future deficit control. A tall order!
  
• The Fed is currently debating the pros and cons of providing additional stimulus should it be warranted. The FOMC recently decided to prevent a passive tightening of monetary policy by reinvesting proceeds from agency-related bonds into Treasuries. This action caused Treasury prices to rally strongly because of previous schooling that it pays to buy what the Fed is buying and because investors expanded their horizon for expected stability in the funds rate.
  
• The ultimate direction of bond yields, however, will be driven by the inflation outlook. Currently, Treasuries are priced for significant disinflation. We believe significant disinflation from here is unlikely barring a double dip. Should the economy appear to be headed for that dreaded outcome and debt-deflation is in tow, then it will be no holds barred for the Fed and Congress given how costly debt deflation would be for our economy.
  

• Second-quarter real GDP growth was revised down to 1.6% from 2.4%. The downward revision reflected a larger drag from net exports and a smaller boost from inventory accumulation than previously realized. Net exports pulled 3.4 percentage points from overall GDP growth, an unusually large outcome.
• Final domestic demand (excludes inventories and net exports) was revised up to 4.3% from 4.1%. This reflected a large upward revision to consumption to 2% from 1.6% and a small increase in investment spending 19.5% from 19.1%.
• Dwight view: The recovery was developing very well until a series of mini-shocks—health care and financial reform; the surge in European sovereign credit risk; Goldman's SEC lawsuit; BP's rig disaster and the threat of tax hikes—encouraged market participants to retrench. Sluggish activity and fragile confidence leaves the economy vulnerable to additional shocks. Public authorities should seek to restore confidence.

• The economy has most of the necessary ingredients—strong corporate cash flows; adequate household income; low interest rates; improving credit access; improved household balance sheets; and plenty of pent-up demand—to expand at a 3% or faster pace. The missing leavening ingredient is confidence.
• Extensive media hype that the economy is on the verge of a double-dip has helped bring about a self-fulfilling prophecy of slower economic activity. We believe the recovery will be sustained as long as the labor market continues to expand.
• Dwight view: We have revised our 2010 GDP forecast down to 2.7% from 3%, and our 2011 GDP forecast to 2.2% from 2.5%. Factors behind our forecast revision include: the tepid pace of employment growth; increased uncertainty about fiscal policy; and the sudden reluctance of economic participants to spend and invest.

• Generating increased labor income is the key to not only a sustained recovery but also a successful transition from public assistance to independent living. Growth in private aggregate hours bodes well for an eventual transition to a self-sustaining recovery, but the pace is too slow to pull this off in the near term.
• In July, nonfarm payrolls decreased by 131,000, but this figure was depressed by the firing of 143,000 temporary census workers. Private payrolls increased by a tepid 71,000, a better showing than the June increase but quite weak relative to March and April gains. Early forecasts for August assume private payrolls will rise by just 50,000.
• Dwight view: We are cutting our 2010 nonfarm payroll growth forecast to 1% from 1.5%, and maintaining our 2011 forecast of 1.5%. Business managers have defied our expectation that stronger earnings growth would boost hiring. Our new forecast expects nonfarm payrolls to rise by an average of 100,000 jobs per month in 2010.

• The unemployment rate held steady at 9.5% in July. The story here is depressing; the labor force has shrunk by 1.2 million people in the last three months, while household employment has fallen by a half a million.
• A significant impediment to reducing the unemployment rate is the fact that small business formation and expansion is being stifled by the lack of credit creation and uncertainty about taxation, regulation, and final demand. Small businesses usually account for more than half of new hiring during labor market recoveries.
• Dwight view: We expect the unemployment rate to end 2010 between 9.5% and 10%. By the end of 2011, it will probably still be above 8.5%. High unemployment will continue to be a major political topic and could result in additional, job-related stimulus despite newly discovered fiscal rectitude.

• Disposable income growth is sufficient to support nominal consumption growth of roughly 4%, but consumers are very hesitant to increase spending absent increased confidence in the labor market and general economy.
• Consumers retrenched in May and June, but they peaked out of their bunkers in July. Media-spread prophecies of an impending double dip has probably factored into weakness in consumer spending. We do not agree with such prophecies, but consumers are correct to be concerned about high unemployment and large public budget deficits.
• Dwight view: Consumers are currently focused on paying down debt and rebuilding their savings. This is a healthy development, and it should eventually lead to sufficient pent-up demand to push consumption growth notably higher. For now, we expect real consumption growth to average about 2%.

• Recent revisions to personal income and consumption data revealed that the personal saving rate reached a 2009 peak of 8.2%, nearly two points higher than previously realized. From this high, the saving rate declined to 5.1% before it rebounded to the current 5.9%.
• The most important driver of the saving rate over the long term is household wealth. Not surprisingly, the recent stock market correction has boosted the saving rate.
• Dwight view: We are assuming that financial and real estate asset values will remain relatively stable in our GDP forecast. Weakness here would obviously hamper the recovery, while strength would brighten the outlook. One should not underestimate the very large impact that financial conditions can have on the real economy.

• The overall trend in core durables goods orders and shipments continues to point to healthy growth in capital goods spending, but we need to watch these data closely because the July data were surprisingly weak. We hope the July report will prove to be an outlier.
• During the second quarter, capex spending on equipment and software increased at a blistering 25% pace following a 20% rate in the first quarter and a 15% rate during the final quarter of 2009. Third-quarter spending will probably be up marginally while this sector catches its breath.
• Dwight view: Capex has added an average of 1.2 percentage points to GDP growth over the last three quarters compared to just 1.1 points for the consumer sector. Not bad for a sector that is only one tenth the size of the consumer sector.

• Outsized gain in capital goods spending is not unusual at this point in the cycle, but the cycle could last longer than usual given the extent that capacity has shrunk and continues to shrink.
• Industrial capacity was flat in July following 21 consecutive monthly declines. In July, capacity was 0.7% below its year ago level, which was 0.7% below the prior year's level.
• Dwight view: Corporate earnings growth has been robust and companies are flush with cash. This financial backdrop, combined with shrinking capacity, augers well for continued strong capex spending. We expect capital goods spending to increase by about 13% in 2010 and 9% in 2011.

• The housing market, being the epicenter of the crisis, has received massive public support. We are currently in a pay-back period following a policy-induced jump in housing demand.
• Mortgage rates have been hitting record lows in recent weeks, and banks have started to ease their restrictions on lending. Potential homebuyers, however, remain reluctant to sign on the dotted line because of economic uncertainty. The new housing sector has been further depressed by very low inventories and less attractive pricing.
• Dwight view: Barring renewed confidence in the economy or a new policy incentive, it is doubtful that sales will rise materially anytime soon. This is not a major risk for the economy as long as house prices decline only modestly. Risks are currently pointed toward a larger decline unless banks can successfully manage the pace that foreclosed homes are liquidated.

• Single-family housing starts fell 4.2% in July, marking the third consecutive monthly decline. Single-family starts are now at their lowest level in a year and not far from their January 2009 low, which was the lowest level on record dating back to 1959.
• Housing completions and the number of homes under construction are at record lows, so there is a negligible flow of new supply into the housing market from new construction. The ongoing flow of foreclosed existing homes, however, will keep the overall level of inventories elevated for quite some time and weigh on house prices.
• Dwight view: Residential investment is now just 2.5% of GDP, so it is quite unlikely that this sector will appreciably shrink from here. This reduces the risk of a double-dip recession, but it also makes it unlikely that the housing sector will materially add to economic growth anytime soon.

• Volatile headline inflation and declining core inflation have not disrupted surveyed inflation expectations; they have remained remarkably steady. As long as this is the case, it is unlikely that the economy will experience a pernicious bout with deflation.
• The core CPI was up about 1% from a year ago during the second quarter, while the core PCE deflator was up about 1.5%. The divergence between the two core consumer inflation measures is mostly a result of the much higher weighting of shelter costs in the core CPI.
• Dwight view: After falling sharply during the first quarter, shelter prices have increased during the last four months. This bodes well for a mostly sideways trend in the core CPI. While the Fed would prefer to see both measures of core inflation above 1.5%, they are probably relieved to see the disinflation trend easing.

• Deflation is often characterized by a negative wage-price spiral. Thus, falling unit labor costs do not bode well for maintaining positive inflation. Most economists (ourselves included) expect unit labor costs to become positive again by 2011, but the output gap is likely to remain quite large through 2012.
• Deflation can also be caused by cash hoarding or a general decrease in the velocity of money, particularly as bank credit is reduced. These conditions are currently prevalent and are reasons for concern.
• Dwight view: While inflation fundamentals are disheartening, we do not believe deflation is a likely outcome in the short run barring a large and sustained decline in inflation expectations. We expect core inflation will trend sideways this year before rising somewhat in 2011. Importantly, consumers and business managers still expect the general economy to produce inflation, and they are not materially changing their buying habits because of expected price changes.

• The Fed's liquidity programs relieved market logjams, while its large-scale bond purchase program resulted in lower lending rates, particularly for mortgages. Also important is the fact that Fed actions helped restore confidence.
• The Fed's job has become appreciably harder. Lower interest rates are providing only a limited boost to the economy, and many market participants are wondering if the Fed is pushing on a string. The Fed's recent decision to reinvest the proceeds of mortgage bonds into Treasury notes succeeded in bringing down long-term interest rates, but the stock market was roiled by fears about deteriorating fundamentals.
• Dwight view: We believe the biggest impediment to economic growth is confidence and uncertainty. We think it behooves policymakers to address this shortfall. We do not expect the Fed to engage in QE II unless it becomes clear that the economy is in danger of growing by less than 2% in 2011.

• Treasury yields are being pulled lower by safe-haven demand and a sharp reduction in implied probabilities for Fed tightening in 2010 and 2011. Investors now place less than 50% odds that the funds rate is increased by even 25 basis points in 2011.
• Lower Treasury yields have pulled down borrowing rates, and you can now get a conforming, 30-year mortgage for roughly 4.5% if you put 20% down and qualify as a good credit. Corporate and consumer borrowing rates are also low.
• Dwight view: Domestic economic fundamentals warrant higher Treasury yields, but safe-haven demand from retail and institutional investors, steady demand from central and private banks, and little competition from private issuance has helped to sustain a bid for Treasury bonds. These low yields will help ensure the sustainability of the recovery as long as animal spirits remain lit.

• The federal budget deficit is expected to be near 9% of GDP this year, and the Bloomberg consensus forecast indicates that it will still be 6% of GDP in 2012. The CBO expects the deficit to slow to 4.2% of GDP by 2012, but their estimate assumes that all tax cuts and spending plans expire as scheduled and the AMT is not patched.
• The CBO also projects that government outlays will remain well above the historical average, and revenues will rise to levels well above the historical average assuming current laws are not altered.
• Dwight view: While Congress clearly needs to address their structural budget problem, they must be careful about when and how they do this. Destroying the recovery by tightening prematurely will only exacerbate the problem. We believe any fiscal easing today must be accompanied by realistic plans for future deficit control.

• The CBO projects that the interest expense will reach 3% of GDP by 2017. If the interest expense is 3%, then the government will need to run a primary surplus of 3% of GDP to balance the budget. The government could potentially raise a little over 2% of GDP by getting rid of all the special tax deductions, but these deductions are popular.
• The White House is determined to raise taxes on the rich, but Goldman Sachs' research points out that the marginal tax rate would have to increase by nearly 40 percentage points on the top two tax brackets to generate 2% of GDP in revenues. Moreover, Goldman Sachs is assuming no change in behavior in their estimate.
• Dwight view: The President's fiscal commission will report its recommendations on December 1. The assignment is to determine how best to balance the primary federal deficit by 2015. We expect the commission to recommend a combination of expenditure cuts and tax increases. We doubt, however, that Congress will be willing to act on these recommendations in the near term.

This information reflects the viewpoint of Dwight Asset Management Company LLC as of August 27, 2010, and is subject to change. This report is provided for informational purposes only.