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Outlook for the Economy

Special factors hit the economy hard in the first half, but there are fundamental concerns, too.

Robert Johnson, CFA, 06/29/2011

  • The Japan disaster, high gas prices, and poor weather hampered the economy in the first half.
  • Inflation and real wage growth are key fundamental concerns affecting the consumer, which is the main driver of the economy. 
  • Consumers are still holding up reasonably well considering the headwinds they're facing.
  • Data may continue to be soft in the near term, but decent productivity growth, favorable demographics, and an eventual real estate recovery are positive longer-term drivers.

The economy clearly hit a soft spot in the second quarter as a wide range of indicators--including industrial production, retail sales, purchasing manager surveys, auto sales, and various housing metrics--all registered disappointing results.

The data caused me to reduce my full-year GDP growth estimate from 3.5% in my last quarterly report to a range of 2.5% to 3.0%. Inflation for the year is still likely to be around 3%, though that rate is clearly moderating now. I still think monthly private-sector employment growth of 200,000 (or about 2% annualized) remains a real possibility, though the 250,000 number I had hoped for looks like a bit of a stretch. Given a combination of labor force drop-outs and these better employment numbers, I still believe that the unemployment rate can fall below 8.5% by the end of this year.

Slower Economy Leads Investors to More Defensive Stocks
Slowing growth showed up in this quarter's stock data as health care and utilities--heretofore poor performers--were the best performers, as investors flocked to more defensive sectors. Meanwhile commodities and tech stocks, which had led the market, trailed far behind in the quarterly performance derby. The popping of the commodity bubble and a greater fear of risk assets contributed to the underperformance.

Special Factors Hit the Economy Hard, But There Are Fundamental Concerns, Too
The economic slowdown appears to be partially due to several one-time factors that should reverse themselves (earthquakes, tornadoes, and gasoline prices) in the second half. However, some fundamental factors are contributing to the softness as well.

I believe the root cause of the current slowdown in economic growth was a slowing in real hourly wage growth. Given that the consumer represents over 70% of the economy and that consumer incomes come primarily from wages, the hourly wage data can provide important clues about consumer spending capabilities. Real hourly wages began slowing in February and moved into negative territory in May, when computed on a three-month moving average basis. Real hourly wage growth is calculated by taking wage growth and adjusting for the effects of inflation.

 Real Wage Growth Goes Negative
 
YOY Real Wage Growth (%)
3-Month Moving Avg
October 2010
1.00
November 2010
1.00
December 2010
1.00
January 2011
1.10
February 2011
1.00
March 2011
0.70
April 2011
0.20
May 2011
-0.10
Source: BLS, Morningstar

Actual hourly wages before inflation have been stuck in a very narrow range of 2%-2.3% for over a year; meanwhile, inflation has moved from about 1.1% to 2.2%, putting the consumer behind the eight ball.

The good news is that I expect inflation to moderate in the months ahead, which should put the consumer back on top. Gasoline prices have fallen from almost $4 per gallon to around $3.60, a 10% decline in just a matter of weeks (see more on gas prices below). As detailed by our consumer team, food prices are also in the process of peaking. Wholesale crude food prices are off significantly for three months in a row. Auto prices, which have also been a major bugaboo, should begin to back off as the Japanese auto manufacturers bring major chunks of capacity back online over the next several weeks.

Besides the real wage growth issue, which appears as if it could subside, a number of anomalies rocked the economy during the quarter. In fact, it's a bit surprising to me that the economy has held up as well as it has given a surprisingly long list of negatives. The list includes major supply chain issues related to the Japanese earthquake, sky-high gasoline prices resulting from unrest in the Middle East, and weather so chilly and stormy as to disrupt normal seasonal buying patterns.

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