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Our Outlook for the Economy

Even as some fret about Fed actions behind the curtain, the U.S. economy is finding its own strength.

Robert Johnson, CFA, 06/26/2013

--The roots of the U.S. and world economic recoveries go well beyond a loose Federal Reserve.

--Oil, housing, advanced manufacturing, improved balance sheets, and labor flexibility will drive the U.S. economy.

--A weaker China, a tougher Fed, and a tightening U.S. federal fiscal policy will keep a lid on short-term economic activity, but don't be fooled: The long-term fundamentals are strong.

The famous book and movie The Wizard of Oz bears a lot of similarity to the relationship between the U.S. economy and the U.S. Federal Reserve. In the story, the Wizard hides behind a curtain and manipulates a bunch of levers to produce a lot of scary images and sounds that thoroughly frighten the citizens of Oz. The people are convinced of the Wizard's powers, both good and bad, to change their world.

Although the Fed has certainly tried to be transparent about its maneuvers, it indeed still hides behind a curtain and is still thought to be all-powerful. The Fed's behind-the-scenes maneuvers remain less than well understood by the people, who still shake in fear every time the Federal Reserve chairman pulls a lever.

But most interesting to me is the very end of the story, when the great Wizard is discovered to be a mere mortal. When Dorothy and her crew of travelers further press that their wishes be granted, the Wizard makes a critical and stunning revelation. The Cowardly Lion had already developed the courage that he sought during their long journey to Oz. The Tinman had developed a true heart and no longer needed to be granted a heart by an outsider. Finally, the Scarecrow showed guile and wits during their adventure, proving he really didn't need a new brain; he had already developed one on his own without intervention from a scary, unpredictable outsider.

Similarly, the U.S. economy has improved and strengthened during the current recovery. It doesn't need the continued intervention of an outside, modern-day wizard named Ben Bernanke to save the day. The strength and fundamentals were there all along and just needed a nudge.

U.S. Economic Strengths Are Right in Front of Our Faces
Morningstar's quarter-end sector outlooks, which will be published this week, will paint a picture of some real economic and structural gains. The energy sector outlook is subtitled: "The remarkable surge in U.S. crude oil production is a sight to behold." The 30-year decline in oil production ended five year ago, and progress is still continuing, according to our energy team.

Not to spoil the surprise, but oil production has already moved from 6.2 million barrels per day for all of 2012 to a rate of 7.3 million barrels per day halfway through 2013. By 2016, production could hit as much as 8.9 million barrels per day. Oil imports are dropping through the floor. U.S. production now exceeds imports for the first time in decades. And that's just the oil situation; it doesn't include the even better news from the natural gas sector, where production has spiked sharply over the last five years, although that sector could be plateauing.

Our industrials outlook is chock full of good news, too. Auto sales are back over 15 million units per year, up from a meager 9 million sold (and far fewer built) in the dark days of 2009. In fact, the U.S. is now exporting automobiles to some markets that were considered untouchable just a few years ago. And the short-term auto news appears to be getting better, too, with auto sales on target to make a new recovery high of 15.7 million units in June, according to market forecaster LMC.

Housing Growth Driven by a Lot More Than the Fed
The news on housing remains good, too. Although low interest rates have certainly helped housing, it's not the only reason for excitement. Population growth, pent-up demand, and still near-record affordability mean that the best of this story isn't over just yet. In fact, home production is still running at half the levels it was at the peak, and just two thirds of the rate that would be justified by population growth. For all the interest rate doom and gloom, just remember that our last housing boom occurred when mortgage rates were in the 6%-8% range. Thirty-year mortgage rates have moved up from the mid-3% range to over 4%, and could end up over 5% before all is said and done. But with rates at 16% when I finished grad school more than 30 years ago, a move back to 5% doesn't seem all that scary.

Boeing: A Sign of Strengths and Weaknesses of U.S. Manufacturing Ingenuity
And then there is Boeing BA. The industrial team outlook details accelerating growth rates, sales forecasts, and fair values for the aerospace giant. Because of the industry's size and complexity, Boeing is one of only two major airliner manufacturers. The Boeing story partially reveals what is right about the economy. Boeing took some major league chances in developing its latest generation of aircraft. It didn't have to--and indeed it has paid a price in the short run with a three-year production delay followed by battery issues that grounded the 787 for a couple of months.

However, longer term its new composite material and battery technologies will create major new industries and lead to innovation in a lot of other sectors. So much for U.S. manufacturing losing its mojo. I am now reading that other industries, including engine manufacturers, are considering--and spending real cash on--developing products using more lightweight composite materials.

The Health-Care Cost Curve Has Been Bent
Although our health-care team is a bit ambivalent about it, they do note that the health-care price curve has been bent--at least a little and at least temporarily.

Due largely to the expiration of a lot of patents and the inflow of competing generics, costs among the overall medical products and drug category of the consumer price index were unchanged not just for one month, but the course of a full year. New higher deductibles and co-pays are making consumers tougher shoppers for many other medical products and services, too. While some of these positives may erode slightly in the years ahead, even short-term good news is something no one really saw coming. The effect of slowing medical care inflation rates is large enough that it was cited as one of the contributors to the massive improvement in the U.S. federal budget deficit outlook, published in April.

Consumer Debts Take a Plunge
In addition to these sector fundamentals, I would also point to a greatly improved, less-debt-ridden consumer balance sheet, markedly improved manufacturing productivity, a sounder banking sector, and tremendous labor flexibility as real signs of economic improvement.

While not exactly miserly, consumer debt as a percentage of income has fallen from 140% to 112% between 2008 and 2013 after spending years in an upward trajectory. This is a real, not imaginary, improvement. Total consumer debt is down almost a trillion dollars on a base of $14 trillion of debt.

Speaking of debt, even the federal government's annual deficit has been cut back by more than half already, and within a year it will potentially be back at pre-recession levels. The deficit calculated as a percentage of GDP is currently projected to fall back to 2% by fiscal year 2015 after reaching a recession high of 10%, and compared to a fiscal 2013 estimated level of just about 4%.

Manufacturing Improvement Is Notable
Manufacturing is often much maligned in the U.S., but the progress continues to be real. I often cite the auto industry as an example of the tremendous gains being made in the manufacturing sector. Auto sales and production are now running at over 90% of the pre-recession highs recorded in 2005. Yet the number of workers employed directly by the auto industry is currently running at just above 70% of its highs, also recorded in 2005. And it's not just the auto industry. Since the recovery began (roughly three years ago for the sector) manufacturing-based industrial production is up about 20% while employment is up only 5%. These huge productivity gains mean that more manufacturing jobs can stay here. Unlike the past three recessions, manufacturing employment is moving up instead of continuing in a secular decline.

Labor Flexibility a Hidden Strength
Labor flexibility also continues to be a real economic strength. One industry that exemplifies that flexibility is nursing. Census data through 2011 indicate that the proportion of men working as nurses moved from 2.7% in 1970 to 9.6% in 2011. Many of these new nurses were formerly construction or factory workers. Furthermore, nursing school enrollment data suggest that male nursing students now account for 13% of all nursing students. This type of flexibility is unheard of in a lot of other economies. These jobs, while perhaps not paying as much as construction work, are good jobs with real benefits that pay well above the minimum wage.

U.S. Banking System a Pillar of at Least Relative Strength
Finally the U.S. banking system is much better off than it was in 2008. The Federal Reserve's and Treasury Department's strong actions to recapitalize and stress-test banks in 2009 have put the U.S. banking system in better shape than banks in both the East and West. Europe has yet to come fully to grips with bank issues that date back to before the recession. Cross ownership and government involvement have greatly complicated Europe's bank restructuring efforts, which have been worsened by even deeper bank issues in Europe's southern reaches. And China's banking system is no paragon of virtue, as more problems continue to creep up. Conversely, Fed Chairman Bernanke took time out of a recent press release to note that most major U.S. banks could already meet strict Basel III capital standards, a statement that few of his world banking colleagues could make.

To those who say the U.S. economy is on artificial steroids or at least a sugar high, and that is the sole reason for rising markets and an improved economy, I say balderdash. The advancements are real and hard-earned. These certainly have not been good times for workers and managers alike. But to confuse hard work, innovation, sacrifices, and thriftiness with a drug problem does all of the U.S., and even the world economy, a huge disservice.

Despite Some Real Underlying Strengths, There Are Short-Term Hurdles
This is not to say everything is perfect in the short run. The growth rates of the economy, consumption, and employment remain solid, but slow at around 2%, which will still leave employment below peak levels for at least another year. Additionally, the Congressional Budget Office notes the overall economy is still operating more than 5% below its potential, remaining near record-high underutilization.

Furthermore, some of the engines of the economy are taking a pause, and although new sectors are slowly beginning to make up the difference, the offset may not be fast enough. One such slowing sector is exports, which are now being hit hard by a slowing world economy. Many of the quarterly outlooks speak to real weaknesses in both Europe and China (paper and chemicals are two groups singled out for particular weakness). While slowing exports won't kill the recovery, it will slow the rate of growth.

I never thought I would say the words, but overly tight government fiscal policy is also slowing economic growth. Hopefully, some of those pressures will ebb by year-end as the worst of federal tightening passes and state and local governments take up some of the slack.

The Big Bad Fed Is Not the Only Game in Town
The Fed putting the world on notice that free money won't last forever certainly isn't helping matters, and its timing clearly wasn't wonderful. Rates will likely continue to move higher, hurting potential borrowers, helping savers, and moving others off the fence in order to make home and business purchases and investments before it's too late. So the longer-term impact of higher rates isn't as clear as many naysayers believe.

Although one never wants to underestimate the Fed, it's important to note that the size of the Federal Reserve balance sheet relative to the worldwide bond market isn't as large as many would have you believe. While the Fed is a large and influential player, its total balance sheet is just around $3.4 trillion out of a worldwide $80 trillion bond market. Even in the mortgage market, where it is most influential, it accounts for approximately $2 trillion of about $10 trillion of residential mortgages outstanding in the U.S. That's big, but not at the levels of a company town with just one bank. And compared with consumers' net worth of $70 trillion, the Fed looks positively tiny.

The Road Ahead Is Rocky, But Moving in the Right Direction
All things considered, the markets could be rocky over the next few months, as the world adapts to the new Fed regime and slower growth in China. However, this is not 2008 all over again. Fundamentals are far stronger than they were five years ago, and there are far fewer apparent bubbles. I expect the underlying economic strengths to shine through the fog, perhaps as early as this fall.

More Quarter-End Outlook Reports

And stay tuned Friday for Morningstar analysts' take on the big themes and best opportunities in:

  • Health Care
  • Industrials
  • Tech & Communication Services
  • Utilities

 

Robert Johnson, CFA, is director of economic analysis with Morningstar.

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