Wed, 22 Feb 2012
Take Europe and China off your big worry list and focus instead on the consumer and inflation, says Morningstar's Bob Johnson.
Jason Stipp: I'm Jason Stipp for Morningstar.
With the mountains of economic data available to investors, it's sometimes hard to know what to focus on.
Morningstar's director of economic analysis, Bob Johnson, has a few ideas on what's important to pay attention to right now and what might not be so important for the economy today. He's here with me to share those. Bob, thanks for joining me.
Bob Johnson: Great to be here.
Stipp: So, let's get the things you maybe don't need to pay so much attention to out of the way. And that doesn't mean that these aren't important at certain points of the cycle ...
Stipp: ... But right now, there are some things that really will be guiding where the economy goes and some things less so. The first one might be somewhat of a surprise to folks, but manufacturing, you say, is less important to look at right now. Why is that?
Johnson: Manufacturing tends to go up and down with inventory cycles and a little bit with end-user demand. So, at the beginning of a recovery, when inventories are remarkably low, even though manufacturing is a relatively small part of the economy, it has an outsized effect, a huge effect, on the economy.
Then, as the economy picks up steam, [the manufacturing sector] tends to overshoot, and then they've got it cut back, and then they overshoot again, and it's not end demand so much as inventory adjustments that are driving things. So I tend not to pay attention to manufacturers at this part of the cycle.
Stipp: And so that would include reports like PMI, for example. You get some of that noise of the inventory in there, and can't necessarily take it as a cue that the economy is going to go down or the economy is going to go up.
Johnson: Well, that's important to mention. Everybody is focused on the PMIs and the latest thing is ... the one in Europe, the one in China, it's 49.7 instead of the 49.8 that we are all hoping for, and everybody gets [worried because] it's below 50.
But again, those are all kind of made up numbers, and they are all within almost rounding errors. People are paying attention to these numbers like they think they're cast in concrete, but [the PMI reports] are asking a bunch of people, are things up or down? And it makes no attempt to weight whether it's up a lot or up a little, and everybody keeps talking about this magic 50. The magic number is not 50, which would literally be half [of respondents] saying up and half saying down. The magic number is really something in the mid-40s, because there are a lot of businesses in the cycles that actually normally have down sales--think of telephones and certain grades of paper. Those are things that are just naturally declining. So, the baseline case for a growing economy is about 45, not 50.
Stipp: So, it's important to keep that in the proper context and perspective. Another couple of things you say not to pay too much attention to right now, I found surprising--Europe and China. It seems like they are dominating the headlines right now.
Stipp: Let's start with Europe. Why would you say, don't place too much of your attention on Europe?
Johnson: We export very, very little to Europe. It represents about 3% of our GDP, and some of that goes to more of the stronger economies and some of that's related to food, and so it's clearly things that aren't going down. So, it really makes a very small difference to our U.S. economy for things that are shipped from the United States over to Europe, tiny.
Stipp: Is there a fat tail possibility, though, that if Europe completely falls to pieces that we see some kind of contagion effect in the financial system that actually could fundamentally affect our economy if we see a really worst-case scenario over there?
Johnson: I think that's certainly something that's out there, and I have said many times, I think there is maybe a 10% probability of having that, and that is something you have to think about when you're constructing a portfolio.
But again, Greece is small and this whole idea of contagion, it's not like the mortgage situation where we've got 20 people betting on the same mortgage, half up and half down, and it destroys and wipes out companies. The size of the Greek debt is very, very small, and we don't have bets against bets against bets the way we did with some of the mortgages here, and I think some of the contagion fear is probably a little overdone.
Stipp: OK. So, let's spin the globe and take a look at China. It's increasingly prominent in the world's economic system, but you're saying don't spend too much time right now worrying about China as it would affect the U.S. economy. Why is that?
Johnson: Now, if we ask the question for Germany's economy, it might make a difference, and there China slowing may have a difference [for Germany] and maybe that's why people are paying more attention to it. But again, if we ship 3% of our GDP to Europe, it's only 2% to China, and most of that is soybeans and maybe a few pieces of construction equipment.
So, as China heats up, what it does is, it tends to increase their demand for commodities, for oil, for copper, and drives those prices up, which really just absolutely kills the U.S. consumer. It absolutely kills the consumer. So, I take a contrarian point of view. I like China; I don't want them to fall pieces, obviously--I don't wish that on anybody. But I like to see slower growth there. I mean this idea of them pumping up commodities is just ridiculous.
Stipp: The last thing, Bob, I think a lot of investors are keyed into, especially right now as we're reaching the end of this earning season. People are looking at the earnings surprises, the negative surprises, and they're wondering what this says about the economy, but you're saying don't read too much into that, either.
Johnson: This will be one the slowest-growth quarters, the fourth quarter of 2011, and I think [earnings] growth will be down in the mid-single-digits when all the numbers are counted. And that's up from double-digit numbers at the beginning of the year. So, clearly, the rate of growth has really come way back in, and a lot of it's because of slowing in Europe and China. But again, some of those sales in Europe and China are manufactured in Europe and China, so we don't see the effect on the U.S. economy.
So, we're going to have the weakest quarter of S&P earnings growth, in the 5%-6% range in the fourth quarter 2011, and it's going to end up being the very best quarter of GDP growth in the United States, probably 3% in the fourth quarter. So, you've got that disconnect we've been talking about, and I think we're going to continue to see that.
Stipp: So, now we know that we shouldn't pay too, too much attention to manufacturing, the Europe and China issues, and the earnings.
So, if I'm trying to get a handle on which direction the economy is going, you have a list of things that we really should watch. And the first one is what you call the recovery killer, which is a scary thing to me, but it's certainly one you want to keep an eye on, and that's inflation.
Why are you watching inflation and what are the worry signs for inflation? When has it gotten too hot?
Johnson: Inflation is extremely important because it's what has stopped every recovery dead in its tracks. And what happens is, prices go up fast and wages don't adjust nearly as fast, the consumer has to cut back, they buy less, factories produce less, they employ less, less income, and you get this vicious downward spin.
Now, consumers are able to adjust to small [price] increases from time-to-time, or if it's limited to one commodity, they can kind of adjust around a little bit. But when you get overall inflation on a year-over-year basis, over 4%, that has killed almost every economic recovery that we've had. So that's the number one thing that I'm watching right now to determine when this recovery is going to end here in the U.S.
Stipp: And we know that [inflation] started to get a little bit too hot for you. I know that you were getting a little uncomfortable, but where are we right now? What's the inflation trend recently saying about that?
Johnson: Well, we got right up against that 4%. We got to 3.9%, I think, late this summer, and now we are back down around 3% for year-over-year growth in the consumer price index. So, it's in the safe zone again.
Stipp: A little bit more breathing room.
Johnson: A little bit. We'll have to see what gas prices do. That's why I keep my eye on it. With gasoline prices kind of reviving again and a few commodities up again, I do have to worry a little bit.
Stipp: Definitely one to keep an eye on.
The second one, Bob, and I know that you've said this several times, that it is important to watch the consumer. How you watch the consumer is also important. I think everyone knows how you feel about the sentiment reports, but one thing that you do watch to get a handle is those International Council of Shopping Center reports. Why is that key right now and what are you looking for there? What do you like to see?
Johnson: Well, it's what the consumer's actually buying, not somebody asking them what they'll buy. We get the numbers every week. We've got a track record of them going back, and we have been stuck in a very, very narrow range of 2.5% to 4% same-store sales growth year-over-year, averaged over five weeks, forever. And this morning's number was the same, more the same, 3.2% growth just for the single week and the five-week moving average. So, we are still in the safe zone there. Consumers have not panicked or drastically changed their behavior. And this report leaves off a lot of the little stuff that's in the consumption reports, the utility bills, and some of the other things that are on there that are kind of red herrings, if you will. So that's why I like to focus on this one. It's the stuff you buy in a store.
Stipp: Another thing that you look at actually can give you a little bit of insight into maybe how the consumer is feeling, how confident they actually are, and it's not a confidence survey, but it's auto sales.
I know that you track that carefully. What insight is that telling you about the economy and what do you look for there? What trends do you hope to see?
Johnson: That's certainly more of mid-term indicator. Obviously if you're going to buy a car, you've got to think, I am going to have a job for a little bit, and I've got enough money, and I feel a little bit more flush. And so, it's an intermediate-term indicator. If you've got one day of a better economy, you're not going to say, I am going to go out and buy something. One day of better data, you might go out to a good meal or something like that. If it's a month's worth, you might go buy an iPod, but if you're going to buy a car…
Stipp: That's a longer-term commitment. You have those bills every month.
Johnson: So that's why I like to watch that number, as an intermediate-term confidence indicator, and it certainly, in January, has its best number of recovery. It was tied with the one "cash for clunkers" month at 14.2 million units. So that was a great unit sales number for cars. Now, weather and a couple of things helped, so it may back off here for a couple of months, but if it drips back to 12 million, then I get scared. That's what I am watching.
Stipp: Right now we're in the 14 million range, and we don't want to see it get anywhere near 12 million again. This leads to another question though. It's good to see consumer spending, we like to see them spending on longer-term purchases, like a car. But how they're finding that money, I think, is of concern to a lot of market watchers. And there has been a lot of concern that people are dipping into savings or starting to take on credit again, and people say, "Well, this can't go on forever; this is a short-term burst that we're getting because people are dipping into savings." What are you watching to get a handle on that?
Johnson: I watch the real disposable personal income number; it's a real mouthful, but it takes earnings from all sources--wages to dividends to rents and so forth--everything that everybody gets as income and is adjusted for inflation, and takes away taxes. And that's a number for growth that I watch. Certainly, last year we had some months ... in late summer when inflation got so high when the number was actually negative.
The number has been much better the last three months. I think we've had a couple of months where it was up 0.3%, so that was a pretty good number. I am looking for a good number here in January because we've got Social Security increases kicking in, we've got some minimum wage increases kicking in, better employment, which leads to better overall wage numbers.
So, all of those things combined, I am looking for a great number here in January. But then I need to sustain that number, because you can't have consumer spending go on forever dipping into savings.
Now, our savings rate right now is about 3.5% or so, and we were down as low as 1%. So I suppose we can get another year of dipping into 2%, and we're still OK. But I really don't want to see that, and I'll look to the January number for some hope that we have broken that bad trend.
Stipp: So it definitely gives you some indication about staying power for the consumer there.
And the last thing that you look at on the consumer front is the broad categories that they are spending in. And we've seen, of course, a lot of spending on goods, electronics and things like that, but that's not the only kind of spending you'd like to see.
Johnson: One of the things we've talked about is the services economy, which is probably bigger than the retail goods part of the economy, it's larger--it has been a little bit of a slower grower. Now, it didn't go down as far, either, but it's been a slow grower.
Unfortunately when people buy goods, iPods or electronics or even certain cars, they come from overseas, and it affects our balance of trade. If you buy services, typically the services are produced in this country and add to our employment and don't subtract from our GDP, and aren't affecting the balance of trade in a negative way.
So, I'd really like to see the services sector do better. Now, it's not mandatory, but it's one that I watch, and I'd really like to see the services sector catch fire. We've got a little optimism: The purchasing managers survey looked a little bit stronger last month on the services side, but maybe that was just a flash in the pan; we'll see.
Stipp: All right, Bob. There are so many numbers to keep track of, but thank you for joining us today and telling us the really important ones and giving us some of those red flag signs and also what you'd like to see. It's been very insightful. Thanks for being here.
Johnson: Thanks for having me.
Stipp: For Morningstar I'm Jason Stipp. Thanks for watching.