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By Jason Stipp | 02-22-2012 01:00 PM

The Most (and Least) Critical Things to Watch in the Economy

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 ...

Johnson: Exactly.

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.

Johnson: Yes.

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.

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