US Videos

Session 1: Is the Economy Really Losing Steam?

Robert Johnson, CFA

Jason Stipp: Hello and welcome to Morningstar's 2012 Midyear Financial Checkup for Premium Members.

I'm Jason Stipp, site editor for Thanks for joining us today.

We've got a compact but robust couple of hours for you here. We're going to start at the very top with Bob Johnson. He is our director of economic analysis. He is going to give us the big picture on the economy. What are the drivers for the economy? What are the risk factors? And also, are we, as some have suggested, slipping back into a recession? Bob will be addressing those issues in his presentation.

Next up after Bob, we'll have Christine Benz, our director of personal finance. She will be walking you through the steps of doing a [midyear portfolio review], given some recent market activity that we've seen. She's also going to, importantly, highlight three key risk areas that might be present in your portfolio. She will tell you how to stress-test your holdings for those risk factors, and also give you some solutions around those.

Lastly, we're going to be checking in with some of Morningstar's top analytical minds from our ETF and our mutual funds team, as well as our equity research team. They are going to talk about individual investments, where are some of the opportunities today, where are some of the risks today? They will really bring it down to that individual investment level. That's going to be a Q&A session, that last session, and when I say "Q&A," I mean real a Q&A session. We want participation from you. We want to make this as interactive as possible and hear your questions.

If you look right below the webcast player there on your screen, you'll see a "Submit a Question" form. Please enter your questions, hit enter. We'll check and review those questions during the whole webcast. We'll try to get as many of your questions in, but we definitely want to hear from you. So please do take advantage of that.

So are you ready? Let's get going!

Up first, Bob Johnson, our director of economic analysis. You probably know Bob from his weekly economic videos. He also writes a weekly column on Saturdays, basically recapping the economic reports released during the week. Today, though, he is going to step back and give us a much bigger picture on the economy and some of the signals that investors should be looking for to truly gauge the health of the U.S. economy.

So, without further ado, our director of economic analysis, Bob Johnson.

Bob, thanks for joining us.

Robert Johnson: Thank you, Jason. It's great to be here this afternoon.

Let me dig right in and give you my economic forecast to start with, and then we'll talk about some of what helps me form that forecast overall, and tell you some of indicators you can watch for yourselves at home to try to figure out which way the direction of the economy is going.

My forecast for the year--and by the way this slide is a slide that I've been using since November of 2011. I really have not changed my forecast. We've had little blips up and down quarterly in terms of the real economy, but in terms my forecast, I'm basically at where I was in November. I think a lot people have gone through a string of thinking, oh, the economy is really strong, or it's really weak. But we've kind of stuck with this forecast for long time, so I apologize for those of you this is kind of a review for. But my forecast is for about 2% growth in the economy, and that's adjusted for inflation, so we are doing real growth--it's not just all about prices. It's about to 2% to 2.5% growth for the overall U.S. economy.

To put that in some perspective, we grew at 1.7% last year, that is, in 2011. So, we're growing a little bit fast than we were. In a typical recovery, we might be looking at something more like 2.5% to 3%, but this time around, we've got a little bit lower population growth--we're growing population maybe at 0.8% instead of maybe 1.5%. So maybe some of the slowing in GDP growth is more population-related than anything else. So I'm not horribly concerned about 2% to 2.5%. Unfortunately, though, it's not enough to cure some of our unemployment problems.

I do think our unemployment level will come down this year, as you can see in this slide. I'm thinking maybe something like under 8% by the end of the year. Some of that will be because people have jobs, more jobs than they had. And some of that will be because people drop out of the workforce. As people drop out of the 99-week unemployment programs, I think we'll begin to fall down just a little bit in our participation rate here, and as people go back to school, we have seen some of that happen already.

So, some of it will be good news, some of it will be bad news about why the unemployment rate is going to go down, but I think we will be under 8% by the end of the year. And I think we will get back to something like 190,000 to 200,000 jobs per month created, which works out to about a 2% growth rate, about the same as I'm expecting for GDP, which is pretty typical. [Employment growth is] typically just a little bit under [GDP growth]. So that's how I get to that number.

I think that the U.S. economy this year will be driven more than anything else by a better housing market and lower inflation. I think that's going to be the key driver. If we look at the different things that are in my forecast, autos have certainly been a big help, and we'll see more about that later in the presentation, but autos have certainly been the number one improving factor in this recovery, and it's kind of saved the day.

Housing has been a real laggard. It's almost always one of the first things to move in a recovery. This time it's one of the last. And the good news is that it's going to extend the recovery a little bit further than it might normally go because it's coming on later in the cycle. Unfortunately, some of the other things are going to start to soften. So we won't get to see the big explosive growth rate that we typically see coming out of [recession], but you will get a longer-lasting, steadier-state recovery.

Certainly, overall the consumer drives everything. The consumer is 70% of the U.S. economy, and even though the U.S. only represents 25% of the world economy--we're about, say, $15 trillion out of $60 trillion world economy--we represent a substantially greater portion of consumption of goods. So that's why the U.S. consumer drives the world economy, hence the headline of my talk.

We're not without risks. I'm continuously worried about inflation, because inflation kills almost every economic recovery. You look at the data, and a lot of the old thinking was that it was interest rates that killed the economy, but it's really not [interest rates]. It appears that inflation seems to be the primary effect, and then interest rates go up to kind of cause inflation to stop, but it's inflation that's the key driver. And we saw last spring, in 2011, where rates went down, inflation went up, and the economy slowed. So there is a close relationship between inflation and economic activity. Once we get up above 4% year-over-year inflation, that's typically associated with a recession. We got dangerously close last spring; luckily we backed away from the abyss a little bit, and we are now running less than 2% year-over-year inflation. So that's really good news for the economy, but inflation is my number one worry.

Incomes of consumers have been outpacing their spending for a good part of the last year, and the savings rate therefore came down. The last three months have been better, and we'll talk about that a little bit in the slide later on.

Certainly, I am worried about Iran and geopolitical issues, and there is always one that we never think of that comes along--sometimes it's Korea, sometimes it's Cuba, sometimes it's Russia--but obviously that's certainly always a risk in the economy.

Europe is a concern, and we haven't heard the last about Europe, and Europe is not going to go away overnight. There are parts of Europe where their debts are higher than they can possibly repay. And they can't decide who is going to ultimately foot the bill for that, and until they finish passing that hot potato around and decide that they are going to write some of it off, Europe is going to be in flux, and I think that could be another three to five years. So I wouldn't expect a lot of improvement there. And every time the market goes up because they have signed some new agreement, I really don't think that's a good reason for the market to be going up, because it is going to take some time to cure all of this.

Then another thing that people really become obsessed with is manufacturing data lately, especially from around the world. There's a data set called PMI, Purchasing Managers Indexes, that people have used. Two years ago, I used to have to spell that out for everybody, explain what it meant, that it was founded by Hoover to get a faster read on the economy. Now I get people from Europe calling me and asking about ...  the regional survey orders component. So people have become really obsessed with manufacturing at a time when manufacturing is a much smaller part of the U.S. economy than it's ever been, in terms of employment anyway. And so it's not a big driver here; it's probably a bigger driver in China. It's a bigger driver even in Europe than it is here. Here it's probably 10%-11% of our employment. So it's a relatively small part, and the U.S. economy can do very well without manufacturing necessarily doing very well. So I'm not focused on manufacturing. I'm focused on the consumer.

So, where are we now? From the slide I've got this concept that we're kind of muddling along. We're really not ... booming, we're not busting is another way that I put it. And I don't think the economy is quite as delicate as people claim it is. We've had huge oil price runups, we've had a big scare out of Europe, and really we've had pretty consistent growth over the last year--not great growth, trust me--but it's been growth nonetheless, and we've had some really bad things happen that we survived better than I think most pundits would have thought possible. So we do continue to muddle through here.

Just to give you an example, by the way, we're in our third year of this economic recovery. The official start of this recovery was in June of 2009, and so now here we are in July of 2012, just over three years later, and we've still got a very slow recovery. In the slide that I've got up right now, you can see that we had one of the worst contractions of the last 10 recessions. We've had 10 recessions since World War II, and this was the worst one. We were down about 5% overall. But yet our recovery rate is about half of what it typically is, so we've certainly had a slow recovery, and I think there have been two primary causes. One is housing has not come back, which is always an important part, and the second is government. Government is usually a huge part of the recovery, and it really, frankly, hasn't been much of a contributor at all. In fact, it's been a detriment recently. We've lost jobs in the government sector, and unfortunately the news there may even get worse.

But there are a lot of people going around saying we're in a recession already, and some of the data from the second quarter looks a little softer than I'd certainly like to see, but I think there are a lot of odd things happening. I think, for example, Microsoft's got a new operating system coming out, so people are saying don't buy computers, because the new operating system is coming out, so that slowed that market. We've got a little bit of a saturation issue in digital TVs right now that's certainly beginning to affect some of our imports on that side of the house. We've got some odd things happening with gasoline prices that makes consumption look just a little bit lower than it is, and we've even got helpful things like a lot of major drugs going into generic form, which dramatically cuts the prices and the spending on drugs. And all those things are coming together to make a lot of the economic numbers look a little weak.

Certainly, consumers aren't spending those savings. I don't want to say the consumer is booming or going crazy, but on the other hand, he saved some money recently in the last three months, and he isn't spending that money just yet, but there are certainly a lot of positive signs. And as weak as some people think the economy is, I ask you this question. I asked you these common sense questions. Let's put the data aside and just ask, would housing sales be at the best levels of the recovery? Would auto sales be almost in kind of booming type of territory? Would consumers be taking out more loans in a world where they thought things were falling apart? I think that the fundamental answer is no. Maybe because of seasonal factors, maybe because of these special things that I'm talking about, things look a little weak today, and I think they may [look weak] for another month or two, but I think overall my 2% growth rate for the full year remains very much intact for the U.S. economy.

I think certainly one of the things that's got people concerned is exports. Exports have gone up as a percentage of the U.S. economy. They're now about 14% of the economy. Back in the '60s, '70s it was more like 5%, 6%, 7%. So we've certainly become more dependent on exports, and exports were probably one of the fastest things to recover in this recovery, but remember they also got killed because there were five or six months where we literally couldn't ship anything overseas because we couldn't get letters of credit for banks. And so a part of it was just a bounce. We're not very much further ahead in exports than we were to begin with. So exports were important, but are becoming less and less important all the time in terms of our growth rate.

If you look at the next slide, I have also lined up the various world economies. People say, well, Europe is falling apart, what does it mean? Well, Europe represents about 3% of the U.S. GDP, our broadest measure of economic activity, 3%. A lot of that is agricultural products, a lot of it is Boeing aircraft that are under long-term contract. They are things that aren't going to go away. So even if Europe was to go into a really bad spell, I doubt that Europe would fall much below 2.4%-2.5% of the U.S. economy. So I'm not terribly worried about Europe from an economic effect.

Now whether the banks fail and cause something to happen to our banking system over here is an entirely different question. There is a 10% to 15% probability that it does cause that type of banking situation. It's something that certainly should be on everyone's radar, but in terms of economic effects, I think it's relatively minimal.

Europe is also important to a lot of S&P 500 companies, and it affects their earnings, but it doesn't so much affect U.S. employment, because a lot of the things that multinational companies sell in Europe are made in Europe or made in the Far East, but certainly not made in the United States. That's why, for the last three years, earnings of corporations have been booming at the same time that employment in the United States has barely budged. Now, as we go in reverse, and Europe slows and earnings slow, it doesn't necessarily mean that U.S. employment is going to get any worse, because none of those jobs were here to start with.

And also, just on the bottom of the slide, I know that everybody is mainly concerned about Europe, but China is even a smaller percentage of our economy. They are about 1% of our economy, and most of that is actually soybeans.

And people say, oh the slowing, it's going to hit us in terms of exports! And it's slowed. I said, it was the very best help to the economic recovery in the first few months, but every year the effect has become a little less and a little less.

You can see in this slide, in 2010 overall export growth was about 21% across all economies. Then in 2011 that fell to the 15% range, and now for the first five months of this year (we haven't got the June data yet), we are down at around 7%. So, we've already seen some of the slowing. It isn't like this remarkable thing is going to come out of the sky, and our 50% growth ends tomorrow. This has been an ongoing trend, like you get in every recovery; you get the big boom at the beginning, and then you kind of flatten out, and that's just what's happening this time around.

So, now it's the consumer that's really the most important part of the recovery, as they usually are, because we are about 70% dependent upon the consumer, which is the largest of any other major economy. The consumer is important. I always say don't watch the manufacturers--that's the wrong thing to be watching most of the time because manufacturers will manufacture if the consumers have the demand. Manufacturers don't make goods for the fun of it, or just to stack an inventory or to have it around because they think it might sell next week. They usually make it because they've got an order in hand, and if the consumer is strong, manufacturers are going to build, they are going to hire more people in their factories, they are going to build more capital goods for their factories so they can make more. That higher employment and those higher orders of capital goods mean more incomes in consumers' pockets, which means more spending, and you get this wonderful virtuous cycle. And that's the thing I really think is really important to keep in mind in the economy. Ultimately, the consumer is the center of that stage.

So, why am I optimistic on the consumer? Well, the number one reason is dealing with employment. I know the numbers of the last month or two haven't looked as bright as some months, but again I caution you, there are a lot of seasonal factors here, and if you look at the numbers on a year-over-year basis, we're still pretty close to a 2% private sector growth rate, a little bit less if we strip out government. That number has been relatively consistent for a large period of the recovery. And the more people you have working, you get that virtuous cycle that I was talking about, moving again and again all the way through. So, that's one of the reasons I'm optimistic on the consumer.

Even if we add just one job, that puts more income in consumers' pockets, and we've also seen the hours worked and wages per hour have been going up recently as well, which will further help consumer incomes.

Initial unemployment claims: Here is something you can watch every week; you don't have to wait a long time. They give you every week the data on the number of people laid off. And we're certainly at probably one of the best levels of this recovery right now, and we saw the best number of the recovery actually last week--although that might have been at least partially due to the Fourth of July holiday. I expect the number on Thursday to be just a little bit higher than that. But in general, if you watch this number, especially the four-week moving average, which they give in the press release, it is one of the best indicators of the job market that's out there.

The other reason I'm really optimistic about the economy is the consumer's ability to spend in [light of their ability to] service their debt. I look a lot at things like mortgage payments, car payments, credit card payments, student loan payments--all of those things are rolled together in a bundle here on this slide that you're seeing. They are taking those fixed payments, and they compare it to the amount of consumer income in aggregate.

You can see that we've gone from about 19% of spending on those types of things, all the way down to about 16%, and I think we'll get pretty close to 15% by the end of the year, as incomes go up and interest rates stay relatively low. I think we're going to get even a little bit better, with the only fly in that ointment maybe being a little bit higher rents in that number. Rent counts as one of those fixed payments.

So, that's where the extra money is coming from, if you will, that the consumers have to spend is that they've seen this fixed payment ratio go way down. I don't think a lot of people track it. We only get the number from the Federal Reserve once a month. You can look it up on their website. Just type in the search engine, "financial obligations ratio" and you can get this very critical ratio, which has been improving nicely for several months now.

Inflation: That's another thing I've been worried about, and here is the chart that kind of backs up my statements. On it you can see a bunch of pink bars; those represent every time that we've gone into a recession. Then you'll see a red line, and that's the inflation level at about 4%, and then you'll see the up-and-down blue line indicates the rate of inflation, again, on a year-over-year basis, a three-month moving average.

Every time ... we cross that red line, we usually go back into a recession, and sometimes we get a little bit more lead than another, but every time we get near that line, it's been very bad for the economy. And this is just the proof of that, and we got dangerously close, as you can see, last year, but now we've fallen back into what I'd call a safe zone again. So I'm really glad to see that, and that's one of the reasons I'm more bullish than most people are about the economy. Not ravenously bullish, but I've kind of been more consistently bullish.

But things aren't worry-free. My latest worry is the drought here in the Midwest, and what that's doing to the corn crop, and what that ultimately does to the food supply. As worried as we all were [about gasoline]--my first slide here used to be about gasoline prices, which have now come way back in--but gasoline actually is only about 5% of the economy, whereas food prices are more like 10% of the economy. So, if corn prices really go through the roof and drive up a lot of other food prices, that certainly isn't good for the economy. So, I'm certainly doing my rain dance here in Chicago to try to get a little bit more rain to the Midwest that may head off some of that food inflation.

I mentioned consumer incomes have been relatively flat. If you look at the graph, we had a nice boom in that, mainly because consumers actually had a period of deflation. So maybe their earnings growth was 2%, but then we had deflation, which effectively gave them 1% more in their paycheck. So, we got to 3% income growth at one point in time. That got pretty close to zero a few months ago.

Again the nominal number, the non-inflation number, was still about 2%, but then we had some pretty high year-over-year inflation numbers that really brought that income way down. Now that gasoline prices have come down, inflation has come down, those incomes look a little better at 1%. I'd really like to see that number a lot closer to 2% to keep the economy going, but certainly the consumer does have a little bit more room to borrow for cars or for long-term assets, which I think is a worthwhile thing to do. Not credit card spending on junk, but I think long-term assets are a good thing to borrow for, and we've seen more borrowing in the economy. I think we'll see better income growth in the months ahead as inflation continues to fall.

My other worry is housing prices, at least based on the Case Shiller Index, are still down year-over-year, and you can see we are not making any great strides forward in terms of price increases, but I think in the next month or two we will start to see some price increases even in Case Shiller Index. Many of the other more sensitive indicators, if you will, have already shown housing prices going up, but right now the general thought in consumers' minds is that housing prices are going down, I'm not buying, and it make them a little bit more frugal overall. That’s one of my other worries about the consumer, the driver of the economy.

The consumer confidence, I think, is improving, and I don't look to the University of Michigan Confidence survey, and I don't look at the Conference Board survey. I think if you stick a microphone in somebody's face and say, what do you feel about the economy, and he has just seen a negative TV program or a headline about "prices up" or "economy slowing" or "troubles in Europe," the first thought out of his mind is not going to be, "Oh, yeah, I feel bullish." And he doesn’t want to look like a fool to this reporter or this data gatherer, and so he is going to say, I just saw some negative-sounding stuff. I am going to say I am not confident.

But yet you can look at the very same day that some of those surveys are taken that we have record auto sales or something. So I look at what consumers do, and I have three stages I like to look at, and that’s represented on this picture here with a youngster who is kind of in the growth stage, kind of a middle-aged person in the middle [representing] middle-term confidence, and then the older person representing the long-term confidence in the economy. And let's look at what I use for each one of those, and you can track all of these at home.

Certainly, the first thing I look at is retail sales. I get that from the shopping centers, and like the unemployment data, it comes out every week, which is why I just absolutely love this data, because I can always get a quick check on where we are at. This comes out on Tuesday morning, and I do four weeks together. It's always hard. You don’t want to take just one week all by itself, because anything can happen in a week. But take a number of weeks and then compare it to the year-ago period to get over the seasonal adjustment factor, which is a big deal that messes with a lot of the numbers.

I watch that and you can look at this graph, and you see a narrow range between kind of 2.5% and 4%. Every time we get towards the lower end of that band, we seem to rebound, and it seems like it may have happened again this time. The number we got this week was certainly a little bit better again than we've seen in some time. So, it's certainly good to see this going in the right direction, despite what you're going to hear about the consumption numbers and the retail sales numbers, which were, again, already back for June. This is the stuff right up-to-date, right up to the middle of July.

Now, let's move to that middle stage of confidence here: auto sales. You need a job, you need a good economic prospect and you probably need some income to ... buy an auto, and certainly we've seen some great news on the auto industry. I'm really excited about what we've seen there. We got down in some months where we had sales of about 9 million autos [seasonally adjusted annualized rate], and we are forecasting now for this year we'll probably get all the way up to 14.5 million [seasonally adjusted annualized rate], and that's been revised up most of the year. So, I'm really glad to see that, and it really has been a key mover of the economy.

Here is just another way of looking at it. We're back nicely, but still not all the way back to where we were at peak levels. So, we've still got more room to operate.

Then the housing industry. This graph shows housing starts, and we got a housing starts number this morning, which looked very good. We certainly are improving on that front. But we're way off the top, so we still haven't built in that really good long-term confidence that I like to see. But it's better than it was, a lot better. We're actually 40% off the bottom right now, and it frankly hasn't shown up in some of the numbers just yet.

I think there are a lot of positives going for housing. The affordability is at near record levels, people's incomes have gone up a little bit. Interest rates have come down a lot, and housing prices have come down a lot, and if you put them all together, you're monthly payments on a home today are probably going to be about half of what they were four or five years ago ... relative to incomes and so forth. So I think that's really good news, and that's the key reason I remain bullish. We've got household formations are very small. People have moved home with their parents. I think that's not a long-term sustainable thing, and that as those children get a little bit older, I think they'll move out, and I think that will move the economy along as well.

And now we know how to deal a little bit better with foreclosures. It's been coming up on five years that we really have been in this housing problem. Now there are ways to buy blocks of houses, and the banks have learned how to negotiate a short sale. They've got the staff to do it. [When] a foreclosure came on the market in 2009, nobody knew what the heck to do with it, and it really depressed prices, and people slashed prices to move it. Now it might be more of a [situation] where the bank knows what to do, and they will get an answer back to you a little bit faster than they used to be able to.

So, I think those are some of the positive signs for the economy, and it's really shown up in the data you see in the next slide, on the Slide 30 here. And again, I won't go through each of the data, but certainly new-home sales, which drive GDP directly, have done very well. We're up  ... 20%-25% on a year-over-year basis, which is a pretty dramatic improvement. Again, it hasn't turned up in the employment [data], it hasn't turned up in furniture sales yet, which is one of the reasons I'm optimistic about the second half [of the year].

Existing home sales have been a little bit slower to grow. There just haven't been enough quality homes on the market anymore. Inventory is sparse in some markets--not all markets--and especially for a quality piece of [property], it's really beginning to pinch.

Pricing is getting better, and again you can pick a metric, you can get any story you want, but all of them are showing improvement in pricing, and inventories are way down. So, that's why you get the prices up.

But credit requirements are tight. I speak to young people all the time. I have worked with a lot of them. Most of them, if you go around the room and ask, will you buy a house in the next five years, I just asked the group of about 50 people that, I had two hands out of 50 go up. And it was five years, and these were 25, 26, 27 year olds. Then a couple of them said, well, I might if I have a family. So certainly that's not going to help the market, but as those people hit that childbearing age, I think, you're going to see some more improvement in the housing industry. It may take some more time yet, but I think we're getting there.

What does all my data suggest? I think that certainly I'm very worried about emerging markets. Part of that may already be in the prices of emerging-market stocks and funds. They've been some of the worst performers. But again, this slide is the same as it was six months ago, and I've been cautious about emerging markets because they are very dependent on each other, they're very dependent on commodities. So, I certainly have some concerns about emerging markets, and I think people will say, what about Europe being weak? What is it going to do to the United States? It doesn't do a lot to us, but it does a lot to China, and then China being weak does a lot to Korea and Taiwan and even to some more developed economies like Australia and Brazil that send a lot of commodities to China. So I certainly have some cautiousness there.

Bonds, I'd say you need them to balance your portfolio, but watch your durations. I don't think these low rates stay forever. I buy stocks where companies have pricing power. Consumers are fighting back. They are very smart about shopping for deals--call it the Groupon effect, where everybody wants a discount. So you want companies that have strong pricing power, which is our so-called "wide moat" stocks, which you'll hear more about later in today's talks.

Then I'd also say one thing to think about is small-cap stocks. Small-cap stocks tend to have a little less exposure to overseas markets. As you know, that's an area where I'm cautious. So [small-cap stocks] might be an area that you want to take a look at. And again that's just my view and what falls out of my economic forecast. The individual stock picks depend on what our [equity research] team says, but that just gives you some view from the economic standpoint where I'm coming from and what it might mean.

Thank you so much for joining me this afternoon to talk about the economy. We'll now be glad to take your questions, and let me turn it over to Jason.

Stipp: Thanks, Bob. So, as Bob mentioned, we are taking Q&A now. There is a feedback form underneath your webcast player. You can input your questions there, and we'll take them in real-time. We are looking at them right now. So please do go ahead and put your questions for Bob in there.

I also wanted to let you know that you can review Bob's slideshow. There's a link on the name of Bob's presentation, also the name of Christine's upcoming presentation. Those are both underneath your webcast viewer there. You can click those. You can see the slideshow. You can review those in case you want to look again at something that Bob mentioned. We'll also have a replay of this webcast available for you in a couple of days, so you'll be able to watch his presentation again if you'd like.

Bob, thank you very much for that presentation, for the overview. We've got a few questions for you here.

I'd like to start with a risk factor that a lot of folks are seeing today in the market with the tax issue and the stalemate that we're seeing in Congress and the concern about the expiration of the tax cuts that might be coming at the end of the year. When you think about the tax rates potentially going higher if no action is taken, does it worry you, the effect that might have on the economy?

Johnson: Sure. The numbers, if the laws [expire] as written, are certainly large numbers. I have seen different estimates that look like it could be as much as a 3% to 4% impact on GDP. It'd be a quick, bad hit in the first quarter where it would turn up in all the statistics, but I really don't believe that's the most likely case. I really think that the legislators after the election and all the posturing is over, I mean it's just not a good thing, and people came to agreement after the last election when everybody thought there was going to be Armageddon, and really did put something together. And I think when they put their feet to the fire, we'll probably get a solution that puts this off, because I think they all realize they will get blamed for it if they don't do something about it.

I'd also add that some increases would probably not kill the economy. Certainly, we're not as strong as we were in the 1990s, when we went through the Clinton tax increases. It certainly didn't ruin the economy, and a lot of the worst of the tax increases will fall on the high-income earners, who have other options about spending and where to get their funds from. It may not have as big an impact.

And we've already seen an awful lot of government programs roll off. ... Most of the states, you can no longer get the 99 weeks of unemployment, and that keeps rolling back and rolling back already. I think some people, when they cite the numbers, think they are taking the highest number and saying it's all going to fall off as of January, but we're already halfway back. We had 13 million people on unemployment at one point. We're now down to between 5 million and 6 million collecting unemployment.

Stipp: Since we're talking about taxes and the fiscal health, a lot of folks will look at Europe and the problems they've had over there with their sovereign debt issues and what that means for their austerity measures that they have to take in trying to get things back on track, and I think they also look at debt issues that we have in the U.S.

Does the debt load in the U.S. worry you from an economic perspective or do you think we have more flexibility to handle that over a long period of time? When does it become a crisis? When do people have to start worrying about U.S. is another Spain or U.S. is another Ireland?

Johnson: Well, we've got a much more flexible economy. We've got oil in this country, we've got agriculture in this country, we've got a services economy, we've got a labor force that's more flexible in terms of changing locations. We've got a lot of things going for us. We aren't an economy that's stuck with a poor distribution of natural resources in a mountainous climate or something that makes it exceptionally difficult to adjust.

So I think we've got a greater ability to adjust than an awful lot of other economies. I think our debt would have to get a lot higher. And certainly there are a lot of programs in place, as you mentioned, if one is going to think that the austerity and the tax increases are coming, well then I assure you the deficit problem is taken care of. The deficit as a percentage of GDP comes down dramatically with the [tax cut expirations] that are written in the law right now. I think if they come to something that's between the law expiring and keeping [all the existing tax cuts], that we'll have some improvement in the deficit. I think we will get better.

Stipp: So I want to press you a little bit on your economic outlook for the rest of the year. So, Bernanke came out this week, and he had pretty a gloomy forecast for economic growth. I don't think he was forecasting doom, but he certainly seemed to glum, maybe more glum than he did before. We also heard from the ECRI folks; these are the folks that in the future will tell us when recessions happened and when recoveries starts to happen. They also said they think we might already be in recession.

So my question to you is, you haven't necessarily changed your overall forecast for the year, but the first half has slowed down. I don't think there is any denying that we've seen slowness in the first half...

Johnson: ... That's correct.

Stipp: ... Which means that according to your forecast, we'll have to see acceleration in the second half. At what point, if we don't see that, do you have to start looking at your estimates and maybe think we might have to bring the whole year down. When do you have that much data?

Johnson: Well, I think it's going to take a little bit more time yet, and I think we're not going to get it in the next month or two. I think it's going to take a little bit of time to play out.

I think we've got a number of things that make the second half potentially look a little better. The housing data is an awful lot better than it was. It's certainly not anywhere near the high standards it was at. But we haven't seen any of benefit, even in things that are direct like construction employment. I would have thought by now--we were making 500,000 homes and now we're making 750,000 new homes on an annualized basis--that we'd have seen more construction workers. We really haven't yet, maybe because it doesn't take much to pour a foundation, but it takes a lot to finish houses.

So I'm thinking that maybe it's just a matter of time, and the same with furniture sales and a lot of the ancillary stuff that goes with buying a home. So I think we've got that to come.

I think we've gone through a computer cycle right now, where another version of Windows isn't available until later in the year, so people are holding off. I think that's put a damper on the whole tech sector. So I think there are a few things out there like that that are holding the economy back a little bit, and maybe we will see a little bit better numbers in the second half.

Certainly, the second quarter will look a little weaker. We'll be in the 1%-2% range versus the kind of 1.9% that we had in the first quarter. But remember, even at the end of 2011, we got on videos again and again and said remember that auto sales got a post-tsunami [bounce-back] benefit and don't look for such good things [to continue]. Actually it turned out the first quarter was probably a little bit stronger than everybody thought it might be, and now we've had a little bit of weakness here in the second quarter, which is in pretty much all of the data, but I think that the cards are already lined up so that we'll see better news in the second half.

Stipp: Let's turn and talk about the employment market, because we had a string of disappointing monthly employment reports. I think that you're expecting that we would see, hopefully, an acceleration in the second half of the year if we start to see some of these other economic factors move into play. What kind of growth rates do we need to start to see in order for us to reach your yearly goals for GDP and for the economy in general in the employment market? What kind of turnaround do we need to see in the next few months?

Johnson: Well, to give you some idea the baseline is 2% to 2.5% GDP growth. At 2% GDP growth, then you always get employment growth being a little bit less, because you've got efficiency and productivity things going on. So we'd get about 1.5% employment growth, which would equate to maybe something like 130,000-140,000 jobs per month.

If you get up to 2% employment growth, which probably is more closely correlated with a 2.5% GDP growth rate, that's a number that looks pretty close to 200,000 jobs per month. We were better than that in the first [quarter], but some of that was weather related. We made it up for it in the second quarter. So we were over 200,000 by a lot in the first quarter. We're probably right around 100,000 in the second quarter. So now I think in the third quarter we will probably come back, the pendulum will swing back, and we'll probably end up somewhere in the 150,000 to 175,000 [range] and maybe a little bit better in the fourth.

Stipp: All right, so we will hope to see the numbers come in around that level.

Also, in the labor market, you mentioned that participation rates, so folks dropping out of the labor market and how that can bring the unemployment rate down, but I think a lot of folks see this as also a concern. Folks can't find a job, so they just give up and they move off the labor rolls.

To what extent do you feel like not participating in the labor market and seeing people not look for a job anymore is a big concern, even if it does bring the unemployment rate down?

Johnson: Well, you know, the one thing that we don't know, and we don't see, is how many people are going back to school. My sense is, until recently, those numbers have been moving up pretty good, as a lot of people have gone back for training. I always cite the stories in Cleveland, where a number of factory workers--men, even--have gone back for training to become, say, nurses or radiologists or something in a hospital. There's a lot of that remaking of the economy. I think that going back to school is a good thing, and if that's why they're dropping out, that's not an all-bad thing. If they're dropping out because I just don't care anymore; that's certainly a bad thing. I think we have a little bit of both going on right now, and I think both of them will happen if we get under 8% unemployment.

Stipp: Do you think that there was a trend where some folks, especially during the economic crisis, went back to work who maybe in better times wouldn't have to work, and they are sort of in the labor market right now, but if we see the economy get a little bit better, they might decide, well, maybe I really don't need to stick with this job that I have right now; I'd rather be doing something else,  or I have other needs that I need to attend to and so they would drop out [of the labor market].

Johnson: Right. There are always certain situations, especially for some people in construction, and a spouse takes a job to pick up the slack, and then they get a job back and then, gee, do I really need two working full time, and maybe one goes part-time or something happens.

So there's certainly some aspect of that out there. And also, another thing to keep in mind that a lot of people miss, is the participation rate should be going down and should be going down rather dramatically over the next 10 years as the baby boomers hit age 65, because there's no top age when they count the participation rate. It's everybody age 16 and over. It doesn't throw out the age 90 and over [population]; they are all counted. So, certainly that's something that's in the numbers that people have to keep in mind--the natural trend in that number should be down.

Stipp: So last question for you, since we are running low on time, I do want to ask you a little bit about the Fed and what the Fed is looking at. So employment is one of the things that the Fed closely watches--that's part of their mandate. And also inflation. So, a reader had asked us, when do you think interest rates might go up? So, the Fed has said through, I think, 2014 rates are going to stay very low. Certainly, the employment report has indicated that stimulus probably will still be on the table at least. When do you suspect that we'll start to see rates go up?

Johnson: Well, there are really two things--and part of that is probably a little bit of a trick question. But in terms of the Fed, you said their dual mandate is low inflation and high employment. That's their dual mandate from Congress, the so-called Humphrey-Hawkins. So what they have to do, if you look at the numbers, employment is still not so good, and inflation is below their target. I said the year-over-year number is about 1.7% in total. Now you can play whether it's core or total, but it's below their target right now. And so ... that says that they have to keep rates low. If you look at their mandate and how they are charged, that's what they've got to do.

I caution that rates aren't entirely set by the Fed, and if growth were to pick up, their hands may be tied a little bit; rates may go up without them. I think everybody has gotten this view that the Fed controls interest rates on every level--short, long, medium and whatever--and that's really never been the case. I think right now, because the economy is so weak, they're able to keep it tight, that's for sure. But if things really got booming again, I think you would see rates, despite what they try to do, go up.

Stipp: All right, Bob. Thanks for the insights and answering our questions and for the presentation. It was very enlightening.

Johnson: Thank you.