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Johnson: Fed Still Has Room to Run

Jason Stipp
Robert Johnson, CFA

Jason Stipp: I'm Jason Stipp for Morningstar.

Fed testimony and statements yesterday, coupled with some negative economic news out of China, sent the global markets on a wild ride overnight. Here to offer his insight on some of the Fed statements and the impact on the global economy is Morningstar's Bob Johnson, our director of economic analysis.

Thanks for being here, Bob.

Bob Johnson: Great to be here.

Stipp: The Fed initially testified before Congress, and the markets went up. Then there were some Q&A and some minutes released from Fed meetings, and the markets went down. That got worse overnight as some economic news came out of China [indicating] a slowdown there.

Let's start with the Fed first. Why did we see the up and then the down, based on how the Fed was answering questions yesterday?

Johnson: I think Bernanke was very clear in his statements before Congress, and the thing that everybody took solace in and what put the market up so much initially was that he seemed to be saying, we're not going to prematurely withdraw support. If we do, and do that prematurely, that will slow the recovery. In fact, it may even turn the recovery into a recession.

So, using language that strong made people think that, wow, there is no chance that rates are going to be going back up or the Fed is going to stop their bond buying [anytime soon].

Stipp: So the implication there was the economy is still somewhat fragile and still weak, and this stimulus will continue. So it's a little bit of good news and bad news at that point. But then later when he was answering Q&A questions, he was asked if some of the stimulus might be tapered by the September timeframe, and after some hemming and hawing, he said, it's possible that it would, and the markets did not like that.

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Johnson: Exactly. It seems kind of odd when [at first] he is talking about things being weak and we're not withdrawing [stimulus] until everything is much stronger. Then somebody asked [a question] about short range in September, and he is hemming and hawing. It was really kind of surprising. I don't know exactly what was going through his head, if he was just trying to leave himself maximum openness or what, but that clearly got the markets going.

Then, when the minutes were released, it was kind of a follow-up. The minutes are from a prior time, and it's [the viewpoints] of all the governors--remember that Bernanke doesn't make the decisions in a vacuum, but he's got a board of governors he has to work with. Some of those people were saying we might want to taper here at some point; as things get stronger, we'll gradually back off. And you put that together was his question flub, and you had a pretty bad market yesterday afternoon.

Stipp: Now it seems like we have two things going on after we got some data overnight from China that seems to indicate that they're going to potentially be slowing down. So now it seems like we're seeing slowing happening, and the Fed maybe not absolutely positive, or at least he wasn't taken to be positive, that the stimulus would continue forever.

So, how do you look at the underlying economy, because that's going to be a key component of the Fed's decision about how much and how long they continue stimulus. Is the economy as weak as he seemed to be implying earlier yesterday, especially in light of some of the data we've gotten since then?

Johnson: I did worry yesterday when I saw some of his statements … about being light in terms of recent weakness that we have seen. This is like the week before the employment report about a year ago when he said, "… with all the weakness out there," and I was thinking that the [recent] data was not that weak, and then the week after we get a bad employment report.

And I wonder if we had some knowledge of the Markit reports that came out this morning, which measure manufacturing output throughout the world. They do an index for every part of the world. It's not my preferred metric for manufacturing, but the nice thing about it is that it's early and it comes from around the world.

So, we got China's PMI, which was down and below 50. We've got Europe, which was basically flat and still below 50. And we've got a smaller decline and still positive territory for the U.S. So, the data we got overnight supports a weak worldwide manufacturing economy, and if it's strong anywhere, it's in the U.S.

Stipp: There were a couple of other data points that weren't so great either this week, earlier this week, one of them is the Billings Index. What did that indicate about where we are?

Johnson: The Architectural Billings Index is a good measure of the non-residential part of architecture, meaning commercial buildings and so forth, and that number was a little bit soft. That dipped below 50 on a single-point average. So, that would tend to indicate that all the boom we're seeing in the housing industry might be offset a little bit by less commercial building.

Stipp: The consumer weekly shopping center data that you looked that also look soft this week.

Johnson: It was better this week than it's been for some time. We were up about 3% from a year ago, which gets us back into a normal range, but the five-week moving average that I tend to like to use on this metric still showed us at just 2.2%.

After all the bad weather we've had, we finally had a burst of really nice weather and the storms kind of paused for a moment. When you put it all together, we should've had a 4% number to come out of this mess, and we got 3%, which is good. We're on the right track and the U.S. economy certainly isn't falling apart, but it wasn't quite the big [growth] that I expected.

Stipp: And new home sales data actually looked better, or it looked better compared to some of the other data points we got?

Johnson: That was the best that we've seen in the recovery on the new home data, and it's finally kind of broken out decisively here, and they revised some of the earlier numbers for housing sales for earlier months this year as well. So that all points to a still-good U.S. economy driven by real estate and probably driven by the auto industry more than anything else, and a weak economy in most of the rest of the world.

Stipp: A couple of other data points on the broader economy: Exports is not the biggest part of the U.S. economy, but you said that we could see some headwinds on exports instead of it being a benefit, which it had been earlier in the recovery.

Johnson: That's why I've got to be careful. I think so many things are going right about the U.S. economy, but we're not getting to the 4% [GDP growth], we're not getting to the escape velocity or the rocket ship economy that everybody keeps talking about.

Exports will certainly be a headwind. As you point it out, it's not a big part of our economy. [Exports to] Europe is up 3% and China is about 1% of our economy, and lot of those are necessity. So, a small slowing isn't going to kill the U.S. economy at all, but it certainly is not a tailwind, either, which I was hoping it might be if things began to pick up in emerging markets.

Stipp: And if we do see some slowing in China, how is that going to impact the export picture?

Johnson: Well, the whole situation--it's not just China--but some of what we're seeing with Japan … scares me a little bit. With the yen falling so much, it now makes [Japan] more competitive with China, and China was already seeing a little softness, and China also has a big export market into Europe, which is much weaker than most people believe. And you combine that with the fact that now Japan is much more competitive with China than they used to be, and China is also facing problems with other emerging-market countries, which are also competitive with Japan. So, you've got a very bad situation there, where Asia looks like it's going to be a little bit softer.

Stipp: And another issue that we're facing here domestically is fiscal tightening that's happening. So, Bernanke did mention that the monetary stimulus that they're doing won't be able to completely offset some of the fiscal tightening that's happening there. So, how much of a headwind from tighter fiscal spending will we see on the economy?

Johnson: The old C plus I plus G--the consumption plus investment plus government--is what makes up the economy, and the government portion is going to be a lot softer than anybody had been thinking. It's going to continue to be a detractor, which is very unusual at this stage of a recovery. We talked about the fiscal cliff, and what resulted was about a $250 billion increase in taxes and so forth, and that certainly hurt the economy, but then we got the sequester on top of that. It made an amount that's closer to $350-$400 billion, and that's enough to really inflict little pain on the U.S. economy. So that's weighing on the numbers, too.

So we've got exports not looking so hot, we've got government not looking so hot.

Stipp: Consumer could be a little bit stronger.

Johnson: Consumer could be, and housing would be our two bright spots.

Stipp: So, when you wrap it together and you look at some of the headwinds and maybe some of the brighter spots in the economy right now, when you're looking forward, do you think that the Fed possibly could start tapering or do you think it's not likely that the Fed would start tapering, given your view of the fundamental strength of the economy? Again, he is not probably going to pull the stimulus back if the economy really is as fragile as he seemed to indicate earlier yesterday.

Johnson: My view is that the Fed will keep their policies about the same as they are until the economy gets better, and I mean significantly better, and if doesn't get significantly better, then they're not going to take the money away almost no matter what. With inflation being so low, they've got a lot of room to follow up with that threat.

So, I think they will remain stimulative. I think the economy may be strong enough where they have to think about tapering sometime this year, but I don't think it's going to be rocketship strong. The government and the export headlines alone will keep economic growth in the 2% to 2.5%, not the 4% that some of the crazies out there are projecting.

Stipp: The way that the market has been volatile based on these statements that the Fed have made would seem to indicate at least some people think that a lot of the market right now is underpinned by that stimulus. When the chance of the stimulus being removed--or part of it being removed--in the near term came up during that Q&A, the market sold off.

How much do you think that stock market is underpinned right now, and the economy is underpinned, by the Fed's stimulus efforts?

Johnson: There is no doubt that the stimulus has gotten the ball rolling. It's certainly been helpful in moving markets along and nudging people out of 0% savings account and into the stock market, and that's certainly been a help. But a lot of the fundamentals in U.S. economy are strong, and the markets are up so much, I think, because of the strong fundamentals, say, in real estate and in consumer spending. … To say that it's all the Fed, and if it weren't for the Fed, there'd be nothing here, is absolutely ludicrous.

We've had pent-up demand in housing. We had consumers for a while that really saved, for them, a substantial amount of money, and now they're letting some of that savings back out again. And that's what's driving the economy, and that's what, I think, is underlying a decent stock market. This concept that the Fed is the only thing that's keeping the stock market up is ridiculous.

I've lived through some pretty good bubbles, and certainly the NASDAQ bubble in 2000 and even where the stock market valuations were in 2000 and 2007-2008 are far above where they are today. Our own internal research suggests that markets are just about fairly valued, not real cheap, not real expensive. So to say that [the Fed is] driving the U.S. stock market to a bubble is just a fallacy.

Stipp: All right, Bob. Some very interesting insights. Thanks for helping us talk through all of these activities and actions causing some volatility in the market over the last day or so.

Johnson: Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.