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5 Headwinds on the Recovery

Jason Stipp
Robert Johnson, CFA

Jason Stipp: I'm Jason Stipp for Morningstar. We're now over four years into the economic recovery, an impressive amount of time, but the strength of the recovery itself has failed to impress. So what's holding us back?

Here to offer some insights is Morningstar's Bob Johnson, our director of economic analysis.

Thanks for joining me, Bob.

Bob Johnson: Great to be here today.

Stipp: You have listed several factors that have been holding back the recovery, and you also have some ideas on whether those will continue to be headwinds or whether they might give us a little bit of relief at some point.

The first one is new taxes. We did see taxes go up this year as part of the fiscal cliff dealings. How much have they held us back, and are we going to see any relief on that front?

Johnson: Between taxes and spending, we probably took over 1%, maybe even 1.5%, off of what GDP growth otherwise would have been. It's a very, very significant number.

The payroll tax alone going up is $110 billion, and that amounts to about a 1% number in terms of personal income. So it's a huge number. Then you've got income taxes, where some withholding [amounts] went up at the beginning of the year. But the real big impact is [going to occur] when people make their estimated taxes, when they write their final check for 2012, and start doing their planning for what they're going to pay for 2013. Some of that's ongoing. And I think that those numbers are still going to be difficult. I think everybody knows and understands the payroll tax. That one is pretty well behind us. We've adapted. I think with the income tax, we might see more of an impact here in the second half, but then if we look forward to 2014, hopefully, that tax penalty is well behind us.

Stipp: So we're not necessarily expecting taxes to go down, but people will get used to the levels where taxes are now and eventually will adjust, and we'll be able to see growth after that.

Johnson: Exactly.

Stipp: Another issue I know that's had an effect perhaps across the economy, but maybe especially in housing, is that credit still remains tight, even though we have the financial crisis pretty far in the rearview mirror at this point.

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Johnson: They have remained remarkably tight on mortgage loans. We've talked before about needing to bring paychecks to your closing to show them that your actual last check was the same as the one before, to make sure nothing happened between here and there. We've talked about, if you have any blemish on your record at all, that you're not going to get credit.

So despite the Fed doing all these easing policies, and many thinking we've got easy money, mortgages are harder to get today than ever. It's almost getting worse, because now [we have] all sorts of new regulations [on banks] saying, you can't do this and you can't do that with a mortgage, and if you securitize it, you have to do this, and maybe you have to hold a little of it. So it may not even be totally done yet. Mortgage credit is tight and is likely to remain tight at least for the next couple of years. So that's an issue.

If that could somehow … get easier, that would be probably the biggest thing to make a difference, because you can see it in the data. In autos, the credit has been remarkably easy, because the Fed has not been watching. There are no new special regulations on auto financing. In fact, if anything, auto financing is now easier, because during the recession, [almost] nobody gave up or lost their cars to foreclosure. So those loans are as good as gold. It used to be like that with mortgages; nobody ever went bad on it. [Auto-loan] credit has been very easy, the rates have been attractive and, lo and behold, the auto market is now back to where it was at the top of the last market; we're back to 16 million cars. So it shows you that easier credit will do the job.

Stipp: Another issue that you mentioned when we talked about taxes, is government spending. There are, of course, very compelling reasons why we need to relieve government spending and the debt load. But it does have an immediate effect on the economy when the government stops spending as much as it has before.

Johnson: Yes, and it's been a little bit more drastic than anybody thought it would be. I think part of it was some of the wars winding down in addition to sequestration and some of the budgetary laws all combined to bring in the numbers a little quicker than people thought it would happen. Government certainly has been a subtraction on the GDP calculations for many quarters, and that really hasn't happened many times [before]. When we wound down the war in Vietnam and the war in Korea were the two other times. And this time it's actually a little bit broader in timeframe and amount.

We've lost 500,000-some government jobs. By the way, it's not just the federal government. State government has been tight when all the revenues disappeared in the recession and have remained tight at the state and local level, because now they've got to fund all those pensions. That means they've got to lay the cash out for the pensions, but they aren't able to hire more people, despite the fact that they've got more tax revenue. So, unfortunately, I think the government issue is going to be ongoing.

Now, the worst of the sequestration will probably hit in the next fiscal year, in 2014. So government on the federal level is going to get a little worse in the next six months, and then after that, government in 2015 and [beyond] should start to grow again and not be a detriment to the economy.

Stipp: Another issue you mentioned, is building and construction. Are you talking about commercial building being a detractor? What about the housing market? How do you think about building and its contribution, or failure to contribute, to the economy?

Johnson: As you know, I've been very excited about the housing market, which has done relatively well and has been an add to the economy, but even there I'd say there has been a little bit more improvement in apartment buildings than there has been in single-family homes, and that's held back some of the growth in employment that you'd normally expect to see.

But I'm a little bit more worried about commercial buildings. You've got the Amazon effect, where more and more people are not going to brick-and-mortar stores to buy their things, and instead they're ordering them online. That's certainly caused a softness on the retail side of the house, which is normally a pretty good part of building growth, and we're certainly not seeing great numbers there. That's holding things back. And the government buildings are clearly not a good thing, either.

There are a few things that are doing a little better--maybe warehouses, probably again because of Amazon, and manufacturing is doing just a little better this time around. So there are some good spots, but typically you would have expected construction to be a really big adder to the economy by now, and this time, not so much.

Stipp: And you're not necessarily seeing big catalysts that this would be something that might turn around at least in the near term?

Johnson: No, unfortunately not. I think the Amazon phenomenon is going to continue, and maybe the only thing that's going to do all that well is warehouses.

Stipp: The last point, Bob, that is important to pay attention to with respect to the economy is the rise in income inequality. This is, of course, a very passionate issue with debate on both sides. But when you see income inequality, there is a direct impact on the economy and the drivers that would have the economy grow or not grow.

Johnson: I think the problem when you've got income inequality in terms of economic growth is that people in the upper income brackets tend not to spend as much money. In fact, they may save as much as half of their incomes when you get into the very upper brackets, so they don't have to spend the money, which is sometimes in the long run good for investment, but in the short run they're not consuming; whereas, people in the lower income brackets tend to spend every dollar they get, which means that you get this multiplier effect: An auto worker spends more money in a restaurant, and the restaurant worker spends more at the grocery store, which gets the snowball going of recovery.

Unfortunately, this time almost all of the income growth has come at the top end of the income scale, and that's certainly held things back as those people are little bit more conservative with their money and how they spend it. When you need to come out of a recession, you need people to spend money to get that employment engine growing.

Stipp: So another way to say that is more of that money is essentially discretionary when a smaller number of people hold it, because they don't have to spend it for their basic needs.

Johnson: Yes, correct.

Stipp: What about the trends that we're seeing here as far as what's causing some of that income inequality? Are they likely to continue, or are we seeing that … folks at the other end of the scale could have a little more income?

Johnson: I'm afraid the income inequality may continue a little bit. Now the higher tax brackets may weigh on the top group and bring things a little bit back together. But the general trend toward more income flowing to higher brackets is a trend that's hard to break. As you get more and more things dependent on how much education you have and so forth, it tends to narrow the number of people that are very successful a little bit, unfortunately.

Stipp: Bob, as always, very interesting take and perspective on the economy. Thanks for joining me today.

Johnson: Thank you.

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