Consumers Hold the Key

Over the past seven months I have been very bullish on the economy and have raised my GDP estimates on several occasions. The improvement drama has played out exactly according to the script: Housing is stabilizing, manufacturers are increasing production and slowly rebuilding inventories, and exports are marching upward. While overall consumer spending has shown new life, the improvements have proceeded at a pace that can charitably be described as glacial, erratic, and hesitant. The improvement has been slower than I anticipated, but stronger exports have helped offset some of the disappointing results.

Overall, the economy's performance has amounted to a real turnaround story. We moved from GDP declining by more than 6% during the March quarter, to growth approaching 3% during the September quarter. As recently as April, the consensus forecast for September was 0.4%, with many economists anticipating a decline. We have come a long way fast. However, I am paring some of my short-term forecasts. I would be a bit suspicious of a market that has come so far, so fast, especially since the economy is moving into a stage that is more difficult to predict.

Low-Hanging Manufacturing Fruit Has Been Picked
Some of the low-hanging fruit that has fueled this recent economic growth has long since been plucked. At the end of 2008, many manufacturers cut production levels to well below already-depressed sales, exacerbating economic results. During the second and third quarters of 2009 manufacturers really had no choice but to raise production back to at least replacement levels.

This is just aligning sales and production. It is not restocking, as some are characterizing it, since inventory levels are still declining. For one month during the recession, auto production was half of already-depressed sales levels. Over the last six months, auto production has risen dramatically, helping drive up a lot of my indicators and GDP numbers. As early as November, auto production, sales, and employment will be in pretty close alignment for the first time this year.

Any more improvement in auto production and employment will have to come from real end-user demand. Auto sales still have plenty of potential upside, as last month's sales were a measly 10.6 million units (on a seasonally adjusted annual rate basis) compared with 14 million to 18 million during more halcyon times. Similarly, our technology team has cautioned that a lot of the strong semiconductor results during the second and third quarters were driven by inventory rebuilding and not end-user demand. While partially company specific, poor results from  Dell  this week confirm some of those fears.

Government Spending, Help or Hurt?
I am also increasingly concerned that federal government actions are hurting the economy much more than they are helping. In the latest example, Congress thought it had extended unemployment benefits with a bill passed several weeks ago. It turns out that the extension was based on another bill that was scheduled to expire. Now they are going to have to go back and fix that, potentially delaying benefit payments in January for some recipients.

This one is relatively easy to fix, but the highway bill has turned into a real debacle. Baseline highway spending is based on a very large, five-year appropriation. That bill expired several months ago. Thus far, Congress has approved two 30-day extensions, but that hasn't helped projects that go beyond the extension. The interaction of the stimulus bill and the highway bill means that some of the stimulus money can't be spent until there is a clearer picture from the highway appropriation bill.

I am also seeing more articles indicating that the process of getting stimulus-related projects under way has been far more difficult than anticipated. While the ineptitude here is not as jaw-dropping as the bungled Hurricane Katrina response, it certainly raises some questions regarding government competence.

Also, as I discussed last week, all the uncertainty surrounding health care and who will ultimately pay for it has caused some major consternation among business owners large and small. Last week I indicated that small- and medium-sized businesses, the pistons in the great economic growth machine, were slowing hiring until a clearer picture of their health-care obligations emerged. Apparently, small businesses aren't the only ones concerned. Last week, David Farr, CEO of  Emerson (EMR), lashed out, claiming that Washington is doing everything in its power and capability to destroy U.S. manufacturing. He went on to cite cap-and-trade legislation, health-care reform, and labor reform as among his flashpoints of concern.

My Outlook for 2010 Is Still 3.5%
That said, I am still quite bullish on the economy for 2010, with forecasted growth of 3.5%. A rebound in housing and automobiles, both of which continue to operate at well below natural long-term demand trends, could prove to be key growth drivers in 2010. Improved export sales to developing markets will also help, along with some inventory restocking.

Second-Half 2009 Growth Forecast Reduced to 3% from 3.5%
Overall growth in the second half of 2009 is likely to look a little more sluggish than I anticipated just a few weeks ago. The first report for September-quarter GDP indicated 3.5% growth. That number is likely to be revised downward next week to 2.5%-3.0%, largely due to a revision of the September retail sales figures and some inventory adjustments. I was forecasting about a 3.75% increase for the December quarter but now believe that a 3.25% increase may prove closer to the mark than my earlier forecast. A weaker-than-expected industrial production number for October is the key factor driving my reduction.

Indicators Looking Sluggish
Besides industrial production, a lot of the indicators this week were disappointing. Housing starts dropped more than 10%. Jobless claims were flat, and prices were a little higher than I had hoped. On the positive side, retail sales were generally better than expected. Monthly billings by architects also improved, as did weekly rail shipments. I had been warning for the past three or four weeks that both the housing and manufacturing sectors were probably due for a pause as we approach the holiday season. The housing starts data was probably depressed by the threat that the federal government housing credit would expire (it was subsequently extended through April and expanded to cover more buyers).

Industrial production grew by a paltry 0.1% rate, versus growth during previous months that topped 1%. Auto production was a key culprit, as production finally appeared to catch up with sales. Retail sales looked really strong at 1.4%, driven by an improvement in autos (sales have been volatile because of the "cash for clunkers" program and production had, until this month, been showing steady improvements). Ex-autos, the growth figure was a more modest 0.2%. Backing out gas, building materials, and autos, the figure actually showed an increase of 0.5%, the fourth monthly increase in a row. As I surmised, the street reacted strongly and positively to the retail sales number, while the response to the more-negative numbers this week was more muted than I would have anticipated.

Consumers Hold the Key to Growth
I believe it will take more robust end-user demand before the economy can get better traction under its tires. It all comes down to when the 90% of the people with jobs, and those with limited debt, have the confidence to spend more of their incomes. Unfortunately, consumer spending moods are a lot harder to predict than cyclical rebounds in manufacturing. I am optimistic that the 60%+ move in the stock market from its bottom, bigger bonus potentials at financial firms, and reduced layoffs could spur holiday sales above last year's levels. However, things still remain rough at the bottom of the economic totem pole, which adds to the festering economic uncertainty.

The key to a successful holiday season will be exactly how the dance between cagey, cash- strapped consumers and battle-scarred retailers plays out. If retailers hold the reins on pricing too tight and inventories too low, it could turn out to be a miserable holiday season. However, selective holiday bargains could be just the ticket to encourage consumers to part ways with some of their cash. Another wildcard over the holiday season could be how many businesses announce the reinstatement of benefits, 410(k) matches, and wage hikes for 2010. Some firms have already announced some positive news on this front.  J.P. Morgan (JPM) even announced a special one-time payment to all of its employees. I am hopeful that I will see more of these announcements over the coming weeks as 2010 budgets and planning are finalized.

On Tap: Lots of Data for a Short Week
Next week, we get a week's worth of data crammed into just three days because of the Thanksgiving holiday. Statistics will encompass a lot of housing data including the Case/Shiller housing price index, which may cool down after last summer's healthy gains. Existing home sales are also due. These should look better based on strong pending home sales data and a weak market for new home sales. Given the potential expiration of the homebuyers' credit, new home sales will probably look weak.

Consumer sentiment numbers are also due, though I am not sure they deserve much weight. Given that headline unemployment crossed the 10% mark early in the month, it's hard to believe we would see improvement in this statistic.

We will also get consumer income, expenditures, and savings numbers for October. Though this data is a bit dated by the time it comes out, it will be interesting to see how much cash consumers were willing to part with. I am also very curious about the income numbers that have been stagnant over the past several months.

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