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Quarter-End Insights

Outlook for the Economy

The economic waters grow more treacherous.

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After months of seemingly conflicting data, almost every indicator was beginning to show improvement at the end of the first quarter. Even the wayward employment data was moving upward.

But when it was finally impossible to deny that we were in an economic recovery, the market peaked in April, and the S&P 500 fell 12% from late April until late June. Riskier stocks, retailers, and commodity stocks fell even more sharply. Just one quarter after the uniformly bullish March numbers, I am back to interpreting data that is decidedly more mixed.

A faltering stock market, the European crisis, and continued tightening in China certainly didn't help the moods of consumers or investors during the second quarter, either. Temporary census workers (literally hundreds of thousands of people were quickly hired for the 2010 census and will be just as quickly let go in the months ahead) and expiring housing credits have already complicated the interpretation of both housing and employment data and could potentially continue to do so for another two or three months. Congress' decision not to further extend unemployment benefits will be another complicating factor for the economy in the months ahead.

Investors Have Itchy Trigger Fingers
Unfortunately, investors are quite jittery, seeing subprime monsters under every bed. Who can blame them after the violent and sudden downturns of the 2001 and 2007 recessions? Better to take some money off the table than chance a replay of those very ugly movies.

To me it seems odd that analysts who managed to deny that any recovery was under way after almost a year's worth of positive indicators are now grasping at those same indicators after only a month or two of decline. After just one month of disappointing, yet highly volatile, revision-prone employment data, everyone seems to want to throw in the towel. But six of the last seven months of employment reports have been up, and April's data was shockingly strong (though May's growth was admittedly disappointing). I believe even a modest improvement in the June employment data will put some of those employment fears to rest.

Two Months Do Not Make a Trend
While we have had a month or two of relatively weaker economic data, it is still too soon to hit the panic button, in my opinion. Economic recoveries seldom move up in a straight line each and every quarter. During the last two recoveries, growth slowed into the 1%-2% range for a quarter or two before reaccelerating to a rate of over 4% the following calendar year. These decelerations occurred about a year after the recovery began. Given that I believe the recession ended in June 2009, this recovery fits that pattern of past recoveries, with growth taking a pause after the first year of the recovery.

The Pause That Refreshes
I remain bullish on the economy and continue to believe that it can potentially grow at close to a 4% rate this year. This is down a bit from my previous growth estimate of 4.5% for 2010. Slower export sales due to a strengthening dollar and modestly slower consumer spending in the first half of 2010 are the primary reasons for my reduction.

For several quarters, consumers had been accelerating their spending faster than their incomes. This is relatively typical, as the 90% of workforce population that has jobs gains greater confidence and spends some of their hard-earned dollars on bargain-priced goods. I had anticipated that as incomes finally began improving, those extra dollars would be spent, accelerating the pace of recovery. Instead, it appears those dollars are being saved, at least so far. Whether this is due to fears about the European crisis, a falling stock market, or permanent newfound frugality is hard to determine. However, my guess is that as incomes continue to increase, spending will eventually follow, with a lag.

Our Sector Teams Are Cautious
The outlook based on a bottom-up view from our individual sector teams is mixed. Their concerns mirror remarks that I hear about the broader economy. The primary worry of each of our teams is a bit different. Our financials team remains very concerned about the European situation although they don't expect any of the large U.S. banks to run into solvency or liquidity problems as a result of the financial difficulties of Europe's spendthrift nations. 

Meanwhile, our basic materials team is more worried about the potential of a cooling Chinese economy. China has played an important role in rising commodity prices and more broadly, a rising world economy. And our consumer team worries about sluggish consumer incomes, a reluctance to spend, and a high unemployment rate here in the U.S.

Our industrials team remains the most bullish, but they are a bit concerned that some of the rates of improvement are slowing from their breakneck pace. However, they also believe that inventories are still unsustainably low and the manufacturing economy remains incredibly strong.

Our health-care team is relieved that health-care reform legislation is complete but still believes that Wall Street is severely underestimating the positives for the industry in the recent legislation.

 

Higher Incomes, Low Inventories, and an Improved Manufacturing Sector
My personal outlook is more bullish than our individual teams'. My short-term optimism is based on two premises. First, consumer incomes continue to improve, recently in a dramatic fashion. Second, manufacturing has yet to really catch up with improved consumer spending.

The industrials outlook highlights inventories that are still at record lows. Every time production is increased, sales of finished goods increased even faster, so the ratio of inventories to sales remains at record lows. Morningstar associate director Eric Landry's article does an excellent job of sorting out just how low inventories still are and why this is so important to a stronger manufacturing economy.

While consumer spending has recovered all the ground that it lost in the recovery, industrial production has recovered only half of what was lost. Recent increases in new orders are supportive of future increases in industrial production, which should eventually lead to further improvement in employment. An improving manufacturing economy should eventually lead to positive changes in the larger services part of the economy.

The Consumer Has More to Spend
As for the consumer, I think all the focus on a couple of soft months of spending is misplaced and that investors should be more focused on incomes, which generally are a better leading indicator. The trend in consumer disposable incomes has turned quite positive over the past several months as shown in the chart below:

  Real Disposable
Income
Real Spending
January 2010 0.1% 0.1%
February 0.0% 0.5%
March 0.3% 0.4%
April 0.6% 0.0%
May 0.5% 0.3%
Year to Date 1.4% 1.3%
YTD Annualized 3.4% 3.1%

Source: Bureau of Economic Analysis, Morningstar

Just as relatively weaker income growth in January and February led to softer spending in April and a little bit in May, I believe that recent strong income gains will turn into spending gains in the months ahead. So while the world is focused on two months of slower nominal growth in consumer spending, my eyes are firmly on improvement in inflation-adjusted numbers in general and income numbers in particular.

Housing and Exports Will Drive the Economy Longer Term
I still believe that the housing and auto industries are functioning substantially below long-term demand needs. While those industries probably aren't going back to their record high production levels, I still believe that housing construction can easily double from here, and autos can increase another 40%. (My optimism is based on population growth and normal wear and tear for existing assets.)

However, no one can tell with any certainty whether we will get back to those levels over the next two years or the next five years. Nevertheless, I think better growth in these sectors will return, adding further fuel to a longer-term, sustainable recovery. Exports to emerging markets are another source of longer-term economic improvement that will provide more opportunities for developed economies. I think those strengths stretch well beyond China to India, Brazil, and several other emerging economies. It is not a one-country story, in my opinion.

Government Policy, the Scariest Monster Under the Bed
My biggest concern continues to be government policy changes or external shocks to the system that could derail the economy. An adverse tariff or trade decision, or suddenly frugal fiscal policies remain my biggest concerns. As always, Middle Eastern political issues remain a major concern as Iran inches ever closer to developing a nuclear weapon.

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