Outlook for the Economy

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• GDP Growth Likely to Accelerate in 3Q and 4Q with Total 2010 Growth of 2.5%-3.0%
• Consumers are Scared but Continue to Increase Spending at a Consistent Rate
• Improvement in Net Exports Will Be a Key Driver in the Second Half of 2010
• Under-Invested Corporations Are Scrambling to Catch Up

 

Can't Just Lay Down a Ruler
I think many economists and market pundits have laid down a ruler on the graph of the last three quarterly gross domestic product reports--which show a smooth decline in GDP growth from 5.0% in the fourth quarter of 2009 to 3.7% in the first quarter of 2010 and finally to 1.6% in the second quarter--and have concluded that the next move in GDP growth is likely to be down. Mixed signals out of both China and the manufacturing sector helped bolster that mentality. I think that those fears are misplaced, and in fact growth could reaccelerate in the second half of 2010 and stabilize in the 3% range for 2011.

Consumption Remains the Economy's Driving Force
In a nutshell, I believe relatively stable consumption growth of 2% or more will combine with an improvement in the second quarter's anomalous net export numbers and slower but still decent growth in business investment spending to drive GDP growth higher in the months ahead.

Unfortunately, slower construction spending and lower real estate brokerage commissions will counter some of those positive GDP trends. I am still optimistic on residential housing longer term, but for now the best thing I can say about housing is the market is stabilizing at depressed levels. New home construction has become such a pathetically small portion of GDP that even a double-digit percentage increase or decrease wouldn't move the economic needle in the short term. However, I still think housing can provide a mid-recovery boost (instead of its more typical role of early-cycle rocket fuel) for the economy in late 2011 or 2012 as consumers gain more confidence and a better balance sheet.

Overall Employment Growth Should Resume in 4Q
I am also convinced that employment will manage to continue to inch upward in the months ahead given that corporations seem to be running low on techniques to get even more out of tired and bruised employees, as indicated by diminishing productivity numbers.

Given that increased production must come from either more labor or more machines, and that investment spending collapsed during this recession, in the short run, I think increased consumer spending will lead to a greater need for labor and employees. Nevertheless, rather anemic employment growth won't make a very big dent in the more than 8 million jobs that were lost over the course of the recession.

But There Are Risks to My Forecast
The biggest risk to my relatively optimistic GDP estimate is an outside shock, possibly a geopolitical shock that spooks the consumer. An inflation scare or a surprise move in interest rates could also harm my forecast. It remains unclear to me whether the uncertainty and the potential for a tax increase would provide enough of a shock to the system to unravel the recovery.

Personal Consumption Growth Lays Down a Base of Stability
There are a number of very important statistical reasons why the economy should accelerate, but the primary reason for my optimism is the slow upward trudge of consumer spending. Consumer spending accounts for 70% of the gross domestic product in the U.S. Variations in consumer spending are usually the smallest of all the major GDP categories and tend to show some persistence over time. Meanwhile things like capital goods spending, inventory, and net exports all key off of consumer spending, but exhibit a lot more volatility and widely varying leads and lags.

The pattern of consumer spending has been remarkably stable this recovery, at least on a quarterly basis.

Real Personal Consumption Growth and Disposable Income
Quarter	Consumption Growth Rate	Disposable Income Growth Rate
3Q 2009	2.0%	-4.4%
4Q 2009	0.9%	0.0%
1Q 2010	1.9%	1.3%
2Q 2010	2.0%	4.0%
3Q 2010 E	2.1%	2.5%
Source: Bureau of Economic Analysis, Morningstar Estimates

I Believe the Savings Rate Has Peaked
As is typical at the beginning of a recovery, consumers tend to spend a little more than their income growth. That gap has now closed with consumers spending less than their income growth. Without a fairly meaningful decline in income, I don't expect to see a drop in consumer spending without some major external shock to the system, such as a sudden rise in inflation and interest rates.

With the economy showing some signs of improvement, it would seem a bit odd for consumers to drastically raise their savings rate from here. That rate has already been boosted from under 2% to about 6% over the last three years. Prior to this recession, one would have to go all the way back to 1998 to find a higher savings rate. Typically, savings rates peak shortly after the conclusion of a recession. This is why I might argue that if consumers were to feel a sudden bout of optimism, they could easily spend a little bit more of their income growth and move the savings rate a little lower.

 

Consumers Have Surprised Me Before
I am just a little cautious on the consumer after being whipsawed by consumer data earlier this year. As stable as the quarterly consumer numbers have been, the monthly numbers exhibited some very odd behavior this spring. Monthly retail sales numbers literally exploded on the upside in February and March, then slumped through June. I mistook the March jump for a permanent increase and raised my 2010 GDP estimate as high as 4.5% for 2010. However, the spike proved to be a mirage related to some very favorable holiday timing and some great weather. The European debt crisis and May's flash crash brought consumers back down to earth in May and June. That short-lived boom-and-bust cycle has taken several months to ripple through employment, production, and even housing.

Our Consumer Team Warns That Shoppers Are Still Extremely Frugal
News from our consumer team was glum after returning from a major consumer goods conference in September. Some executives in this sector went so far as to say that we were still in the throes of a recession. Consumers still appear to be shunning expensive branded goods in favor of private-label items. Branded consumer goods companies have resorted to heavy promotional activity to move goods. If it isn't on sale, consumers aren't biting.

Big ticket items aren't moving well, either, with auto sales to consumers barely off this recession's bottom. Only apparel and consumer electronics seem to be doing reasonably well. Much to the disappointment of American workers, a lot of those goods are made overseas. And the larger services sector, normally a bright spot in a recovery, has been anemic, as restaurants, travel, and even health care have not been able to catch much of a break this recovery.

Even Our Health-Care Team Is Worried About the Consumer
Our health-care team's outlook details a troublesome slowing in the growth of health-care spending, which hasn't been seen in previous recessions. According to the team:

"In real dollars, personal consumption expenditures on health care declined sequentially by 0.1% in the first quarter of 2010 and increased a meager 0.2% in the second quarter. On a per capita basis, health-care spending declined 0.2% in the first half of 2010 (data from the Bureau of Economic Analysis)."

The only good news here is that there are a few catalysts for at least modest improvement, as folks rush to use up annual health-care dollars and as deductibles for 2010 are met later in the year. More mandated preventive health-care measures should also boost 2011 results. An improving job market should also help move health care out of the doldrums.

Imports Hurt GDP Growth in 2Q and Should Partially Reverse in 3Q
Net exports subtracted 3.4% of the GDP calculation in the second quarter, one of the largest subtractions on record, as imports surged. The surge in a couple of suspicious categories (diamonds and pharmaceuticals) largely reversed themselves in the first month of the third quarter.

Consumer electronic imports haven't helped matters, either. However, some of consumers' ardor for flat screen TVs and computers seems to be fading, and that could provide a further aid to overall GDP growth if consumers opt to spend those extra dollars on U.S. goods and services.

Exports should also look a little better, too, as the demand for capital goods from emerging markets continues to increase. Capital goods manufacturers ranging from  Deere (DE) to  Caterpillar (CAT) to  Eaton (ETN) are all reporting strong overseas orders and are increasing production accordingly. (All report that U.S. orders aren't too shabby, either.)

Although too small to make a huge difference, sales of U.S. agricultural goods abroad will be aided by severe weather problems in many parts of the rest of the world, especially Russia. Overall, I suspect a substantially smaller negative impact from net exports in the third quarter.

Business Spending Is Another Bright Spot
Business spending is a small category but was a relatively big help to second-quarter GDP growth. Non-residential fixed investment jumped more than 17% in 2Q on an annualized basis and was one of the largest contributors to growth that quarter. While it may be difficult to match that in 3Q, investment spending should be up nicely based on economic reports we have seen so far this quarter.

According to Morningstar's industrials team, businesses substantially underinvested during the recession compared to normal levels and are now making up for lost time. Certainly large cash hoards and a very willing bond market are facilitating the investment process. Many major industrial expansions announced in the first half will commence construction in the second half, aiding overall economic growth. Interestingly, many of our sector teams note that scores of corporations are opting to buy rather than build their way into better growth. Merger and acquisition activity has accelerated in many sectors, especially technology.

While the World Watches Manufacturing, I Am Watching the Consumer
Lately, the market has become infatuated with manufacturing data, making huge moves when key manufacturing data points are released. The release of favorable manufactured durable goods orders in late September caused almost a 200-point rally in the Dow Jones Industrial Average, similar to the 250-point gain on Sept. 1 when a favorable purchasing managers' report was released. Conversely, a disappointing July PMI report dropped the market more than 100 points on the day it was announced.

I have been a huge proponent of using manufacturing data, and the PMI data was instrumental in helping me to identify the economy's bottom. However, in the middle of the cycle, manufacturing growth typically moderates and other sectors take the stage, rendering manufacturing data less useful and requiring a more nuanced interpretation.

For example, the PMI data has suggested a lot more recessions than have actually occurred. One only has to glance at the chart below to see that zigs and zags can fake out investors who use the data to predict recessions. (It does do a better job of forecasting industrial production.)

So why is manufacturing data less useful in the middle of a cycle?

I think part of the answer is that manufacturing is a volatile but not a particularly large part of the economy. Services represent a far larger part component. In the early stages of a recovery, huge moves in manufacturing dominate economic growth as massive swings in even a small component dwarf the more steady-Eddie services numbers. However, as manufacturing returns to more sustainable, normal growth rates, changes in the services sector become more important.

I think it is important to understand causation, too. Manufacturing generally increases because of increased consumer demand. Manufacturers don't make goods for their own health, but rather typically in response to consumer demand. (However, exports can provide a small boost at critical times, as they did early in this recovery.)

Inflation-Adjusted Hourly Wages, Hours Worked, and Employment Take the Stage
Without dipping into savings, it is hard for consumers to spend more than they earn. Therefore analyzing consumer incomes becomes increasingly important. Wage income is a factor of real wages, hours worked, and total employment. Typically real wages move up first, followed by hours worked, and finally employment.

Real-wage increases (primarily because of stationary nominal wages and deflation) were the single earliest markers of the recovery. Stagnating real wages this past winter were probably one of the earliest indicators of our modest summer slump. Those numbers have shown some improvement lately, but not nearly as much as I would like to see.

Hours worked have also shown some improvement recently, but again I need to see a little more growth if this recovery is to pick up any steam. The good news about these numbers is that other than the inflation component, they are available in the monthly employment report that is published the first Friday of the following month. Full consumption numbers and personal income data aren't available until nearly a month later.

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