QE or Not QE, That Is the Question
This week's indicators showed steady improvement. Will more quantitative easing help the situation?
Other than durable goods orders, this week's pack of economic indicators was positive and consistent with a slowly improving economy driven by better consumer spending. However, this week's indicators were largely ignored as investors focused on new guesses about the timing and the magnitude of the Fed's quantitative easing program, a novel attempt to reduce long-term interest rates.
Fears that the easing may not be as big as some hoped drove the market down early in the week. The 2.0% real GDP growth rate for the September quarter, announced on Friday, was certainly a positive, though the market was less than excited about this piece of data. Even more impressive, consumer spending increased 2.6% in the quarter compared to 2.2% in the prior quarter, continuing an accelerating quarterly trend.
Given my fundamental belief that it is the consumer that is the ultimate driver of economic activity, this was clearly the best news of the week. On the manufacturing side, durable goods orders, stripping out aircraft data, were disappointing. Softening the blow a bit was a highly positive regional purchasing managers' report for Chicago that showed this key metric improving substantially from the previous month. Though not terribly meaningful, both new and existing home sales were better than expected, but still at highly depressed levels. Initial unemployment claims also fell an additional 21,000 after a meaningful decline the previous week, inspiring some hope that October's jobs report will look a little better.
Looking ahead, I still think real GDP growth will accelerate slightly in the fourth quarter to 2.5% on the back of lower net exports, improving residential and construction data, and continued strength from the consumer. For all of 2011, I suspect that improvements in auto sales, housing sales, and construction, as well as more net exports, partially offset by smaller inventory builds, will drive 2011 GDP growth to close to 3.0%. That's enough to keep the forward positive momentum but not enough to make much of a dent in the ranks of the unemployed.
What's Bob Watching? Services and Things That Drive Consumer Income
Retail spending on "things" has shown marked and steady improvement, at a pace that isn't terribly far off of what I'd call an average recovery. Industrial production is also performing close to average, too, although not as well as retail sales. Consumer electronics and apparel are two of the bigger factors driving improving retail sales so far. Unfortunately, many of those goods come from overseas--hence, the lag in U.S. production.
Services, which are a much bigger portion of the economy, have seen a lackluster recovery. Health care has been a particularly big laggard this recovery, along with restaurant dining and travel services. Recent operating results from the restaurants and the announcement of better holiday bookings from the airlines are two positive developments. Improvement in the health-care sector remains an open question. Whether consumers rush out and use up their insurance deductibles and pretax health-care dollars during the fourth quarter will be one item I will be watching closely. The ISM also has a nonmanufacturing based index, and that will be another indicator that I keep my eye on.
The other big items that I'll be watching are inputs that drive consumer incomes. At the beginning of recovery inventory replenishment and higher business spending can drive the economy forward even if consumer spending is lackluster. However, almost a year and half into the recovery and with inventories now replenished, consumer spending will be the key driver for economic growth. Only higher consumer incomes or lower savings rates can drive that spending.
On the wage side, the largest category of personal income, I will be watching not only total employment, but hours worked and inflation-adjusted wages per hour of work. I don't need all three moving in tandem, but I do need enough movement in one indicator to keep overall wage and salary income going up. I am relatively optimistic on this front, encouraged by the potential for higher holiday hiring from the retail sector and the fact that the airline sector is now beginning to recall furloughed pilots. Higher inflation would also clearly hurt spending, so that is also on my watchlist.
Increased Taxes and Unemployment Expiration Could Damage Consumer Spending
However, my biggest worries are the potential for increased taxes and more people reaching the end of their 99 weeks of unemployment. With the potential for a lame-duck Congress after the election, I worry that there is at least a small probability that the Bush tax cuts will expire. Even a small tax increase could wipe out the relatively small income expansion that I am anticipating.
On the unemployment side, the emergency 99-week extended unemployment benefits will need to be renewed in the near future. Each successive extension has proven harder to pass, and this one may prove the hardest of all. Even if emergency benefits are extended, I don't think too many congressmen would vote to extend benefits beyond the current 99 weeks. And within another few months, those people hitting the 99 week mark (and therefore losing their benefits) will be from the masses of people laid off in the darkest days of 2009 instead of the relatively small pool of people laid off in early 2008.
Talks of Quantitative Easing Have Driven Markets Up Since the End of August
As we discuss in this week's video, quantitative easing (the primary goal being to reduce long-term interest rates) has a lot of plus and minuses for most economies. However, many of the more typical benefits of rate reductions, such as immediately stimulating the housing industry, will not accrue to the economy this time around.
I believe the Fed is hoping that lower rates will power the stock market higher, through the mechanism of a lower discount rate on corporate earnings and by putting additional cash in investors' hands (by directly purchasing bonds for cash). A higher stock market boosts consumer spending through what is known as the wealth effect. As asset prices go up, consumers tend to spend some of that price appreciation. Studies have by and large shown that consumers will spend 3%-5% of their increase in the value of their asset holdings. I am a bit skeptical that QE will do much beyond inflate asset prices. And unfortunately, some of the assets that may get inflated include emerging markets as well as commodities, which certainly won't help U.S. consumers.
That's why I will not be terribly disappointed if the quantitative easing program turns out to be a little smaller than some market participants had hoped. The consensus among economists seems to be for $250 billion of easing in each of the next two or three quarters followed by re-evaluation of the program. However, I think some traders are still hoping the Fed tries to "shock and awe" the markets again with a program almost as large as 2009's $1.7 trillion mortgage repurchase program. Therefore, rumors of the smaller program and disagreement among Fed members sent shock waves through the market on Tuesday. The Fed will announce its intentions on Nov. 3.
GDP Growth Report Checks in at 2.0%, Consumer Spending Grows 2.6%, Highest Since 2006
The GDP report showed real GDP growth of 2.0% for the September quarter, slightly better than recent consensus but far better than the fears that were prevalent just a couple of months ago that GDP would decline meaningfully from 1.7% in the second quarter. Even better than the headline number was news that consumer spending accelerated to 2.6% growth--the best growth rate since 2006. The trend here looks particularly good
|Consumer Spending Accelerates|
|Annualized Growth Consumption (%)|
|Source: Bureau of Economic Analysis|
So much for the consumer being dead and completely tapped out. Though the monthly data on consumption won't be released until Monday, I believe the numbers will show that consumption accelerated sharply during the last month of the quarter, which provides a strong base for fourth-quarter results. The one potential negative of such a strong September number is that it may have stolen a little from the month of October as well.
Within the consumption numbers, the service sector began to show some signs of life. For the first time this recovery, services made a bigger contribution to GDP growth than the goods-producing part of the economy. This is exactly what I'd been hoping for, as services spending tends to benefit U.S. companies instead of flowing into other pockets overseas.
Exports Disappoint, Inventory Growth Offsets
The net export number was a bit of a disappointment as it subtracted about 2% from quarterly GDP growth instead of the 1% rate I'd been anticipating. However, that was still better than the 3.5% ding in the second quarter. I think a lower dollar and increased productivity will move the net export number in the right direction in the months and quarters ahead.
Offsetting the negative net export effect, inventories were a better contributor to GDP growth than most anticipated. Growth in production whether it is sold or goes into to inventory is counted in GDP. The key question was whether the inventory build represents a backup of goods in the supply chain or intentional inventory building to support growth.
Durable Goods Orders Disappointing
Like last week's disappointing industrial production report, the durable goods report came up short of expectations but was far from a disaster. Remember that some slowing in the manufacturing sector is typical at this stage of a recovery. Eric Landry of Morningstar's industrials team summed up the report as follows:
Employment Report Is the Key to Next Week's Indicators
Friday's employment report will be the first one in many months that isn't encumbered by a strong fall-off in census workers. Consensus job growth for October is pegged at 73,000, which strikes me as just a little light given the string of national and regional purchasing managers' reports indicating employment growth. Unfortunately, merger and acquisition activity earlier in the year will continue to weigh on the employment report. I am hoping for some growth in real hourly wages and hours worked, which were both stuck in neutral last month.
Don't Sweat the PMI Data Next Week
The National PMI manufacturing report is also next week; the market is bracing for another decline, with consensus expecting a 53.4 reading compared with 54.4. Our industrials team also expects a decline. Interestingly, the Chicago PMI report along with several regional reports have actually shown some improvement this month. The Chicago report, released Friday, jumped back over 60 with strong readings in almost every category including employment and new orders. Though these regional reports may not be able to fend off a small national decline, they should enable the index to avoid a catastrophic decline that pushes an already spooked market over the cliff. No matter what the market thinks, manufacturing will not be the key driver of the economy in the months ahead.
Normally, I ignore the ISM service index, but I will be taking a closer look at next week's reading in light of my newfound interest in the services sector. Consensus is for a modest improvement to 53.2-53.4.
Productivity on the Uptrend Again?
Third-quarter productivity is due next week, and I suspect a return to stellar growth given better-than-anticipated GDP growth and September's flat hours worked statistics. Better U.S. productivity combined with a sharply weakened dollar should give the U.S. a leg up in export markets in the months ahead. This would represent a sharp turn from the second quarter when productivity fell sequentially and the dollar moved sharply upward due to the European debt crisis. U.S. net exports moved swiftly the wrong way in the second quarter and improved only modestly in the third quarter. Net exports could be the "sleeper" category of GDP improvement in the months and quarters ahead, especially if Boeing (BA) gets its act together on the shipments of the new 787 aircraft due in early 2011.
Individual Retail Sales Reports Could Disappoint
Individual retail sales reports are also due next week; my guess is that analysts will be disappointed and may not get the 2.5%-3.0% growth that they are forecasting. Our retail team is a little worried about those numbers. Given that September was unusually good and October is always seasonally a little soft, some weakness here wouldn't scare me--but it certainly won't help retailers next week.
Robert Johnson, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.