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Quarter-End Insights

Outlook for the Economy

Despite all the predicaments that arose during the first quarter, consumer spending continues and the market has been resilient.

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Note: Bob Johnson is on vacation this week, but in case you missed his Economic Outlook, first published on Monday, we are re-featuring it in place of his regular column today. For insights on Friday's employment report, please click here.


  • Real GDP of 3.5% to 4.0% is still possible if inflation--which could hit 3%--doesn't get out of control.
  • Watching the consumer is key. There are headwinds and tailwinds, but focus on spending.
  • Corporations are investing in themselves again.

For once, I am really glad I didn't have a crystal ball to predict the future. Three months ago, if my crystal ball had foreseen almost $4 per gallon gasoline, major rioting, government changes across the Middle East, and one of the largest earthquakes in history, I would have concluded that consumer spending was in for a major tumble and that the stock market would fall at least 10%-20%.

Instead, consumer spending continues to increase while the S&P 500 is off less than 4% from its recovery high.

This is in stark contrast to the spring of 2010 when the market fell 16% and consumer spending moved from near-double-digit rates to close to zero in a couple of months on the heels of "just" the European debt crisis and the mysterious May 2010 Flash Crash.

I suppose the pessimists could claim it's just a matter of time before the market wakes up to the bad news and tumbles again. However, I believe a stronger economic base and an economic recovery that has finally reached escape velocity may explain the market's patience this time around. (But I still worry that the market has pooh-poohed the effect of the Japanese situation a little too soon.)

Real GDP of 3.5% to 4.0% Still Possible If Inflation Doesn't Get Out of Control
I believe that 3.5%-4.0% U.S GDP growth is still in the cards for 2011, despite all the predicaments that arose during the first quarter. I base my optimism on a consumer that seems determined to spend, even in the face of all these problems. That said, all the current issues are likely to make the quarterly GDP numbers look a lot more volatile. Don't expect flat-as-a-pancake 3.75% growth each and every quarter. In fact, growth in the first quarter could slow to the 2.0%-3.0% range versus expectations of 3.0%-4.0% just a couple of months ago.

The biggest risk to my full-year forecast is that inflation continues to increase faster than wages, putting an end to the consumers' mini-spending binge. The odds of inflation ending this recovery have risen dramatically since my last quarterly update. However, I need to see several more months of inflation and poor wage growth to declare that another recession is a foregone conclusion. Watchful waiting indeed.

Inflation Could Accelerate to 3%
I suspect that inflation this year might run higher than the 2.0%-2.5% I was anticipating at the beginning of the year, perhaps approaching 3%. On a year-over-year basis, inflation in February is now running at over 2% after falling to 1% late in 2010. Without many changes from here, year-over-year inflation could approach 3% as early as June based on rising fuel and food prices that are already in the pipeline. The annualized increase for the Consumer Price Index over the last six months is an even more frightening 3.9%. Admittedly, that six-month period perfectly captures most of the runup in energy prices, perhaps putting inflation in the worst possible light. Morningstar's vice president of global equity and credit research, Heather Brilliant, highlights the risk that inflation poises to both businesses and markets in her quarterly market outlook piece.

Unemployment Could Drop to 8.0%-8.5% by Year-End
Employment data have been the biggest positive surprise of the quarter. Initial unemployment claims have finally broken out of their rut. Although volatile, weekly claims have fallen below the 400,000 level after being stuck in the mid-400,000s for more than a year. After peaking at over 674,000 in 2009, the claims level is now approaching the 300,000-350,000 level that one might hope for in the best days of the economic cycle.

The high unemployment rate seems to be a function of the same people remaining on unemployment longer rather than hoards of new people being thrown into the ranks of the unemployed. However, even the unemployment rate has fallen further than anyone really dreamed as recently as late last year. In stair step fashion, the unemployment rate has fallen from 9.8% in November to 8.9% in February.

Barring more natural disasters, I think that rate could fall to 8.0%-8.5% by year-end. However, much more improvement from that level will have to wait for better days in the construction and homebuilding industries. Depending on how you count, those industries were directly responsible for 20%-25% of the job losses this recession. Ancillary industries such as furniture, real estate brokerage, and mortgage lending would push that total even higher.

The Tale of Two Recoveries: Rich vs. Not So Rich
At the depths of a recession, things are pretty bad across the economic spectrum with the high earners losing major stock market wealth and bonus income, while the poorer families lose their jobs. Lack of any economic cushion tends to make things rougher on the low-wage families. However, this recovery, the news for the better earners has been excellent while the low earners (especially those with less education) continue to face double-digit unemployment and higher food and energy costs that consume a higher portion of their incomes.

The table below highlights some of the areas where lower earners are hit harder than those better off:

 Household Income
% of Income Spent On: < $70k $70k-$100k $100k+
Food 9.10% 7.40% 5.90%
Utilities and Fuel 9.10% 7.00% 5.40%
Gasoline 4.70% 4.20% 3.20%
Health Care 7.50% 6.40% 4.80%
Total 30.40% 25.00% 19.30%
Source: Survey of Consumer Spending from the Bureau of Labor Statistics, Morningstar.

Recent company reports seem to support this analysis.  Wal-Mart (WMT), which relies on the low-end consumer, is still seeing same-store sales declines in the U.S. Meanwhile higher-end and luxury good manufacturers have managed to show double-digit growth over the last year.  Saks (SKS) and  Nordstrom (JWN) have reported particularly good results. Nevertheless, households making less than $70,000 per year still account for 52% of all spending. Further pain in that income bracket will make it difficult to accelerate economic growth from here.


The Tale of Two Recoveries II: Manufacturing vs. Services
As detailed in our industrials sector report, manufacturing continues to burn up the track this recovery. After a slow fall season, manufacturing has returned with a vengeance this winter. Purchasing manager reports on the manufacturing economy, both here and overseas, are at recovery highs with only China showing modest signs of slowing (and even that "apparent" slowing may be due to the Chinese New Year). The strength is driven by a better farm economy, a reinvigorated auto sector, and capital goods manufacturers. Purchasing manager data and company reports indicate continued strength in the months ahead.

In the recoveries of 1990 and 2001, economic improvement merely slowed the rate of manufacturing job losses. This time around, the manufacturing sector has actually added 195,000 jobs since December 2009.

In terms of dollars, the consumer goods sector of the economy has contributed three times as much to this recovery as the consumer services portion of the economy.

 Consumer Goods Growth Trounces Services Growth
Contribution to
GDP Growth %
1Q 2009 2Q 2009 3Q 2009* 4Q 2009 1Q 2010 2Q 2010 3Q 2010 4Q 2010 Whole
Consumer Goods 0.6 -0.7 1.6 0.4 1.3 0.8 0.9 2.3 1.9
Consumer Services -0.1 0.1 -0.2 0.3 0.0 0.8 0.7 0.8 0.6
* Recovery begins.
Source: Bureau of Economic Analysis

Watching the Consumer Is Key
As I have mentioned before, consumer income and spending is the key to understanding the economy. The news has been, by and large, positive--but not uniformly so. Numerically, there are a lot more positive items than negative ones. But some of the negative categories are very important to the consumer.

I have constructed the list below to remind both the bulls and the bears that neither case is air-tight. I suppose the mixed consumer scorecard explains why most of our sectors (with the exception of industrials) are reporting steadily better results but nothing that is setting the world on fire.

 Consumer Positives Outweigh the Negatives
Positives Negatives
Payroll Tax Cut Nominal Wages
Stronger Balance Sheets Inflation
Strong Stock Market Hours Worked
Higher Dividends Housing Prices
More Small Business Income  
Source: Morningstar

Rather than trying to put some numerical weight on each category and guess what the consumer might do, I am going to focus on their spending over the next several months. The news so far is "all systems go." Retail sales and auto sales continue to hold up well. However, I caution that changing weather and a much later Easter holiday mean that March results will look weak. The trick to analyzing this data will be comparing March and April combined to March and April of last year

Where Will All That Cash Go?
One theme across our teams seems to be the continued build-up of cash and marketable securities at corporations. Our stock analysts report that corporations may finally be putting that cash to work. Corporations are taking a lot of grief for the large cash balances, but they may have been busier putting that cash to work than they are given credit for.

Some of that cash is finding its way into the merger-and-acquisition market. According to Thomson-Reuters, global merger and acquisition activity increased 58% in the first quarter of 2011 compared with the first quarter last year. The jump was largely driven by mega-deals, such as  AT&T's (T) planned acquisition of T-Mobile USA and  Sanofi-Aventis'  (SNY) planned acquisition of Genzyme. However, there were a lot of smaller deals, too, with many of our teams reporting acquisition activity. For the full year, which may not include as many blockbusters, I suspect M&A activity may be up as much as 10%-20%.

All that cash means more dividends as well. Morningstar has seen a steady stream of dividend initiations and increases throughout 2011. Even technology stalwart  Cisco (CSCO) initiated a $0.06 per share dividend during the quarter.

In addition, bank stocks should finally begin to contribute to the stream of increasing dividends. Just this month, the Federal Reserve completed another round of stress tests on banks. After those tests, the Fed will permit many banks to raise their dividends for the first time since it began its various bank rescue plans. These increased dividends could fuel additional consumer spending.

Corporations Are Investing in Themselves Again
When a recovery begins and demand increases, corporations often ship goods out of inventory to meet demand. Then, as inventories run low, they step up production in existing factories and perhaps even ramp up employment. Finally, when things really get moving, businesses invest in new factories and capital equipment to increase capacity. According to our industrials team, these "later cycle" companies are really beginning to shine. Businesses that make factory equipment and instruments such as  Emerson (EMR),  Rockwell Automation (ROK), and  Honeywell (HON) are reporting particularly strong results.

 Business Investment in Equipment and Software Rises From the Dead: Quarter to Quarter % Increase, Annualized
1Q 2008 2Q 2008 3Q 2008 4Q 2008 1Q 2009 2Q 2009 3Q 2009 4Q 2009 1Q 2010 2Q 2010 3Q 2010 4Q 2010
3.0 -6.0 -11.1 -29.5 -31.6 0.2 4.2 14.6 20.4 24.8 15.4 7.7
Source: Bureau of Economic Analysis

Overall business spending on equipment and software accelerated sharply off the recession lows, then growth fell to a more sustainable rate late last year. Now I expect continued growth in the year ahead as the equipment side of the equation continues to accelerate.

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Robert Johnson, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.