Outlook for the Economy
Special factors hit the economy hard in the first half, but there are fundamental concerns, too.
Quarter-End Insights
- The Japan disaster, high gas prices, and poor weather hampered the economy in the first half.
- Inflation and real wage growth are key fundamental concerns affecting the consumer, which is the main driver of the economy.
- Consumers are still holding up reasonably well considering the headwinds they're facing.
- Data may continue to be soft in the near term, but decent productivity growth, favorable demographics, and an eventual real estate recovery are positive longer-term drivers.
The economy clearly hit a soft spot in the second quarter as a wide range of indicators--including industrial production, retail sales, purchasing manager surveys, auto sales, and various housing metrics--all registered disappointing results.
The data caused me to reduce my full-year GDP growth estimate from 3.5% in my last quarterly report to a range of 2.5% to 3.0%. Inflation for the year is still likely to be around 3%, though that rate is clearly moderating now. I still think monthly private-sector employment growth of 200,000 (or about 2% annualized) remains a real possibility, though the 250,000 number I had hoped for looks like a bit of a stretch. Given a combination of labor force drop-outs and these better employment numbers, I still believe that the unemployment rate can fall below 8.5% by the end of this year.
Slower Economy Leads Investors to More Defensive Stocks
Slowing growth showed up in this quarter's stock data as health care and utilities--heretofore poor performers--were the best performers, as investors flocked to more defensive sectors. Meanwhile commodities and tech stocks, which had led the market, trailed far behind in the quarterly performance derby. The popping of the commodity bubble and a greater fear of risk assets contributed to the underperformance.
Special Factors Hit the Economy Hard, But There Are Fundamental Concerns, Too
The economic slowdown appears to be partially due to several one-time factors that should reverse themselves (earthquakes, tornadoes, and gasoline prices) in the second half. However, some fundamental factors are contributing to the softness as well.
I believe the root cause of the current slowdown in economic growth was a slowing in real hourly wage growth. Given that the consumer represents over 70% of the economy and that consumer incomes come primarily from wages, the hourly wage data can provide important clues about consumer spending capabilities. Real hourly wages began slowing in February and moved into negative territory in May, when computed on a three-month moving average basis. Real hourly wage growth is calculated by taking wage growth and adjusting for the effects of inflation.
| Real Wage Growth Goes Negative | |
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| YOY Real Wage Growth (%) 3-Month Moving Avg | |
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| October 2010 | 1.00 |
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| November 2010 | 1.00 |
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| December 2010 | 1.00 |
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| January 2011 | 1.10 |
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| February 2011 | 1.00 |
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| March 2011 | 0.70 |
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| April 2011 | 0.20 |
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| May 2011 | -0.10 |
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| Source: BLS, Morningstar |
Actual hourly wages before inflation have been stuck in a very narrow range of 2%-2.3% for over a year; meanwhile, inflation has moved from about 1.1% to 2.2%, putting the consumer behind the eight ball.
The good news is that I expect inflation to moderate in the months ahead, which should put the consumer back on top. Gasoline prices have fallen from almost $4 per gallon to around $3.60, a 10% decline in just a matter of weeks (see more on gas prices below). As detailed by our consumer team, food prices are also in the process of peaking. Wholesale crude food prices are off significantly for three months in a row. Auto prices, which have also been a major bugaboo, should begin to back off as the Japanese auto manufacturers bring major chunks of capacity back online over the next several weeks.
Besides the real wage growth issue, which appears as if it could subside, a number of anomalies rocked the economy during the quarter. In fact, it's a bit surprising to me that the economy has held up as well as it has given a surprisingly long list of negatives. The list includes major supply chain issues related to the Japanese earthquake, sky-high gasoline prices resulting from unrest in the Middle East, and weather so chilly and stormy as to disrupt normal seasonal buying patterns.
Japanese Supply Chain Issues Hit the Manufacturing World Hard
As I warned in my last quarterly outlook, the impacts of the quake were badly underestimated. Our industrials team goes through all the details in their quarterly report, but I will offer two previews here. Toyota (TM) unit production in the U.S. fell from 111,000 in February to a mere 31,000 units in May. (The latest week of production in mid-June indicated the monthly run rate has now increased to just over 90,000 units). The issue in Japan was even worse, where total industry sales for April fell from 731,829 in April 2010 to 292,000 units in April 2011. Given that many of the parts and commodities that go into Japanese cars come from around the world, it's not surprising that global manufacturing data is falling in unison. Those numbers are just about to reverse themselves. Though harder to define, there were supply-chain issues in other industries, too, including electronics.
Japanese Issues Also Affect Inflation, Consumer Spending, and Employment
Beyond manufacturing, the Japanese issues raised U.S. inflation, cut consumer spending, and certainly didn't help the employment situation. Car prices are now up by more than 1% for two months running. Ford (F) has increased prices three times this year, and incentives reached a nine-year low.
High prices and lack of supply cut consumer spending on autos, which depressed the most comprehensive measure of U.S. retail sales for May. In fact, retail sales for May declined for the first time in 11 months. However, excluding auto sales, consumers continued to increase their spending during the month. While direct auto manufacturing employment hasn't decreased much, I suspect many supplier types were forced to make cuts that turned up in the employment data.
Gasoline Prices Hit Consumers in the Wallet, But Are Subsiding at Last
High gasoline prices weigh particularly hard on the consumer's wallet and psyche. Gas prices are posted in big numbers and are visible every day as consumers drive to and from work. Low-income households, which spend a higher portion of their incomes on gasoline, were hit particularly hard.
Gas prices are finally moving in the right direction, though they remain at a higher level than I would like to see.
| Gasoline Price Declines Approach 10% | |
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| Price per Gallon ($) | |
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| 5/2/11 | 3.96 |
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| 5/9/11 | 3.97 |
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| 5/16/11 | 3.96 |
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| 5/23/11 | 3.85 |
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| 5/30/11 | 3.79 |
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| 6/6/11 | 3.78 |
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| 6/13/11 | 3.71 |
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| 6/20/11 | 3.65 |
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| 6/27/11 (e) | 3.60 |
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| Source: St. Louis Federal Reserve |
Cold, Wet, Stormy Weather Takes Its Toll
Weather is also affecting some consumer spending sectors, especially clothing and home centers, and even manufacturing. Manufacturing was particularly hard hit in April as a combination of stormy weather and a near-record month of tornadoes diminished manufacturers' ability to operate factories across broad swaths of the South. Most of that did come back in May (only to be offset by slowing auto production and poor utility production due to cool weather).
May was an exceptionally chilly month, just like most of the rest of 2011. This slowed sales of all types of merchandise from lawn and garden items to outdoor sporting goods to apparel. Below is a chart of National Weather Service data showing how far below normal temperatures have been so far in 2011:
Again there is some ray of hope as June temperatures are running slightly above normal so far.
Looking for Clues in All the Wrong Places
The market is currently focusing on both manufacturing data and commodity prices as key indicators of economic direction. At different parts of the recovery, especially economic bottoms, these can be important indicators, but perhaps less so at other times. For example the three-month moving average of the National ISM Purchasing Managers' Survey was a great and early predictor of the current recovery. However, this indicator tends to be hyperactive at tops. During the 1990s this indicator fell below 50 (anything below 50 is generally considered indicative of a slowing) on three separate occasions, and no recession followed, before making its fourth plunge right at the end of the decade that did finally lead to a recession.
Attempts to keep inventories in line with demand lead to a lot of over- and under-shooting in the manufacturing sector. And keep in mind that manufacturing employment represents less than 10% of U.S. employment. Some of the weaker purchasing managers' reports did indeed lead declines to softer industrial production, but strengths in other sectors of the economy offset some of the weakness in the smallish manufacturing sector.
The most important point to remember is that manufacturing is driven by consumers and not vice versa. Manufacturers aren't going to produce goods for the fun of it. They can only react to what consumers are demanding. Therefore, keeping an eye on consumers is the key to determining the direction of the economy.
Interpreting commodity prices in relation to the economy can get really tricky, too. Right now, commodities can seem to do no right. Prices go too high, and the market frets that the consumer will have nothing left to spend after paying up for commodities, especially gasoline. Prices fall too far, and the market interprets it as a great secret indicator of economic weakness.
At the moment, I believe that recently falling commodity prices are a really good thing. As I noted above, high inflation, which has been driven almost entirely by commodities, has been the biggest threat to consumer spending. Therefore, a fall in commodity prices (as described in more detail in many of our sector updates) should free up more cash for goods and services produced in the United States. However, falling commodities probably do mean at least some weakening in the manufacturing sector.
So Just How Is the Consumer Holding Up?
Though things aren't perfect, consumer spending is holding up amazingly well. Weekly same-store sales of goods bought at chain stores have consistently ranged from 2.5% to 3.5%, despite the rise and now the fall of gasoline prices.
More comprehensive retail sales data that includes autos, gasoline, and restaurant sales have been more volatile for reasons described above. Restaurant sales, often an indicator of short-term consumer confidence, were surprisingly strong in the most recent month. Auto sales had been on a roll for most of 2011 until supply and price issues resulting from the Japanese earthquake turned this longer-term confidence indicator down.
Employment Still Moving Up, Helping Consumers
Perhaps that spending confidence is not misplaced. Employment reports for two of the three months of the quarter looked sharply better, according to government data. May data was softer, but other labor market indicators (Challenger Gray's layoff report, Manpower's (MAN) employment outlook, and the BLS household survey) didn't indicate as much softness. For the first five months of 2011, private sector job growth has averaged 182,000 per month, or 2% annualized. That's a respectable rate and above the 98,000 average, or 1.1%, for 2010.
Consumer Balance Sheets Improving Sharply
One consumer metric that I follow closely is the financial obligations ratio, which compares consumer financial payments to income. Obligations measured include mortgages, rents, car payments, lease payments, credit cards, and other loan payments. This ratio peaked at almost 18.9% of income in 2007 and has subsequently dropped to 16.4% for the first quarter of 2011, its lowest level since 1994 and below the 30-year average of 17.2%.
The series low was 15.7% in 1981 and has been as high as 18.9%. The ratio is down nearly 1% from a year ago, providing yet another source for consumer spending growth. A combination of income growth, lower interest rates, and lower loan balances is responsible for the dramatic improvement. Since most of the debt is fixed-rate mortgages, and as incomes continue to rise, I believe the ratio could make a run at its all-time low over the next year or two.
Cheap Houses, a Double-Edged Sword
While many economists continue to focus on underwater homeowners and their ability to draw down home equity loans, it cannot be forgotten that new homeowners are spending substantially less than the last generation did on their mortgage payments. Remember that since the crisis began (2007), more than 20 million homes out of a base of very roughly 75 million have changed hands at reduced prices with lower interest rates. Each year the proportion of homeowners with cheap homes and low-interest-rate loans continues to expand.
The Healing Process Should Continue, but Slowly
This quarter's report is perhaps a bit more short-term oriented and tactical than I am accustomed to. However, I think it's best to identify the short-term problems front and center so they lose some of their panic power.
The economy is still operating close enough to the edge that we have the capability of scaring ourselves into another recession. Another bad geopolitical event combined with a little old-fashioned panic could indeed sink this recovery.
But as bad as the numbers will look over the next month or two, there are some hopeful signs just down the road. Longer term, I am convinced that decent productivity growth, favorable demographics, and a sustained real estate recovery beginning in 2012 could drive the economy forward for some time. That is, if the politicians don't mess it up.
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