Outlook for the Economy
The U.S. economy will muddle through better than most, but consumer incomes and overall inflation should remain on the radar.
Quarter-End Insights
- Slow but steady U.S. GDP growth, moderating inflation, and rising employment growth is on tap for the remainder of the year.
- The U.S. economy is gaining strength as other world economies are slowing.
- Fears over the effects of gasoline prices, a slowing China, and higher interest rates are overblown.
The U.S Should Muddle Through Economic Uncertainty Better Than Most Countries
My economic forecast for 2012 remains virtually unchanged from my last quarterly report at the end of December. I still believe inflation-adjusted GDP growth will fall in the 2.0% to 2.5% range, with lower rates in the first half and higher rates of growth in the second half. Consumers, housing, and construction will be the primary drivers of the recovery. Slower exports and limited inventory increases will likely be detractors, while corporate spending probably won't swing enough to make a big difference.
On the inflation front, I am modestly raising my range of expectations to 2.0%- 2.5% based on higher gasoline prices than I had been anticipating (at the moment, year-over-year inflation is running about 2.9%). I still expect job growth of 200,000 (about 2% annualized) or more per month, although the first two months of the year ran a bit higher than that. I still believe unemployment will drop to below 8% by year-end; we are currently running at 8.3%.
My Biggest Worry Remains Consumer Incomes and Inflation
Near term, the markets have grown concerned about rising gasoline and oil prices, a slowing China, and a less-generous Federal Reserve. Although none of these things are wonderful for the economy, I think these particular fears are overblown, and in fact, news on these fronts may have some silver linings, as I discuss in more depth below.
My fears continue to be centered around stagnating inflation-adjusted consumer incomes and higher inflation. These two factors are tightly intertwined. Inflation has held back real wage growth--non-inflation-adjusted wage growth has remained relatively constant at 2%--as inflation has had more violent ups and downs.
Typically, year-over-year inflation in excess of 4% has produced a recession in short order. I am relatively confident that higher gasoline prices by themselves will not push us to that level. With other commodity prices declining, especially food, I think we will fall short of the 4% threshold of pain. However, poor weather, crop failures, or a bad ending to the Iranian situation could all toss my inflation optimism out the window.
Recurring Sector Themes: Improved Employment, Slowing Europe and China, Redeployment of Corporate Cash, Limited Pricing Power
A few common themes have bubbled up from our individual equity sector research teams. Better employment is helping a number of sectors, including housing, restaurants, and even health care. However, a number of sector teams, and especially our industrials team, continue to worry about slowing demand from Europe and China. (Slowdowns in these regions are harmful to individual companies but not necessarily to the overall U.S. economy, because many of those goods are not produced in the U.S.).
Redeployment of corporate cash is also playing out across many, if not all, of our sectors. The acquisition market continues to be active, especially in technology and health care, with several multibillion-dollar deals. However, some companies are giving that idle cash back to investors (which should help consumer spending, the U.S. economy, and maybe the stock market to boot). Even notoriously stingy Apple (AAPL) launched a dividend and a share repurchase program in mid-March. Corporate pricing power also continues to be on the wane in most sectors, as even justified price increases are being roundly rejected by frugal consumers. Finally, most of our analysts remain convinced that the majority of the stocks that they cover are fairly valued with a dearth of both really cheap and really expensive stocks.
Outlook Could Mean a Weaker Bond Market, Better Wide Moat Stock Performance, Falling Commodity Prices
In terms of investment themes that fall out of my economic forecast, I continue to worry about the bond market with rates still abnormally low even as the economy shows more signs of life. Also, it seems that U.S. growth rates are generally trending up even as Europe, China, and the emerging markets continue to slow.
Although it is difficult to tell what is already priced into stocks, it would appear that companies poised to benefit from the U.S. economy with more limited exposures to non-U.S. markets might be better performers. A relatively strong U.S. economy often tends to benefit small-capitalization companies that have typically had a smaller portion of their revenues from non-U.S. sources. A less-generous Fed and slowing international markets may also limit the upside of commodity markets. Finally limited pricing power means that investors should focus on wide-moat or narrow-moat stocks that tend to have greater pricing flexibility. The only cautionary note on wide-moat names is that these stocks tend to be the companies with greater non-U.S. exposures.
How Important Are Oil and Gasoline Prices to the Economy?
One of the biggest fears in the market is that high gasoline prices will kill the U.S. recovery. While high gas prices certainly aren't going to help the economy, I don't believe that by themselves they will stop this recovery.
To put gasoline in some perspective, the Milken Institute recently published a report that highlighted the relative importance of gasoline and oil prices on the U.S. economy. According to the study, U.S. citizens consumed about 172 billion gallons of gasoline in 2011, which equates to just over $400 billion, before taxes. For some perspective, that represents about 3.7% of the total $10.7 trillion that consumers spent in 2011. While not insignificant, a lot of categories are considerably larger, including food, which represents about 10% of GDP.
Although it is hard to disentangle individual factors, it is not entirely clear that gasoline prices were responsible for consumers' ups and downs in 2011. Some of the cheapest gas prices in 2011 were in November and December, when a number of measures of consumption and retail sales were about the slowest of the year. On the other hand, April saw one of the bigger spikes in gasoline prices and was indeed one of the weaker months in terms of various sale metrics. Considered holistically, retail sales (ex-autos and gasoline) were stuck in a very narrow range of 5.2% (April) to 6.2% (July, August, and September) for all of 2011. Evidently in a year when gasoline prices swung from $3.07 to $3.97 and back down to $3.23 at year-end, consumer spending wasn't nearly as volatile.
The gasoline impact has also grown smaller over time as consumers have sharply cut back on their gasoline usage. Per capita gasoline usage has fallen 10% from 610 gallons in 2006 to 555 gallons for 2011. Because of population growth overall, U.S. gasoline consumption has fallen a slightly smaller 7% over the same time frame, according to Milken.
Looking more broadly, the U.S. dependence on oil has been cut by more than half over the last 40 years, according to the Milken report. In the 1970s, the U.S. economy used 3.3 barrels of oil for each dollar of GDP. Today we use just 1.5 barrels for each unit of GDP.
The decline in usage helps explain why the Institute believes the impact of higher oil prices will be relatively muted. Overall they are projecting that each $10 increase in the price of a barrel of oil (sustained for an entire year) will reduce U.S. GDP by 0.3%. For an economy that is growing just 2% or so, that is meaningful but not a deal-killer for U.S. GDP growth.
Can a China Slowdown Stop U.S. Growth?
Over the past several weeks, a lot of data, including both official government pronouncements and purchasing manager surveys, suggest that the Chinese economy is slowing. Government data suggest that China's typical 10% growth rate is likely to fall to 7.5%.
If the Chinese government is successful in stopping the growth rate decline to the 6% to 7.5% range, I believe the news is more helpful than harmful to the U.S. economy (though many individual companies could be hurt, especially those related to the commodities boom in China). Exports to China constitute just over 2% of U.S. GDP, even less than the U.S. exports to Europe. And the biggest portion of those exports is soybeans.
Meanwhile a slowing China, combined with a less generous U.S. Federal Reserve, is likely to bring in the price of many commodities. Last year rising commodity prices held back U.S. consumption and temporarily boosted inflation perilously close to the 4% danger zone. I believe that the tiny benefit that we got from higher exports to China was more than offset by the dramatic rise in commodity prices. However, I do note that a slowing Chinese economy will affect commodity-based economies (Australia and Brazil) and capital goods-related exporters (think Germany).
Will Higher Rates Bring an End to the Recovery?
The last couple of weeks brought a real scare, as U.S. 10-year interest rates moved from about 2% to 2.4% in a very short period of time. Better U.S. economic news and the Fed's failure to mention the possibility of a new quantitative easing program were both behind the sudden rate rebound. Like higher gasoline prices, higher rates are unlikely to be good news, but I don't think they will stop the economy dead in its tracks, either.
Consistently low rates have meant that both businesses and consumers have had little incentive to race out to buy things. Slightly higher rates and the fear of even higher rates may be just what it takes to get some of these fence-sitters off of dead center.
Low rates have also destroyed retiree income. Overall interest income in the economy has slowed dramatically, holding back personal income growth even as wage growth has seen at least some improvement. Lower rates have also negatively affected pension plans that invest in fixed income. Many of the worst off pension plans are run by state and local governments that already have more than enough fiscal issues to deal with.
Higher rates could also slow some of the speculation in commodities, which, in addition to China's slowing, could really pull the rug out from under commodity prices in the year ahead. While higher rates could theoretically hurt housing, I believe lending standards and employment, as well as consumers' changed attitude toward housing, will play a far bigger role in the housing market than interest rates in the two or three years ahead. Higher rates, through the mechanism of discounting of future earnings, are unfortunately likely to hurt the stock market as well.
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