Our Outlook for the Economy
Worldwide central banks are driving the markets, but will fundamentals follow?
Quarter-End Insights
- An improving U.S. housing market will drive up economic activity during the fourth quarter and in 2013.
- Equity markets are looking beyond soft market fundamentals to the future benefits of coordinated central bank easing globally.
- The United States successfully dodges the bullet of softer European and Chinese economies.
During June, just as I was writing my quarterly column, the situation in Europe looked very dismal, and there were many who feared that Europe would drag the rest of the world, including the United States, down with it. Just after the end of the second quarter, a number of pundits went so far as to say we were already in a recession, and we just didn't realize it. Those fears have not come to pass, and it now looks as if U.S. gross domestic product growth in the September quarter will accelerate from the 1.7% of the June quarter and even the 1.9% growth rate registered in the first quarter.
Although consumer spending levels looked weak in May and June most of what was lost was regained in a very strong July and a moderate August for the consumer. Even exports haven't suffered as much as many had feared. Business spending on both people and capital goods, however, has remained constrained. Housing has been a bright light in the third quarter while the government doesn't appear to be as big an anchor to growth as in previous quarter.
Still Anticipating 2.0%-2.5% GDP Growth and Low Inflation
Not meaning to sound like a broken record, but I am still not changing my economic forecast that I first produced last November. I think overall GDP growth for both 2012 and 2013 will still be in the 2.0% to 2.5% range after adjusting for the effects of inflation, no boom and no bust. That level of growth is lower than the 2.7% rate of the last 30 years or so, but not by much. At least part of that slowing is the result of smaller population-growth rates. Even though the recent drought has me a little worried, I still believe that year-over-year inflation will stay lower than 2% for the rest of 2012.
In terms of employment, I had hoped for average private-sector job growth of 185,000 jobs per month, or just about 2% growth. I still think we can get there with a stronger second half of 2012, especially with the labor-intensive housing industry beginning to show signs of strength and better-looking seasonal adjustment factors beginning to kick in. That said, it will be more challenging than I had anticipated given that job growth for the first eight months of 2012 averaged just 151,000. Also, I still anticipate that the unemployment rate will drop to less that less 8% by year-end as new jobs are added and as some folks leave the labor force. For instance, individuals could go back to school, run out of unemployment benefits, or decide to stay home with the family.
Central Bank/Government Action Driving Markets--Fundamentals to Come?
Markets were surprisingly strong in the third quarter, reversing most of the damage suffered in the second quarter. Corporate fundamentals, if anything, looked a little worse than in the second quarter. Indeed, the number of early warnings for the third quarter is truly scary, including those from normal bellwethers FedEx (FDX), Norfolk Southern (NSC), and Intel (INTC).
But it was really actions by central banks that drove markets higher. European Central Bank president Mario Draghi's promise (followed by at least a few concrete actions in Europe) to do "whatever it takes" to keep the eurozone together, a new bond-buying program from the Federal Reserve, and additional infrastructure programs in China all made investors believe that better days were just around the corner. Although I have not been a huge fan of a lot of these programs, it has been increasingly hard to deny that a combination of low rates and pent-up demand in the U.S. is allowing the U.S. housing industry to come out of its six-year funk.
Housing-Related Issues Will Drive the Second Half
An improved housing market will be the key to an improved second half. In fact, improvements related to the housing industry should more than offset the weakness that I expect to see in U.S. exports.
The strength in the housing recovery has been building for most of 2012 but has yet to have much of an impact on overall economic activity. I think that will change in the second half as existing homes purchased in the first half are remodeled and furnished. Furthermore, homes started earlier this year will approach their more labor-intensive finishing stages. To see the second-half gains in housing-related activity, I don't need to see much change in either housing starts or existing-home sales from current levels; the benefits (furniture, paint, and so on) of earlier sales take as much as six to 12 months to show up. On top of the improvement in construction-related activity, higher home prices mean better consumer confidence, easier home refinancing, and potentially more assets for consumers to draw on during the second half.
The scope of improvement is very broad as shown in the table below:
The table above demonstrates that most of the improvements are very consistent with levels of three months earlier, unlike 2011 when the real estate market fell back after a relatively strong spring. The pricing categories have even managed to accelerate their improvement since this spring's reports. Based on pending home sales price data, there should be even more positive pricing news in the months ahead, according to CoreLogic . Further declines in inventories (shown in the table above) combined with near-record levels of affordability should also continue to boost housing activity and prices in the forthcoming months. Also, during the past three months, the improvements have become much more broad-based geographically.
Housing Not a Huge Part of the Economy but Exceptionally Important to Further Economic Gains
Whether looking at GDP or employment, housing wouldn't seem to be that important. Depending on how one cuts it, saying that 2% or 3% of the economy comes directly from the residential housing industry would be generous. However, the effects flow well beyond the actual building dollars that go into the GDP accounts.
In the last recession, 2 million of the more than 8 million jobs lost were in construction-related fields. If one adds in real estate agents, mortgage brokers, lumber yards, furniture makers, an so forth, more than half of the job losses were in some way related to the construction industry. Even with the improvement in housing starts, overall construction employment is still very near the recovery low point and hasn't changed much from a year ago. But I expect that will change as the publicly traded homebuilding firms continue to expand sharply in the second half to meet order books that are up 40% or more in some cases. The improved level of construction employment is one of the key reasons that I remain optimistic about second-half employment.
Higher Home Prices Will Be a Big Help
With the exception of the Case-Shiller Index (which is a month older than some of the other data points), home prices are now up more than 3% year over year with more good news in the works. Although I'm not fond of comparing prices from different months of the year--for instance, spring sales are seasonally strong--CoreLogic notes that prices are up a stunning 9% since March lows. Also according to CoreLogic, 12% of the underwater mortgages at the beginning of the year are no longer underwater as of June. Another 5% price increase (we are already half way there with July and preliminary August data) would clear another 12% of the underwater mortgages.
With higher prices, more homeowners will be eligible to refinance their homes at the current near-record-low rates. That in turn gives these consumers more money to spend somewhere else in the economy. A truly virtuous cycle. Furthermore, higher home prices raise the probability that someone will be able to move to take advantage of an employment opportunity. Higher home values also should mean that fewer pending real estate deals fail to get to a final closing for lack of appraisals. August's huge jump in closed sales (existing-home sales) might have been partially the result of more homes appraising at the deal price. Higher prices might also encourage (or enable) more homeowners to remodel their existing homes rather than thinking that they are throwing good money after bad. They just might be able to get that home equity loan they needed, too.
Stock Prices Up, Fundamentals Flat, We're All Economists Now
Turning to Morningstar's individual sector teams, the analysts' quarter-end outlooks showed lackluster fundamentals that were neither definitively collapsing nor booming. Meanwhile, most teams reported sharp stock price improvements, combined with limited improvement in fundamentals during the September quarter. This in turn made valuations far less attractive than at the end of June quarter. It was a quarter where cyclical, more economically sensitive stocks generally did well while more staid industries, such as utilities, generally underperformed the markets. Many of our sector reports made note of macroeconomic trends and central bank/government actions as the primary driver of recent stock price actions. Significantly improving fundamentals (with the possible exception of the natural gas industry) were nowhere to be found.
Higher Dollar Beginning to Bite, M&A Activity High, Emerging Markets Still Count
Many of our teams made comments about a stronger dollar undercutting sales growth and that there was a general fear that the higher dollar was likely to depress margins in the months ahead. However, many firms noted that better fixed-cost leverage and better supply chain management had thus far limited the damage from a higher dollar. Generally high margins and conservative capital spending have kept cash levels high at major corporations. A lot of that cash is still finding its way to a lot of merger and acquisition activity, in addition to increased dividends, according to our team members. Much of the merger and acquisition activity as well as general corporate growth stories continue to be built around emerging-markets growth, despite near-term pressures in some of those markets.
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