Market to Congress: Time to Work

This week the economic data flow was pretty thin, with markets focusing largely on the U.S. elections, and then the fiscal cliff. Along the way, markets took a detour on Thursday for news of worsening economic news in Europe followed by reports on Friday that seemed to indicate China's economy had hit bottom and is on the mend.

On the U.S. economic front, a surprisingly good trade report forced economists to drastically raise their third-quarter GDP estimates from 2.0% to 2.6%. However, until all of the inventory data is in, I wouldn't be counting all my chickens before they hatched. The last of the inventory data could put a damper on some of the more optimistic GDP projections. I also have a suspicion that combined, the third- and fourth-quarter GDP estimates are likely to average little better than 2%. Any outperformance in the third quarter is likely to be followed by underperformance in the fourth quarter. Retail sales reports and employment data both suggest GDP growth closer to 2.0% than 2.6% for the second half of 2012.

Housing Market Still Looking Up
Separately,  CoreLogic also indicated that September home prices accelerated again, increasing over 5% year over year, an acceleration from the previous month. Plus, recent U.S. Census Bureau data reported by the The Wall Street Journal suggests that household formation rates are finally increasing again, which should also bode well for the housing industry.

The U.S. Faces Two Very Different Budget Issues
With the election behind us, markets turned to face the fiscal cliff and budget deficits. This week's video focused on the deficit. There are really two main deficit issues: The first issue is how to move government revenue and spending into line after all the measures that were taken to keep the U.S. economy from falling into a recession. The second problem is how to deal with Social Security and Medicare, which will start to dig the budget hole much deeper in another 10-15 years as baby boomers begin to retire en masse. I am going to put the longer-term deficit issue aside for now and save that for another day.

Both Government Revenue and Expenses Are Out of Line With Long-Term Averages
The first, shorter-term issue is that federal government spending got as high as 25% of GDP while revenue (that is, taxes) fell to a stunningly low 15%. In more normal times, expenses run closer to 20% and revenue runs a couple of percentage points lower than that. The inflow side of the equation has been limited by poor corporate tax collections, sluggish income growth, and a dearth of capital gains to tax, no matter what the rate. And there were various tax reduction/extension measures that made the situation even worse.

On the expense side, unemployment and disability payments, high payments for foreign wars, as well as the stimulus plan, raised expenses.

Going Over the Fiscal Cliff Might Theoretically Balance the Budget in Short Order ...
With continued sluggish economic growth, it doesn't seem possible for the U.S. to grow its way out of this mess (although the continued growth will help somewhat). Given that both revenue and expense are about equally out of whack versus long-term averages, it appears that some adjustment to both is necessary. The measures embodied in the fiscal cliff do just that. The combined spending cuts and tax increases get the budget pretty close to balanced in just a few short years. Below are the key items that make up the fiscal cliff:

... Although First, the Fiscal Cliff Might Kill the U.S. Economy
However, the price tag of fiscal-cliff-related matters is woefully high at $720 billion, or 5% of the GDP in just the first year. There is little doubt if we drive over the fiscal cliff, the U.S. would probably move into at least a modest recession, maybe worse. 

The U.S. Could Survive a Smaller, More Rational Fiscal Cliff
On the other hand, we have already been chipping away at the deficit as stimulus measures and various tax credits have already begun expiring. The deficit has moved from a high of $1.4 trillion to $1.1 trillion in fiscal 2012 (ended September). In fiscal year 2012 alone, the U.S. trimmed $200 billion off of the deficit. Despite the deficit haircut, it looks as though the economy managed to grow by almost 2.3% over that same time frame.

So if some of the themes and policies embodied in the fiscal cliff measures were implemented over three years instead of one, the U.S. economy could probably tolerate the $240 billion per year in reductions. The mathematics of the situation seem tolerable for the short-term deficit. However, the devil is in the details of the necessary cuts and tax increases, which is why Congress has put off this work for so long.

Most other economists and I believe that Congress will manage to avoid the fiscal cliff and come together for the common good. I believe that markets, with large declines this week, were trying to tell Congress to get to work--now. I couldn't agree more.

China Looking Better, Europe Not So Much
Though my focus is generally on the U.S. economy, there was meaningful news out of both China and Europe that I really can't ignore. The data largely confirms the results of the worldwide purchasing managers' report that I discussed a couple of weeks ago. Both those reports and this week's data suggest that the Chinese economy has turned the corner after a period of slower growth rates and that Europe, with perhaps overly tough austerity policies, is continuing to weaken. Even Germany, heretofore the stalwart of European economies, showed a decline in industrial production of 1.8% for its most recent reading. In its fall update, the European Commission is now forecasting a real GDP contraction of 0.3% for 2012, a smallish 0.4% increase in 2013, and 1.6% for 2014. The U.S. is expected to grow at a rate of more than 2% for each of those same periods, and China by more than 7%. Interestingly, what little growth there is in Europe is coming primarily from exports as internal consumption has been down for some time. No wonder European markets breathed a sigh of relief when better economic news emerged from China.

The good news out of China has been building for a month or two, with construction and real estate markets finally showing some improvement after more than a year's worth of decline (which was partially engineered by the government). Then a couple of weeks ago, data there showed that Chinese purchasing managers were feeling more optimistic. Then this week, inflation came in much lower than expected, giving the government more room to stimulate the economy, if necessary. However, Friday morning data suggests that maybe additional stimulus won't be necessary. Industrial production was up 9.6% and retail spending up 15%, both better than expected. Even electricity usage jumped 6%, its best reading since March. Many analysts look to the electricity data because the data is easier to collect and harder to manipulate. Unlike in the United States, most electricity is used for industrial production in China.

While I like the news out of China, I caution that when things were getting worse, I believed China probably wouldn't hurt U.S. GDP growth. Likewise it probably won't help a lot as things get better. It might, however, help Europe. And it will also help multinationals, which have been counting on China for additional earnings growth.

Trade Report Causes Economists to Rethink Third-Quarter GDP Growth
The trade report is usually a long and sleepy document that gets occasional attention only because it comes out during a week when there are seldom any other economic reports. This week there was an incredible amount of data crammed in the report, including reduced oil imports, huge exports of iPhones from China, rebounding soybean sales, and slowing, but not collapsing, exports to Europe.

However, the real attention grabber is the overall headline number, which was so good that economists were forced to revise their forecasts for the second revision of second-quarter GDP growth due later this month. The average GDP forecast moved from an acceptable 2.0% to 2.6%, which would make it one of the best results of the recovery. I caution that soon-to-be-released inventory data often offsets portions of the benefits of an improved trade report. The government doesn't have the import/export data for September when it compiles its first estimate of GDP, which was released more than two weeks ago. Their estimates (along with mine) were far off the mark for the month of September.

In a world economy that many feared was slowing sharply, exports managed to increase 4% while imports grew at a slower pace of 2%. More than half of the import increase was related to new shipments of the iPhone. (It wouldn't surprise me if increased production of iPhones and iPads in China was at least part of the reason the Chinese economy is looking a little better.) Combined, the trade deficit was $41.5 billion, its lowest and best reading since 2010. That compared with a downward-revised figure of $43.5 billion for August. Most economists thought that high oil prices and iPhone imports would make the deficit get worse and not better in September. An almost billion-dollar, one-month swing in soybean exports sure didn't hurt. An increase in oil-related exports was also a help. (That's not a typo; the United States is now a meaningful exporter of various oil products.)

Export data for U.S. shipments to Europe was a mixed bag. Exports were up 2% from August to September but down more than 7% from year-ago levels. Year-to-date exports to Europe are still up 2%. So far, shipments to Europe are slowing, but they certainly aren't collapsing as many had feared. In addition, exports to Europe are neither helping nor hurting U.S. GDP results. The number is just very small at 3% of the GDP.

Next Week: Lots of Data, Lots of Special Factors
News on the economic front will remain relatively quiet until Wednesday, with the release of the retail sales report. Later in the week we get more data on inflation and finally on the manufacturing economy. The normal strengths and weaknesses cited by these reports will be almost the polar opposite of recent updates. Retail sales are likely to show a decline, prices are likely to be close to unchanged, and production data is likely to surprise analysts on the upside. However, there are a lot of factors that will make next week's worth of data less than representative.

Autos and Lower Gasoline Prices Will Weigh on the Retail Sales Report
First, retail sales are expected to show an outright decline for October, with analysts expecting a 0.1% decline in sales, including autos, and a modest 0.2% increase without autos. Frankly, I think these numbers are too optimistic given the huge rush to purchase iPhones in September that probably abated in October, eroding gasoline prices in October, and pricing issues at several restaurants. That's in addition to the fact that auto unit sales were down almost 5% between September and October, according to the Bureau of Economic Analysis, at least partially due to Hurricane Sandy. (Other than autos, the October retail sales calendar ended the Saturday before the storm hit, so the impact on the report will be limited.) Stripping out autos and gasoline sales and looking at year-over-year data, I still suspect that that retail sales growth will be stuck in the same old 4%-6% growth rate that it has been in for most of the year. Also even the month-to-month data ex-autos, gasoline, restaurants, and electronics should look better than it did in September, based on stronger same-store sales reports that were released last week.

Initial Unemployment Likely to Spike Next Week
I usually don't make any attempt to forecast initial unemployment claims, but I did want to warn everyone that claims could spike to 400,000 new claims (up from 355,000 this week) in the weeks ahead. Don't panic over this storm-related jump--it is not the beginning of the end. This week's numbers were depressed by some unemployment offices being closed (so no claims could be filed). Also, many potential filers had other more pressing issues to deal with first, and they will be applying for benefits in the weeks ahead.

Falling Gasoline Prices Likely to Drive Price Increase to Close to Zero
From the beginning of October, gasoline prices have fallen about 7%, which will put a serious lid on the Consumer Price Index in October. Expectations are for a very modest 0.1% increase after two months in a row when prices increased a painful 0.6%. However, I caution that that gasoline prices also fell sharply last year during October, so there will not be any improvement in the more important year-over-year change in the rate of inflation. That year-over-year rate is likely to show an increase of 1.8%, which would be up from the prior month. However, that is still well below the 4% rate that usually triggers a recession. 

I will also be watching food prices for any further effects from the drought. So far the higher prices of grains and soybeans have been offset by lower meat, fresh fruit, and vegetable prices. Packaged-goods manufacturers haven't passed along the recent price of raw material just yet because of very frugal consumers. So far, the U.S. has been lucky on the food price front, but it remains to be seen if that luck can continue. Food has about a 15% weight in the CPI, and gasoline, about 6%. The consumer can get into real trouble if these two categories begin moving upward together. The good news is that November events suggest a continued decline in gasoline prices during the important holiday season.

Economists Expecting the Worst for Industrial Production, but I Believe They Are Wrong
Industrial production declined 1.4% in August, largely due to seasonal factors and the auto sector, and then improved just a little to 0.4% growth in September, but auto production was still down.

For one reason or another, economists are forecasting a really crummy 0.1% growth rate for October. My read of the auto production numbers showed a huge increase in raw production for October, and a smaller but still large increase when adjusted for seasonal factors. This alone should push industrial production up to the 0.4% increase registered for September. More production at  Boeing (BA) and an improving housing industry could further aid the industrial production figures. However, export-related production, especially basic iron and chemicals that are sold into world markets, will indeed have some negative impact on the overall report.

When all is said and done next week, I think consumers are continuing to spend, manufacturing is slowly improving but will never be the engine of growth that it was early in the recession, and inflation remains under control but is not running at zero, either. While Hurricane Sandy and seasonal factors will muddy the issue for several months, I am expecting more of the same. That is, a slow but steady consumer, and more recently, housing-related recovery in the U.S. economy.