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Quarter-End Insights

Outlook for the Economy: A Longer, if Not Stronger, Recovery

What this recovery has lacked in robustness it may make up for in longevity.

Robert Johnson
  • Although the U.S. economy remains relatively strong, it's not ready for a rocket ship-like performance, either. Growth in most U.S. metrics has been slow for three months or longer. Some of that stagnation is weather-related, but certainly not all. Up-and-down bounces related to the government shutdown and budget settlement, major inventory buildups, and higher interest rates have all been negatives for recent economic activity.
  • Despite the current soft spell, there are several major positives that could make this recovery one of the longest on record. What this recovery has lacked in robustness may be trumped by longevity. This recovery has already lasted longer than half of all post-World War II recoveries. The housing market still has a huge runway in front of it, oil and gas production continues to accelerate, government austerity measures should continue to soften, and the world economy is again showing signs of life, potentially boosting U.S. exports.
  • There are factors that will potentially hold the economy back in 2014. In the short run, good but slowing growth rates in autos, housing, and jetliners mean that other sectors will need to pick up the slack. Higher interest rates and new geopolitical uncertainties won't be helping matters, either.
  • In the longer term, demographics and socioeconomic trends may permanently keep the U.S. GDP growth rate at 2.0%–2.5%, or perhaps even less. This is thanks to an aging population that spends less; a move to e-commerce from employment-heavy and construction-needy brick-and-mortar retailers; and the declining need for office space as more workers do their jobs with less space or work from home. Technology, generally a very good thing, also seems to be putting a real dent in employment opportunities.

The U.S. economic data has shown signs of weakening for the past three months running, despite some real optimism that developed in the fourth quarter of 2013. That optimism was based on the end to the fiscal stalemate in Washington in October, a 4.1% GDP growth rate in the third quarter, and a 3.2% growth rate in the fourth quarter (later revised down to just 2.4% growth). Sky-high retail sales data that was subsequently revised sharply downward also contributed to economists' bright mood at the end of 2013.

However, poor weather seems to have interrupted the upward trajectory. The effects of abnormally cold and snowy weather seem real, but the weather is not the only cause for the recent weakness, in my opinion. Parts of the economy, including the housing sector, were already showing some slowing even before the cold weather arrived.

The Economy: A Rocket Ship Ready for Blast-Off, or an Ocean Liner Stuck in Its Wake?
Putting the weather aside (poor weather will likely make the first quarter weaker than it otherwise would have been, but could make the second quarter stronger), there is an ongoing debate about the underlying strength of the economy.

Prior to the weather news, many economists believed the economy was set to grow 3.0%–3.5% or even more in 2014. They believed that the economy had finally reached its so-called escape velocity. There was a second group of economists who believed that while some sectors of the economy were indeed improving, other sectors were beginning to stall out. I generally subscribe to this second point of view. I also believe that over the past three years, the economy has been on a fairly steady, but slow, 2% growth trajectory. Like a slow-moving ocean liner, it has been nearly impossible for the economy to speed up, slow down, or change direction.

Compared with the quarterly outlook we presented in December, my current economic forecast is little changed, as shown below:

My unemployment rate forecast dropped from a range of 6.2%-6.5% to 5.9%-6.2% as the December unemployment rate came in better than expected. I had also held out some hope that extended unemployment benefits would be renewed by Congress, which tends to encourage labor force participation, inflating the unemployment rate. That was the sole change that I made in the forecast. Meanwhile consensus GDP estimates for the full year 2014 have generally been dropping from 3% or so in December to the still-too-high 2.7% average now.

What Changed Over the Course of the First Quarter?

Geopolitical Events Reduced Investor Confidence. While my annual forecast is unchanged, there were a lot of unexpected events and short-term changes during the first quarter. Certainly the situation in Ukraine was a surprise that could upset consumer and business confidence. And if sanctions are implemented, European growth and energy markets could be upset.

Interest Rates Make a Surprise Move Down. Second, the first quarter saw falling interest rates instead of the rising rates that almost everyone had been anticipating as a result of the Fed's decision to taper bond purchases. The interest rate on the 10-year U.S. Treasury bond fell from 2.9% at the end of 2013 to 2.6% as of mid-March. Slower-than-expected growth, both in the United States and in China as well as a flight to safety may have helped interest rates fall instead of the anticipated rise. Low corporate revenue growth rates (less borrowing need for working capital and expansion) and sluggish housing and auto markets (both big users of credit) may have also kept a lid on rates. I can't help but wonder if the move to a more services-oriented economy, continuing excess capacity, and less capital intensity for the businesses that are growing the fastest (think Google (GOOG) and many Internet companies) may have an even longer-term depressing effect on interest rates. However, I do have to agree with our credit team's outlook that suggests rates are likely to be modestly higher than now, but maybe not by a lot.

China's Slow Growth Spooks World Markets. The news out of China has not been particularly robust lately, either. Although analysts had generally expected China's growth to slow from 7.7% in 2013 to 7.5% in 2014, there was a lot of hope that they could do better.

China seems to have been successful at cutting some export- and investment-oriented spending as they had planned. However, Chinese consumers have not yet picked up the slack as much as hoped. Though the Lunar New Year complicates any data analysis, both January (which should have been soft because of the holiday) and February (which should have been a big rebound month) combined were soft. Exports in February were particularly bad, with results down 18%. However, retail sales, fixed investment, industrial production, and purchasing manager surveys have also been disappointing. According to a Wall Street Journal survey, economists now believe that China's growth rate will be the biggest threat to the world growth rate. Both the quarterly outlooks written by our basic materials and credit teams discuss the softer outlook for China. Over the intermediate term, an outright decline in the Chinese working-age population cannot be ignored.

The China bulls often cite intentional policy shifts for China's slowing growth, but that may not be the whole story. To the bulls, it is just a matter of time until the policy shift away from exports and questionable infrastructure investments to Chinese consumers succeeds, causing growth rates to return to the good old days. Or if that doesn't work, the government resorts to tried-and-true methods of looser loan standards and more infrastructure programs to save the day, and growth accelerates again. It's a win-win situation.

But total Chinese debt (public and private) has soared and now approaches 200% of GDP, making lending a little more difficult. Poor demographics and a shrinking working-age population will only make matters worse. Trading partners are also likely to object to China resuming its growth through some type of engineered export binge. Competitors in Southeast Asia, including Vietnam, mean that China is not the only game in town anymore, either. Ever-worsening pollution issues also make it more difficult to go back to the days of heavy industry as an engine of growth. Don't get me wrong: China isn't falling apart, but the days of huge commodity booms and 10% growth rates are probably gone for good. In fact, today's 7.5% growth could look downright exhilarating just five years from now.

Weather May Be Distorting Short-Term Data. It is nearly impossible to tell if recent economic weakness in the United States is entirely weather-related or if that is merely an excuse for poor results. Housing starts for January and February combined were below year-ago levels, and that is likely to be true again in March. Weather could have kept some builders from physically being able to dig a foundation or buyers from even looking at homes. However, markets with great weather (the West Coast) haven't been doing so well, either. Also, some of the more weather-addled markets have looked better than one might expect (the Northeast). So although the statistics have clearly been hit by weather, the economy still looks to be less than robust.

If it really was all about the weather, I would expect to see huge volatility in the weekly shopping center reports. Not every week is affected by weather, and certainly one might rightly expect that shopping centers should have seen periodic booms in sales when the weather lifted and busts when the worst storms hit. Instead, the weekly shopping center data has barely budged from week to week. Sky-high utility bills may be keeping a tight lid on other spending in the short run.

Long-Term Growth Drivers Remain Intact ...

Housing Continues to Have a Huge Runway in Front of It. Certainly the housing market remains potentially the largest driver of economic activity in the short and intermediate term. Residential spending, which includes new homes of all stripes, remodeling expenses, and brokerage commissions on new and existing homes, have averaged more than 4.7% of GDP in the postwar era. Sometimes that percentage has spiked very close to the 7% level. This recession, spending got as low as 2.4% and still stands at a meager 3.1%.

The runway in front of the industry remains immense. Furthermore, construction is a large employer with high weekly hours and high hourly wages. The industry also has a lot of knock-on effects across other industries, including furniture, mortgage brokerage, transportation, and lumber. For now, the construction industry has recovered less than a quarter of the 2 million jobs lost during the recession, explaining a great deal of the slow economic recovery.

Analysts Have Consistently Underestimated the Current U.S. Energy Boom. The oil and gas boom in the United States continues to surprise even the experts and remains one of the bedrocks of this recovery. Growth in oil production had been slowing for several decades until new technology enabled drillers to tap new fields and producers to recover more oil from current wells. That production could expand even further for another couple of years. Things could get even better, as experts have consistently underestimated the boom. The current 2020 forecast is now 50% higher than it was in a government forecast that is just a year old, as shown by the gap between the red and blue forecast lines below.

Like the housing industry, the oil boom benefits many sectors beyond the drillers. Low natural gas and oil prices enable the United States to have unusually low electricity prices compared with the rest of the world. In turn, these low electricity prices, combined with direct use of natural gas, benefit large portions of the manufacturing sector including chemicals, steel, and plastics. Low energy prices even benefit offices, which now have lower electricity bills.

The World Economy, With Some Key Exceptions, Is Picking Up Steam. The U.S. currently derives 13.6% of its GDP from exports, up from something more like 5% 50 years ago. With this higher dependence on export partners, the level of world growth becomes more important.

The news is looking better on this front, according to the IMF. After a small decline in world GDP growth in 2013, the IMF is now expecting growth to accelerate sharply from 3.0% to 3.7%, as developed markets in general and Europe in particular begin to pick up steam.

Much of that improvement is due to less fiscal austerity and better consumer attitudes as well as a better export picture. Meanwhile, emerging markets will show only modest improvement as lower commodity prices, oscillating currencies, and China's economic restructuring all weigh on these economies.

Government Might Be Less of an Economic Headwind. The Congressional Budget Office estimates that various budget-balancing measures had a large effect on economic growth in 2013. A combination of higher taxes, lower spending, and sequestration caused the budget deficit to fall from $1.1 trillion to $670 billion, its largest one-year decline in history. That's the good news. The bad news is that it may have reduced GDP growth by 1.0%-1.5%, compared with actual GDP growth of just 1.9% (full year to full year) for 2013. Although the CBO estimates seem a little high, it is a fact that the increase in the payroll tax alone reduced incomes and probably spending by over $100 billion (about 0.6% of GDP).

... But There Are Some Short-Term Impediments to Growth

Auto Sales Growing, But at a Reduced Rate. Collapsing auto sales were a major contributing factor to the most recent recession and have been one of the truly bright spots of the economic recovery. On an annual basis, auto sales peaked in 2005 at 16.9 million units, fell to 10.4 million units in 2009, and have now rebounded to 15.5 million units in 2013.

However, as the industry approaches the old high-level mark, growth will likely continue, but not at the relatively high and unsustainable rates of the early recovery. The annual growth in auto sales peaked at 13.4% in 2012. If the current forecast for 2014 holds, that growth will drop to about 4.3%, which is impressive but slower than in the past two years.

Housing Hits a Rough Patch. The housing market and the financing of those purchases were the root causes of the most recent economic recession. The construction industry by itself accounted for more than 2 million of the almost 9 million jobs lost in the recession. That's even before counting losses in the lumber, mortgage brokerage, furniture, and other aligned industries that may have lost more jobs in total than the direct construction jobs. In other words, housing and related industries likely lost more than 4 million jobs or half of all jobs lost during the recession. The collapse in housing starts was particularly stunning, with a fall from 2.1 million units at the peak to 560,000 units at the bottom in 2009, versus a long-term average of 1.5 million units. Housing starts rebounded to 927,000 in 2013.

Although both existing-home sales and housing starts continue to grow, the rates of growth have already begun to crumble. Temporary factors may have also been in play, but housing was a net detractor from GDP growth in the fourth quarter of 2013.

Future Lending Policies in the Housing Market Will Dictate Future Success. Tight lending conditions go a long way in explaining why the improvement in the housing industry has been relatively slow versus the auto industry, where credit has been widely available. The auto industry is very close to being back to where it was before the recession, and the housing industry has yet to reach the halfway point in the recovery. The graph below shows a drastic increase in credit scores for Fannie Mae on approved mortgages as the housing market collapse got into full gear, moving from 715 to 760 between 2004 and 2009.

Still, credit didn't get much easier from 2009 all the way until 2012, although the economy bottomed in mid-2009. Conditions did get better in 2013, and the FICO score finally began to move down, nicely correlating with better home-price performance and a higher level of housing starts. This will be a key indicator to watch in 2014 (along with similar data from the FHA) to determine whether the housing market can get stronger.

Higher Mortgage Rates, a Slower-Growing Boeing, and Pricier Health Insurance Hurt, Too. There other potential reasons for worry near term including higher interest rates, weak commodity prices (which slow growth in emerging markets that are dependent on commodities), and diminished growth in Boeing (BA)'s 787 Dreamliner program. Higher weather-related utility bills (plus a secular trend in higher natural gas prices), lower food stamp payouts, and the end to extended unemployment benefits will likely hurt consumers, especially at the low end of the income curve. Higher health insurance rates and higher deductibles won't help, either. It does remain to be seen if a greater number of insured workers utilizing more health care might offset some of that pain.

Research Team Cautious on Valuation
Morningstar's security research team remains cautious as stocks in most sectors appear to be overvalued. Recurring themes include short-term weather effects, a relatively stable economic environment, worries about higher interest rates, and continued strong merger and acquisition activity, including a leveraged buyout market that is really picking up steam.

News from Europe is generally better while emerging-market activity varies substantially by market and sector team. However, the general feeling is that China will not be returning to heady growth rates anytime soon.

Interestingly, I am a little more worried about the construction industry after seeing a number of very unfavorable macro trends in this quarter's outlook pieces. Our retail team highlights the ongoing moves to e-commerce, which will diminish the need for new retailing space. This has been an ongoing trend that may be reaching a tipping point. It may not be good news for retail employment, either. The banking team reports a similar trend with less interest in branch banking and the need for huge branch networks as more and more transactions are handled online and via smartphones. Finally both the real estate and housing teams (reporting in the industrials sector) note the interest in multifamily homes compared with more labor-intensive and expensive single family homes. That's not good news for builders or the industrial economy.

The U.S. Likely to Muddle Through
On the upside, the economy has continued potential growth from the normalization of the residential housing market, direct benefits of more oil and gas production and indirect benefits of lower energy costs on manufacturers. However, unfavorable demographics, negative ramifications of online retailing and remote workers, as well as population shifts back to the city and away from remote areas could offset some of those favorable trends.

The key question is, can the economy manage to find the next big thing that can drive long-term economic growth? Is there another Internet out there just waiting to be found?

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