Orlando's Outlook: March Madness, Washington style
Bottom line Fourth-quarter Gross Domestic Product (GDP) was revised marginally higher yesterday, due to better trends in housing, business investment, and net exports, all of which helped to slightly offset weaker readings from consumer and government spending and a larger inventory drawdown. To be sure, there are metrics that are generally firming within the U.S. economy, such as consumer confidence, manufacturing, initial weekly jobless claims and housing, while consumer spending has weakened over the past two months. Against this mixed economic backdrop, then, it is puzzling to us why our elected officials in Washington would allow the automatic spending sequester to take effect today, with its potentially deleterious impact on both GDP growth and employment.
GDP revised higher
In its first revision for the fourth-quarter of 2012, the Commerce Department said economic growth improved from -0.1% to 0.1%, which was still well below consensus estimates for 0.5% growth and represents a significant sequential decline from the third quarter’s relatively healthy 3.1% GDP reading. That keeps the full-year at 2.2% GDP growth for 2012, versus 1.8% in 2011. Here are the details:
- Housing continues to accelerate Marking its seventh consecutive quarterly gain, residential investment leapt by 17.5% in the fourth quarter, up from a flash reading of a gain of 15.3%, compared with a 13.5% third-quarter increase.
- Inventories plunge The pace of inventory restocking fell further to only $12.0 billion in the fourth quarter, down from a preliminary reading of $20.0 billion, which was down sharply from $60.3 billion in the third quarter. Hurricane Sandy certainly hurt this metric, as did the desire among businesses to keep inventories lean heading into an uncertain Christmas season, which proved to be a good decision. All of this suggests that there will need to be an inventory restocking rebound at some point, but the timing is clearly uncertain, given near-term developments in Washington.
- Business capex strengthens Real business fixed investment was revised up to a 9.7% fourth-quarter gain, versus a flash increase of 8.4%, which compares with a 1.8% third-quarter decline. Business structure investment, such as factories and office buildings, was the big surprise here, rising by a revised 5.8% in the fourth quarter, versus a preliminary1.1% decline, compared with no change in the third quarter. Business equipment and software spending rose by a revised 11.3% in the fourth quarter, which was slightly weaker than the flash 12.4% gain, compared with a 2.6% third-quarter decline, the weakest such reading in three years.
- Net trade improves The trade deficit shrank to $387.9 billion, the smallest since the first quarter of 2010. Exports declined by a revised 3.9% in the fourth quarter, which was a smaller decline than the preliminary drop of 5.7%, versus a gain of 1.9% in the third quarter. Imports were revised to a larger-than-expected decline of 4.5%, versus a flash drop of 3.2%, compared with a modest 0.6% third-quarter decline.
- Government spending falls even further Total government spending dropped at a revised 6.9% annual pace in the fourth quarter, versus a preliminary decline of 6.6%, compared with a 3.7% third-quarter increase. The decline was largely driven by a 22.2% decline in military spending—related to President Obama’s automatic spending sequester—which was the biggest quarterly defense cut since the Vietnam War in 1972.
- Consumer spending softens Personal consumption expenditures, which account for 70% of GDP, rose by a revised 2.1% in the fourth quarter, compared with a preliminary gain of 2.2%, versus a tepid 1.6% increase in the third quarter. We also know that this trend is poor heading into the first quarter of 2013. Low-end consumers have been hurt by the 2.0% increase in the Social Security payroll tax to 6.2%, the 18% increase in gasoline prices over the past two months, and the delayed IRS tax refunds due to the very late date of the fiscal cliff deal on New Year’s Day. High-end consumers have been hurt by President Obama’s increase in the marginal tax rate and the phase-out of deductions and exemptions, among other changes in the personal tax code.
What does the economic future hold? We here are Federated are expecting an improvement in the pace of economic growth in the first quarter to a still-anemic 1.2%, compared with a 2.0% consensus estimate. For the full year 2013, we are forecasting a tepid 1.7% GDP growth rate, versus an almost equally disappointing 1.9% consensus estimate. We believe that ongoing fiscal policy dysfunction in Washington is largely responsible for these weak sub-trend GDP growth estimates.
What are the terms of the sequester? President Obama is expected to sign his $85 billion, automatic spending sequester into law today, with an additional $1.1 trillion in spending cuts coming over the next decade. Half of these cuts will be focused on defense spending (which accounts for 18% of total federal spending), and the other half will come from non-defense discretionary spending (which accounts for about 16% of total federal spending). Importantly, entitlement spending—accounting for 60% of total federal spending—will largely be spared from this budget-cutting exercise.
Remind me why we’re doing this again? To be sure, no one likes this mindless, meat-cleaver approach to cutting spending—not President Obama, not Congress—but no one can agree on what to substitute. Republicans would like to reform entitlement spending, while President Obama would like to raise taxes further and eliminate more deductions. The potential economic impact from the automatic sequester would be roughly a 0.5% to 0.6% annual hit to GDP growth and perhaps 400,000 jobs lost this year and 750,000 over the next two years.
It’s the president’s prerogative to change his mind President Obama hit the nail on the proverbial head earlier this week during a speech in Virginia: “These cuts are wrong. They’re not smart. They are not fair. They are a self-inflicted wound that doesn’t have to happen,” he said. While we agree with President Obama completely, the irony here, of course, is that the sequester was his idea—a “Plan B” after the promising Grand Bargain between the president and House Speaker John Boehner fell apart after a tentative agreement in July 2011.
Washington fiddles while the economy burns Rather than locking themselves in a smoke-filled room to negotiate a better solution over the last month, however, President Obama and Congress are spending their time holding dueling press conferences, delivering campaign-style speeches to rally their base, and pointing fingers of blame. That’s clearly not a productive use of their time, and while the clock inevitably ticks toward the imposition of the sequester, the U.S. economy continues to underperform, limping along at roughly a 2% GDP run rate for the last four years. Trend-line growth in the U.S. is 3%, and we continue to believe that we should be growing at 4% right now, given where we are in the economic cycle. According to the Congressional Budget Office, the difference between growing the U.S. economy at our current 2% rate versus a 4% growth rate would generate an extra $6 trillion in revenues for the federal government over 10 years. Because this would solve all of our budget and spending concerns, shouldn’t we be trying to grow the economy faster?
So how do we fix this?
We need to turn the clock back to July 2011 and the Simpson-Bowles-style Grand Bargain that was nearly completed. The CBO tells us that we need a three-to-one ratio of spending cuts to revenue increases to balance the budget and begin to repay $16 trillion in debt—with a focus on reforming entitlement spending, which is on a demographically unsustainable trajectory.
At that time, Speaker Boehner had offered $800 billion in new revenues, and President Obama had agreed to $2.4 trillion in spending cuts, centered on entitlement reform. When the president then demanded an additional $400 billion in revenues—a 50% increase, to lower the overall ratio to two-to-one—Speaker Boehner balked, and the automatic sequester was born.
Speaker Boehner already provided the president with $600 billion in tax increases in the fiscal-cliff deal on New Year’s Day, without any corresponding spending cuts from the president. So to ensure the balanced approach that we all want, President Obama should now propose $1.8 trillion in longer-term spending cuts through entitlement reform; then we can cancel the dreaded $1.2 trillion automatic sequester, and its damaging across-the-board near-term cuts to spending. We can achieve this by raising the retirement age for Social Security, Medicare and Medicaid, fixing the cost-of-living allowance (COLA), and means-testing benefits.
But that’s all easier said than done, to be sure. Let the March Madness begin.