Orlando's Outlook: GDP outlook strengthens
Bottom Line The U.S. economy appears mired in a temporary spring economic swoon, as manufacturing, net trade, government spending, inventory restocking and the labor market have all softened in recent months, perhaps in response to higher tax rates and reduced spending in Washington earlier this year. But consumer confidence has started to improve, and with it, consumer spending, housing and autos have begun to reaccelerate as well. Combined with a strengthening “Wealth Effect” due to rising real estate and stock prices—which we believe will start to offset the negatives from Washington’s self-induced fiscal drag—some of these underperforming economic metrics may start to firm later this year and into calendar 2014.
The financial markets’ recent focus, however, has been on monetary policy, and the widespread concern that the Federal Reserve will imminently begin to taper its aggressive monthly bond purchases. While we vehemently disagree with this assessment, stocks have corrected by some 5% over the past three weeks, and benchmark 10-year Treasury yields have soared from 1.60% to 2.25% over the past six weeks, as investors have begun to discount the consensus expectation of the Fed’s reduced accommodation. In our view, this provides equity investors with an attractive longer-term buying point from oversold conditions.
GDP outlook strengthens The equity and fixed-income investment professionals who comprise Federated’s Macro Economic policy committee met on Wednesday to discuss these fiscal and monetary policy crosscurrents, and we made the following changes to our estimates for Gross Domestic Product (GDP):
- The Commerce Department revised its disappointing first-quarter GDP flash down from 2.5% to 2.4%, largely due to weaker government spending and a smaller inventory build. The final revision will be released on Wednesday, June 26.
- While we continue to expect that the northeast will begin to rebuild in earnest from Hurricane Sandy during the second quarter, we are also concerned about the economic weakness associated with poor manufacturing trends and the federal government’s spending sequester. So we are keeping our second-quarter GDP growth estimate at 1.7%, while the consensus estimate remains at 1.8%.
- Consumer spending, housing and autos are beginning to perk up again after softness earlier this spring, so we are boosting our third-quarter GDP estimate from 2.3% to 2.7%, while the consensus estimate declines from 2.4% to 2.3%.
- We’re now expecting solid Back-to-School and Christmas retail seasons, along with some recovery in manufacturing activity and inventory restocking. So we are raising our estimate for fourth-quarter GDP growth from 2.6% to 3.0%, while the consensus remains at 2.6%.
- That increases our full-year 2013 GDP estimate from 1.9% to 2.0%, compared with the Blue Chip consensus, which is reducing its estimate from 2.1% to 1.9%.
- Because we expect that these trends may gather some positive momentum into next year—despite the expected full implementation of the Affordable Care Act—we are increasing our full-year 2014 GDP estimate from 2.7% to 3.2%, compared with the Blue Chip consensus, which lowered its estimate by a tick to 2.6%.
Federated’s Macro Policy Committee also made the following investment observations:
The Fed’s $64,000 question We strongly disagree with the consensus forecast among Fed Watchers, who believe that the central bank will begin to taper its aggressive bond-buying program at the upcoming two-day Federal Open Market Committee (FOMC) meeting on June 18-19. In our mind, the Fed’s “QE to Infinity” bond-buying program, in which the central bank is purchasing $85 billion of Treasury and mortgage-backed securities each month to keep interest rates low, has helped to successfully spark a “Wealth Effect” in the equity and real estate markets, which has partially offset the economic drag from Washington’s suboptimal fiscal policies. Given the spring economic swoon, however, we fully expect the Fed to wait for an economic uptick before it commences its tapering strategy. That is, we believe that the Fed will likely keep its bond-buying program in place until at least the September or December FOMC meetings later this year—or perhaps the March 2014 meeting—before beginning to taper. But the key takeaway is this: ultimately, this will be an important data-dependent decision, and the Fed will only begin to pull back if the economy is demonstrating sustainable strength, a positive which the equity market should eventually come to embrace fully.
Inflation remains benign Core inflation on a year-over-year basis is running at well-behaved levels of 1.7% for both the wholesale Producer Price Index (PPI) through May and the retail Consumer Price Index (CPI) through April. The core Personal Consumption Expenditure (PCE) index—the Federal Reserve’s preferred measure of inflation—is running at a very benign 1.1% year-over-year through April, which is within the Fed’s 1% to 2% target range and well below its 2.5% inflation trigger to reverse its current Zero Interest-Rate Policy (ZIRP). In our view, benign inflation provides the central bank with a very generous cushion to keep its aggressive monetary policy accommodation in place longer.
Employment treading water The employment picture over the past three months has been middling, with nonfarm payrolls adding an average of 155,000, compared with a more robust gain of 332,000 jobs in February. Not surprisingly, manufacturing has been weak, with outright job losses in each of the past three months. But the household survey has enjoyed a nice rebound, with strong gains of 319,000 jobs in May and 293,000 in April, versus a loss of 206,000 jobs in March. The ADP report, which is an important leading indicator, has been soft over the past three months, adding an average of only 134,000 jobs, versus a stronger 202,000 average for the previous five months under its new methodology. However, initial weekly jobless claims—another important leading economic and employment indicator—fell to 334,000 for the week ended June 8, which is just above the five-year low of 327,000 claims in late April. The unemployment rate ticked up to 7.6% in May, as the labor-force participation rate also ticked up from a 34-year cycle low to 63.4% last month, which tells us that formerly discouraged workers are feeling sufficiently confident that they are starting to look for work again. We believe that the Fed is looking for a sustainable run of at least 200,000 nonfarm jobs added in each of several months, before they begin to taper their bond purchases.
Autos and housing kick back into gear After some early spring softness, auto and housing sales have resumed their ascent. Auto sales soared by 70% from 9 million units at the bottom of the cycle in February 2009 to 15.33 million units annualized in February 2013, before slipping by 3% during March and April. But they recovered most of that lost ground in May, and we believe that they’re poised to run higher this summer. The housing-market index (HMI)—a key confidence indicator––had slipped from a six-year high of 47 in January 2013 to 41 in April, although it was still nearly triple from where it was at 14 in September 2011, when the housing market bottomed. But the HMI has since rebounded to 44 in May, a positive trend we expect to continue in coming months. Starts and permits have already doubled to one million units off of half-century lows, but they need to triple just to get back to historically normal levels. Household formations have already rebounded to normalized levels of one million per year, mortgage delinquencies and foreclosures have fallen sharply, and pricing hit a seven-year high in March, rising by almost 11% year over year. Affordability—the combination of housing prices and family income—has never been better, mortgage rates are starting to rise off of record lows, and new and existing home sales are grinding higher, a trend that we expect to continue for several more years.
Retail sales and consumer confidence rebound Retail sales had been choppy in the early going this year, with a poor January, a good February, a weak March (probably due to an early Easter and cold weather), and a solid April. We lay the blame squarely at the feet of Washington’s fiscal-policy missteps (higher tax rates and reduced federal government spending), which are probably starting to fade, replaced by a stronger “Wealth Effect” driven by the increase in real estate and stock prices. Importantly, consumer confidence has started to improve. The Conference Board’s consumer confidence index hit a five-year high of 76.2 in May (up from 61.9 in March), while the Michigan consumer sentiment index hit a six-year high of 84.5 in May (up from 76.4 in April). In the wake of this improving consumer confidence, then, it was little surprise to us that May’s retail-sales results were the strongest in three months, which will help to offset poor manufacturing data in the second quarter, and could lead a possible second-half economic resurgence with stronger Back-to-School and Christmas sales, as consumer spending accounts for 70% of GDP.
Manufacturing is the economy’s black hole The national ISM manufacturing index has plummeted from a solid 54.2 in February to 49.0 in May, which implies that the manufacturing portion of the U.S. economy has slipped back into “contraction” mode from “growth.” This negative trend is confirmed by five of the seven regional Fed indices we monitor, which have experienced a sharp sequential decline in recent months. The net trade balance weakened in April, due to slowing export growth because of economic weakness overseas, while capital goods shipments turned negative in April, both of which will contribute to softer second-quarter GDP. Factory orders and wholesale and business inventories have been choppy over the past four months, as the pace of inventory restocking has been slow in the face of softer end-market demand. Finally, industrial production was unchanged in May from April, when it posted its weakest reading in eight months, and capacity utilization is down over the last few months.