Orlando's Outlook: Soft patch now, second-half bounce later

Bottom Line Domestic economic growth clearly slowed during the second quarter, with particular emphasis on negative retail sales during April, May and June, as consumer spending accounts for 70% of Gross Domestic Product (GDP).  Additional concerns include: the deepening recession in Europe, with worries that Spain must now be bailed out, while Greece will soon be thrown out of the eurozone; the lagged economic impact from the sharp winter spike in energy prices; a possible emerging-markets hard landing in China, Brazil and India; and ongoing policy dysfunction in Washington, with particular uncertainty surrounding the looming fiscal cliff and the upcoming Presidential election.  In conjunction with the second-quarter weakness in manufacturing and employment, we decided to trim our GDP forecasts for the balance of this year and 2013.  But we are reiterating our expectation that we are currently mired in a temporary economic soft-patch rather than sliding into a double-dip recession.  We continue to believe that GDP growth will firm in this year’s second half, compared with the economy’s disappointing first-half performance.

The fixed-income and equity investment professionals who comprise Federated’s Macro Economic policy committee met recently and we reflected upon the sharp deceleration in second-quarter economic growth, prompting us to reduce our GDP forecasts.  But we also reiterated our soft-patch forecast for 2012, as we continue to expect that the second quarter will likely serve as the trough of this year’s economic cycle. 

• The Commerce Department recently issued revisions for the last three years of GDP.  They took the full year 2009 up from a decline of 3.5% to a smaller decline of 3.1%; 2010 was reduced from an increase of 3.0% to a smaller gain of 2.4%; and 2011 saw a tick up from a 1.7% gain to 1.8%.
• In terms of recent quarters, the Commerce Department revised the fourth quarter of 2011 up from an increase of 3.0% to a sharper gain of 4.1%, and they ticked up the first quarter of 2012 from a gain of 1.9% to 2.0%. 
• Due largely to weak consumer spending, the Commerce Department flashed second-quarter GDP growth of only 1.5%, which was right in line with our own estimate here at Federated and a tick higher than consensus.  So with sequential GDP growth now sliding from 4.1% in last year’s fourth quarter, to 2.0% in the first quarter of 2012, and now to only 1.5% in the second quarter, it would appear that our long-standing soft-patch forecast for 2012 has been affirmed.    
• Although energy prices are now 20% lower that their recent peak and interest rates are just above record lows, those economic positives are offset by the recession in Europe, slower growth in the emerging markets and economic uncertainty emanating from the ongoing fiscal policy drag in Washington.  As a result, we are trimming our third-quarter GDP estimate from 2.5% to 1.8%, while the Blue Chip consensus estimate has dropped from 2.2% to 2.1%. 
• We continue to expect bold fiscal and monetary policy responses from central banks and governments both here and abroad post Labor Day, which we believe will spark stronger trends in employment, consumer spending and manufacturing into year end.  We remain concerned, however, about timing, lags, and the potential for policy errors, so we are trimming our estimate for fourth-quarter GDP growth from 2.7% to 2.4%, compared with a modest reduction by the Blue Chip consensus growth estimate from 2.4% to 2.3%.  
• By combining the soft first-half GDP with our second-half estimate reductions, we are also lowering our full-year 2012 GDP forecast from 2.2% to 2.0% (versus revised 1.8% growth in 2011), while the Blue Chip consensus estimate remains unchanged at 2.1%. 
• We continue to expect good election results on Nov. 6, and we believe that Washington will address and defuse the ticking fiscal-cliff time bomb during the first three months of 2013, resulting in stronger economic growth next year compared with this year.  But because of the smaller base for 2012, and the potential for weak first-quarter growth due to Washington-related uncertainty, we are also lowering our full-year 2013 GDP estimate from 2.8% to 2.6%, versus the Blue Chip consensus, which is cutting its estimate from 2.4% to 2.3%. 

The Macro Policy Committee also made the following investment observations: 

Second-Quarter Earnings Season OK As measured by market capitalization, we’re about 80% of the way through the second-quarter reporting season, and the results have generally been mediocre, with revenues a little softer than expected, but earnings somewhat better than expected.  Revenues have risen by about 2% on a year-over-year basis, but only about one-third of the companies have beaten their top-line estimates, with the average company actually missing estimates by about 0.6%.  On the profit side of the equation, earnings for the average company are actually down by about 0.5% on a year-over-year basis.  But about two-thirds of the companies that have already reported have beaten their estimates, and the average earnings report is 4.3% above consensus expectations, which means that Wall Street was expecting weaker earnings. Management guidance has generally been cautious, given the lack of visibility on so many fronts.    

Inflation Eases Despite Volatile Commodities Agricultural commodities are soaring due to the worst drought conditions in half a century in the Midwest.  Since mid June, corn has soared by 60%, wheat has surged by 50%, and soy beans have risen by 30%.  If weather conditions don’t improve soon, then these sharply higher prices could begin to work their way through the inflation pipeline over the next several quarters.  Crude oil (West Texas Intermediate) has been on a rollercoaster, soaring by 44% from $77 per 42-gallon barrel last October to $111 in early March, then round-tripping by 30% back to $77 in late June.  With the imposition of the Iranian oil embargo on July 1, however, crude has rebounded by 14% back to $88 currently.  All of that has taken the national average price for a gallon of unleaded gasoline down from $3.95 to $3.35 and now back up to $3.55.  From a timing standpoint, however, the recent commodity-price increases have not, as yet, negatively impacted inflation, which is now running at relatively well-behaved levels of 2.6% and 2.2%, respectively, for the wholesale Producer Price Index (PPI) and the retail Consumer Price Index (CPI) through June on a core year-over-year basis.  The core Personal Consumption Expenditure (PCE) index – the Federal Reserve’s preferred measure of inflation – is running at 1.8% year-over-year through June, which remains comfortably within the Fed’s 1.0% to 2.0% target range.  But inflationary pressures may reassert themselves in coming months, potentially taking benchmark Treasury yields higher, so we’re keeping our duration target at a very low 85%.    

Fed Quiet Until September? At its June Federal Open Market Committee (FOMC) meeting, the Fed already had extended “Operation Twist” through year end and pledged to keep its current near-zero interest rate policy (ZIRP) in place into late 2014, so we expected nothing out of the Fed’s Aug. 1 meeting.  But we do expect some meaningful policy thoughts from Chairman Bernanke at his annual Jackson Hole speech at month’s end.  Moreover, given two additional labor reports (July and August) in hand and a possible peek at what ECB President Mario “Whatever It Takes” Draghi has in mind,  it would not surprise us for the Fed to appropriately adjust monetary policy as warranted at its two-day Sept. 12-13 FOMC meeting.  But we still see a relatively high economic hurdle for a new QE3-type program, as the Fed would like to keep some dry powder in case the U.S. economy plunges back into recession due to some global economic shock. 

Consumers Spending Poised to Rebound? On the heels of relatively healthy retail sales in January, February and March, recent weak employment trends and the winter spike in energy prices conspired to sink retail-sales results for April, May and June, which were all negative for the first time since the fall of 2008 at the height of the financial crisis.   Although June and July tend to be relatively unimportant summer clearance months for the industry, we believe that consumers will return with a vengeance for the important Back-to-School (BTS) season in August and September, for several reasons.  First, consumers drove their personal savings rate up to 4.4% in June, which is the highest in a year, amassing some dry powder.  Next, lower energy prices and interest rates create additional spending capacity.  Third, rising equity and housing prices will help to spark a wealth effect.  Fourth, the Conference Board’s consumer confidence index rose in July for the first time since February, to 65.9 versus 62.7 in June.  Finally, the National Retail Federation is projecting a 14% increase in year-over-year BTS spending, potentially its fastest pace since 2003.  Clearly, this would have a positive impact on third- and fourth-quarter GDP trends, as consumer spending accounts for 70% of GDP.

Employment Rollercoaster Bottoming After posting a relatively healthy average monthly gain of 252,000 jobs during December, January and February, nonfarm payrolls plunged to a three-month average of only 75,000 during April, May and June.  But the good news is that initial weekly jobless claims, which are an important leading economic and employment indicator, have begun to firm, falling from a weekly peak of 392,000 in mid- June to 352,000 for the week ended July 7, before backing up to 365,000 in late July.  In addition, the ADP report, which is an important leading indicator of private-sector job growth, added relatively healthy gains of 163,000 and 172,000 in July and June, up from 131,000 and 112,000 in May and April, respectively.  Unemployment, which is now sitting at 8.3%, compared with a peak of 10.1% in October 2009, has only declined due to the 2% drop in the labor force participation rate, which has also plunged to 63.7% currently, just above a 30-year low.  Unemployment is now above 8.0% for 42 consecutive months, the longest such stretch of labor-market ineptitude since the government starting collecting data in 1948. 

Manufacturing Remains Soft The national ISM manufacturing index has now posted readings just under 50 for both June and July, which implies economic contraction.  This is consistent with poor readings from several of the important regional Fed indices we monitor – such as Philly Fed, Richmond, Dallas and Milwaukee – although Chicago and Empire did perk up in July.  Factory orders and core durable goods orders were surprisingly negative in June, although business and wholesale inventories remained positive through May.  Industrial production rebounded back into positive territory in June, while capacity utilization hit its highest point since August 2008.  After falling by 9% over three months into May due to the spike in gasoline prices, total vehicle sales have risen modestly in June and July to 14.05 million annualized units, a level just above replacement demand.  But the overall sales trends are still up by 54% from the cycle trough of 9.1 million units in February 2009, a positive trend we expect to continue.  Finally, the trade deficit shrank by nearly 4% in May, its second consecutive monthly decline, due to a sharp energy-related drop in imports, while exports rose modestly to a level just below March’s record high.