Orlando's Outlook: Wait and see

Bottom Line  Although it’s not our base case, we remain on recession watch due to the near-term economic impact from Hurricane Sandy and the uncertainty associated with the looming fiscal-cliff and debt-ceiling drama down in Washington. As we saw in Japan early last year, our best guess is that Sandy will probably reduce GDP growth by about 0.5% in each of the next two quarters, but then shift gears from a headwind to an economic tailwind next spring, when the rebuilding begins in earnest in the Northeast. Our bigger concern is the lack of visibility surrounding the outcome of negotiations between President Obama and Congress. While we believe that we’ll ultimately get a deal, we also recognize that failure to reach a pro-growth fiscal compromise in a timely manner will trigger automatic tax increases and spending cuts that will approximate a $600 billion hit to the U.S. economy, which will almost certainly translate into a recession with an estimated negative GDP of about 3-4%. At a minimum, even if Washington does manage to avert this cliff before year end—as we expect will happen—their intransigence to date has created an economic chilling effect that has already begun to impair both business and consumer spending at a critical time of the year.

The equity and fixed-income investment professionals who comprise Federated’s Macro Economic policy committee met today to review Sandy’s economic impact and the status of negotiations down in Washington. 

• The Commerce Department recently revised up its third-quarter GDP from an initially flashed 2.0% to 2.7%, which was exactly in line with our expectations, largely due to stronger exports and inventory restocking in September. 
• But with Sandy chopping an estimated 0.5% from fourth-quarter GDP, Europe in recession, a potential economic chilling effect on business and consumer spending due to the fiscal-cliff and debt-ceiling stalemate in Washington, growth could be at risk. But economic data from October and November haven’t been quite as bad as we had originally feared, so we are raising our estimate for fourth-quarter GDP growth from 0.9% to 1.7%, while the Blue Chip consensus is cutting its estimate from 1.8% to 1.7%.   
• That keeps our full-year 2012 GDP forecast unchanged at 2.2% (versus 1.8% growth in 2011), while the Blue Chip consensus estimate also remains unchanged at 2.2%. 
• Given our expectations for a cold and snowy winter here in the Northeast, Sandy likely will still be an economic drag during the first quarter of next year.  Moreover, while our base case continues to expect that Washington will successfully defuse the ticking fiscal-cliff time bomb in a timely fashion, there’s clearly a risk that we could be wrong. Given the lack of visibility on this issue, businesses and consumers have been cutting back. But we’re growing more confident that cooler heads in Washington will ultimately prevail here, so we’re raising our first-quarter GDP estimate in 2013 from 0.5% to 1.0%, while the consensus estimate comes down from 1.7% to 1.6%.
• We expect that the fiscal-cliff and the debt-ceiling issues will be resolved by the end of the first quarter, and that the Northeast begins an aggressive rebuild from Sandy as soon as the weather permits, such that GDP growth should begin to ramp higher. So we are ticking up our second-quarter GDP growth estimate from 1.3% to 1.4%, while the consensus estimate is unchanged at 2.2%.
• We are raising our third-quarter estimate from 1.5% to 1.9%, versus no change in the consensus estimate at 2.6%.
• We are raising fourth-quarter GDP growth from 1.8% to 2.2%, while the consensus estimate moves up from 2.8% to 2.9%.
• That takes our full-year 2013 GDP estimate up from 1.3% to 1.6%, versus the Blue Chip consensus, which remains unchanged at 2.0%.

The Macro Policy Committee also made the following investment observations: 

Food and energy prices fall Due to the worst drought conditions in half a century, corn, wheat and soy bean prices soared by 67%, 58%, and 38%, respectively, over the summer.  But these important agricultural commodity prices have all fallen by about 14% over the past four months. Similarly, the imposition of the Iranian oil embargo on July 1 sparked a 30% increase in crude oil (West Texas Intermediate) to $101 per barrel by September, before retreating by 15% to $85 over the last three months, with the national average price for a gallon of unleaded gasoline also falling by 15% from $3.87 to $3.29 now. So the sharp spike in nominal inflation we saw over the summer has clearly started to unwind, and core inflation is now running at relatively well-behaved levels of 2.2% and 1.9%, respectively, for the wholesale Producer Price Index (PPI) and the retail Consumer Price Index (CPI) on a year-over-year basis through October. The core Personal Consumption Expenditure (PCE) index—the Federal Reserve’s preferred measure of inflation—is now running at 1.6% year-over-year through October, which remains well within the Fed’s 1.0% to 2.0% target range. 

Fed provides transparency and targeted approach for its dual mandate In part because of the aforementioned benign levels of core inflation and its concern about ongoing fiscal-policy dysfunction in Washington, the Federate Reserve, at the conclusion of this week’s two-day Federal Open Market Committee (FOMC) meeting, spelled out specific inflation and unemployment targets for their monetary policy plans for the first time. With “Operation Twist” set to expire at year’s end, the Fed will roll that $45 billion of monthly Treasury purchases into its ongoing “QE to Infinity” program, which will now total at least $85 billion per month. But instead of selling short-dated paper (whose available supply is rapidly diminishing) to purchase the longer-dated mortgage-backed and Treasury bonds, the Fed will simply add reserves to the banking system instead, which means that they will fire up their printing press. The Fed said that is will keep its Zero Interest Rate Policy (ZIRP) and its expansive bond-buying policy in place until the rate of unemployment comes down to at least 6.5% (from 7.7% now) and so long as its long-term inflation forecast is no more than half a point above its 2.0% core inflation target. While the Fed’s objective is to keep interest rates low to encourage home buying, business and consumer spending, and equity investing to engineer a wealth effect, one of the unintended consequences could be longer-term inflationary pressures.  

Employment remains lackluster Initial weekly jobless claims, an important leading economic and employment indicator, have now come full circle with Sandy, starting at a pre-storm 363,000 claims for the week ended October 27, 2012, spiking to 451,000 for the week after the storm, and returning to a normalized 343,000 last week. Frankly, we fully expected a much more deleterious impact on nonfarm payrolls (up 146,000) in November due to Sandy, although manufacturing and construction both turned negative last month. The household employment survey, however, was a major disappointment, plunging to a loss of 122,000 jobs in November, down sharply from gains of 410,000 in October and an aberrantly-strong surge of 873,000 jobs in September, which was boosted by 600,000 part-time jobs and 200,000 government jobs. So the important household survey has literally swung by one million jobs negatively in the past two months. Where did all those workers go? The unemployment rate fell two ticks to 7.7% in November compared with a peak rate of 10.0% in October 2009, while the total rate of unemployment (U-6) also dropped by two ticks to 14.4%, but these improvements came for the wrong reasons, as the labor-force participation rate also fell to 63.6% last month due to an increase in discouraged workers, which is just a tick above its 31-year cycle low of 63.5% in August. 

Consumer spending softens Because Back-to-School (BTS) spending was very strong this year, and because BTS and Christmas tend to be very highly correlated, and because consumer spending accounts for 70% of GDP, we’d ordinarily conclude that fourth-quarter GDP should be pretty good, goosed by a positive contribution from important Christmas sales. But we’re understandably concerned about the exogenous impact that Sandy and Washington may have on Christmas sales, much like they’ve already had on business spending. While consumer confidence had strengthened through November, with Michigan sentiment at a five-year high at 82.7 and the Conference Board’s consumer confidence indicator at a four-year high of 73.7, Michigan hit an air pocket with its preliminary December reading, plummeting down to 74.5. Will the Conference Board’s index follow later this month?  To that point, October retail sales were negative thanks to Sandy, and November was disappointingly soft, as the Thanksgiving-weekend start to the critically important Christmas shopping season was solid but unspectacular, as general merchandise and department store sales fell by 0.9% and 0.8%, respectively, possibly due to the economic chilling effect related to the ongoing fiscal-cliff and debt-ceiling negotiations that continue to drag on down in Washington. 

Manufacturing mixed The national ISM manufacturing index slipped back under 50 in November for the fourth time in the past six months, which implies economic contraction, while the important regional Fed indices we monitor remain a mixed bag.  Exports fell in October by the largest monthly decline in four years, while factory orders and wholesale and business inventories in October failed to keep pace with robust September levels. Durable and capital goods orders did perform better than expected in October, and industrial production and capacity utilization in November rebounded solidly from Sandy-impaired October results to a two-year high. Auto sales hit a four-year high in November at 15.5 million units, up 9% from October, which was depressed due to storm damage.  Autos are now up 70% from the bottom of the cycle in February 2009, and along with housing, continue to be a bright spot for the economy.