Orlando's Outlook: All eyes remain on Washington
Bottom Line For better or worse, it’s all about Washington right now. We’re budgeting that Hurricane Sandy will probably reduce GDP growth by about 0.5% in each of the fourth quarter of 2012 and the first quarter of 2013, before shifting from a headwind to an economic tailwind by spring. So our bigger concern is the outcome of fiscal-cliff and debt-ceiling negotiations between President Obama and Congress. Their New Year’s agreement, in our view, was the easy one, partially resolving the tax side of the ledger: the Bush tax cuts; exemptions and deductions; dividends and capital gains; the alternative minimum tax (AMT); the estate tax; extended unemployment benefits; the Medicare doc fix; and the Social Security payroll-tax holiday. But the upcoming spending discussions in late February and March—which will likely commence after this weekend’s inauguration and the State of the Union speech on Feb. 12—will attempt to tackle the $16.4 trillion debt ceiling, the March 1 automatic sequester, and the federal government’s continuing spending resolution—which expires on March 27 and could shut down the government at least temporarily—among other important spending issues, such as entitlement reform. At best, we fear an economic chilling effect that could hamper business and consumer spending over several quarters, an outcome that we do not believe is currently priced into financial markets.
The fixed-income and equity investment professionals who comprise Federated’s Macro Economic policy committee met this past Wednesday to review the current status of Washington developments and their likely impact on economic growth and financial-market performance:
- On Dec. 20, the Commerce Department revised up its third-quarter Gross Domestic Product (GDP) from its initial report at 2.0%, to its first revision at 2.7%, and then up to a final reading of 3.1%, largely due to stronger exports, consumer spending and inventory restocking in September.
- But due to the psychological economic drag on business and consumer spending from the last-second fiscal-cliff deal in Washington, we are cutting our estimate for fourth-quarter GDP growth from 1.7% to 1.2%, a move that the Blue Chip consensus has followed. The Commerce Department will flash fourth-quarter GDP growth on Wednesday, Jan. 30.
- That does not change our full-year 2012 GDP forecast at 2.3% (versus 1.8% growth in 2011), while the Blue Chip consensus estimate also remains unchanged at 2.3%.
- Sandy could still be an economic drag during the first quarter, and Washington punted the tougher spending decisions to the back half of the quarter, which will collectively continue to pressure first-quarter GDP. But because third-quarter GDP was revised higher, the stronger base prompts us to adjust our first-quarter GDP estimate in 2013 from 1.0% to 1.2%, while the consensus estimate remains unchanged at 1.6%.
- Our base case continues to expect that Washington will resolve these looming spending-cliff issues by the end of the first quarter, although we may not be totally enamored with the details. We also expect that the northeast will begin to rebuild from Sandy, so we are raising our second-quarter GDP growth estimate from 1.4% to 1.7%, while the consensus estimate ticks down from 2.2% to 2.1%.
- We are raising our third-quarter estimate from 1.9% to 2.1%, while the consensus estimate slips from 2.6% to 2.5%.
- We are ticking up our estimate for fourth-quarter GDP growth from 2.2% to 2.5%, while the consensus estimate ticks down from 2.9% to 2.8%.
- That leaves our full-year 2013 GDP estimate unchanged at 1.7%, versus the Blue Chip consensus, which also remains unchanged at 2.0%. Please note that Federated’s and the consensus’ full-year GDP estimates are both well below trend-line economic growth of 3.0%, which suggests that the U.S. economy continues to underperform due to poor fiscal policies emanating from Washington.
The Macro Policy Committee also made the following investment observations:
Earnings season off to a decent early start We’re into the second week of the fourth-quarter 2012 reporting season, and with about 15% of S&P 500 companies having reported to date, results haven’t been bad. Revenues are up about 5.8% year over year, which is a 1.5% positive revenue surprise, with 56% of companies beating consensus estimates so far. Earnings (including financials, which have rebounded strongly here in the fourth quarter) have surged by 16.8%, which represents a 4.6% positive surprise, with 63% of companies beating consensus estimates. If we back out financials, earnings are down 3.5%, which represents a 3.2% positive surprise. However, first-quarter management guidance has been poor thus far—due to Washington-related concerns over visibility—with 80% guiding lower by an average of 2.5% below consensus. But revenue and earnings reports from such industry bellwethers as J.P. Morgan and General Electric have set a generally positive tone.
Inflation pressures ease Largely due to the fourth-quarter decline in food and energy prices, the spike in nominal inflation we saw last summer has rolled over, and core inflation has declined over the past few months. On a year-over-year basis through December, core inflation is now running at well-behaved levels of 2.0% and 1.9%, respectively, for the wholesale Producer Price Index (PPI) and the retail Consumer Price Index (CPI). The core Personal Consumption Expenditure (PCE) index—the Federal Reserve’s preferred measure of inflation—is now running at a very benign 1.5% year-over-year through November, which remains well within the Fed’s 1.0% to 2.0% target range.
Fed on hold We were pleasantly surprised with the Fed’s new trigger mechanisms to help achieve their dual inflation and employment mandates. The Fed plans to keep its Zero Interest Rate Policy (ZIRP) and its expansive “QE to Infinity” bond-buying program in place until the rate of unemployment comes down to at least 6.5% (from 7.8% now) and so long as their long-term inflation forecast is no more than 0.5% above their 2.0% core PCE inflation target. We believe that with benign levels of core inflation and legitimate concern about ongoing fiscal-policy dysfunction in Washington, the Fed is justifiably on hold for now, although we do remain concerned about the potential for longer-term inflationary pressures.
Employment starting to improve? Although the recent employment picture for nonfarm and private payrolls has been relatively stable and uninspiring, there are two positive leading indicators on the horizon which suggest that job growth may be ready to improve. Initial weekly jobless claims—an important leading economic and employment indicator—plunged to a five-year cycle low of 335,000 for the week ended Jan. 12, which is the survey week for the upcoming January employment report to be flashed on Friday, Feb. 1. Also, the ADP report, which is a forward-looking proxy for private payroll growth, gained 215,000 jobs in December, compared with 148,000 in November and 157,000 in October. The ADP survey is now three months into a new methodology, a larger sample, and a new external partner, and it’s demonstrating some early strength. In addition, manufacturing and construction both rebounded back into positive territory in December due to the recovery from Hurricane Sandy.
Mediocre Christmas due to weakening confidence December, while far from strong, was a pleasant surprise, after a dismal Sandy-impacted October and a decent start to the critically important Christmas season over Thanksgiving weekend in November. Ordinarily, because Back-to-School (BTS) spending was very strong in 2012, and because BTS and Christmas tend to be very highly correlated, and because consumer spending accounts for 70% of GDP, we’d conclude that fourth quarter GDP would be pretty good, due to a positive contribution from Christmas. But we continue to believe that the economic chilling effect related to the ongoing fiscal-cliff and debt-ceiling negotiations in Washington hurt Christmas spending, and the tax increases that will start to hit consumers now will negatively impact their spending trends through at least the first half of calendar 2013. The recent air pocket in consumer confidence would seem to support our contention. Consumer confidence had strengthened last fall, with Michigan sentiment at a five-year high at 82.7 in November and the Conference Board’s consumer confidence indicator at a four-year high of 73.1 in October. But Michigan has since plummeted to 71.3 in January, while the Conference Board’s index fell to 65.1 in December.
Autos and housing strong, manufacturing remains mixed After the Sandy-impaired decline in October, auto sales have rebounded strongly over the past two months, with sales at 15.3 million annualized units in December, as the northeast needed to replace damaged vehicles. Autos are now up nearly 70% from the bottom of the cycle in February 2009, sitting just under a four-year high. The housing-market index—a key confidence indicator—has tripled to a six-year high at 47 over the past 16 months, while starts and permits have surged to four-year highs just over 900,000 annualized units. New-home sales are sitting at a two-year high, prices have surged over the past five months, and mortgage delinquencies have plunged over the past three years.
The national ISM manufacturing index has climbed back above 50 in December for the third time in the past four months, which implies economic growth, while three of the important regional Fed indices we monitor have fallen back into negative territory. Although they increased in November, exports lost ground to surging imports, which could hurt fourth-quarter GDP. November factory orders consolidated from strong September and October levels, while gains in wholesale and business inventories were solid. Durable and capital goods orders performed well for the third consecutive month in November, and industrial production and capacity utilization in December continued to rebound from weak Sandy-impaired October results.