The economy is picking up speed
We have come to the conclusion that the weight of recent economic evidence suggests economic growth is accelerating. We believe this acceleration in economic growth appears sustainable-at least over the next two to four quarters.
With this in mind, we are increasing our outlook for 2010 and 2011 GDP growth rates. Correspondingly, we are increasing our outlook for S&P 500 corporate profit growth. While we maintain our belief that domestic economic growth will continue to be below-trend, due to deleveraging (paying down of debt by the private sector), and other issues which are highly documented in our
past writings, from a cyclical standpoint, it appears GDP growth may show some degree of acceleration over the next six to 12 months.
One challenge some are not yet focused on is a potential acceleration in consumer inflation, driven primarily by rising food and gasoline prices. This may be a new dampener on economic momentum.
Evidence – What Evidence?
While we are firmly in the “slow economic growth” camp going forward, we have observed a number of indicators over the last few weeks which are refreshing. Initial unemployment claims have glided lower, and a number of business surveys have improved. It will be important that congress makes some progress on the taxation question over the next few weeks.
ISI recently surveyed a number of businesses as to conditions. The results of their retailer survey increased to 46.7 percent as compared to the reading of 40.0 percent of 10 weeks ago. The NFIB index, the furniture buying index, the CEO Magazine business confidence index and consumer confidence (both University of Michigan and Rasmussen) all increased recently. The employment picture released on November 4 showed the economy created 151,000 jobs during the month of October.
We are of the camp that the next report, to be issued on December 3, will again show employment growth in excess of 100,000 jobs during the month of November. Employment is the economic key. Stimulation of final demand and business visibility are both important to job creation, as most private employers will not hire people, unless good demand patterns are present and a belief of the sustainability of those demand patterns can be maintained.
So, what are the stimulus keys to moving final demand to the upside? We suggest it isn’t the bond (interest rates) or currency markets, but rather the stock market, through which the wealth effect has the ability to create an increase in consumption and final demand.
Economic and Market Outlook
Historically, there has been a positive link between stock prices and changes in consumption growth rates. Normally, if stock prices rise, consumption tends to rise as well (with a short lag). The same is true with real estate (housing) prices, but with a much more delayed, long-term lag. As prices of these two asset classes tend to rise or fall, people feel more, or less wealthy. As those feelings and levels of balance sheet improvement/debasement occur, consumption patterns tend to shift. From an economic standpoint, this is called the “wealth effect.”
How direct and meaningful, from a historical standpoint, has the “wealth effect” been? The academicians tell us that about 3.0 percent of the value of rising stock prices tends to shift towards consumption patterns. In other words, for every $100 in wealth that is created by rising stock prices, about $3 gets spent at retail stores.
How Much Money
The market capitalization of the largest 4,000 publically-traded stocks is currently $13.8 trillion (according to Ned Davis Research as of the end of October). On August 27, Chairman Bernanke said “The Committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly.”
This was widely reported from the symposium held in Jackson Hole, Wyoming. Market participants surmised the Chairman was referring to the now-famous “QE2” program, which was formally announced recently. Since this speech, the stock market has gained 12.6 percent (as measured by the S&P 500 Index through close of business last Friday). If the wealth-effect ratios mentioned above hold true, consumption may accelerate by $52 billion, due to an increase in the equity market. Our economy is massive at $14.4 trillion in GDP.
If an additional $52 billion is spent due to a rise in the equity market, from a numerical standpoint, GDP should rise by about 0.3 percent. Consumption should rise by about 0.5 percent, with discretionary spending leading the way at roughly 1.7 percent gain. This analysis assumes stock prices don’t retreat rapidly from current levels.
This doesn’t sound like a major move, and indeed, it isn’t. But when the economy is growing by about 1.9 percent on an annualized basis for the last six months, an additional 0.3 percent growth isn’t bad. Importantly, retail sales are starting to turn. Over the last three months, retail sales have increased at an 11.8 percent annualized rate, as compared to 3.9 percent annualized rate-of-change over the last six months.
Additionally, this weekend, many parking lots in shopping areas in suburban Kansas City were near capacity. We are gaining signs that inflation is starting to creep into the consumer’s wallet. Rising food and energy prices appear to be gaining traction, which may negatively affect consumption patterns. All of this leads us to the conclusion that economic growth may accelerate slightly.
Consequently, we are increasing our GDP outlook to 2.3 percent growth for the fourth quarter of this year. Additionally, we are projecting GDP growth of 2.5 percent to 3.0 percent for all of 2011.
It is fair to say that risks are abundant. What happens if the Fed abandons QE2? Stocks will probably decline. What happens if unemployment takes a significant shift to the upside? Stocks will probably decline. What happens if our leaders in Washington do nothing about the tax question? Stocks will probably decline. From a short-term standpoint, we believe the odds of these events occurring are reasonably small. Consequently, we are increasing our view of GDP growth rates for the remainder of this year and next.
Let’s keep this in perspective. Longer-term, we are firmly of the “slow-growth” camp. Our thematic piece “Long Hard Slog” from November 2007 outlined our long-held view that GDP growth, and consumption growth rates are going to be much lower than normal for the next number of years. Since the end of World War II, the U.S. economy has grown by 3.3 percent per year, after inflation. We don’t believe we see a time in the short-to-intermediate future where the economy will grow significantly above “average.”
Additionally, risks (which we have documented in past issues) are present with the launch of QE2. Thoserisks center on the potential for currency debasement and rising inflationary pressures. What about Chinese economic growth? It very well may slow. Risks appear to be accelerating in Europe. The problems in Ireland are real, as they are in Portugal and Spain. U.S. housing prices have stalled. All of this is to point out that longer-term problems are real, and are not abating.
QE2 – Making Sense?
Regarding the “wisdom” of QE2. Should the Fed pursue this strategy? While we enjoy rising stock prices, we harbor serious concerns regarding this strategy. Our concerns over the intermediate-term center on the potentially negative effects this strategy may have on inflation and the value of the dollar. Debasing one’s currency is seldom a good idea, and normally is used as a last resort to serious default issues. It has been some time since we as a society faced a systemically rising inflation problem.
Our current President was born in 1961. The CPI was running in double-digits when he was a teenager and in college. In other words, we have a new group of leaders in our country who haven’t felt the sting of secular inflation. Don’t get us wrong as we don’t expect inflation and interest rates to make a significant move to the upside (due to our debt levels, our economy would probably collapse under the weight), but we fear many of our current leaders don’t understand how insidious inflation can become.
How will the Chinese react to this plan? As we have seen over the last week or so, not well. Along with most of the rest of our trading partners, there is a growing concern that we in the U.S. are willing to debase the value of our currency, and repay our debts in a devalued dollar. Is an additional 0.2 percent to 0.5 percent growth in GDP worth all of this activity? What we don’t know about the ultimate effects of QE2 swamps what we are aware of – which is the Fed’s balance sheet was expanded by another $600 billion, as we monetize our debt.
With these cross-currents, on what should an investor focus? In a word, quality. During a time of economic transition and change one needs to focus on quality. We sense better economic reports may be forthcoming, as retailing and consumption make a shove to the upside. However, we are not sounding the “all clear” for investors, as we continue to move down the “Long, Hard Slog.