Can the Economy Pass the Rough Spots to the Other Side?

The long term looks good, but getting there will be a bumpy ride.

Robert Johnson, CFA 19.10.2010
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One of the real challenges as an economist is to give some context to a continuing flow of almost random and often contradictory economic indicators. To be blunt, a lot of data came in last week, but none of it really added much to my understanding of the recovery. Inflation was a little lower--good news, in my view. Retail looked surprisingly good, but that was foreshadowed by the strong individual store results announced the week before last week. The trade report was somewhere between the decent July report and June's unmitigated disaster.


Even early corporate earnings reports had a distinctive "on the one hand, but on the other hand" feel. Intel's numbers were good, but it reported weaker consumer shipments. Alcoa's just-reported quarter wasn't anything to write home about, but on the other hand the firm raised its aluminum shipment forecast for the rest of the year. Only Google's results were something to unequivocally cheer about.


Nothing in Last Week's Reports to Stop the Quantitative Easing Train

The data last week, especially the miniscule Consumer Price Index increase, should help lay the groundwork for additional quantitative easing (Fed debt purchases that reduce medium- and long-term interest rates, not just the short-term ones that are already near zero), perhaps as early as the Federal Reserve's early November meeting.


Fed chairman Bernanke hinted as much in a Friday speech. Now, however, the market is beginning to sweat the details. How big will the program be? Will the Fed shock and awe us with a massive program, or will it take baby steps? Bernanke's speech provided no guidance, and markets, which abhor uncertainty, reacted in kind even as the quantitative easers will now clearly get their way.


Amalgam of Data Points to a Higher September Quarter GDP Report; 3% a Possibility versus 1.7% for the June Quarter

A better-than-expected retail sales report for September and an upwardly revised August report, combined with a lower-than-anticipated inflation rate, were fodder for a more optimistic third-quarter GDP report later this month. The consensus just six weeks ago was for a meager 1.4% increase. It has subsequently moved to 2%, and even that looks too low now. My forecast of 2.5% is looking like it might be a little light. Last week's trade report, while not excellent, wasn't bad enough to sink GDP growth in the September quarter.


The Long Term Looks Great, the Short Term Outlook Has Improved...It's the Part in Between That Worries Me


Short Term: Consumers Continue to Spend, Weak Dollar Lifts Exports

The data pouring in over the last month clearly indicate the economy is not falling back into the abyss but isn't lighting the world on fire, either. Third- and fourth-quarter outlooks have improved as the consumer continues to spend, and underinvested corporations gear up their capital expenditures. Shipments to emerging markets, especially by major capital goods manufacturers, should be another boon to short-term demand. A falling dollar won't hurt U.S. export sales, either. Rising stock markets couldn't come at a better time, as rising stock prices are often a good precursor to improved holiday sales.


Long Term: Housing and Auto Sales Almost Have to Get Better

Over the longer term, say the next two to five years, homebuilding will have to move back to something like natural demand of 1.5 million units. That's nearly triple where we are today.


That natural demand doesn't take a miracle; it represents normal population growth and steady household size. Though homebuilding has shrunk dramatically in importance recently, a tripling of a small number will still have a big effect. A resurgence in home sales also pulls through a lot of ancillary sales, like furniture, appliances, and household goods, that begin to add up. The auto industry is also still operating well below natural long-term demand and is likely to be a source of future long-term demand. Favorable U.S. demographics versus other developed economies, higher productivity, and a highly flexible labor force all bode well for long-term growth.


Medium Term: Stagnant Consumer Wages Hit Home

It is the period beginning January 2011 and continuing for the next one or two years that has me scared. Inflation-adjusted consumer incomes aren't really budging after respectable growth early in the recovery. Recently, hours worked, wage rates, and employment have been stuck in neutral. And the news has gotten a little worse for the past several months.


The lack of a cost of living increase for Social Security recipients for 2011 won't help consumer spending and incomes either. At this point in an economic recovery, the easy fuels of inventory restocking and renewed capital spending have usually burned themselves out. What really needs to grow is consumer spending, which represents more than 70% of the economy. Spending obviously is most dependent on consumer income. With the potential for at least some tax increases next year and the ability to borrow more limited than in past recoveries, the importance of increasing wages and salaries and keeping inflation low is even more critical.


Exports and Lower Saving Rates: The Bridge Between Long and Short Term

There are some ways out of our predicament, but the stock market seems unusually confident that the stars will properly align. First, the savings rate has jumped from just over 1% to almost 6% after years of secular decline. Even a small decrease would have a direct effect on consumption, production, and employment numbers in the short run. I am not advocating a return to a 1% savings rate, but given where we are in the recovery (savings rates generally peak after a recovery is well under way), I think a lower savings rate may be in the cards, perhaps as early as the third quarter of 2010. Export sales, which depend on the state of the dollar and the health of foreign economies, could be another way to get around our short-term issues with consumer spending. Right now, those factors are looking quite favorable, but the export sector is small, highly volatile, and fickle when compared with consumer spending.


Business spending that outruns consumer spending could be another savior. For the last two quarters (and potentially for another one or two), business investment spending has outpaced consumer spending. Even meager growth in consumer spending combined with underinvestment during the recession, obsolescence, and normal wear and tear might have the potential to sustain business investment spending at higher levels and for longer than many currently believe possible.


I suppose the income data that make me feel a little dour now could be revised for one reason or another, too. It's happened before. Also there is a shot that the August/September data aren't terribly representative of long-term trends. August is affected by summer vacations, and September often marks the beginning of year-end lockdowns on employment and salary increases. Those lockdowns end with new budget cycles in January.


Inflation Stabilizes at a Low Level

The consumer price index increased just 0.1% for the month of August (1.2% annualized), while on a year-over-year basis, the index increased a mere 1.1%. While these levels are generally below what the Fed was hoping for, I believe it's a good thing at this point in the recovery. The result was below the 0.3% registered in the last two months and below my forecast of 0.3%.


The week before last week I cited a slowing in hourly consumer wages and was fearful that another jump in the CPI could potentially wipe out those meager hourly wage gains. So a lower-than-anticipated inflation rate was a good thing, in my opinion. I am just as pleased to see the year-over-year increase stabilize at a 1.1% rate over each of the last four months. The relative flatness of the increase should make it a little easier for consumers and businesses to plan.


The underlying data were a little more mixed with both meaningful increases and decreases basically canceling each other out. Flat costs for shelter, which represent 40% of the index, also helped keep the overall index in check. Note, however, that most analysts prefer to look at the CPI excluding food and energy; I tend to favor looking at the index without that adjustment. These are critical items in household budgets, and ignoring them would overestimate consumer purchasing power.


Inflation Categories a Mixed Bag


Annualized Sept.
Increases (%)

Big Gainers 

Medical Services




Food, Home


Food, Restaur.


Medical Goods




Biggest Losers 



Used Cars








Source: Bureau of Labor Statistics


Census Bureau Retail Sales Report Shows Strong Results

A great retail sales report was not totally unexpected, as reports from the International Council of Shopping Centers and individual store results announced before both presaged a good September report. Sequentially, sales were up 0.6%, 7.2% annualized.


Even excluding autos, sales were up 0.4%, 4.8% annualized. These results are particularly impressive given the low rate of inflation for September discussed above. (Retail sales are not adjusted for inflation.) For the most part, sales were strong in almost every category, with only apparel stores and department stores showing any deterioration. Even these negative results can be explained by lower apparel prices and particularly warm September weather. Besides the previously mentioned strong auto sales, Internet-based retailers and electronics stores were the only real standouts on the upside; otherwise, growth rates were surprisingly similar between categories.


There was even more good news. August's sequential increase was moved up to 0.7% from 0.4%. So we got the daily double of a very good September number and a nicely revised August number.


What's All the Whining About?

While there's no denying that consumers are being frugal, overall retail sales have done quite well and have been relatively stable, excluding the big March binge and the May and June hangover. Just like the inflation numbers discussed above, the retail numbers have been particularly stable over the last three months:



Retail Sales Stabilizing


2010 Total Retail & Food Service
Sequential Growth Rates (%)



















Source: Census Department, Morningstar Calculations


When I look at the recovery in general, retail spending is one of the few items that is recovering at a fairly "normal" pace (services spending and employment are strong underperformers). Despite retailers' whining, consistently lousy consumer sentiment data, and my apparently misplaced worries about consumer wages and incomes, consumers are continuing to shop, at least according the Census Bureau.


Though retail sales are just one component of the all-important consumption category of the GDP, it's not a bad leading indicator. Given that retail sales have been very consistent the last three months, I would suspect the total consumption figure should also display a lot of stability. In fact, both July and August inflation-adjusted consumption numbers were up 0.2% (2.4% annualized), and I would guess these will be revised upward based on last week's retail sales report. I believe the September consumption number, to be reported later this month, will be about the same or maybe even better than July and August given a lower inflation rate. So at a minimum, consumption should be up 2.4% for the third quarter, inching ahead of the June quarter's 2.2% growth rate.


Balance of Trade Report Carves a Middle Ground

Last week's video highlights the relatively complicated balance of trade report. The deficit of $46.3 billion gave neither bulls nor bears compelling ammunition. While the balance was considerably better than June's $49.8 billion debacle, it was considerably worse than July's $42.6 billion and the consensus of $44 billion. Import growth of $4 billion was close to expectations, but exports showed no growth at all, which was quite a surprise.


Tearing the numbers apart, a $1.7 billion decline in aircraft shipments was the primary culprit for the disappointing report. Strong growth in food and agriculture related products forced the overall export growth number back to just above zero. On the imports side of the deficit, consumer goods and autos accounted for the bulk of the rather large increase.


The primary takeaway from this report is that the net exports number will not kill the third-quarter GDP report nearly as badly as it did in the second quarter, when it took over 3 points off GDP growth. Instead, it looks like the GDP impact of net exports is more likely to fall into the 0% to negative 1.0% range, a considerably weaker headwind. A slowing consumer electronic sales trend (much of which is imported) reported by Intel and talk of a large second-half ramp-up of capital goods shipments to developing markets in the fourth quarter bode well for a positive contribution from trade in the fourth quarter. A sharply lower dollar, especially relative to the euro, should also help exports. The dollar is down close to 20% versus the euro just since June.


Manufacturing and Housing Data on Tap for This Week

This week brings more news from the manufacturing sector. Last week the Empire State Manufacturing Survey showed surprising strength, consistent with a nicely growing manufacturing economy, after a couple of months of softness. This week we get the Philly Fed report, which sometimes contradicts the New York report. Last month this indicator dropped into negative territory for the first time during this recovery. Also, Monday will bring the Industrial Production report, and our industrials team predicts a small decline. Again, at this point in a recovery, some occasional slippage should be expected as other parts of the economy take the stage. Also, slower purchasing manager data, which became evident this summer, should begin showing up in this fall's production numbers.


The consensus for housing starts is for continued anemic but modestly improved housing starts of 600,000 units on a seasonally adjusted annual rate basis for September, compared to 571,000 units the prior month. While improved from its low, this number remains painfully below its 2.2 million peak and below natural demand of 1.5 million units. Paradoxically, all the mortgage paperwork fiascos and subsequent foreclosure moratoriums may favor new home sales over existing home sales. Lack of supply of new foreclosures plus buyer reluctance to purchase a home without a clear title may push buyers into the new home market, which is free of these mortgage issues, according to Morningstar's housing team.



This is an edited version. The article originated from Robert Johnson’s column at

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Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis with Morningstar.

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