Our Outlook for the Economy

More modest growth may go hand-in-hand with a longer, more durable recovery.

Robert Johnson, CFA 14.01.2013
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•       U.S. GDP growth, consumption, inflation, and employment could all grow by about 2% in 2013.

•       Increased oil production, an improving housing market, and a strong agricultural market make the U.S. a good growth pick for 2013.

•       U.S. economic growth decoupled from both world growth and corporate earnings in 2012.

•       As long as inflation remains below 4%, the U.S. should be able to avoid another recession.


My 2013 economic forecast seems to center around the number 2. I suspect that real GDP growth, inflation, and consumption will come in at 2% or slightly more in 2013 with employment growth pulling up the rear at 1.8%.

Because of productivity growth, employment is almost always destined to trail total economic growth. With the exception of higher housing starts and lower unemployment, the forecast doesn't look much different than the likely results for all of 2012.


Compared with long-term averages, GDP growth and consumption growth are lower than average, at least partially due to lower population growth. But at least a couple of pieces of good news are embedded in that slower growth rate.

First, slower growth continues to keep a lid on inflation, with the inflation rate running just about half the rate of the long-term average. And it appears that more modest growth may go hand-in-hand with a longer, more durable recovery. Four of the last 10 economic recoveries (since World War II) were already over by now, and we should match the length of yet a fifth recovery early in 2013. By the way, the recovery is now approaching 3.5 years in length.


A Slow-Rolling Recovery

While the consumer has been a relatively durable contributor to the recovery, exports, manufacturing, and business spending have had their ups and downs. For example, year-over-year growth in industrial production peaked at 7.8% but is currently running at a more modest 3.2%. Housing, normally the go-to factor in jump-starting a recovery, is just now making a net contribution. Ditto for industrial construction.


And although government made some nice early contributions to the recovery, it's been pretty much downhill since mid-2010, with only one quarter of growth (3Q 2012) since that time. This almost unprecedented trend is weighing on the economy more than many might suspect. Since winding down the World War II war machine and the Korean War effort in the 1950s, government spending has never declined as fast as the 4% year-over-year decline experienced in mid-2011.


Housing the Big Change Factor in 2013

Looking to 2013, the recovery growth drivers are likely to change again. Although housing clearly began to turn in 2012, the effects were relatively muted. While direct housing investment will be a meaningful contributor in 2013, some of the ancillary goods and services that are housing related will also finally kick in. I am talking about things like mortgage brokers, furniture sales, and remodeling fees that may take longer to recover than housing starts, which are already way off their bottoms.


Consumer Spending Stable to Modestly Higher in 2013

The consumer is one thing that is not changing a lot. That's good news and bad news. The consumer represents about 70% of the U.S. economy, making it difficult for overall economic activity to move more slowly than the consumer, but it's also hard for it to grow faster.


The news for the consumer has been surprisingly good in 2012 and could look at least slightly better in 2013. Good news for the consumer includes slow but steady employment growth, stable inflation, rising financial assets, and a nicely improving real estate market. On the downside, unemployment remains high, and we still haven't recovered all the jobs lost in the recession.

No matter exactly how the fiscal cliff is resolved, it remains clear that taxes, at least on the federal level, will be higher in 2013, especially on high-earning individuals. Although my overall consumer spending growth rate is higher in 2013 than 2012 at 2.0%, I suspect that lower income and especially middle income earners will do better than high income earners in 2013. Higher taxes and potentially smaller capital gains in 2013 may put high earners in a more negative mood. Middle income earners will likely be bigger beneficiaries of rising home prices (and their newfound ability to refinance those homes).


Slow World Economy Could Keep Inflation Below 2% in 2013

Tame inflation should also help the consumer again in 2013. Unfortunately, my 2% inflation forecast comes with less confidence than most other components of my analysis. Combined energy and food prices represent more than 20% of consumer prices, and these two data are nearly impossible to project solely on economic factors. Slow worldwide economic growth and more controlled commodity demand from emerging markets would point to slower food and energy prices in 2013 driving overall inflation potentially down as low as 1.5%. However, the drought of 2012 and the potential for another crop disaster in 2013, along with oil prices that seem more influenced by geopolitical events than supply and demand, cause me to add at least a small fudge factor in my inflation forecast.


As Long as Inflation Remains Below 4%, I Am Not Too Worried

I can say with some degree of certainty that as long as inflation remains under about 4%, the consumer will continue to power the economy ahead, and a recession is not the most likely outcome. The track record of high inflation forecasting a recession is extremely solid. And remember it is total inflation, including the volatile food and energy sectors, that counts. Even though the "core" inflation levels that exclude food and energy prices may look more muted or tame, consumers have to eat and drive, and more money spent on those items means less available for other expenditures.


Worries About Expansive Fed Seem Premature

Although I've talked of inflation mainly as a factor of worldwide supply and demand, at least some economists are beginning to worry about inflation from an excessively easy Federal Reserve. The discussions of the fiscal cliff served to hide what was one of the more expansive moves by the Federal Reserve during this recovery. Perhaps the most noteworthy piece of information in the Fed's December press release was that purchases of longer-term bonds would no longer have to be matched by selling shorter-term notes or bills, essentially printing more money instead. However, I note that continuing tight lending requirements should keep the Fed's largesse from igniting inflation in day-to-day goods. A lot of money is sloshing around on bank balance sheets, but it remains difficult to find qualified borrowers to lend it to. Until those lending standards get meaningfully easier, price increases are likely limited to houses, financial assets, and perhaps commodities.

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

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

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