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Market Update -- Economic Chartbook

July 6, 2010

Written by Jane Caron, CFA, Chief Economic Strategist

Economic Outlook:

• Investors are fretting about the sustainability of the recovery. While we agree that there are serious risks to worry about, we cannot find sufficient reason to materially reduce our base-case forecasts for real GDP growth of near 3.5% in 2010 and 3% in 2011. Still, with risks weighted to the downside, investors are right to be cautious.
• Our forecast already factors in many of the fears du jour such as severe state and local budgets constraints, tightening fiscal policy at the federal level, weak nonresidential real estate spending, a declining lift from inventory restocking, and slower export growth in coming quarters. The forecast also assumes that the upswing in domestic demand will level off now that the economy has reached a moderate cruising speed.
  
• We are on the lookout, though, for a policy mistake such as an overly aggressive tightening of fiscal policy. We are also watching out for signs of dimming animal spirits because of all the hype in the media about an impending double dip. There is scant evidence that households or business managers are significantly reducing their spending or investment plans, but confidence has certainly taken a hit.
  
• While we cannot rule out a double dip, the odds of one happening are low. The economic recovery is well advanced and quite broad based, and this should provide protection. Moreover, key cyclical areas such as durable goods spending and home construction are already at extreme lows. There is a risk of painfully slow growth, however, if the labor market does not accelerate as we expect.
  
• Payroll growth has been weak, but the labor market has been generating firm labor income growth nonetheless. During the second quarter, wage and salary incomes increased at a rate consistent with 3% real consumption growth. During the second half of 2010, we expect income growth to remain firm, but real consumption growth should slow to around a 2.5% pace as consumers seek to save a bit more.
• A clear area of weakness in the economy is the residential real estate sector, but residential investment has dwindled to less than 2.5% of GDP and is no longer in a position to seriously harm the recovery barring a renewed nosedive in house prices, which just doesn’t seem likely.
  
• Global fiscal austerity will weigh on GDP growth, but we think public officials will not derail the recovery by tightening too aggressively. It would be self-defeating to do so. Instead, we expect the Fed to maintain an ultra loose monetary policy and for Congress to tighten fiscal policy by a manageable amount. We will be watching this front closely, however, because a policy mistake could prove costly.
  
• Core consumer inflation, meanwhile, has slipped below 1% as measured by the core CPI and is 1.3% as measured by the core PCE deflator. We believe it is likely that both of these measures will spend a fair amount of 2010 below 1%, but we do not expect that they will spend any meaningful time below zero. Headline inflation, meanwhile, could fall to less than 1.5% this yearh.
  
• We believe it is unlikely that we will experience a debilitating bout with deflation. It would take either a double dip or a large deterioration in inflation expectations to bring this about. Moreover, Fed Chairman Bernanke knows that the best way to deal with deflation is to avoid it, so it seems like an unlikely outcome as long as Bernanke has the tiller.
  

• Real GDP increased at a 2.7% annualized rate in the first quarter of 2010. Inventory rebalancing accounted for a substantial 1.9 percentage points of this growth, while real final sales (GDP less inventory contribution) added just 0.8 percentage points.
• The pace and quality of second-quarter real GDP growth appears to have been significantly better. We believe real GDP increased near a 4% annualized rate last quarter, and we think real final sales will also post roughly 4% growth. We expect little contribution, if any, from inventories.
• Dwight view: Investors and consumers are fretting about the sustainability of the recovery. While we agree that there are serious risks to monitor, we are mostly maintaining our 2010 and 2011 real GDP forecasts. In 2010, we have marked down our 2010 forecast to 3.3% from 3.5%, but we are leaving our 3% 2011 forecast unchanged.

• The Conference Board’s cyclical indices are showing strength. While these indicators suggest that GDP growth will level off in the next few months, they are certainly not pointing to a precipitous decline in activity.
• Bears frequently cite the Economic Cycle Research Institute's Weekly Leading Index (WLI) as an indicator of impending economic weakness. The WLI is down 9% from its high, but its current level suggests that the economy is transitioning from 3–3.5% growth to a 2.5–3% pace.
• Dwight view: The decline in stocks also indicates slower GDP growth, but it is important to distinguish between a sharp deceleration in the second derivative of GDP growth versus a sharp deceleration in GDP growth. We think the economy is leveling off rather than rolling over.

• Generating increased labor income is the key to not only a sustained recovery but also a successful transition from public assistance to independent living. The rising trend in private aggregate hours worked bodes well for a successful transition.
• In June, nonfarm payrolls decreased by 125,000, but this figure was depressed by the firing of 225,000 temporary census workers. Private payrolls increased by 83,000, a better showing than the May increase but quite weak relative to March and April gains.
• Dwight view: We anticipate a 1.5% increase in nonfarm payrolls this year, which equates to an average monthly gain of 162,000 jobs. Aggregate hours worked should rise by a faster rate as current employees work longer hours. The pace of hiring will determine the rapidity of the overall recovery.

• The unemployment rate declined to 9.5% in June, but this decline was due to a 652,000 plunge in the labor force relative to a 301,000 decline in household employment. Thus, this decline will probably prove temporary.
• A key question for 2010 is just how quickly individuals will decide to rejoin the labor force once it becomes evident that there are jobs available again. If reentrants are robust, then the unemployment rate could remain elevated.
• Dwight view: We expect the unemployment rate to remain above 8.5% in 2010, and it could hold near 10% if there is a rapid pickup in the participation rate. High unemployment will continue to be a major political topic and could still result in additional, job-related stimulus in 2010 despite newly discovered fiscal rectitude.

• Investors were generally disappointed by data in the June employment report that implied weak labor income for the month. For the quarter as a whole, however, labor income was up strongly relative to the first quarter.
• Private wages and salaries appear to have expanded near a strong 5% annualized rate during the second quarter, up from a healthy 4% pace in the first quarter. During the second half of the year, labor income should slow to a 3.5–4% pace.
• Dwight view: Tax cuts and government transfers have been key sources of support for consumption growth, but we expect income growth to take the baton for the rest of the race. Higher taxes in 2011 will dampen disposable income, but a strong labor market should deliver healthy income growth nonetheless.

• Consumer spending has been advancing at a surprisingly fast clip despite being constrained by high unemployment, greatly reduced nest eggs and limited access to credit. Real consumption growth in the first half of the year is on track to average 3% (annualized pace).
• Consumer confidence plummeted in May, but we are not ascribing too much significance to this decline. The May survey was taken shortly after stock prices collapsed and the labor market was reported to have weakened. Unless the labor market begins to truly deteriorate and stock prices keep declining, we expect confidence to recover.
• Dwight view: Our forecast assumes that real consumption growth will average a growth rate of near 2.5% during the second half of 2010 and 2011. Recent data, however, suggest that our consumption forecast could be too pessimistic.

• Consumption represents 71% of GDP, so it is obviously one of the most important sectors for the overall economy. Also important is business investment because it is close to 9% of GDP.
• Business spending on equipment and software is on track to rise in excess of a 15% annualized rate in the second quarter, marking the third consecutive quarter that spending will have risen at a double digit pace. Despite recent strength, new capital investment on equipment and software is still not keeping up with depreciation.
• Dwight view: We expect spending on equipment and software (6.5% of GDP) to contribute at least a full percentage point to overall GDP growth in 2010, while investment spending on structures (2.5% of GDP) should remove less than one-third of a point for the year. On net, we expect non-residential investment to add about 0.7 points to GDP.

• The strongest contributions to first-quarter GDP growth of 2.7% came from consumption (added 2.1 points) and inventories (added 1.9 points). Investment spending on equipment and software (added 0.7 point) was also strong, but spending on structures (subtracted 0.5 point) held back the total non-residential investment contribution.
• Weakness in the first quarter was also seen in residential investment (subtracted 0.3 point), government consumption (subtracted 0.4 point) and net exports (subtracted 0.8 point).
• Dwight view: The quality of growth in future quarters is expected to improve. Consumption and capital goods spending should be the main drivers, while inventories and net exports should have only small impacts. In the second quarter, laggards such as residential investment and business investment in structures should also lift GDP.

• The housing market, being the epicenter of the crisis, has received massive public support. This helped stabilize the market, but not before it collapsed to extraordinarily weak levels.
• Existing home sales have risen from their lows because of three main support factors: very high affordability rates; a perception that the bottom in house prices is nearby; and generous tax credits. New home sales have been hampered by a lack of inventory, particularly for lower priced homes.
• Dwight view: The housing market is in the midst of a setback. We expect sales to start to rise again during the third quarter because fundamentals are improving. We are assuming that house prices remain fairly stable, an important condition for not only the health of the housing market but household and bank balance sheets as well.

• Homebuilders are having a hard time competing with the existing homes market where there are a lot of relatively new homes selling for heavily discounted prices. Thus, single-family starts have remained near their February 2009 low, which was the lowest level on record dating back to 1959.
• New home inventories, at a mere 213,000, are at their lowest level since 1971. Nonetheless, there is 8.5 months of supply on the market because of the weak sales pace. If sales pick up, even moderately, inventories could quickly fall to unsustainably low levels because of low inventories and depressed housing starts.
• Dwight view: Residential investment will post a strong gain in the second quarter because of a rise in home completions ahead of the tax credit expiry. This gain, however, will barely move the needle for GDP because residential investment is now less than 2.5% of GDP.

• Headline inflation has been volatile in recent years, but core inflation has been benign, while long-term inflation expectations have been steady. In 2010, we expect similar conditions to persist.
• Core inflation measures have fallen sharply since the third quarter of 2008, but there are a few signals that this disinflation trend could flatten out in the next few months.
• Dwight view: Inflation is likely to remain quiescent in 2010 as economic slack remains pervasive. We expect core consumer inflation to be less than 1%, and believe headline consumer inflation will slow to less than 1.5%.

• Deflation is often characterized by a negative wage-price spiral. Thus, falling unit labor costs do not bode well for maintaining positive inflation. Most economists (ourselves included) expect unit labor costs to become positive again as the labor market expands.
• Deflation can also be caused by cash hoarding or a general decrease in the velocity of money, particularly as bank credit is reduced. These conditions are currently prevalent and are reasons for concern.
• Dwight view: We are carefully monitoring deflation risks, but we currently believe a debilitating bout with deflation will be avoided. Our view is based on our expectation that the recovery will remain intact and inflation expectations will remain stable. If these conditions fail then we could be in serious trouble. Fortunately, Fed Chairman Bernanke knows that the best way to fight a battle with deflation is to avoid it.

• Monetary policy changed materially in September 2008 when the Fed stopped sterilizing liquidity programs and allowed excess reserves to accumulate. By the end of 2008, excess reserves reached $800 billion and the monetary base doubled in size.
• Because banks did not lend these reserves, the money multiplier collapsed. Thus, the monetary base expansion did not translate into an increase in the money aggregates such as M1 and M2. The Fed's policy was still successful, though, because targeted liquidity programs relieved market logjams, and the asset purchase program brought down mortgage ratesy.
• Dwight view: There has been increased investor talk that the Fed will need to print more money. We think additional quantitative easing will not be necessary because we believe the recovery is not about to collapse. Our forecast assumes that the Fed keeps the funds rate unchanged until mid-2011.

• Treasury yields are being pulled lower by safe-haven demand and a sharp reduction in implied probabilities for Fed tightening in 2010. Investors now believe that there is only a 15% chance that the funds rate will be increased this year. Furthermore, the futures market is priced for a mere 25 bps increase by mid-2011.
• Lower Treasury yields have pulled down borrowing rates, and you can now get a conforming, 30-year mortgage for less than 5% if you put 20% down and qualify as a good credit. Corporate and consumer borrowing rates are also attractive.
• Dwight view: Domestic economic fundamentals warrant higher Treasury yields, but safe-haven demand, a sidelined Fed, and little competition from private issuance has helped to sustain a bid for Treasury bonds. These low yields will help ensure the sustainability of the recovery as long as animal spirits remain relatively vibrant.

• The federal budget deficit is expected to be near 9% of GDP this year, and the Bloomberg consensus forecast indicates that it will still be 6% of GDP in 2012. The CBO expects the deficit to slow to 4% of GDP by 2012, but their estimate assumes that all tax cuts expire as scheduled and the AMT is not patched.
• Prior to the passage of the healthcare legislation, the CBO already projected that government outlays will remain well above the historical average, while revenues will also rise to levels well above the historical average. Healthcare legislation will most likely exacerbate the trends exhibited in the chart above.
• Dwight view: Congress must get its fiscal house in order before investors push interest rates significantly higher. The CBO assumes that interest expense will rise to more than 3% of GDP within 10 years, but they are assuming that the average 10-year treasury yield will remain below 5%. We see significant upside risk in this forecast.

• If the interest expense is 3% of GDP, then the government has to run a primary surplus of 3% of GDP to have a balanced budget. The government could potentially raise a little over 2% of GDP by getting rid of all the special tax deductions, but these deductions are popular.
• The White House is determined to raise taxes on the rich, but, Goldman Sach's research points out that the marginal tax rate would have to increase by nearly 40 percentage points on the top two tax brackets to generate 2% of GDP in revenues. Moreover, Goldman Sachs is assuming no change in behavior in their estimate.
• Dwight view: The President's fiscal commission will report its recommendations on December 1. The assignment is to determine how best to balance the primary federal deficit by 2015. We expect the commission to recommend a combination of expenditure cuts and tax increases, and we would not be surprise to see new taxes, such as a value added tax on consumption, included.

This information reflects the viewpoint of Dwight Asset Management Company LLC as of July 6, 2010, and is subject to change. This report is provided for informational purposes only.