Economy Could Use a Little Luck

To get GDP growth much in excess of 2% now will require a few breaks in weather, inflation, and Europe.

Robert Johnson, CFA 21.06.2013
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World markets seemed to believe that the U.S. economy was accelerating sharply, and the rocket ship was approaching escape velocity. Bonds and high-yield stocks got shellacked early in the week, believing that Fed tightening and tapered bond purchases were just around the corner. (The stocks managed to do a little better than bonds but were still off as Germany and the rest of Europe decided to back off a little bit from their misguided austerity kick.)

The "evidence" that sent bond markets into a tailspin was just a little flimsy. The basis? Nearly useless consumer confidence reports and month-old real estate price data. The sentiment around these reports was at least partially reversed later in the week when the GDP revision for the first quarter had the wrong sign and the consumer income and expenditures report showed a sizable gap between income and spending. Spending itself remained stuck in the same 2% annual growth trajectory it has been on for more than two years. Meanwhile, income growth remains considerably below that level, which suggests that even if the consumer is optimistic, the fuel necessary for more spending is running a little low. The top income quartile (who are big savers) really needs to step it up spending-wise, and weather and gas prices need to cooperate to keep the U.S. economy from settling back a little in the second quarter and in the second half of 2013.

Don't get me wrong--I think 2013 will still turn out OK with 2.0%-2.25% GDP growth, inflation well below 2%, and employment growth of about 1.8%. Real estate and consumer spending (especially on housing-related items) remain not only the bedrock, but also the anchor to my 2013 forecast, as I discuss later. Government, business spending on structures and technology, and exports will provide a headwind for most of 2013. The Affordable Care Act could be either a headwind or a tailwind.

To get GDP growth much in excess of 2% now will require a few lucky breaks in weather, inflation, and Europe. All possible, but it's hard to take that to the bank. In fact, just a couple of bad breaks and the Fed's next move might be more loosening, not tightening.

Pending Home Sales: A Step Up at Last
Pending home sales showed a modest uptick in April, which should bode well for existing-home sales in the months ahead. Pending home sales are recognized when the initial home contract is signed, and existing-home sales reports count homes that have gone through the entire closing process and the title is transferred.

Typically, the span between a signed contract and a closing is about 60 days. Optimally, pending sales transaction growth would run ahead of the existing-home data. Second best is an accelerating trend in pending home sales growth that is running relatively close to existing-home sales growth, which is the situation the market is in currently.


I was pleased to see the year-over-year pending data pick up for the second month in a row, with a meaningful improvement in the latest data point. (Cheating a little bit, the single month un-averaged data for April was up 11%.) Maybe the improved level of inventories shown in the last several months is finally working its way through the system. Low inventories and still-tight lending conditions are the two major factors currently holding back the housing market.

Case-Shiller 20-City Price Indexes Increase Edge Into Double-Digit Rates
The market got really excited about the Case-Shiller Home Price Indexes released on Tuesday. (Although for readers of this column, those are old news.  CoreLogic(CLGX) reported the same data and gave an estimate for one additional month (April) more than three weeks ago.)

The full set of real estate pricing information is now in for March. The news here is uniformly good, and growth rates are continuing to accelerate. I do caution that all of the indexes show that every geographic market is not participating uniformly in the large increases. States showing the biggest declines in the recession are now the biggest gainers (mainly along the West Coast). Some of the more stable Eastern markets are barely growing in terms of price. Although not by nearly the same amounts, all 20 markets are indeed up year over year for three consecutive months, according to Case-Shiller.


It now appears that the 6%-8% price appreciation seen in 2012 could be followed by an 8%-10% move in 2013. I still don't think that will put us anywhere near bubble territory (the Case-Shiller 20 is still about 28% below its all-time high, and affordability remains near record-high levels).

With the Case-Shiller and pending home sales data we now have a complement of real estate data through May 31. The data continue to show good improvement in most categories, though price metrics are looking stronger than activity levels. Prices are continuing to accelerate while things such as housing starts and existing-home sales are plateauing a little. Besides prices, breakouts in the real estate market data were pending home sales, which are finally improving again, single-family starts, and new home sales, which made a big jump recently. Furthermore, inventory shrinkage is finally beginning to abate (in fact, the new home inventory growth rates are finally increasing), which may help the activity levels and potentially slow some of the price increases we have been seeing.


Real Estate Improvement Is Impressive, but not Moving the Needle Enough

I think the real estate market has made some really nice gains, but those gains have been ongoing for some time and are unlikely to accelerate dramatically. Housing starts have doubled off of the bottom from 0.5 million to 1.0 million units or so, which is fabulous.

I believe the long-term potential is something like 1.5 million units per year, which is only a 50% upside move from here. Those who think housing growth is going to be a huge new adder to GDP growth over the next two years are mistaken. Over the last five quarters, residential investment has added between 0.2% and 0.4% to GDP growth each quarter. With a lot of the housing data plateauing, it's hard to see an improvement in real estate's contribution much beyond 0.5%-0.6%, and that's pushing it. That compares with a 1%-2% average contribution from consumption expenditures (70% of GDP) and overall GDP growth of around 2%.

Don't get me wrong--real estate has been a good contributor to growth, but its best days may be behind us. Real estate is likely to be a stable contributor to growth for many years to come; it's just not coming in one big, new burst. There are other benefits from an improved housing market: More home sales may aid a lot of other consumer goods and improve consumer confidence, which are effects not to be dismissed.

Consumer Spending Remains Incredibly Stable, but Ahead of Income
I am going to dispense with talking about the month-to-month consumption numbers that everyone gets alternately excited and depressed about every month. I take it the monthly consumption numbers were a little disappointing on this basis, but I really and truly do not care. The year-over-year data shows to be exceptionally stable and tells a story of slow and steady improvement--if anyone is listening.


Consumption growth (the middle column above) has been stuck in a 1.8%-2.1% year-over-year growth rate, averaged over three months for the last year, with a slight upward bias to the numbers. I could go back into 2011 and still see relatively the same pattern. These consumption figures are comprehensive and inflation-adjusted. They also represent 70% of U.S. GDP. If consumers spend, businesses will eventually have to hire more workers, invest in more equipment, and attempt to put more goods in inventory.

The table of consumption data suggests slow but steady growth for the economy and certainly shouldn't spook the Fed or all the Fed watchers who are fearful of some type of bust or boom that would necessitate a massive change in policy in either direction.

But Incomes Don't Seem to Support All the Spending
For the last two months, spending growth has exceeded income growth by a decent amount, after four months where income growth was way ahead of spending growth (see the gap column at the far right in the table above). In fact, December saw a savings rate of over 7% that now "appears" to have collapsed to 2.5%.

The income measure is real disposable personal income, quite a mouthful. It means income from all sources (wages, dividends, small-business income, rents, Social Security, unemployment insurance) less taxes and adjusted for inflation. It's the broadest measure of the firepower that consumers are packing. However, it doesn't include capital gains on equities and home sales, nor does it include amounts of money borrowed for legitimate purposes. Nor does it include the potential to dip into assets, which currently approximate 5-6 times current income. So spending can outrun real disposable income for some time.

And there are a few goofy factors and some deadly serious ones in the current set of numbers. Fears about the fiscal cliff and new taxes tended to cause corporations to accelerate both dividend and wage payments from January and February 2013 to November and December 2012. Besides simple shifting, dividends and deferred wage accounts built up over years were emptied out in one fell swoop in anticipation of even more tax increases ahead. This caused massive jumps in income, some of which was actually long-term savings and not really available for spending. However, some of the excess cash that was paid out clearly slipped into spending in 2013. It just took a little time to deploy. Also, when higher gasoline price levels (and the subsequent inflation jump) are the primary culprit for short-term dips in the inflation-adjusted income, consumers tend to spend through the increases, correctly surmising that gas prices will fall back again.

Income Growth Could Be Meager for a Few More Months
The April numbers begin to strip out some of the wild income swings in both directions, generated by all the income-shifting tax-avoidance maneuvers. While improved, income growth was still a relatively paltry 0.9% as the increase in the payroll tax took about 1% off of incomes. (It's a 2% increase, but tax-exposed wages only account for about half of personal income).

Looking ahead, it seems very difficult for real disposable income growth to exceed 1.0% on a year-over-year basis for at least the next three months. That will in turn make it more difficult, if not impossible, to maintain the current steady-Eddie 2% consumption growth rate that the U.S. economy has experienced over the last two years.

To keep consumption humming, higher earners, who spend a much smaller portion of their incomes, will really need to step up to the plate. Some of those stock market profits might become available for spending. Low inflation, especially in food and gasoline prices, could be another savior for consumer spending. Finally, consumer borrowing, which is still growing at a low rate, could accelerate under looser lending conditions. That includes home equity loans, which are finally becoming feasible again, as well as mortgage refinances and credit cards.

Spending Can't Exceed Incomes for Large Blocks of Time
That said, big blocks of time when incomes exceed consumption by a lot are not the norm. Between 1995 and 2005, the gap between income and spending averaged negative 0.26%. There was a stretch of 12 months of negative data from 1999 to 2000, which did eventually lead to a recession. Fortunately, the U.S. built up a few income credits between November 2012 and February 2013, so two months of slippage are not fatal. However, another 6-12 months of slipping data would not be helpful.

Manufacturing, Trade, and Employment Data on Tap
As usual, the most important number of the week comes with the employment report on Friday. Markets aren't really expecting anything special, with employment growth expected to be steady at about 168,000 jobs added, about the same as April. Annualized, that would be about 1.5% growth. That won't be enough to boost consumer incomes much unless both hours worked and average hourly wages are up, too. Usually employment is a lagging piece of data, but it may have at least a small leading component right now because without more income, it will be hard for consumers to sustain even today's modest spending increases.

Autos: A Test of Consumer Endurance
Auto data is due on Monday, and markets are expecting that sales for May will pop back over the 15 million level to 15.2 million annualized units. It's a decent performance in light of the tax increases, but it's still not the best monthly performance of 2013, and sales aren't really showing signs of acceleration. Anything below 15 million vehicles would show that the consumer funk might be deeper than most of us suspect.

Construction Data Might Matter this Time
Speaking of funks, I will also be looking at the recent construction data when it is released on Monday. I usually don't care about this number a whole lot, but some of the leading business real estate indicators have been weak again recently. Furthermore, low business spending is offsetting a lot of the great news on the residential side of the equation. Low business-related construction data held back GDP growth in the March quarter. Weak government spending and a move to more electronic retailing aren't helping matters, either. The market is hoping for a 1% growth rate for construction compared with a 1.7% decline in the previous month.

Manufacturing Expected to Be Flat, but Could the Boys in Chicago Be Right?
Economists aren't willing to go out on much of a limb this week, with purchasing manager data from the ISM also expected to be about the same as last month, moving from 50.7 to 51.0.   Boeing (BA) is back online with its Dreamliners, automakers are forgoing one week of summer shutdowns, and   Ford (F) is promising to increase production. So, I suspect that the ISM data will surprise to the upside some month in the very near future. The Chicago regional data certainly looked unusually strong on Friday morning.

More Tame Trade Data Expected
Trade data is due on Wednesday with a slight widening in the deficit from $38 billion to $41 billion expected. With world economies a little softer than the U.S. economy, I suspect that exports might take a hit while imports continue to show modest growth. However, even at $41 billion, the trade deficit is a full $11 billion below the deficit level of a year ago. Trade is usually a huge impediment to economic growth at this point of a recovery (imports are much larger than exports, so if both go up equally on a percentage basis, the trade deficit worsens), but the U.S. oil boom and stingy consumers have kept a lid on the damage this time around. Trade detracted just 0.2% from GDP in the first quarter versus a more typical 0.5%-0.6%.

 

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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