Again markets spent most of the week reacting to news out of Washington, and not much time on fundamentals. It looks like the market continues to believe that Congress will come to a relatively quick resolution of both the shutdown and debt ceiling issues. And after that, it looks like everyone is anticipating a big jump in economic activity and corporate earnings. The huge rally on Thursday, when there were early hints of a settlement, shows how much everyone is afraid of missing the next move up. There seems to be little concern about the strength of the economy. That is a big mistake, in my opinion.
Last week's key markers, including auto sales, pending home sales, and the ISM services data, all showed signs of a plateauing or even slowing economy, even before the government shutdown began. This week's data wasn't much better, with soft weekly retail sales, a somewhat suspect jump in initial unemployment claims, and a reduction in worldwide growth forecasts from the International Monetary Fund. I don't put much weight on either, but consumer sentiment and small-business confidence were also both down in this week's reports, although perhaps less than I might have guessed.
Continued Slow Earnings Growth, Fourth-Quarter S&P Earnings Growth Too High
The earnings news this week was mixed, with a slightly favorable bias because of substantial improvements in financials and relatively good news from Alcoa(AA). However, the bigger picture is that the third-quarter S&P 500 earnings per share growth rate is expected to be a lethargic 3%, down from a forecast growth rate of 6.5% at the beginning of the quarter, according FactSet. So far, 91 companies in the S&P 500 have provided negative earnings forecasts for the third quarter, the highest level since 2006. Worse, estimated earnings for the fourth quarter look too high at 10% year-over-year growth, especially with the government shutdown likely to impinge on fourth-quarter results.
I Believe the Odds of a Last-Minute Settlement Are 90%, but I Worry About the Other 10%
I still believe a continued government shutdown and a debt ceiling violation combined would be nearly catastrophic and cause markets around the world to sink 10% or more in a very short period of time. Declining government employee incomes, slower GDP growth, business and investor uncertainty, and potentially higher interest rates would justify that kind of decline and maybe a lot more. I surmise Congress and the president know this could be an economic disaster and will come to some type of eleventh-hour agreement and/or extension to avoid it. The chances of no agreement are worrisome at a 10% probability.
There Is a Way Out of This Mess
Furthermore, Republicans have more cards to play than many realize, creating room for negotiation. If Congress even just extends current laws and expands debt limits, there are still large cuts in government spending written into current law. All of the sequester rules won't disappear without Republican approval. It's a bit surprising that Republicans are objecting so vocally to extending current law, because current law represents substantial cuts in spending. Currently written laws come close to eliminating the deficit for a few years. That is, until baby boomers hit both retirement and health-care programs in earnest in 2023. Some negotiations centering on short-term spending relief and long-term changes in retirement and health-care programs might just tempt both sides into some discussions.
The Economic Damage From the Shutdown Is Already Real
Unfortunately, more damage has already been done than most of us realize. In a world that is increasingly services-oriented, returning government workers can't eat enough meals, stay in a enough hotels, or fly enough flights during the rest of the fourth quarter to make up for what was missed in the first couple of weeks of the month. At a minimum, the shutdown has already taken at least a quarter of a percentage point of the consensus growth estimated for the fourth quarter. That's assuming the weekly rate is relatively similar to the 1995 shutdown, when the services were a smaller part of the economy and just-in-time inventory systems and flexible part-time workers were less prevalent.
For those thinking that we seem to have survived the first 11 days of the shutdown just fine, some of the damage will begin showing up next week. Full government employee payroll checks were issued on Sept. 27, just before the Oct. 1 closure. Also softening the blow is the fact that August was a three-payroll check month (in a biweekly pay system employees receive three checks a month twice a year). However, the check on Oct. 11 was effectively one half of a check, which is pay for just one week, the last week of September, because of the lack of funding. The problem for government employees becomes acute on Oct. 25 when a full normal check could potentially be missed, days before monthly rent and mortgage payments are due. Time cards for the next pay period are due on Oct. 18. So if workers aren't back by then, it is quite possible the government couldn't process even a retroactive paycheck by then.
Retail Sales Remain Stuck in Neutral
The average weekly shopping center figures indicate neither mass panic nor any signs of improvement. Growth remains subpar, even by the lowly standards of this recovery, as shown below. However, we weren't very far into the shutdown when the data was collected on Oct. 5.
A bit more troubling is the quarterly data that shows a relatively persistent declining pattern of shopping-center sales. Part of the answer is in both higher payroll and income taxes that have sucked a lot of life out of the economy. Volatile, but generally higher gasoline prices aren't helping, either. It's only fair to point out a mix shift toward online ordering and a disproportionate weighting to teen retailers (limited teen jobs), and more spending on autos and home goods are having some effect on these indexes.
IMF Reduces World Growth Outlook
Another bulwark of recent economic optimism for the U.S. is improving growth prospects for the rest of the world. However, two things are working against that optimism. First, exports are not that large a part of the U.S. economy and second, the international data has not been as optimistic lately. This week's revised world growth rates threw some cold water on positive prospects. The overall world forecast for 2013 was dropped from 3.2% to 2.9% and from 3.8% to 3.6% for 2014.
While many have pointed to the improvement, or at least stabilization, in Europe, slowing emerging-market data is more than offsetting that. A combination of a slower China (the biggest contributor to emerging-market activity), higher interest rates, higher inflation, and slowing commodity prices are behind significant emerging-market slowness.
Slower Price Growth Is a Silver Lining in the IMF Report
However, there were some potential pieces of good news in the IMF report. Commodity prices are expected to be down in both 2013 and 2014, though less so than a quarter ago. Overall, consumer prices are expected to grow more slowly than previously thought (and at tiny rates) in developed countries, while worker currencies are expected to make inflation a slightly bigger problem in emerging markets.
Initial Unemployment Claims Data Temporarily Worthless
We had all hoped that initial unemployment claims would provide valuable information on the condition of the labor market. Because of the state-based nature of this program, we are still getting weekly data. However, computer glitches with new systems at the beginning of October first depressed and are now inflating the claims data as many claims sat unprocessed during the transition. That news came despite assurances to the contrary just a week ago. Claims jumped from a near recovery low of 308,000 workers last week to 374,000 in just one week. The jump reflects the processing of backlogged claims and perhaps some private-sector layoffs for businesses affected by the government shutdown. However, the data does not include any federal employees collecting benefits just yet. The initial claims data appeared too good to be true, and that now appears to be the case. However, with a four-week moving average of 325,000 claims, the numbers still aren't a disaster. I am guessing that next week's data could include some federal employees, which will mess with the numbers yet again.
Next Week Brings Homebuilder Sentiment, But What About the Consumer Price Index?
Next week brings really slim pickings given that the government statistic mills remain shuttered. I thought we would at least get the Federal Reserve-based Industrial Production report because the Fed is fully funded, and it did release a small credit report on Monday. However, the Fed apparently relies on other parts of the government for some of the data in the report, so it has delayed the release. Initial indications are that the Consumer Price Index will not be released, either, which is also a huge surprise. That report is truly essential. Its sets inflation rates in union contracts, Treasury inflation adjusted bonds, or TIPS, and U.S. savings bonds. (Those are just the easy things to think of, but I'm sure there are a lot more.) The good news is the September raw data is probably in a vault somewhere and will be processed someday soon after the government goes back to work. However, I wonder about the collection of the October data if the outage lasts too much longer, in which case the data can never be recovered.
We will, however, likely see a homebuilder sentiment report. Just recently, homebuilders have been incredibly optimistic, especially compared with rather pedestrian-looking housing starts and new-home sales data. Nevertheless, the sentiment indicators have generally been a decent indicator of housing starts and new-home sales, reports that will not be issued unless the government goes back to work. The homebuilder index registered a recovery high of 58 for September and the consensus is for a modest dip to 57 for October.
Robert Johnson, CFA, is director of economic analysis with Morningstar.
