market commentary

WEEKLY ECONOMIC COMMENTARY -- WEEK OF JANUARY 20, 2012

With the onslaught of incoming data rounding out activity for December it is almost time to close the books on 2011. To be sure, the fourth-quarter GDP report will not be released until next Friday, and that first estimate will be revised several times in coming months as information on missing pieces becomes available. But most key ingredients are already accounted for, providing us with a reasonably good picture of how the year wound up. In a nutshell, there were more positives than negatives during the closing months of the year, leaving the economic glass slightly more than half full.

Admittedly this is a modest accomplishment. At this stage of a cycle, more than two years into a recovery, the economy would ordinarily be expected to follow a much stronger growth path, gobbling up unused labor and productive resources and prodding policymakers into thinking about anti-inflation measures. But an array of natural and manmade shocks have prevented a normal recovery from materializing; what's more, the glass has been more than half empty for so long that there is little danger of it overfilling anytime soon. Instead, we are left wondering if more obstacles loom ahead, which would impede even the modest progress that seems to be underway.

The most visible and immediate threat is the intractable European debt crisis that continues to defy a solution. So far, the U.S. economy has not been deeply affected, although exports are already starting to suffer as a result of the sharp slowdown among our European trading partners. In November, exports to Europe, which accounts for more than 20% of total U.S. goods exports, plunged by more than $2 billion. The setback left European exports a mere 5.2% higher than a year-earlier; as recently as April, they were growing at more than a 25% annual rate. Needless to say, the pronounced drop in sales to Europe has made a dent in total merchandise exports, which are now growing at less than half the pace of six months ago.

No doubt, exports have been one of the few shining lights in the recovery, supporting a solid rebound in factory production that led the U.S. out of the Great Recession. Over the past 2-½ years, manufacturing output has increased at a 6% annual rate, more than double the 2.4% pace during the 2001-2009 expansion and an outsize premium relative to the 2.4% growth rate in GDP. The production rebound has spurred an equally impressive increase in factory jobs. Over the same period, manufacturers have added a sizeable 334 workers to payrolls, which actually understate the influence of this sector on the labor market. Keep in mind that when a new factory opens or expands, it tends to attract a Wal-Mart, auto dealer or similar establishment with its own staffing needs. The reverse is usually not the case.

The good news is that factories continued to rev up as the year drew to a close, despite the throttling down of exports. As reported this week, total industrial production increased by a solid 0.4% more than reversing a 0.3% drop in November that was dragged down by a drop in auto output, a volatile sector. The December gain was also held back by an aberrational drop in utility output due to unseasonably warm weather that slashed electricity consumption. More to the point, manufacturing output rebounded by a robust 0.9%, the strongest monthly increase in a year. The gain was broadly based, including a bounce back in auto output. But perhaps the most encouraging aspect of the report was the continued gain in business equipment output, which may fill the void left by the expected slowdown linked to weakening exports.

 

Along with exports, capital spending has been one of the few bright spots in the recovery. Since the recession ended, spending on equipment and software has increased at a robust 13.7% annual rate. Not only is that the strongest pace registered in all but one expansion since 1960 (the 13.9% in the 1971-73 upturn); it kicked in at a much earlier stage of the recovery than usual. Normally, capital spending picks up several quarters after a recession ends, following a rebound in consumer spending that eats up unused capacity. The quick revival this time was sparked by a huge replacement demand for aging equipment and software, as the collapse in capital spending during the recession was the longest and steepest ever recorded during the post war period. While special tax incentives also fueled the upsurge, companies enjoyed a robust gain in profits and cash flow that easily financed the spending increase. Exceptionally low borrowing costs and a receptive bond market also helped. Except for the expired tax incentives, these favorable conditions remain mostly in place, so the recovery in capital spending should continue to support growth in the coming year.

Clearly, the U.S. will have to rely more on internal sources to drive growth in 2012 than was the case over the past two years. Not only is Europe on the cusp of a recession, if not already in one, most emerging market nations, the fastest growing export destination for U.S. products, are also experiencing weaker growth. China, the third largest export market for U.S goods, has cooled down considerably, thanks to aggressive anti-inflation steps taken by the government; growth in Brazil has stagnated, and other developing Latin American countries are suffering from falling commodity prices, a normal cyclical response to weakening global demand. What's more, the sovereign debt struggles of the weaker euro zone members have sent the region's currency on a deep slide. Although it recovered somewhat this week, the euro recently hit a 16-month low. That's because uncertainty over how the debt woes will play out has caused investors and traders to flee the currency and place their funds in safer havens, particularly dollar-denominated assets. As a result, the dollar has strengthened, which makes U.S. goods more expensive on the global market place, reinforcing the drag on exports.

The question is whether the U.S. can find enough strength among domestic sources to drive the recovery on to a faster growth track. Most economists expect that growth will speed up from the tepid 1.8% pace estimated for 2011. Few, however, believe that the acceleration will be anything but modest. We concur. There are still too many headwinds that are visible, and some that remain under the radar, including the risk of a "credit event" should the euro debt crisis spread to the U.S. financial system. As encouraging as the relatively strong holiday shopping season was, we are skeptical that consumers can sustain more than a trend-like pace of expenditures over the next several quarters. Indeed, households took on an astonishing amount of new credit in November and sharply drew down savings to finance their holiday purchases. If that behavior is a sign that consumers are more confident in their financial position and income prospects, the spending outlook becomes more positive. If, however, consumers borrowed more and drew on savings just to make ends meet in the face of lagging incomes, some payback can be expected with a spending cutback a likely outcome.

At best, therefore, the huge household sector promises a mixed bag of possible outcomes. Our sense is that some pullback will take place in the first quarter, but it will be more of a pause than a fundamental retrenchment based on worsening income or balance sheet conditions. By all accounts, the job market is improving, a trend confirmed by this week's report of a sharp drop in initial claims for unemployment benefits. To be sure, even a pickup in job growth in coming months will not fatten the collective paychecks of workers as much as would ordinarily be the case. With so much competition for jobs coming from a huge pool of unemployed and underemployed workers, labor has little bargaining strength to push for significant pay raises. That said, hourly earnings are creeping up as are hours worked. In December, average hourly earnings of all private workers rose by 0.2%, which is spot on with the average monthly pace for 2011 as a whole. The big difference, however, is that workers got to keep all of the increase because inflation was flat in December.

Indeed, the purchasing power of households should enjoy a boost from both growing labor income as well as slowing inflation in 2012. The December reading for the consumer price index was the third consecutive month in which the CPI was either flat or showed a decline. Falling energy, particularly gasoline, prices contributed importantly to the leveling out of the inflation rate but the core CPI, which excludes volatile energy and food prices, has been exceptionally tame as well, rising by just 0.1% in December. Taking a longer perspective, the overall CPI stood 3% higher than its year-earlier level, down sharply from the 3.9% pace seen as recently as September.

 

True, the core CPI edged up to a 2.2% annual rate in December, more than double the pace that prevailed at the end of 2010. However, it would be misguided to view this increase as the seeds of an inflation flare-up that warrants a countermove by the Federal Reserve. Keep in mind that throughout 2010 and the early months of 2011; the major objective of the Fed was to prevent the U.S. from falling into a deflationary spiral that is extremely difficult to arrest once it gets underway. Hence, while a doubling of the core inflation rate may seem ominous on the surface, it actually represents a success story for the Fed, as it moves the nation further away from the deflationary precipice. As it is, the current inflation rate is well within the Fed's target zone, giving it the flexibility to retain an easy monetary policy for as long as it takes to get the economy on a firmer growth path.

However, while the Fed has been successful in staving off deflation, it has been equally unsuccessful in lifting housing activity out of the doldrums. As this week's figures on housing starts illustrates, 2011 was the worst year on record for new single-family construction and permits. The ongoing housing depression, fueled by a huge pipeline of foreclosures, weak sales, persistent home price declines and restrictive credit conditions, was both the catalyst for the recession and the major drag on growth throughout the recovery. The good news is that the housing meltdown hit bottom several months ago, and a modest revival is getting underway. Sales are picking up, homebuilder sentiment is improving and new construction for single-family homes has turned the corner. Single-family starts increased for the third consecutive month in December, accompanied by a similar run-up in building permits. Homebuilding stocks have been one of the best performing sectors in the market over the past three months, reflecting investor confidence that housing is no longer the caboose holding back the economy's growth engine. No doubt, the removal of housing as an impediment to growth would be a welcome development for a recovery that faces enough hurdles as it is.