The U.S. economy survives higher interest rates with slow but steady growth and lower inflation. The European and Chinese economies are picking up steam as emerging-markets economies slump. Beneath a steady U.S. economy, our sector teams point to tectonic shifts in business.
Fine Tuning My Economic Forecast
My overall economic forecast for 2013 has remained basically unchanged since I rolled it out last fall. I am now making a few small tweaks: modestly reducing my overall growth forecast, meaningfully cutting my inflation forecast, and basically leaving the employment-related forecasts unchanged. I am also introducing a 2014 forecast that doesn't look much different than 2013 or 2012.
The key thing I have learned about the U.S. economy over the past several years is that it is like an ocean liner, unable to change course quickly, and steadily maintaining speed and direction. The shock needed to shift the economy is a larger than many of us would have guessed just three or four years ago. The U.S economy endured severe storms, volatile gasoline prices, and several government showdowns while hardly skipping a beat. Reaching some kind of acceleration and an economic boom, or falling back into the abyss have both proved equally difficult. The propensity of most consumers to spend every dollar they make, relatively inflexible wage rates, and the consumer's tendency to keep spending at current rates despite short-term adversity all contribute to the economy's overall stability and slow growth rate.
Economic Data Not as Volatile as the Headlines Suggest
Some of the monthly and quarterly data seem to be extremely volatile. Even the GDP growth rate has been exceptionally volatile, shrinking to a mere 0.1% in December 2012 before quickly accelerating to 2.5% in the June quarter of 2013. Inventory shifts, accounting issues, seasonal adjustment factors, changes in export categories, and volatile weather are behind these swings in reported GDP growth--not real economic changes. U.S. consumption and employment data have been remarkably stable as shown below:
What Did Change in the Third Quarter?
While the overall economy has been quite stable, the third quarter did bring a number of real surprises--some positive and some negative. In the positive camp, Europe appeared to move from recession into recovery, as the second-quarter GDP rate announced in July turned positive for the first time since 2011. Many economists, including me, thought the European recession might extend all the way through 2013. Industrial production and purchasing manager surveys seem to indicate that Europe would continue to show improvement in the September quarter.
Also in the positive column, the U.S., Chinese, and European manufacturing economies appeared to pick up steam in the quarter. Better auto sales and production helped the data, as did some inventory rebuilding and general improvements in consumption from more confident European consumers. Stronger European sales were finally reported by a number of our equity and credit teams. Most notably, McDonald's (MCD) reported a pick-up in European sales.
The Economy Seems to Be Adjusting to Higher Interest Rates
On the negative side of the ledger, interest rates continued higher throughout most of the quarter. The U.S. 10-year Treasury bond approached 3% in the middle of September before settling back a little after the Federal Reserve decided not to taper bond purchases.
Although perhaps too early to tell, the higher yields didn't seem to immediately derail the recovery as a whole. Despite the fact that the Fed backed away from tapering its bond-purchase programs, rates still are substantially higher than they were a quarter ago and are unlikely to approach old lows. Although tapering is off the table for another month, it will happen at some point, and the market knows it. Over the next year or so, I believe the 10-year Treasury bond will be in the 3%-4% range, and a tapering program of some type will begin in the next three or four months.
Housing and Emerging Markets Taking the Brunt of Higher Interest Rates
However, new home sales and housing starts did slow in the face of higher rates, while existing-home sales spurted ahead as homebuyers raced to close home sales quickly before rates moved even higher. Even before the higher rates, housing data had begun to top out as land and labor shortages slowed home construction. This has caused many analysts to scale back their housing growth rate and GDP contribution for both 2013 and 2014.
What's Ahead for the Fourth Quarter and Beyond?
Europe could look better, emerging markets worse. Europe's recovery could begin to feed on itself as consumers begin to feel more confident and businesses continue to rebuild inventories. A stronger market for exports to China could help, too. Also, some of the more onerous government austerity programs are beginning to fade as well. This should be good news for U.S. and Chinese exporters. However, Europe is not completely out of the woods. Many financial institutions are still undercapitalized, and some countries still carry more debt than they ever hope to repay. Also, the rebound in France, Europe's second-largest economy, has not been as robust as in several other European countries.
Developing markets in general are slowing, with the exception of China. At the end of the second quarter, China appeared to be slowing, at least partly because of a government attempt to move to a more consumption-oriented economy and partially because of a weak market for exports. Growth in China had fallen from the 10%-12% range to about 7.5% recently, its lowest reading since 1990. As Europe picked up steam and as Chinese infrastructure spending and other investment spending grew again, China appears to have reversed course. Recent Chinese export and manufacturing data has improved notably. Whether the rebound is sustainable is less than certain.
The rest of the emerging markets were hit hard as the effects of potential U.S. Federal reserve tightening were understood more clearly. When U.S. rates were held incredibly low by the U.S. Federal Reserve, emerging markets saw massive capital inflows due to their higher growth rates and more attractive yields. With the Fed's threat of ending bond purchases, U.S. rates jumped sharply. Those higher rates drew more capital back to the U.S. Those outflows from emerging markets depressed currencies and ignited more inflation, slowing growth at least temporarily. Many currencies are now at record lows, which will eventually aid growth longer term. However, the short-term effects are devastating. Oil prices, which are up even in U.S. dollar terms because of the Syria issue, are compounded in emerging-markets countries whose currencies are sharply lower. To protect the currency, many of these countries are raising interest rates, which is further slowing economic growth.
Low inflation could continue. Inflation seems to be the one thing could upset the economic apple cart. However, inflation has remained remarkably low this year with flat (but high) energy prices, no increases in drug prices, and falling used-car prices. The real surprise this year is that the health-care cost curve has been bent sharply downward. Whether that is a temporary, recession-related phenomenon or a permanent long-term trend is still being sharply debated. But given a near-record output gap, high unemployment, and low capacity utilization, it appears that overall inflation is unlikely to accelerate in the near term.
Potential showdown in Congress could slow the recovery. With everyone so focused on the Federal Reserve and Syria this month, few have stopped to consider the potential for a government shutdown related to the lack of a budget after Sept. 30, or a breach of the debt ceiling in mid-October. Now, near the end of September, there is no budget, and without at least some kind of continuing resolution, the government will be forced to shut down at the beginning of October. With short-term posturing regarding the Affordable Care Act, a quick resolution may not be easy. Republicans in the House are trying to tie the two issues together. Even a continuing resolution, merely extending the current set of laws, is not great news for the economy. While many think we have dodged the sequester bullet, the worst of the effects will be in fiscal-year 2014 and not in fiscal 2013. In fact, the sequester deals with spending authorities and not cash outlays. Therefore, some of the effects of the sequester may not show up for a year or more.
The housing market could stabilize and grow faster again. Higher interest rates, higher prices, inventory shortages, and labor shortages have all held back the housing market over the last quarter. However, some of those factors could begin to wane in the fourth quarter and beyond. The Fed's decision not to end its bond-buying program immediately could cause at least a temporary drop in rates that should pull in buyers who missed the lower interest rates this spring. Inventory levels seem to be building, and some of the housing-production bottlenecks are slowly being broken. Just as importantly, it finally appears that banks are lightening up, at least some, on their very tight credit policies. These positive potentials still have homebuilders excited; their official sentiment data remains at a recovery high, despite the fact that housing starts are down more than 10% from their spring highs.
Sector Outlooks Show Some Major Shifts
Although economic growth overall has been slow and steady, swings within industries have been huge, as highlighted by our equity team (their reports follow). The tech sector continues to see a huge shift from personal computers to mobile devices. Our tech team notes that conventional PC sales for 2013 will likely be down by 8%, while smartphones and tablets are more than making up the difference.
Meanwhile, our consumer team points to a power shift between consumer-goods companies and retailers. A recent spate between Coke (KO) and Costco (COST) kept Coke products off of Costco shelves for more than three weeks, with Coke apparently blinking first. And then there is the ongoing shift between brick-and-mortar retailers and Amazon.com (AMZN).
And our energy team highlighted the shift between Middle Eastern oil, and oil and gas produced within the U.S. These are not small changes, but they are hidden below the calm of relatively steady economic growth. To individuals and executives working in these fields, the world looks more volatile and scary than the steadiness that I frequently describe in my weekly commentaries.
Robert Johnson, CFA, does not own shares in any of the securities mentioned above.
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