Meanwhile, Back at the Ranch…
By Scott Brown
June 29, 2012
U.S. investors have been occupied with worries about Europe and the individual mandate of the Affordable Care Act. With those two issues out of the way (but not put aside completely), we can go back to looking at the economy. At issue is whether recent signs of slowing were an illusion or more real. In p articular, the June job market figures will be critical. At the June 19-20 Fed policy meeting, officials lowered their projections of GDP growth for this year and next. The Fed is still looking for moderate growth in the near term, but expects that a variety of headwinds will conspire to keep growth from being a lot stronger. Firms have already noted weakness in orders in Europe. The loss in exports will be a drag on overall growth, but not too severe. The housing market appears to have turned the corner, with solid year-over-year gains in home sales and construction activity. Granted, this comes from a very low base, but residential construction should add a few tenths of a percentage point to GDP growth over the next several quarters. Still, many homeowners remain underwater on their mortgages, which will continue to restrain consumer spending growth. Bank credit remains relatively tight, but is getting easier. The contraction in all levels of government is keeping GDP growth about a full percent below where it would be otherwise.
While GDP growth is expected to remain moderate in the near term, the risks to the outlook are weighted to the downside. The fiscal cliff and Europe are the key worries. At full effect, the expiration of the Bush-era tax cuts, the end of the 2% reduction in payroll taxes, and scheduled spending cuts would subtract about 4% from GDP in 2013, easily enough to push the economy into a recession in the first half of the year. The consensus view is that most of the can will be kicked down the road, regardless of who wins the White House. However, no action is expected until after the election. The uncertainty could be a negative factor for the markets. While European economic weakness is expected to restrain U.S. exports, the bigger worry is the possible financial fallout that would follow a bigger meltdown in Europe. The fear is that we could see the global financial system seize up as it did four years ago. However, U.S. banks are much better capitalized than in 2008, and central banks are more experienced in providing emergency liquidity. There are some positives in the outlook. Notably, the drop in gasoline prices will add to purchasing power for the typical worker. Retail sales should pick up in the next few months. However, the benefit of lower gasoline prices to upper income households is limited. The June Consumer Sentiment survey showed that households making more than $75,000 per year were more pessimistic about future economic conditions, with uncertainties about the fiscal cliff being a major concern. Those who expected that the Fed’s aggressive policies would push inflation higher have been dead wrong. In fact, there are concerns that inflation may be too low. The Fed’s own forecasts show that officials expect inflation to be at or below the 2% target, while the unemployment rate will stay above target for the next few years. In other words, the Fed is missing on both
sides of its mandate. There’s scope for the Fed to do more.
The Fed’s extension of Operation Twist was an insurance move (the Fed risked disappointing the markets if it did nothing) and is unlikely to have a major effect on the economy. Fed Vice Chair Yellen’s contention that an increase in downside risks to growth could warrant further policy action seems to have gained more traction with the Fed’s majority. Whether that carries forward to the August 1 policy decision will depend critically on the economic data arriving over the next few weeks. There will be only one employment report before the August 1 FOMC meeting (the July payroll figures will arrive on August 3) and the June data will be subject to some possible seasonal distortions. The results are likely to play a large part in setting market expectations of what the Fed will do.
Recent Economic Data and Outlook
The economic data were mixed, but Europe remained a key driver of U.S. financial markets. Anxiety about the European summit drove share prices down early in the week, but unexpected progress helped fuel a rebound on Friday.
The Supreme Court upheld the Affordable Care Act, with Chief Justice Roberts unexpectedly crossing the political line.
The Federal Open Market Committee extended Operation Twist, which was set to end in June, through the end of the year. The Fed will buy about $44.5 billion per month in Treasuries with maturities of six to 30 years, financing that by selling Treasuries with maturities of three year or less (keeping the size of the Fed’s balance sheet unchanged). In his post-meeting press briefing, Bernanke said that the Fed expects moderate economic growth, but noted continued headwinds against growth (Europe, a “still depressed” housing market, tight credit for some borrowers, and fiscal policy restraint at all levels of government). Officials viewed the risks to the growth outlook as weighted to the downside, with financial strains from Europe posing “a significant risk to the recovery and to further improvement in labor market conditions.” Bernanke said that the Fed is “prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions.”
Real GDP rose at a 1.9% annual rate in the government’s 3rd estimate of 1Q12 growth (vs. +2.2% in the advance estimate and +1.9% in the 2nd estimate). Consumer spending as revised slightly lower (to +2.5%, from +2.7%), while business fixed investment was revised higher (to +3.1%, from +1.9%). Note that annual benchmark revisions will be released on July 27.
Personal Income rose 0.2% in May +2.9% y/y). Private-sector wages and salaries were unchanged (+3.9% y/y). Personal Spending was flat (+3.5% y/y), but would have risen 0.2% if not for a drop in gasoline sales. Adjusted for inflation, spending edged up 0.1% (+3.5% y/y, but a 0.4% annual rate over the last three months), but is still likely to post a 1.5% to 2.0% annual rate in 2Q12.
The PCE Price Index fell 0.2% (+1.5% y/y), up 0.1%, excluding food & energy (+1.8% y/y).
Consumer Confidence fell to 62.0 in the advance estimate for June, vs. 64.4 in May. Evaluations of current labor market conditions remained depressed.
Consumer Sentiment fell to 73.2 in June, vs. 79.3 in May and 74.1 at mid-month. The report noted that “the entire June decline was among households with incomes above $75,000.” Lower income households benefited from the drop in gasoline prices.
New Home Sales rose 7.6%, to a 369,000 seasonally adjusted annual rate, in May (+19.8% y/y). The Pending Home Sales Index rose 5.9% in May, following a 5.5% drop in April (+13.3% y/y).
The S&P/Case-Shiller Home Price Index rose 0.7% in April, down 1.9% from a year earlier. The 20-city index fell 3.9% over the 12 months ending in January, but rebounded 1.5% from January to April. Half of the cities saw year-over-year gains.
Durable Goods Orders rose 1.1% in May, boosted by increases in aircraft orders. Ex-transportation, orders rose 0.4% and were mixed across industries. Orders for nondefense capital goods rose 1.6% (vs. -2.3% in March and -1.4% in April).
Economic Outlook (3Q12): +2.3% to +2.8% GDP growth, following 1.5% to 2.0% in 2Q12.
Employment: The pace of job growth slowed in April and May, but it’s unclear how much of the slowdown is due to a return to more normal weather and seasonal adjustment quirks. Government is a drag on overall job growth. Job destruction remains relatively low.
Consumers: Auto sales slowed somewhat in May, but the trend should remain positive, fueled partly by replacement needs. Gasoline prices have been declining, adding to purchasing power, which should provide some support in the near term.
Manufacturing: Orders and industrial production have been mixed, but generally positive. Softer global growth may dampen exports, but domestic demand is expected to remain moderate.
Housing/Construction: Sales and construction have improved over the last year. Mortgage rates are very low and bank credit is getting a little easier. Job growth is a critical factor.
Prices: Gasoline prices, up earlier in the year, have moderated. Commodity prices have been generally softening. Inflation expectations remain well-anchored. There is no sign of inflation coming through the labor market. Interest Rates: Federal Reserve officials expect to keep the overnight lending rate near zero through late 2014, although that depends on how economic conditions develop. Another round of asset purchases (QE3, likely centered in mortgage backed securities) would depend on a faltering in the economic recovery, but the odds have decreased. Long-term interest rates have been low, fueled by a flight to safety from Europe.
For U.S. investors, Europe’s problems are expected to settle into the background for a while (but won’t go away completely). Hence, the economic data should become more important. The focus should be on Friday’s payroll figures, where seasonal adjustment could generate a surprise. Note that this will be the last employment report before the Fed’s August 1 policy decision. Market activity may be a bit thin due to the holiday.
Markit Manufacturing PMI (June, final) – The index is likely to stay near the mid-month read, positive, but lower than in May.
Construction Spending (May) – Single-family residential homebuilding should propel the headline figure higher in May.
ISM Manufacturing Index (June) – Europe is already reported to be having an impact on U.S. exporters. Uncertainty about the election, the fiscal cliff, and Europe may dampen capital spending in the near term. Consumer demand softened in 2Q12, but is poised to pick up as lower gasoline prices add to purchasing power. Look for some moderation in the ISM in June.
Factory Orders (May) – Durable goods orders rose, but lower oil prices should push overall factory orders down in May.
Auto Sales (June) – Unit sales slipped in May, but replacement demand should drive a positive trend in the medium term.
Independence Day Holiday – Markets closed.
BOE Policy Decision – The Bank of England has been leaning towards further quantitative easing, and is likely to pull the trigger at this meeting.
Challenger Layoff Report (June) – Job destruction is expected to remain at a moderately low level in the near term.
ADP Payroll Estimate (June) – The ADP figures are still not seen as a good predictor of the official BLS data, but the financial markets could use a surprise as an excuse (to rally or sell off, depending on the direction).
Jobless Claims (week ending June 30) – The recent trend has been moderate, consistent with payroll growth at or somewhat below a sustainable pace. Note that seasonal adjustment becomes much more difficult as we roll into July (due to seasonal plant closings in the auto industry).
ISM Non-Manufacturing Index (June) – The ISM’s other survey is likely to reflect a moderate pace of economic growth: positive, but not especially strong.
Employment Report (June) – Weather and seasonal adjustment issues were important factors in the first five months of the year. An unusually mild winter lifted figures for January and February, pulling seasonal gains from April and May (and leading to smaller seasonally adjusted job growth in the last two months). We should see a somewhat stronger figure in June, but the various labor market indicators suggest that the pace will be moderate at best. Note that seasonal adjustment is huge in June. Prior to seasonal adjustment, we can expect to lose about 850,000 in education (public and private) and add about 1.3 million jobs otherwise. While the unemployment rate has fallen over the last couple of years, the employment/population ratio has been trending flat, suggesting an economy growing just enough to absorb the growth in the working-age population, but not enough to make up much of the ground lost in the labor market during the downturn.
Next Week …
The economic calendar thins out. The June 19-20 FOMC minutes, due Wednesday, could provide some clues regarding the likelihood of QE3. The FOMC minutes will also include more details behind the Fed’s economic projections.
Coming Events and Data Releases
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