Should auld acquaintance be forgot
And never brought to mind?
Should auld acquaintance be forgot,
And auld lang syne!
For auld lang syne, my dear,
For auld lang syne,
We’ll take a cup o’ kindness yet
For auld lang syne
It’s that time of year again, when we begin to think of what the next one will bring. I will be doing my annual forecast issue next week, but my friend Gary Shilling has already done his and has graciously allowed me to use a shortened version of his letter as this week’s Thoughts from the Frontline. So without any further ado, let’s jump right to Gary’s look at where we are and where we’re going.
Review and Forecast
By Gary Shilling
In the third quarter, real GDP grew 2.8% at annual rates from the second quarter. Without the increase in inventories, the rate would be 2.0%, in line with the 2.3% average growth since the economic recovery commenced in the second quarter of 2009.
Furthermore, the step-up in inventory-building from the second quarter may have been unintended, suggesting cutbacks in production and weaker growth in future quarters. Also, consumer spending growth, 1.5% in the third quarter, continues to slip from 1.8% in the second quarter and 2.3% in the first while business spending on equipment and software actually fell at a 3.7% annual rate for only the second time since the recovery started in mid-2009. Government spending was about flat with gains in state and local outlays offsetting further declines in federal expenditures. Non-residential outlays for structures showed strength as did residential building. The 16-day federal government shutdown didn’t commence until the start of the fourth quarter, October 1, but anticipation may have affected the third quarter numbers.
The 2.3% average real GDP growth in the recovery, for a total rise of 10%, has not only been an extraordinarily slow one but also quite unusual in structure. Consumer spending has accounted for 65% of that growth, actually below its 68% of real GDP, as shown in the second column of Chart 1. Government spending—which in the GDP accounts is direct outlays for personal and goods and services and doesn’t include transfers like Social Security benefits—has actually declined. Federal outlays fell 0.4% despite massive stimuli since most of it went to welfare and other transfers to state governments. But state and local spending dropped 0.9% due to budget constraints.
Residential construction accounted for 9% of the gain in the economy. This exceeds its share of GDP, but still is small since volatile housing normally leaps in recoveries, spurred by low interest rates. But deterrents abound. The initial boost to the economy as retrenching consumers cut imports was later reversed. So net exports reduced real GDP growth by 0.4% in the 13 quarters of recovery to date.
Inventory-building accounted for a substantial 19% of the rise in real GDP, suggesting the accumulation of undesired stocks since anticipation of future demand has been consistently subdued. Nonresidential structures fell 0.1% as previous overbuilding left excess space. Equipment spending contributed 20% of the overall growth, but has failed to shoulder the normal late recovery burst.
Nevertheless, the small intellectual property products component, earlier called software, accounted for 5% of overall growth compared to its 3.9% share of GDP. This reflects the productivity-enhancing investments American business have been using to propel profit margins and the bottom line in an era when sales volume has been weak and pricing power absent.
As we predicted over three years ago in our book The Age of Deleveraging: Investment strategies for a decade of slow growth and deflation, and in many Insights since then, economic growth of about 2% annually will probably persist until deleveraging, especially in the financial sector globally and among U.S. consumers, is completed in another four or five years. Deleveraging after a major leveraging binge and the financial crisis that inevitably follows normally takes around a decade, and since the workdown of excess debt commenced in 2008, the process is now about half over. The power of this private sector deleveraging is shown by the fact that even with the immense fiscal stimuli earlier and ongoing massive monetary expansion, real growth has only averaged 2.3% compared to 3.4% in the post-World War II era before the 2007-2009 Great Recession.
Optimists, of course, continue to look for reasons why rapid growth is just around the corner, and their latest ploy is the hope that the effects of individual income tax hikes and reduced federal spending this year via sequestration have about run their course. Early this year when these negative effects on spending were supposed to take place, scare-mongers in and out of Washington predicted drastic negative effects on the economy. But federal bureaucrats apparently mitigated much of the effects of sequestration, and the income tax increases on the rich, as usual, didn’t change their spending habits much. So the positive influences on the economy as sequestration fades and income tax rates stabilize are likely to be equally minimal.
Furthermore, small-business sentiment has fallen recently. The percentage of companies that look for economic improvement dropped from -2 in August to -10 in September and -17 in October to a seven-month low. Those expecting higher sales declined from +8 to +2 in October. Most of the other components of the index fell, including those related to the investment climate, hiring plans, capital spending intentions, inventories, inflation expectations and plans to raise wages and prices. Other recent measures of subdued economic activity include the New York Fed’s survey of manufacturing and business conditions and industrial production nationwide, which fell 0.1% in October from September.
The New York Fed’s Empire State manufacturing survey index for November fell to 2.21%, the first negative reading since May. Every component dropped—orders, shipments, inventories, backlogs, employment, the workweek, vendor performance and inflation.
The ongoing sluggish growth in the U.S. is indeed a global problem. It’s true in the eurozone, the U.K., Japan and China. Recently, the International Monetary Fund, in its sixth consecutive downward revision, cut its global growth forecast for this year by 0.3 percentage points to 2.9% and for 2014, by 0.2 percentage points to 3.6%.
It lowered its 2013 forecast for India from 5.6% to 3.8%, for Brazil from 3.2% to 2.5% and more than halved Mexico’s to 1.2%. For developing countries on average, the IMF reduced its 2013 growth forecast by 0.4 percentage points to 5%, citing the drying up of years of cheap liquidity, competitive constraints, infrastructure shortfalls and slowing investment. It also worries about their balance of payment woes. For 2014, the IMF chopped its growth forecast for China from 7.8% to 7.3% and from 2.8% to 2.6% for the U.S.
Fed Chairman Bernanke continually worries about fiscal drag. Without question, the federal budget was stimulative in earlier years when tax cuts and massive spending in reaction to the Great Recession as well as weak corporate and individual tax collections pushed the annual deficit above $1 trillion. But the unwinding of the extra spending, income tax increases and sequestration this year and economic recovery—weak as it’s been—have reduced the deficit to $680 billion in fiscal 2013 that ended September 30.
From here on, the outlook is highly uncertain with persistent gridlock in Washington between Democrats and Republicans. So far, they’ve kicked the federal budget and debt limit cans down the road and they may do so again when temporary extensions expire early next year. It looks like many in Congress have no intention of resolving these two problems and may be jockeying for position ahead of the 2014, if not the 2016, elections.
In our many years of observing and talking to Congressmen, Senators and key Administration officials of both parties, it’s clear that Washington only acts when it has no alternative and faces excruciating pressure. A collapsing stock market always gets their attention, but the ongoing market rally, in effect, tells them that all is well or at least that it doesn’t require immediate action.
With muted economic growth and risks on the downside, distrust in the abilities or willingness of Congress and the Administration to right the ship, and falling consumer and business confidence, the burden of stimulating the economy remains with the Fed. Janet Yellen, the likely next Chairman, seems even more committed than Bernanke to continuing to keep monetary policy loose. The Fed plans to reduce its buying of $85 billion per month in securities but the negative reactions by stocks (Chart 2), Treasury bonds (Chart 3) and many other securities to Bernanke’s hints in May and June that purchases would be tapered and eliminated by mid-2014 made a strong impression on the Fed. Similarly, the release of the minutes of the Fed’s October policy meeting— which again said officials looked forward to ending the bond-buying program “in coming months” if conditions warranted—resulted in an instant drop in stock and bond prices.
The Fed is trying to figure out how to end security purchases without spiking interest rates, to the detriment of housing, other U.S. economic sectors and developing economies. It’s moving toward “forward guidance,” more commitment to keep the short-term interest rate it controls low than its present pledge to keep it essentially at zero until the current 7.3% unemployment rate drops to 6.5% and its inflation rate measure climbs to 2.5% from the current 1.2% year-over-year.
The hope is that a longer-term commitment to keep short-term rates low will retard long rates as well when the Fed tapers its asset purchases. This strategy appears to be having some success. Treasury investors are switching from 10-year and longer issues to 2-year or shorter notes. This is known as the yield-steepening trade as it pushes short-term yields down and longer yields up. As a result, the spread between 2-year and 10-year Treasury obligations has widened to 2.54 percentage points, the most since July 2011. Banks benefit from a steeper yield curve since they borrow short term and lend in long-term markets. But borrowers pay more for loans linked to long-term Treasury yields. There’s a close link between the yield on 10-year Treasury notes and the 30-year fixed rate on residential mortgages.
The Fed has already signaled that it may not wait to raise short rates until the unemployment rate, a very unreliable gauge of job conditions as we’ve explained in past Insights, drops below 6.5%. Bernanke recently said that “even after unemployment drops below 6.5%, the [Fed] can be patient in seeking assurance that the labor market is sufficiently strong before considering any increase in its target for the federal funds rate.” At that point, the Fed will consider broader measures of the job market including the labor participation rate. If the participation rate hadn’t fallen from its February 2000 peak due to postwar baby retirements, discouraged job-seekers and youths who stayed in school since job opportunities dried up with the recession, the unemployment rate now would be 13%.
The Fed is well aware that other than pushing up stock prices, its asset-buying program is having little impact on the economy. In a recent speech, Bernanke said that while the Fed’s commitment to hold down interest rates and its asset purchases both are helping the economy, “we are somewhat less certain about the magnitude of the effects on financial conditions and the economy of changes in the pace of purchases or in the accumulated stock of assets on the Fed’s balance sheet.” We wholeheartedly