December Investor Guide
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What are the implications for the economy in the short term?
December Investor Guide
What are the implications for the economy in the short term?
Thanks largely to counter-productive policies; the United States has been very slow to make the kinds of institutional transitions needed to return to robust growth. For a more complete explanation of this economic transition, Strategic Wealth Advisor subscribers should read Ride the Wave by Fred Rogers and Richard Lalich.
To put it concisely, we'll only be able to reap the full economic benefits of the coming wave of digitally enabled technologies once we've revamped our major institutions. Those institutions range from capital markets to labor, education, and regulation.
The disappointingly slow growth we've seen over the past 15 years, and especially the past six years, has resulted from policies aimed at shoring up the status quo institutions designed for the Mass Production Era, rather than transforming those institutions to complement the realities of the Digital Age.
Motivated largely by a laser-like focus on national security, the Bush Administration, and a spend-friendly Congress, pushed temporary "stimulus" spending in 2001 and then followed Larry Summers' Keynesian advice in early 2008 and passed tax credits and even more stimulus. Even the Strategic Wealth Advisor team supported TARP because it was the only solution on the table for halting the global investor panic that threatened the core financial system.
However, it was clear to us that the last thing that was needed was the "stimulus" approved in 2009. And while quantitative easing was a bad stand-alone concept, it was necessary to compensate for the huge drag created by misguided fiscal policy.
This is the reason real GDP growth during the current recovery is the slowest five-year period of growth without a recession in the past 100 years.
Fortunately, a "digital-ready economy" exists in many sectors, like fracking and high-tech; like 3-D printing, the cloud, smartphones, and apps. This portion of the economy is thriving despite government policies and is driven by free markets.
What are the implications for the economy in the short term?
The current recovery started in mid-2009. Since then, real GDP has grown at a 2.2 percent annual rate. Now, despite a negative first quarter caused by weather and inventories, the economy is picking up some speed and we expect 2.5 percent to 3 percent real GDP growth, on average, in the year ahead.
The big plus for faster growth is that government spending as a percent of GDP is falling; it's down to 20.3 percent of GDP in Fiscal Year 2014, the lowest since 2008, and down substantially from the peak of 24.4 percent in 2009.
Government spending is still a drag on the economy, just less of one. The continuing sequester, an end to extended unemployment benefits, and tapering by the Fed are all signals that the tide may have turned.
Smaller government means a bigger and more vibrant private sector. The unemployment rate fell to 5.9 percent in September and weekly initial claims for jobless benefits plummeted to 264,000 in October, the lowest since 2000. The labor market is still far from its full potential, but layoffs are few and far between.
Let's consider the specifics, starting with retail sales:
After a very solid report out of the retail sector in August, consumers took a breather. Retail sales fell 0.3 percent in September, led by a decline in the very volatile auto sector, which was expected.
But even outside of the auto sector, retail sales were down 0.2 percent. Gas station sales were a large culprit, falling 0.8 percent in September as oil prices continue to drop. Prices at the pump on a national average are now down 4.5 percent from a year ago.
The widespread use of fracking and horizontal drilling is making this possible, which means consumers can take the money they save on filling their tanks and spend it on other things. It's important to remember that even in the best years, retail sales still fall in three months out of the year; so the decline in September, coming on top of the very strong August report, is not something to worry about.
Overall retail sales still remained up a very healthy 4.3 percent from a year earlier. "Core" sales, which exclude autos, building materials and gas, were unchanged in September and were up at a 4.3 percent annual rate in the third quarter versus the second quarter average.
Consistent with an expected rebound in the fourth quarter of 2014, U.S. consumer sentiment rose in October to the highest in more than seven years, boosted by views on personal finances and the national economy.
The Thomson Reuters/University of Michigan preliminary October reading on the overall index on consumer sentiment came in at 86.4. The data show absolutely no signs that fear and panic is about to overtake the consumer sector, despite broader concerns about the global economic meltdown, escalating military conflicts, and rising concerns about Ebola.
Industrial production soared 1 percent in September, easily beating consensus expectations. About half of the gain was due to strength in utilities and mines, which are very volatile from month to month, but manufacturing output grew 0.5 percent despite a 1.4 percent drop in the auto sector.
One measure of the underlying trend is that the non-auto manufacturing sector, which climbed 0.6 percent in September, has not dropped in any month since January and was up 3.5 percent from a year earlier. We expect continued growth in the industrial sector.
According to the ISM index, the manufacturing sector was still growing at a robust rate in September, just not quite as fast as in August. The index, which measures factory sentiment around the U.S., came off its highest reading in three years to a still healthy 56.6 in September.
Zigs and zags are to be expected and no one should see the report as a sign of economic weakness. Both the three- and six-month averages for the index are the highest in more than three years. According to the Institute for Supply Management, an overall index level of 56.6 is consistent with real GDP growth of 4.4 percent annually.
While the GDP report came in at a strong 4.6 percent for the second quarter, the ISM report has tended to over-estimate real GDP growth in the past several years and we're projecting growth of around 3 percent for the rest of the year.
In related news, purchases of durable goods, like airplanes, cars, and heavy machinery that is designed to last at least three years, fell by 1.3 percent in September from the prior month to a seasonally adjusted $241 billion. But, excluding the volatile transportation category, orders fell just 0.2 percent.
On the positive side, exports increased faster than imports in August, with the U.S. trade deficit shrinking slightly to $40 billion. As a result, it now looks like net exports will add about a full percentage point to real GDP growth in the third quarter, consistent with our forecast that real GDP grew at about a 3 percent annual rate in the third quarter.
The best news in the August report is that the total volume of trade, imports plus exports, hit a new all-time record high, underscoring continued improvement in the U.S. economy. Over the next few years, higher energy production in the U.S. — due to hydraulic fracturing and horizontal drilling along with seismic imaging — will continue to transform our trade relationship with the rest of the world.
Nine years ago, back in August 2005, the U.S. imported 11 times as much petroleum product as it exported. Since then, petroleum product exports are up 602 percent, while imports are up only 23 percent. So now, petroleum product imports are only 1.9 times exports. Finally, policymakers are helping this trend, with the Commerce Department giving two companies permission to ship a type of ultralight oil known as condensate to foreign buyers.
Given the huge glut of oil in the Permian Basin in Texas, we expect more moves to allow exports over the next couple of years, and for oil prices to keep trending lower. As a result of both the pre-existing trends and new policy direction, we expect the U.S. to move to a petroleum trade balance and perhaps even surpluses in the next few years.
As with the manufacturing sector, the ISM service sector report suggests growth remained strong in September, but at a slightly slower pace than in August. Even with the dip in September, the three-month average for the index showed the fastest pace of service industry growth in nearly 10 years, and the index remained above 50, signaling expansion for the 56th consecutive month.
The business activity sub-index declined 2.1 points in September to 62.9, the second highest reading of the past three years. The employment sub-index ticked higher in September to 58.5 from 57.1 in August, the highest reading we have seen since the start of the recovery.
As employment continues to expand, expect income growth to boost consumer spending and business revenue, which, in turn, will help support even more job growth in the future. In other words, the growth in the economy is self-sustaining and should remain that way until monetary policy gets tight, which is at least a few years away.
What about housing? U.S. housing starts and permits rose in September, a signal the market's recovery is supporting what appears to be growing strength in the broader economy. Groundbreaking rose 6.3 percent to an annual 1.02 million-unit pace, the Commerce Department said.
The average 30-year mortgage rate dropped in October to its lowest level since June 2013, and the level of housing starts is not far from a seven-year high. New housing starts for single-family homes, the largest part of the market, rose 1.1 percent in September, while the more volatile multi-family homes segment jumped 16.7 percent. Permits advanced 1.5 percent to a 1.02 million-unit pace.
In other housing news, it looks like we're finally getting a thaw in mortgage lending. New single-family home sales rose 0.2 percent in September, coming in 17 percent higher than a year earlier and at the highest level in more than six years.
Nonetheless, new home sales still remain at depressed levels relative to where they should be by now in the recovery, and we believe there are three key reasons for this:
Meanwhile, existing home sales look like they're bouncing back. Sales increased 2.4 percent in September, have risen in five of the last six months, and are now the highest in a year. Although overall sales are still down 1.7 percent from the year-earlier level, this masks a huge change in the composition of existing home purchases that bodes well for the future.
Distressed homes, including foreclosures and short sales, now account for only 10 percent of sales, down from 14 percent a year ago. All-cash buyers are now 24 percent of sales versus 33 percent a year ago.
As a result, non-cash sales, where the buyer uses a mortgage loan, were up 11.5 percent since last September. So, even though tight credit continues to suppress sales, we are seeing early signs of an easing in mortgage credit, which suggests overall sales will climb in the year ahead.
Another reason for the tepid recovery so far in existing home sales is a lack of inventory. Inventories were up 6 percent from a year earlier, but down the past two months. In the year ahead, we expect higher home prices to bring more homes on the market, which should help generate additional sales.
Either way, whether existing home sales are up or down, it's important to remember that these data, by themselves, should not change anyone's impression about the overall economy.
All in all, it looks like the tepid recovery continues, while our economic institutions slowly adapt to the new digital paradigm.