Kicking off Morningstar.com's Ideas Week, Bob Johnson, associate director of economic analysis, answers our questions about the state of the recovery, the market runup, possible surprises, and the outlook for 2010.
1. Some market watchers attribute the upturn in third-quarter US GDP
to high levels of government stimulus, and argue that if the government
takes its foot off the pedal, GDP could suffer. What's your take on the
stimulus' impact on GDP, and the fundamental strength of the underlying
economic recovery?
The government has done a lot to both help and hurt the economy over the
past several quarters. On the help side, we have low interest rates and
direct support of capital markets by the Fed. Then we have the official
government stimulus programme that included homebuyer credits, reduced
tax withholding rates, aid to local governments, as well as
infrastructure spending. Finally, there are one-off programmes such as
"cash for clunkers."
On the other side of the ledger, uncertainty about health-care spending requirements has hurt small businesses, a major engine of growth. The auto industry bankruptcy, though necessary, caused some major disruptions in employment this spring. Low interest rates, though helping homebuyers, have severely depressed the earnings of savers, which in turn hurt disposable income. The threat of higher taxes and larger deficits hasn't done wonders to improve consumer confidence, either.
In my opinion, government actions were not the primary reason for the 2.8% growth in GDP during the September quarter. To the untrained eye, it might appear that the cash for clunkers programme may have boosted third-quarter results significantly. However, it was domestic auto production that is directly measured in the GDP number, not the retail sales of automobiles. The auto industry had been producing cars so far below even depressed sales levels, that the industry did not have much choice but to produce more cars in the third quarter. Production plans for the third quarter were put in place well before the cash for clunkers programme was approved. Also, after the cash for clunkers programme was over in August, sales in September were still above the lowest month of 2009. Subsequently, October sales were better than every month of the year except the clunker months, and November was above October. Therefore, production levels should be higher still in the fourth and first quarters.
Likewise, while the homebuyers' credit may have helped home sales, surveys indicated that more than two thirds of all buyers would have bought their homes even without the credit. In the third quarter, most of the government infrastructure spending was still on the drawing board and direct government employment was surprisingly weak for the middle of a recession. Many of the benefits of the stimulus programme have yet to be seen.
2. What are your estimated GDP growth rates for 2010 and what will be
the drivers?
My forecast for 2010 GDP is for growth of 3.5% to 4%. My forecast is
based on consumer spending increases of 3% or more, improved exports
resulting from a weaker dollar,
inventory restocking, slow but steady improvement in housing
construction, and continuing government stimulus spending. Autos should
also be a contributor, although probably not to the degree that they
helped the second half of 2010. Auto sales still have a long way to go
from the 11 million or so units today to more normal demand of 14-18
million units. Likewise, home starts of under 600,000 units are well
below what is demanded by normal population growth (about 1.5 million
units).
3. Much of the government's proposed stimulus spending has not come
online yet. Where do you expect to see the most business and economic
activity given the current stimulus proposals, and when might they begin
to take effect?
As of November 27, 2008, approximately $238 billion of the $787 billion
(or about 30%) of the total stimulus money has been spent. While more
than a third of the tax benefits and entitlement reimbursements have
been recognised, just over 20% of all contracts, loans, and grants
contemplated by the plan have been paid out. Getting this money spent
has been bureaucratically difficult. To give just one example, the
weatherisation programme required that all contracts pay the prevailing
wage. That wage was not established until September, well after the
season for air conditioning weatherisation in many Southern states. I am
convinced most stimulus money will get spent; however, there have been
short-term delays that hurt this year's economic results, but this
spending will aid the economy in 2010.
4. Do you think further stimulus will be necessary after the initial
spending is done?
In my opinion a lot of further stimulus is not necessary. The current
stimulus programme is of the slow-burning variety and still has a lot
more benefit to add to the economy in 2010 and even 2011. Frankly, I
would rather see less government involvement in the economy, not more. I
really don't want corporations refusing to make hard choices like
cutting prices because they figure the government is going to step in
and solve their problems. Some action on the health-care bill one way or
the other would also end some of the uncertainty surrounding business
decisions. I think the latest employment report may take some of the
pressure off of the government for more action.
5. Unemployment is a lagging indicator that has many investors
concerned. How much higher should we expect it to creep up, and when do
you expect to see improvement?
I remain steadfast in my belief that unemployment is a lagging
indicator. Employers will work their employees longer hours and use
temporary workers before they begin adding new employees as business
improves. Also, more potential employees will enter the workforce as
they begin to see signs that there are actual jobs to be had. These two
factors typically combine to cause the overall unemployment rate to peak
more than eight months after the official end of the recession.
Given that I believe the economy bottomed in June 2009, unemployment should peak some time in the first quarter of 2010. The recently reported rate for November was 10.0%, off its high of 10.2% the previous month. I think the rate can still wander up a bit in the months ahead as more people re-enter the workforce. However, I doubt that the unemployment rate will ever match the post-war high of 10.8% reached in the early 1980s.
Some other economists who posit that "this time is different" hold that high employment will cause more home foreclosures and credit card delinquencies. That in turn will cause more trouble for banks and other financial institutions, which will lend even less. My counter argument is that some early delinquency rates (loans that are 30-60 days past due) have shown some improvement even as unemployment has continued to go up. More stable real estate prices may be a factor in convincing mortgage holders to pay up rather than walk away from some loans. I would also note that recently the unemployment rate has gone up more because the same people are staying unemployed longer rather than a new flood of layoffs. Chance are those long-term unemployed are already delinquent on their loans. The further we get away from the peak in initial unemployment claims in March, the better delinquencies should look.
6. Some have been saying that we can't expect sustainable improvement
in the economy until employment recovers, and that if unemployment stays
high too long, it may hinder the recovery. Is there a risk of a
double-dip due to unemployment?
To say the economy can't get better until employment gets better is a
categorically false statement. The economy always gets better before
employment improves. How many businesses are going to say, "Gee, things
are really weak, but I am going to go out and hire 10 people because I
think things might improve"?
What really happens at the end of every recession is that the 90% of people that have a job and the 50% with limited or no mortgage debt feel confident enough to spend more of their cash. Businesses will use price cuts to entice consumers to spend that cash. In some recessions, export sales improve early, driving domestic production levels higher despite high unemployment.
So the path to recovery is led by better exports and consumer spending that leads to more production that finally leads to more employment and ultimately capital goods expenditures.
7. The unemployment rate has certainly had an impact on consumer
spending. What is your forecast for spending, and how do you see the
recovery playing out here (which areas of spending will pick up first,
second, third, etc.)?
Surprisingly, consumer spending bottomed way back in December 2008 and
has increased 1.3% since then even as unemployment moved from 7.2% in
December 2008 to its high of 10.2% in October.
In late 2008, consumers and businesses became incredibly scared because of daily headlines of yet another financial institution failing, car makers begging for cash, and candidate Obama hammering on the weak economy throughout his campaign. Consumer spending fell more sharply than it ever had in a very short period of time.
Since then, spending has shown meandering improvement. In early 2009, there was some relief-buying as consumers began to believe that the economy was not going to fall into the abyss and bargains began to appear in stores. I think continuing housing weakness and some impatience with the rate of improvement in unemployment caused spending to stall for a few months in the spring of 2009 until a better stock market and the cash for clunkers programme revived spending during the summer and fall.
Now with employment statistics on the mend, the restoration of 401(k) matches [employer pension contributions], and the lifting of salary freezes, I believe consumer incomes and spending should continue to show improvement in the months ahead.
Based on year-over-year changes in real incomes and consumer confidence data, I believe that consumer spending could increase 3%-4% in 2010, relatively in line with my expectations for overall GDP growth. Discretionary spending on things like restaurants and durable goods like autos should continue to show good growth from here, while consumer staples are likely to show relatively slower growth. With the strong performance in financial markets (the S&P 500 is up more than 60% since March), it is possible that demand for luxury goods will be higher than anticipated.
8. Which leading indicators did you find were most predictive of the
current recovery, and what are those indicators telling you now?
There are three indicators I used to predict this recovery: change in
initial unemployment claims, annual change in real hourly wages, and the
ISM Purchasing Managers Survey. Improved housing data starting this
spring was also a helpful early indicator. At the bottom of a cycle
there really isn't much else that has a proven track record.
Fed rate cuts and money supply have also been good general indicators over many cycles, but they have often proved to be dangerously early. This time around these two were particularly early and would have caused one to be too optimistic on the economy and on the market. Interest rates and money supply started flashing bullish signals last autumn even before the economy and the market had really started to crater.
Currently my three lead indicators are still bullish, though the ISM data is looking just a little weaker. At this point in the cycle these markers become a little less relevant. Markets, unfortunately, caught on to these indicators after it was too late and are now over-emphasising my big three.
At this point in the cycle I would be watching consumer spending numbers and disposable income instead. Next spring real estate data will begin to regain its importance. That is because the holidays and winter weather issues as well as confusion about tax credits will cloud some of the near-term data.
9. What still worries you about the recovery and what concerns are
overblown? What economic surprises could influence the market on the
upside and the downside?
I still worry a lot about small businesses that have historically been
the engines of growth for the economy. Uncertainties about health care
and regulation as well as tighter lending standards have created a lot
of pain for small-business owners. It has only been in the last couple
of months that small businesses have shown any optimism at all.
Also, like the rest of the world, I believe commercial real estate loans and commercial construction could hurt an otherwise improving economic situation. I think commercial real estate loan losses could be large, but this sector is far smaller than the residential loan market. While painful, I don't believe that commercial real estate lending has the potential to bring down the whole system like residential real estate almost did.
I think some of the budget deficit issues are over-hyped. I think tax revenues can come back a lot faster than people think after falling far more than GDP over the last year. I am also more optimistic on unemployment and growth, both factors that could lead to more tax revenues and less expenses. Our legislators still have the potential to mess up this situation in a big way, though.
I think inflation potential and labour shortage could prove to be the big surprises. A lot is made of the overall capacity utilisation numbers and high unemployment to justify a totally benign inflation environment. I think the pockets of excess capacity (think the chronically under-utilised auto industry) and unemployment (think California construction workers) are disguising more tightness in supply than most suspect. This could lead to higher prices later next year. Overall inflation of 3% would not surprise me.
10. The market began to anticipate an economic recovery in March 2009
and has had a nice run since then (with a few bumps). Given how markets
have preceded economic recoveries in the past, do you anticipate much
more upside in the market?
The market has indeed come a long way. The S&P 500 is now up more than
60% from its March low, making it one of the largest advances since the
Great Depression. Keep in mind, though, that losses were also larger
than during most other recessions.
Looking at Shiller data that uses 10-year average price/earnings ratios, the market is priced at 19 times earnings versus a 90-year average of close to 17. However, markets also tend to overshoot the averages in both directions, so I think there is some potential upside, but a lot more risk, too.
Looking at long-term S&P earnings growth of 6% or so and relatively normal multiples, I think the S&P could at least approach its old highs of 1,500 or more over the next four years. Trust me, that won't happen in a straight line, but I think there is a lot more potential for improvement than most people expect. The government still has a large opportunity to mess this all up. And geopolitical situations like Iran can throw a major wrench in the world economies.
