At the beginning of the year most economic observers had a realistic view of the pace of economic growth for the United States. As usual there were positive and negative cross-currents, but the consensus was that real growth would be about 2% for 2013. The Federal Reserve was engaged in a vigorous program of monetary easing, however, and a substantial amount (perhaps three-quarters of the total) of that money flowed into financial assets, driving the price of equities higher and keeping interest rates low. As a result of the strong stock market performance, some economists increased their growth estimates for the second half and the full year. Now, with two quarters behind us, it is time to take a hard look at how the year is playing out.
The first quarter came in at 1.8% real growth; second-quarter estimates indicate some slowdown from that rate, but 1% is probably a good working number at this point. Year-over-year growth is running at 1.62%. That is hardly an impressive number when you consider that the Federal Reserve is putting money into the economy through bond purchases at an annual rate of $1 trillion. In 2008, when the accommodative monetary policy began, the entire balance sheet of the Federal Reserve, accumulated in the 95 years since its founding in 1913, was $1 trillion, so the degree of monetary stimulus is unprecedented.
If growth is less than 2%, you have to wonder about the structural problems holding the economy back. In my view the economy is suffering from a lack of demand. Companies are reluctant to hire workers when the order book is thin. The global competition is intense in every product category. There are too many folks making too much stuff around the world. There are also structural problems in employment. Following past recessions, at the same point in the recovery, four years from the trough, the unemployment rate would have been close to 5%, but it is now 7.6%. The workforce participation rate is only 63.5%, which is down two full points from the level before the 2008–09 recession. Many able workers have given up looking for a job because they are so frustrated and disillusioned by their failure to find one. Yet there are several million unfilled jobs out there, jobs that require a certain level of technical skill which many jobseekers do not have.
First-half growth may have been held back by several factors. At the beginning of the year taxes on America’s top earners went up and the 2% payroll tax holiday ended. In April the sequestering of government funds for health care and defense went into effect. These changes are estimated to knock 1.5% off nominal Gross Domestic Product (GDP) of 4%, bringing it down to 2.5%. Taking 2% inflation off that number (inflation has recently been running closer to 1%), you are down to .5% real growth. The weather was unusually cold during the winter which also dampened growth. There are some important positives, though. Housing has been strong and domestic oil production has increased significantly. These two factors and some other minor ones could bring real growth back up to 2% for 2013.
One notable fiscal factor which should provide some encouragement to investors is the improvement in the budget deficit. In 2010 the deficit of $1.5 trillion was 10% of GDP. This year, because of tax increases and spending cuts, it should only come in at $700 billion on a $17 trillion economy or slightly more than 4% of GDP. This improvement is likely to continue next year. With the budget deficit declining, Congress has some room to engage in long-deferred infrastructure, research and development and job training programs. It is unclear whether this legislation will be introduced, however.
In spite of the lackluster performance of the economy in the first half, there is a general feeling that the second half will be better. The impact of the sequester may not be as severe and there is a general perception that both corporate executives and consumers are more positive on the outlook. The market hit some rough spots in May–June when Federal Reserve Chairman Ben Bernanke indicated that the central bank might reduce its bond buying program as early as September. From May 1 to July 5, the 10-year U.S. Treasury yield rose from 1.7% to 2.7%, but by July 18 it was back down below 2.5%. Even if the Fed only bought $60 billion of securities rather than $85 billion, it would still be engaged in a significant program of monetary easing, but talk of tapering scared the fixed income market. When Treasury yields moved higher, Bernanke softened his language and calmed down the bond traders.
I know there is a feeling among policymakers at the Fed that the current high degree of monetary accommodation is excessive and should be restrained when the economy has regained its natural momentum. I do not believe we have come anywhere near that point yet. Moreover, the Fed's own targets for implementing a program of restraint have not been met. The unemployment rate is not near the 6.5% threshold target that the Fed has set for itself and neither has inflation reached 2%. Since the economy is running well below its potential, I believe the Fed should maintain its current level of security purchases. Any reduction in the program is a form of tightening and neither the market nor the economy is really ready for that.
Although there is a palpable degree of optimism about corporate performance in the second half of this year, I wonder if it is justified. Companies have generally beaten analysts’ estimates more than two-thirds of the time so far this year, but I think that is mostly because management guided estimates lower so the results would compare favorably. That was certainly the case for Alcoa and Coca-Cola. United Parcel Service did not prepare the market for disappointment and the stock declined sharply. In the technology sector Microsoft, Intel and Google missed estimates. Second-quarter earnings are only expected to be up 2% over 2012 levels and full-year estimates are only projected to grow 4%–6% over last year, with much of that improvement coming from stronger performance in the second half.
It is unlikely that we are going to see better earnings if sales don't improve. Second-quarter sales are only expected to rise 1.25% over last year and full-year estimates are for a 2.75% increase. If there is some pressure on margins from modestly higher labor costs, depreciation and energy prices, that meager level of revenue improvement may not be enough to keep margins from eroding. It has been my view that profit margins are peaking and we should see if that observation is correct in the second half of 2013.
There are other reasons to be concerned. In 2010 world real growth was running at 4% as a result of the post-recession recovery in the United States and strength in the emerging markets. It is only at a 2% rate of increase now. We know that economic activity in China is slowing, but nobody seems to know by how much. China is the engine of growth for the emerging markets, so there is a negative reflective impact there. Europe remains in a recession. Reduced emphasis on austerity should help push the Eurozone into a position of very modest expansion in 2014 but the region is not likely to be an important contributor to overall world growth. Only Japan is providing favorable surprises. Shinzo Abe’s policy of heavy fiscal and monetary stimulus should be successful in bringing the country out of its deflationary recession in 2014. Japan’s monetary stimulus is $600 to $700 billion and its economy is less than half the size of that of the United States, so it is putting money into its economy one and a half times faster than the Fed is doing so in the U.S. There is also a vigorous fiscal stimulus program taking place in Japan at the same time. Abe’s recent success in the Japanese election should give him the confidence to continue his aggressive stimulus program.
There are other signs of trouble which have implications for second half economic performance. The increase in interest rates has moved 30-year mortgage yields up 100 basis points to 4.5%. While this is low on an historical basis, it is substantially higher than recent levels and should have an effect on housing which has been one of the clear positives in the U.S. economy this year. We have seen some evidence of this in slower housing starts and mortgage applications, but that condition may be temporary.
The composite Purchasing Managers’ Index, which includes both manufacturing and services, has shown some signs of weakness, reflecting disappointing demand. The National Federation of Independent Business sentiment, which had been favorable recently, has weakened. Retail sales have shown signs of softness in spite of the fact that household net worth is at an all-time high. The rises in the stock market and luxury real estate have benefited the portion of the population that has the lowest propensity to spend in relation to their income. In contrast we have 45 million Americans on food stamps, substantially higher than ever before. Railcar loadings and bank loans, two important indicators of business activity, have also weakened. First Call earnings revisions have turned down, indicating more disappointments may lie ahead.
I still think the economy will grow at 2% this year, but I worry that final sales will not be enough to offset some margin deterioration. As a result I fear that earnings will be below estimates. I have been worried about economic growth and earnings all year and the Standard & Poor’s 500 has kept working its way higher. The liquidity being provided by the Fed is responsible for that. Valuations are still reasonable and if the easy money policy continues, I recognize that stocks can move up more from here. I think earnings will be below estimates, but investors may not care as long as the Fed’s bond buying program continues. Right now the S&P 500 is trading somewhat above 15 times consensus earnings and slightly more than 16 times the earnings level that reflects a reasonable degree of disappointment. This is not an extreme level of overvaluation, even considering the recent rise in interest rates. Investor sentiment is in optimistic territory, near the level that has signaled a likely decline in the past. Companies have considerable cash on their balance sheets, some of which will be used to buy back stock. That could increase earnings per share, offsetting earnings shortfalls.
According to a report in Barron’s (July 24) by Mark Hulbert, which was supported by considerable academic research, since the 1920s the average multiple for the S&P 500 at market top is 18.7, close to where we are now. Moreover, the market tends to rise sharply just before the top rather than forming a plateau, indicating exhaustion. The average bull market gained 21% in the twelve months before the top; the current 12-month return is 23%. In a blow-off the market multiple could rise to 20, and each multiple point is 100 points on the index. I don’t expect that to happen, but if the Fed keeps pumping money into the economy, anything is possible. While a higher high may be ahead, at some point the Fed will slow its accommodation and investors will recognize the implications of slow economic growth and very modest earnings improvement. That is why I believe a degree of caution is warranted.
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