Volume 58, Number 12 | March 25, 2011
Two weeks after Japan’s earthquake we are still struggling to determine what its impact will be beyond Japan’s borders. Meanwhile, recent events in Libya have extended the likely period for elevated oil prices through the key spring driving season. Recent data on housing and durable goods were both disappointing leading to more slight downward revisions to first quarter GDP forecasts, with the consensus now between 2.3% and 2.8% at an annual rate. This strongly suggests that before the earthquake and Libya, the US economy in 2011 was roughly the same as in 2010 – no acceleration or deceleration in growth or hiring is evident. Meanwhile, the massive injections of liquidity by the bank of Japan are acting like a QE3 lifting equities prices. And, the surge in gasoline prices to over $3.50 is taking a toll on the consumer – especially in confidence – with the consequences to be played out in the second quarter.
We have temporarily put aside our concerns that rising food and energy prices would sap US consumer buying power enough to threaten the expansion by 2012. The current decline in demand from Japan should act as a pause that refreshes for the rest of the developed world. However, Japan will not remain on the sidelines forever and when they come back they will likely be pushing for rapid growth. Thus, we have merely delayed the point at which ever rising Chinese demand for resources will collide with the rest of the world’s attempts to return to robust growth – which requires those same resources. For how long? Japan’s GDP is about $5 billion. We estimate that the earthquake will reduce 2011 GDP by about 6% from where it would have been otherwise. China is a $6 billion economy, so 6% of Japanese growth is roughly enough resources for China to expand another 5% before colliding with the rest of the world again. That represents about six months of Chinese growth (which averages 10%). So the question now is how much can the rest of the world heal its debt imbalances and promote hiring during those six months – and will it be enough that the developed economies have entered a self sustaining cycle or will the same old problems simply reappear late in 2011?
Before the Quake
Fourth quarter real GDP was revised up from 2.8% to 3.1%, with nominal growth lifted from 3.2% to a still anemic 3.5%. Normally, final revisions of GDP are uninteresting – however, in this report there was a significant upward revision to the share of growth occurring in the corporate sector resulting in domestic profits which grew at a 16% annual rate. Earlier estimates had suggested a decline in profits as corporate sector nominal GDP was up at only a 2.7% annual rate while corporate compensation rose at a 3.9% annual rate. The revised data found a whopping $54 billion more in corporate GDP – mostly as a result of a smaller statistical discrepancy (the error term between national income and GDP) – while corporate compensation was reduced by $4 billion. The difference between negative profits and a 16% growth rate is, of course, profound. We have long argued that profits are the key leading indicator of future GDP growth as business leaders control the hiring and investment decisions in the US capitalist economy. Corporate profits have moderated to a steady 15% annualized growth rate over the past three quarters and now recovered to 8.8% of GDP, a level normally associated with economic peaks. Domestic profits are just 7% shy of the $1.4 trillion peak in the third quarter of 2006 (yes, well before the recession began). At this pace, a new peak could be achieved within the six month pause that refreshes that we foresee.
The dilemma remains that profits have not translated into much hiring or investment. Part of this appears due to businesses concerns about what happens to revenue growth once the government reins in stimulus. Initial claims for unemployment have been falling sharply in recent weeks, with the four week average now at 385,000. While this is a good sign for hiring, it is still well above previous claims readings at this point in the recovery. Average private sector employment gains of about 150,000 over the past three months (in both the household and payroll report) are barely enough to keep the unemployment rate falling with normal labor force gains. This week’s soft durable goods orders were disappointing – especially for nondefense capital goods ex-aircraft where 100% expensing should be driving orders. Perhaps orders were pulled into December right after the announcement of expensing for 2011 was announced, but even then orders for nondefense capital goods ex-aircraft are just 2% higher over the last three months than in the previous three months at an annual rate. Orders lead shipments suggesting that the best performance for the equipment sector may already be in the rear view mirror. A lot of analysis has focused on the recent pattern of weak orders in the first month of the quarter and a surge in the final two months. Right now, January and February nondefense capital goods orders ex aircraft are -5.1% below the October-November average. It would take a 10.6% pop in orders in March just to get the quarter on quarter growth rate to zero.
Even if this were to happen, would Japanese supply chain problems limit industry’s ability to turn new orders into production and shipments? Whether the appearance of a Japanese QE3 helps or not will likely depend on how severe Japanese supply chain disruptions affect US production. Automobiles and technology appear the two most vulnerable areas – and both have been on a tear recently. This leads to a second question: whether the decline in supply will hit primarily production and real GDP or will it lift prices adding to inflation fears? With ISM readings on production and pricing power both already quite high it seems likely that bottlenecks will result in price hikes – and profits – in the near term. However, price hike induced profits may again fail to spur hiring and investment if production is sapped by Japanese supply issues.
The current surge in crude oil prices to over $100 a barrel is reminiscent of spring 2008. Interestingly, on March 24th 2008, crude oil prices for the week averaged $104.23 almost exactly the same as the $104.00 close on March 25th, 2011. However, gasoline price this week have already risen to a national average for regular of $3.56 compared to only $3.26 back in the same week of 2008. Using normal seasonal trends, we expect gasoline prices to reach $4.06 on the fourth of July, rivaling the $4.11 reading in 2008. Back in 2008, crude oil prices kept rising to a peak of $142 not seasonally adjusted. Using normal seasonal trends, the current $104 will rise to $122 by late June. Many argue that the price hike this time around is not as bad as we have experienced it in the past. We suspect that it will still put a profound squeeze on the average consumer. Real wages are little changed from 2008 and relatively few of the 250 million cars in the fleet have been replaced as car sales have been running only an average of 12 million since the last oil spike.
Interestingly, ten year notes yielded 3.47% in the week of March 24th, 2008, almost exactly the same as the 3.44% close on the ten year rate this Friday. Back in 2008, that was a very modest bounce off of the 3.32% rate of the week before – which was the low point since the 1950s! This week, the 3.44% ten year note sits in the middle of a range that has persisted since the middle of December 2010, just off the recent low of 3.21% and down from a high of 3.72% in early February. Despite all the talk of accelerating inflation expectations, we seem to remain anchored at the lowest inflation outlook in the past fifty years despite some of the most virulent energy inflation. We see little reason for the Federal Reserve to alter policy in the near term with inflation and inflation expectations low and unemployment high – and uncertainty about the future direction of the economy still at peak levels.