Volume 62, Number 11
It has been our position that the surge in economic activity during the December to February period was enhanced by — indeed, largely caused by — extremely mild winter weather. Thus, as we work our way through March, the key question is does new data bear out that view – or could we be wrong! So far we still see the evidence as suggesting weather was a major factor and that growth in the first quarter, even with the mild weather, about 2%, coming off of a stronger quarter unaided by weather. We see no reason yet to ramp up our second quarter expectations of 2.25% growth or to get excited about the second half. Many analysts see a steady improvement through the year, especially as we move into the second half of the year where some expectations are north of 3%. We believe that concern about how the fiscal atom bomb – the combined effects of the Bush tax cuts and payroll tax holiday expiring, plus the sequester and Obamacare beginning – will lead to more caution, unless the election results are far clearer than they are now. The assumption that it will all work out is very hard to believe given that this mess was created as the solution to the last impasse between Democrats and Republicans. Barring a clear mandate – like either party winning a majority in both chambers and the Presidency – we expect the resolution process of the fiscal atom bomb will remain contentious and messy. Even the most optimistic estimates expect a 3/4% drag on GDP in the first quarter of 2013 – annualized that is -3%, suggesting reported negative real GDP growth for at least that quarter. We expect markets will begin discounting the darker possibilities as part of the process of potentially leading to a political solution.
The Early Evidence on Seasonality
Initial claims for unemployment, the Philadelphia Federal Reserve report and the data for February industrial production all reinforce our view that weather played a large role in the economic uptick. Initial claims for unemployment have flattened out just north of 150,000 over the past six weeks, ending a steady downtrend during the weather effect. True, they have not turned higher, which would indicate the start of a payback, so we expect 2.25% growth for the first quarter rather than less than 2% as we did earlier. However, that is not enough growth to justify recent hiring – suggesting the first quarter may have produced consumer income, but no productivity or profits. Unless consumers leverage that income, the expansion will settle back to a muddle through soon.
The Philadelphia Fed report was solid in the headline, but the details showed considerable weakness. Unlike the national ISM, the headline number in the Philadelphia Fed report is from a separate question, not a weighted average of the sub-categories. So although the headline rose from 10.2 to 12.5, the closely watched new orders sector fell sharply from 11.7 to 3.3. Shipments were also much weaker, inventories were higher, the speed of vendor deliveries was faster and unfilled orders fell. That all sounds to us like the order pipeline was emptied out and fewer new orders were posted because customers’ were already comfortable. True, new orders were still a small positive, so there was no payback after the weather – please, see the paragraph above.
Finally, industrial production in February was flat, with the manufacturing sector rising just 0.3% after an upwardly revised 1.1% gain in January. The lack of a rebound in utility use after two very depressed months in December and January indicates that weather was still at work during February. Still, factory output didn’t benefit from continued mild weather having already swelled in December and January. As we discussed last month, big declines in utility use during the winter are consistent with spikes in factory output as plants put in extra hours. The average 0.7% gain in manufacturing output in January and February translates into a 4.2% annualized rate once we deduct 0.4% each month for the weather effect. This is solid growth, lifted by the surge in car production — not only from mild weather, but from the rebuild after the Japanese quake a year ago. Again, there is nothing in the data to suggest a payback, but also nothing that suggests the winter surge was a sustainable advance. If real GDP growth cools back down to a 2.25% muddle through, employment gains will be far more modest going forward.
On Rates and Home Prices
Now that the risk of a European Lehman like decline has been taken off the table by the three year Long Term Refinancing Operations (LTROs), investors are creeping back out the risk curve and abandoning long term Treasuries. Ten year note rates have risen sharply over the past month, to 2.30% as of Friday, up from 1.80% as recently as January 31st. So far the rise in Treasury rates has had a limited impact on other long term rates since spreads have narrowed as investors returned to risk-on positions. Nevertheless, we remain concerned that the combination of higher ten year notes and an increased desire by banks to move foreclosed properties off their balance sheets will continue to put downward pressure on home values. The Federal Reserve’s recent strict stress test revealed that most of the top 19 banks would make it through a very severe downturn, but the similar characteristic in the four banks that failed was there large residential real estate portfolios with a concentration in risky states. Running the stress tests on the thousands of smaller banks would have revealed that a far larger percentage of them (well over the 20% failure in big banks) would have failed for the same reasons. Big banks, with improving commercial real estate portfolios and exposure to the corporate markets, have been able to write down their residential losses far more aggressively than small banks. Renewed problems in home prices would likely keep the small lenders out of the new loan business – a boon for the big guys, but a significant problem for small local borrowers.
We have heard the argument untold times that a rise in mortgage rates would actually be good for the markets as it would move the fence sitters into action. This has rarely been an accurate observation historically, and never for more than a month. Econ 101 teaches – correctly – that a higher price for credit reduces the demand for credit sensitive assets. The only good news for the housing markets is that if higher rates and increased foreclosures push down home prices once more, there will be more cash buyers waiting to pounce now that the European Lehman is off the table. Moving credit from weak hands to strong hands is always a good thing for the length and strength of a recovery. However, we remain wary that the size of the foreclosure portfolio is still huge (well over two year’s absorption even at peak household formation), that risk taking will lift new housing activity exacerbating the problem for the banks, and that higher rates will limit non-investor buying. Investors maybe testing the waters, but we expect it will take at least a couple of years of home prices rising faster than mortgage rates before the consumer comes back in a big way.
Another Trick of the Invisible Hand
We noted a couple of weeks ago that with free and open markets, policy differentials between developed countries appear to be negated over long periods of time by the invisible hand shifting economic activity to lower cost regions resulting in similar long term growth despite short term policy wins or losses. This week, we look at another data set, originally published by Emmanuel Saez and Thomas Piketty and updated each year by Saez, which reports on income concentration. The data shows an alarming increase in the share of income going to the top 1% of income earners over the past thirty years (basically since the Reagan tax cuts), returning this measure to the peaks last seen in the Great Depression. Put another way, the data shows that average incomes for those in the bottom 90% of the income distribution have seen no growth in real spending power since 1973 (actually -11%), while the top 10% of tax filers have seen incomes grow 63%!
However, on closer examination, we believe the data shows that regardless of top marginal tax rates, after tax shares of income are very stable over time – another trick of the incredible invisible hand as it re-redistributes income after the government does its best or worst. The key is to realize that the Saez data is based on pre-tax adjusted gross incomes from tax returns. An increasingly large source of income for the bottom 90% of America is transfer payments, which are often non-taxable or unreported because households receiving them are below the taxable threshold. We make two assumptions and adjustments to the original data: 1) we assume a flat tax rate based on the rate calculated from all taxes (including FICA from employers and employees) over wages and salaries, proprietor’s income, dividends and interest from the NIPA accounts; 2) We assume that all transfer payments go to the bottom 90% of tax filers by income. Neither assumption is perfect, but they will suffice to a first approximation. The result is a far less uneven performance between the top and bottom of the income scale. The high income earners still outperform since 1959, but that would be altered by using a more accurately calculated progressive tax rate.
Bottom line, we see this as another example of the power of the invisible hand. Since 1982, lower marginal tax rates on high income taxpayers have effectively raised the cost of the compensation they pay to their employees. Moreover, very low taxes on capital gains and dividends have been a strong incentive for businesses to reduce compensation and boost profits. Over time, businesses have significantly reduced the share of income in GDP paid as wages and salaries. The Saez data has a high correlation with wages and salaries in GDP which confirms this trend. Meanwhile, as the Saez data shows the share of taxes paid by the top ten percent has increased (even without progressivity) due to the higher share of pre-tax income that they earn. However, more of those taxes have in turn been used to fund the rise in transfer payments, supporting consumer spending power as a share of GDP. Increased lending from high income households to lower income households has also occurred – and at lower and lower interest rates. As a result, after tax shares of income have changed relatively little since 1959, despite wide fluctuation in the top marginal tax rate. The interaction of political and market forces we know as the invisible hand works to protect the status quo (the existing economic equilibrium).
What appear to be significant changes are often less dramatic once we allow for compensating adjustments throughout the economic system. So if tax rates rise after the expiration of the Bush tax cuts, what offsetting adjustments will employers and government take? Will the surge in revenues to the Treasury be paid back out to reduce planned cuts due to the sequester? Or will higher taxes on those below $250,000 be offset by a permanent payroll tax holiday? Will higher tax rates, especially on dividends, capital gains, and carried interest lead to increased corporate benefits packages and less income? Will resource efficiency fall, as higher tax rates effectively reduce the after tax cost of inputs? Bottom line, the invisible hand will not simply stand still after so dramatic a policy change as the upcoming fiscal atomic bomb – and it will take some thinking ahead and out of the box to be prepared for both the initial impact and the reaction. Forewarned is forearmed.