Investors were already in a bullish mood and there is nothing in the employment report or ISM for manufacturing that will deter them. Forget the bearish GDP report, which now will more than likely be revised higher. The reality is that the Federal Reserve’s expansive monetary policy is trumping the negatives from fiscal policy. Indeed, the massive $300 billion in special dividends paid in November and December to beat the tax hikes have provided more stimulus for high end spenders than the $60 billion tax hike will take away. There is still a lot of bad news out there, but increasingly there are signs of optimism – strong signs – that offset them and add to the bullish sentiment. The sequester is the next hurdle for the optimistic markets – and it will fall on March 1st just as the next ISM reading becomes available (the employment report is delayed a week until March 8th.) We feel we are less bullish than the current consensus, but are by no means bearish. We see continued and strengthening growth in 2013 and 2014 with the next cycle ending mistake likely to develop from Chinese excesses out at the edge of our two year horizon. That said, there are considerable conflicting forces working on the economy that should keep it climbing a wall of worry. In our letter today, we will try and elucidate the key forces in play and how they may balance.
Looking at the GDP report we see the economy struggling to maintain the 4% nominal growth threshold that the Federal Reserve has tacitly been targeting, missing to the low side on both 2% real growth and the 2% inflation. Over the past three quarters, nominal growth has slipped to a 3.1% average annual rate, from a steady 4.1% growth rate in the previous nine quarters. The solution is the new more aggressive quantitative easing, which we suspect will not be tempered until it is clear that 4% or even higher nominal growth can be maintained. In the Fed’s eyes (certainly in Chairman Bernanke’s) the one fatal error that must be avoided is making the 1937 mistake of tightening monetary and fiscal policy simultaneously and prematurely. Fed hawks, like President Bullard today, may call for an end to QE sooner than currently advertised, but we expect no wavering of commitment from the Chairman or his replacement next year.
In many ways, the -0.1% real GDP growth and equally shocking 0.6% deflator reported in the fourth quarter were offsets to unexpected strength in the third quarter. Much of the see-saw was caused by a boom in inventory building in the third quarter which added 0.7% to real growth and an offsetting slowdown in the fourth, which subtracted 1.2%. The -22% annualized decline in military spending in the fourth quarter has also attracted a lot of attention. However, that was partially an offset to the 13% rise in fiscal year end spending for defense in the third quarter. The average of the two quarters was virtually flat to the level of defense spending in the first half of the year. There is no doubt that military outlays will continue to fall in 2013 and beyond as they are one of the main targets of the sequester and future planned cuts. Indeed, it appears the drag from the state and local sector on overall growth is now being replaced by a drag from the federal government sector. The private sector continues to grow at a roughly 3% annual rate with the decline in the 20% of the economy represented by direct government spending (as opposed to transfers) holding down overall growth by roughly 1%. We do not expect this to change any time soon.
Indeed, the most likely scenario for future government spending is that the full force of the sequester falls on the economy on March 1st resulting in roughly $100 billion in annualized cuts – all of which have to be absorbed in the second half of fiscal 2013 via across the board reductions in all non-exempt departments. The House Republicans, who now control the debate, are effectively reversing President Obama’s strategy on taxes – where he said taxes are going to rise anyway as a course of existing law so why not vote for a tax cut for all but the highest income earners. Now spending will be cut dramatically as a matter of law, so why not trade spending cuts on entitlements in the distant future (beyond the next election) for more balanced and limited cuts today. Moreover, by allowing the sequester to fall, Senate Democrats will be incentivized to pass a budget, rather than a continuing resolution that would maintain the sequester’s across the board cuts instead of allocating them more efficiently among departments. The optimistic markets will have to deal with increasing discussion about the depth and effect of the sequester over the next four weeks. The more the markets ignore the sequester, the more likely politicians are to let the likely battle over tax hikes versus spending cuts rage on and on.
The Peril for Profits
Some stock indexes are already at or above all-time highs on optimism over earnings and multiples. Yet, profit margins were already near record levels in the third quarter, and it is tough to see how they were not savaged in the fourth quarter given very limited nominal GDP growth and hefty hiring and wage increases. Over the past four months, private sector payrolls have increased an average of 210,000 a month, or at a 2.3% annual rate, while average hourly earnings are up at a 2.6% annual rate. We guesstimate that GDP based profits fell at a -22% annual rate in the fourth quarter after rising at a 15% annual rate in the third. The average for domestic profits in the second half was virtually flat to the first half of 2012. Now, corporate America has fortress balance sheets and can afford to hire for quite some time while running down margins, but the question is will they? We expect that either the payroll data are too strong or the GDP data are too weak (maybe both) and revisions will narrow the gap. However, it still looks to us like profits are more likely to begin a slow erosion over the next two years as tighter labor markets eat into earning power.
Yes, we realize that the unemployment rate rose to 7.9% and that there are a bevy of underemployed, unemployed and out of the workforce bodies to put back to work. However, wages are rising, because for skilled positions labor is already becoming scarce. Much of the unemployment is permanent, in the sense that older less skilled workers will never effectively be retrained. Rather, they will either move to disability, retirement, or lower pay jobs. Those exiting the workforce are doing so to gain skills at college or because they don’t have skills that are rewarded with higher wages. It will be some time before the college attendees are available to the market at the desired skill level and we do not believe firms will be bribing them out of college (the way tech firms did in the late 1990s) any time soon. So skilled labor should see rising wages for the next couple of years – and firms will pay it as long as profits are rising albeit at a slower rate and with narrower margins.
One signal that profits are slowing is the ebbing of capital investment. Optimists are fixated on the rebound in the housing industry — a warranted optimism since it signals improved bank balance sheets and an easing of lending standards. However, while housing has rebounded to double digit growth rates, the equally large nonresidential construction sector has slowed from double digit growth to no growth for the past three quarters. Meanwhile, the much larger plant and equipment sector has seen growth erode almost monotonically, as stimulus and initially exceptional profit growth has slowed. Durable goods orders for non-defense capital goods excluding aircraft have been below year ago levels for the past six months and are trying to recover to zero. Consumer durable goods orders are nearing zero. Capital spending is the driver of economic growth, as it represents income to suppliers (including labor) without any immediate increase in supply. In essence, the investor is fattening everyone else’s profit margins while awaiting his ship coming in. If successful, this leads to more capital spending and a sustained cycle. If unsuccessful— that is unprofitable – capital spending ebbs and the cycle ends. It is not by accident that profits and the investment cycle are closely linked. They are the classic chicken and the egg.