Economic Rundown: Volume 68, Number 3

Economic data remained uneven this week with weakness in housing – which has been strong – and strength in the Philadelphia Fed Index – which has been weak.  Initial claims for unemployment plunged, offsetting last week’s spike, and the two week average was right on trend.  The Big Kahuna this week, retail sales, was up 0.4% — well below the 0.8% expectation – and core retail sales were up just 0.2% resulting in a new round of reductions in projected third quarter growth.  An unexpectedly large 0.5% rise in the CPI reflected the recent jump in gasoline prices, and the 0.2% rise in the core CPI left real retail sales effectively flat. Industrial production rose 0.3%, lifted by a 1.4% gain in autos.  Indeed, autos remain the dominant strength in the economy right now.  However, after averaging 15.4 million units at an annual rate in the first half, industry analysts still see 15.3-15.6 million as the target for the year.  Bottom line, we see the economy improving from the sluggish 1.0% pace of the past three quarters, but still below 2.5% in the second half of 2013 and far from the 3%+ path expected by the Federal Reserve.

 

Complacency is what we see most in the US economy.  Many businesses and households have adjusted to the new reality of slower growth, lower interest rates, and low inflation – and now appear more interested in maintaining that status quo, rather than increasing risk taking for faster growth.  In the equity market, we see low volume as the retail client has not returned.  Among businesses, there is less merger and acquisition than expected despite robust equities prices.  The level of IPOs and start-ups also remains low.  Weakness persists among small and medium businesses – despite a lack of competition from new entrants and adequate access to credit for expansion according to NFIB surveys.  Capital spending has been sluggish throughout the recovery, and businesses remain focused on cost control as revenue growth is limited.  In the consumer sector, we find a lack of inventory on housing market despite strong appreciation.  Household formation remains moribund despite record high affordability.  Consumers’ investment in durable goods, except autos, is soft as households are running down their stock of physical goods via depreciation in order to rebuild their balance sheets.  Even auto sales at 15.5 million reflect 13 million units of replacement and a 1% increase, due to population, in a 250 million unit fleet.  We see no signals that either business or households are breaking out of the range experienced over the past two years.  Indeed, much of the expectation for growth is that government drag will slow rather than the private sector pick up.  With government deficits still scheduled to shrink for the next two years, we see no break out in that sector either.

 

None of this suggests an imminent recession, but that is not the bogey right now.  The question is whether growth will be robust enough for the Federal Reserve to begin to taper quantitative easing in September as the majority of forecasters expect.  The economy is certainly strengthening from the 1% growth rate of the last three quarters, as anything less would suggest collapsing profits and the start of a recession.  However, the implied Federal Reserve target is 5% nominal growth starting in the third quarter.  The consensus at 2.5% real and 1.0% inflation would leave nominal growth below the 4% average of the past four years.

 

As St. Louis Federal Reserve President James Bullard pointed out at The Global Interdependence Center’s Jackson Hole Conference, the FOMC’s forecasts have been significantly too strong during this recovery.  Indeed, not only has the FOMC’s the central tendency been too high – even the lowest forecast among all Governors and Presidents was too high for the past two years.  The Fed is a model driven institution, and models built on post war economic experience, where risk takers bounced back strongly after recessions, do not catch the new post-Lehman conservatism.  What variable or variables should a modeler use to catch this difference – and how does one forecast them?  How do you incorporate as a new variable the change in the Fed’s balance sheet?  There is limited historical data and great difficulty in forecasting the future as there is experience or data on economic sensitivity to a reduction in central bank balance sheets – domestic or foreign.    An almost universal desire for stability – as reflected in this weekend’s outtakes from the G20 meeting – calls for incremental changes from the status quo rather than bold new policies.

 

Challenges for China

 

China announced real GDP growth of 7.5% in the second quarter compared to a year ago.  Using a quarter on quarter basis, growth for the second quarter was at a 7.0%, slightly stronger than the 6.6% announced for the prior quarter.  These measures all are consistent with the recently announced targets of the new administration, and confirm Finance Minister Lou Jiwei’s indication that somewhat slower than target growth would be acceptable.  However, they do not reflect the true dimensions of the slowdown in China.  China also reported that nominal GDP has risen just 8% from a year ago in the second quarter, implying a meager 0.5% inflation rate.  Based on our manipulation of the Chinese statistics to generate seasonally adjusted quarterly rates for nominal GDP and inflation, we see substantial deflation in the first half of 2013, and nominal growth of less than 5%!   This frighteningly low growth rate for China is consistent with estimates we have heard recently from multinational corporations and banks selling and lending into the Middle Kingdom.

Chinese PPI has been in decline for the past year, suggesting that the deflation in GDP data is accurate.  Remember that only 1/3 Chinese GDP is private consumption, so positive CPI readings do not necessarily translate into rising prices for total GDP.  However, the CPI/PPI spread in China argues for a severe profit squeeze on manufacturers due to labor costs, but strength in consumer spending – as reflected in continuing robust retail sales.  Chinese SOEs are not profit maximizers, so the real question is how long can the central government pump in money to support growth.  Meanwhile, private sector exporters in Guangdong Province, far and away the largest area for trade flows, indicate recent international activity is down 5% from a year ago – implying that driver for Chinese growth is domestic.  Service sectors, like restaurants and hotels, are under severe pressure due to the government crackdown on corruption.  About the only strong sector remaining is property – which the central government has been trying to rein in for the past four years without any signs of success.

 

We are skeptical that the new leadership will be able to navigate the economy through the current slowdown without disruptions to the global economy.  China has little experience with economic cycles and it is unlikely they will stick the landing.  Their last attempt at managing the cycle was the massive $1.4 trillion stimulus of 2009 that set off double digit inflation and wildly spiraling commodities prices and wealth inequality.  Once burned, their approach has been much more measured this time.  One threat to the success of upcoming policy maneuvers is the fact that face is so important in China, and conservatism is revered as a virtue.  Lower level employees typically do not take risks without direction.  It is safer to simply maintain the status quo.  Thus, the leadership must commit to the plan and set clear examples for the populous to follow.  In that vein, we hear a lot of political jawboning – with a heavy emphasis on the need for financial reform and growth of SMEs.  However, we also continue to see the central government and provinces announcing big investment projects – albeit increasingly directed at shortfalls, like medical care and pollution, as opposed to infrastructure.  What is not clear is substantial growth in the private sector – which still seems to revolve primarily around real estate as an investment vehicle.

 

Note that in a nation where the vast majority of economic activity is in the government sector, the private sector primarily serves the government as well.  This is abundantly clear in the leisure and hospitality sector in China where the corruption crackdown has undermined restaurant sales.  The bulk of middle class Chinese consumers either work for SOEs or sell to the middle class, which depends on the SOEs.  The Guangxi system in China introduces government into every step of private business.  Premier Li Keqiang is attempting to strip away layers of government red tape, but you can be sure his first several rounds will result in large numbers of regulations being removed without much fundamental change in behavior.  Virtually every successful business in China owes its prominence to strong government backing.  This is not a system that can change overnight to one driven by market demands.  In China, what the market demands most is direction from their leaders.

Economic data remained uneven this week with weakness in housing – which has been strong – and strength in the Philadelphia Fed Index – which has been weak.  Initial claims for unemployment plunged, offsetting last week’s spike, and the two week average was right on trend.  The Big Kahuna this week, retail sales, was up 0.4% — well below the 0.8% expectation – and core retail sales were up just 0.2% resulting in a new round of reductions in projected third quarter growth.  An unexpectedly large 0.5% rise in the CPI reflected the recent jump in gasoline prices, and the 0.2% rise in the core CPI left real retail sales effectively flat. Industrial production rose 0.3%, lifted by a 1.4% gain in autos.  Indeed, autos remain the dominant strength in the economy right now.  However, after averaging 15.4 million units at an annual rate in the first half, industry analysts still see 15.3-15.6 million as the target for the year.  Bottom line, we see the economy improving from the sluggish 1.0% pace of the past three quarters, but still below 2.5% in the second half of 2013 and far from the 3%+ path expected by the Federal Reserve.

 

Complacency is what we see most in the US economy.  Many businesses and households have adjusted to the new reality of slower growth, lower interest rates, and low inflation – and now appear more interested in maintaining that status quo, rather than increasing risk taking for faster growth.  In the equity market, we see low volume as the retail client has not returned.  Among businesses, there is less merger and acquisition than expected despite robust equities prices.  The level of IPOs and start-ups also remains low.  Weakness persists among small and medium businesses – despite a lack of competition from new entrants and adequate access to credit for expansion according to NFIB surveys.  Capital spending has been sluggish throughout the recovery, and businesses remain focused on cost control as revenue growth is limited.  In the consumer sector, we find a lack of inventory on housing market despite strong appreciation.  Household formation remains moribund despite record high affordability.  Consumers’ investment in durable goods, except autos, is soft as households are running down their stock of physical goods via depreciation in order to rebuild their balance sheets.  Even auto sales at 15.5 million reflect 13 million units of replacement and a 1% increase, due to population, in a 250 million unit fleet.  We see no signals that either business or households are breaking out of the range experienced over the past two years.  Indeed, much of the expectation for growth is that government drag will slow rather than the private sector pick up.  With government deficits still scheduled to shrink for the next two years, we see no break out in that sector either.

 

None of this suggests an imminent recession, but that is not the bogey right now.  The question is whether growth will be robust enough for the Federal Reserve to begin to taper quantitative easing in September as the majority of forecasters expect.  The economy is certainly strengthening from the 1% growth rate of the last three quarters, as anything less would suggest collapsing profits and the start of a recession.  However, the implied Federal Reserve target is 5% nominal growth starting in the third quarter.  The consensus at 2.5% real and 1.0% inflation would leave nominal growth below the 4% average of the past four years.

 

As St. Louis Federal Reserve President James Bullard pointed out at The Global Interdependence Center’s Jackson Hole Conference, the FOMC’s forecasts have been significantly too strong during this recovery.  Indeed, not only has the FOMC’s the central tendency been too high – even the lowest forecast among all Governors and Presidents was too high for the past two years.  The Fed is a model driven institution, and models built on post war economic experience, where risk takers bounced back strongly after recessions, do not catch the new post-Lehman conservatism.  What variable or variables should a modeler use to catch this difference – and how does one forecast them?  How do you incorporate as a new variable the change in the Fed’s balance sheet?  There is limited historical data and great difficulty in forecasting the future as there is experience or data on economic sensitivity to a reduction in central bank balance sheets – domestic or foreign.    An almost universal desire for stability – as reflected in this weekend’s outtakes from the G20 meeting – calls for incremental changes from the status quo rather than bold new policies.

 

Challenges for China

 

China announced real GDP growth of 7.5% in the second quarter compared to a year ago.  Using a quarter on quarter basis, growth for the second quarter was at a 7.0%, slightly stronger than the 6.6% announced for the prior quarter.  These measures all are consistent with the recently announced targets of the new administration, and confirm Finance Minister Lou Jiwei’s indication that somewhat slower than target growth would be acceptable.  However, they do not reflect the true dimensions of the slowdown in China.  China also reported that nominal GDP has risen just 8% from a year ago in the second quarter, implying a meager 0.5% inflation rate.  Based on our manipulation of the Chinese statistics to generate seasonally adjusted quarterly rates for nominal GDP and inflation, we see substantial deflation in the first half of 2013, and nominal growth of less than 5%!   This frighteningly low growth rate for China is consistent with estimates we have heard recently from multinational corporations and banks selling and lending into the Middle Kingdom.

Chinese PPI has been in decline for the past year, suggesting that the deflation in GDP data is accurate.  Remember that only 1/3 Chinese GDP is private consumption, so positive CPI readings do not necessarily translate into rising prices for total GDP.  However, the CPI/PPI spread in China argues for a severe profit squeeze on manufacturers due to labor costs, but strength in consumer spending – as reflected in continuing robust retail sales.  Chinese SOEs are not profit maximizers, so the real question is how long can the central government pump in money to support growth.  Meanwhile, private sector exporters in Guangdong Province, far and away the largest area for trade flows, indicate recent international activity is down 5% from a year ago – implying that driver for Chinese growth is domestic.  Service sectors, like restaurants and hotels, are under severe pressure due to the government crackdown on corruption.  About the only strong sector remaining is property – which the central government has been trying to rein in for the past four years without any signs of success.

 

We are skeptical that the new leadership will be able to navigate the economy through the current slowdown without disruptions to the global economy.  China has little experience with economic cycles and it is unlikely they will stick the landing.  Their last attempt at managing the cycle was the massive $1.4 trillion stimulus of 2009 that set off double digit inflation and wildly spiraling commodities prices and wealth inequality.  Once burned, their approach has been much more measured this time.  One threat to the success of upcoming policy maneuvers is the fact that face is so important in China, and conservatism is revered as a virtue.  Lower level employees typically do not take risks without direction.  It is safer to simply maintain the status quo.  Thus, the leadership must commit to the plan and set clear examples for the populous to follow.  In that vein, we hear a lot of political jawboning – with a heavy emphasis on the need for financial reform and growth of SMEs.  However, we also continue to see the central government and provinces announcing big investment projects – albeit increasingly directed at shortfalls, like medical care and pollution, as opposed to infrastructure.  What is not clear is substantial growth in the private sector – which still seems to revolve primarily around real estate as an investment vehicle.

 

Note that in a nation where the vast majority of economic activity is in the government sector, the private sector primarily serves the government as well.  This is abundantly clear in the leisure and hospitality sector in China where the corruption crackdown has undermined restaurant sales.  The bulk of middle class Chinese consumers either work for SOEs or sell to the middle class, which depends on the SOEs.  The Guangxi system in China introduces government into every step of private business.  Premier Li Keqiang is attempting to strip away layers of government red tape, but you can be sure his first several rounds will result in large numbers of regulations being removed without much fundamental change in behavior.  Virtually every successful business in China owes its prominence to strong government backing.  This is not a system that can change overnight to one driven by market demands.  In China, what the market demands most is direction from their leaders.

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