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The Economy Slows More Than Expected - Now What?

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
August 1, 2006

IN THIS ISSUE:

1.   GDP In The 2Q Was Well Below Expectations

2.   Are We Now Headed For A Recession?

3.   Is A Housing/Real Estate Bust Looming?

4.   The Bank Credit Analyst’s Latest Forecasts

5.   BCA: Stocks Should Rise Even If Profits Decline

6.  Conclusions: No Recession But More Volatile Markets

7.  The Latest Mid-term Election Survey & Analysis

Introduction

This week we will discuss several issues, the most important of which is the latest economic report released last Friday showing that the US economy slowed considerably more than most expected in the 2Q.  Meanwhile, the latest inflation reports continue to show that prices are rising at rates which are above the Fed’s supposed targets.  In the pages that follow, we will look at the latest GDP numbers, the inflation numbers and a host of other economic indicators to see if we should be preparing for a recession as some are now suggesting.

Everyone is speculating widely about what the Fed will do at the FOMC meeting next Tuesday in light of the latest weaker than expected GDP report.  What else is new?  Will the Fed stop hiking rates now that the economy is clearly slowing down?  Or will the inflation hawks at the Fed prevail and raise rates a couple more times, thus raising the odds of a recession?  Personally, I think the Fed has gone far enough and should NOT raise rates next Tuesday, but my bet is the Fed WILL raise rates one more time next week and then go on hold for a while.  We’ll discuss this below.

We will also look at the latest economic and market forecast from The Bank Credit Analyst in light of last week’s surprising GDP report.  As usual, BCA has a little different spin on the upcoming economic and market outlook than most analysts, and I think you’ll be especially interested in their views on the stock markets in light of the latest news on the economy.  (Hint: BCA is still positive on equities, even though hefty corporate profit margins are due to narrow.)

Finally, we will look at the latest state-by-state political surveys to see how things are shaping up for the mid-term elections in November.  The media would have us believe the Democrats will sweep in November and take over majority control of both the House and the Senate.  But the latest Zogby Interactive “Battleground States Poll” indicates that the Republicans will hold control of the Senate, and other polling data suggest the GOP will hold onto the House as well.

That’s a lot to cover in just a few pages, so let’s get right to it. 

GDP In The 2Q Was Well Below Expectations

[Editor’s Note: Before I get into the latest economic numbers, let me assure you that the liberal media will go ballistic with last Friday’s GDP report.  All year long, the media has portrayed the US economy as the worst in years, despite near-record growth of 5.6% in GDP in the 1Q, so you can only imagine how the libs will react to the latest disappointing report.]

The Commerce Department reported last week that 2Q Gross Domestic Product rose at an annual rate of only 2.5% following 5.6% in the 1Q.  The pre-report consensus was for a number in the 3-3.2% range, so the report on Friday came as quite a surprise.  The slower than expected growth in the 2Q was primarily due to trends in consumer spending, equipment and software purchases, exports and federal spending.  

Normally, a weaker than expected major report such as this one would be seen as bad news.  However, because there is so much concern over the Fed and higher interest rates, there was a general feeling of relief in most circles that the economy is finally giving the Fed some room to back off, at least for a while.

Yet while the economy is clearly slowing down, the latest inflation numbers did not cooperate.  The GDP Price Index (formerly the GDP Price Deflator) rose at an annual rate of 4.0% in the 2Q, up from 2.7% in the 1Q.  Excluding food and energy, the GDP Price Index still rose 2.9% in the 2Q.  This is still well above the Fed’s inflation target range of 2% for core prices.  The more widely followed Consumer Price Index was up 4.3% for the 12 months ended June.

So, while the weaker than expected GDP report was welcomed by many on the one hand, the naggingly higher than expected inflation numbers continue to be a problem, at least from the standpoint of Fed policy and interest rates.  We will discuss the Fed and the odds for what happens next a little later, but first let’s round-out the economic overview.

Are We Now Headed For A Recession?

While last week’s GDP report was weaker than expected, and while some are concerned that we are now on our way to a new recession later this year, the broader economic data do not bear that out at this point.  Despite the slowdown in GDP in the 2Q, consumer confidence has held steady over the last two months (June and July) as measured by the Consumer Confidence Index and the University of Michigan Consumer Sentiment Index.  Remember that consumer spending makes up over two-thirds of GDP.

Continuing on the consumer side, durable goods orders have risen respectably over the last two months.  Retail sales rose slightly in June (latest data) and are up 5.9% over June 2005 as well.  And the unemployment rate remained low in June at 4.6%.

On the manufacturing side, industrial production rose by a healthy 0.8% in June and was up 4.5% over the same period a year ago.  Factory orders rose a solid 3.1% in June, the fourth monthly increase in the last five months.  And capacity utilization (the factory operating rate) rose to 82.4% in June, up 2.1% over the same period last year.

These numbers and others do not suggest we are headed for a recession, at least anytime soon, barring some major surprise.  If we average the growth rates in the 1Q and the 2Q, we get an annualized GDP of 4.05% for the first half of the year.  That’s considerably better than the economy did in all of 2005 when it grew by 3.2%, and even marginally better than 2004 when GDP grew by 3.9%.  So for the time being, nothing suggests a recession is forthcoming.

Is A Housing/Real Estate Bust Looming?

Perhaps the greatest risk to the US economy at this point is the housing/real estate market.  At this point, it is clear that the housing bubble of recent years has peaked for this cycle, and further softening almost certainly lies ahead.  Much the same is true of real estate in general in most parts of the country.  The more common question on the minds of homeowners, real estate owners and investors is whether the housing/real estate markets are in for a major bust, or merely a cyclical retrenchment.

Obviously, this is a difficult question, but a major part of the answer lies in your overall economic outlook over the next year or two.  For example, if it is your view that the US economy is going into a recession later this year (perhaps a severe one as the gloom-and-doom crowd promises, as always), then I think you would be correct to assume that home prices and real estate in general are headed into the tank (ie – much, much lower).

We need only look to the recent past for some examples.  There have been two major housing down cycles in the last several decades – 1978 to 1982 and 1988 to 1992, both of which included economic recessions.  In the 1978-1982 downturn, the combined total of new and existing home sales plunged by 55%, in large part due to the severe recession.  In 1988-1992, when the recession was much milder, sales fell by 18%.  In the current cycle, sales of new and existing homes are down just under 9%.  Comparatively speaking, home prices have not fallen nearly as much as in the last two down cycles.  So, if you want to be bearish on home prices, maybe this is the statistic you should key on, in that by comparison to the previous two cycles, we could have a lot more to go.

On the other hand, if your outlook is more in line with that which I have suggested above (ie – no recession just ahead), then you should probably view the current softening in the housing/real estate market as more of a cyclical correction than a major bear market.  That would be my suggestion.  But at the same time, we should not forget that the housing boom of the last decade has far eclipsed anything we’ve ever seen before.  This has been possible due to a combination of the super-strong economy, more Americans working than ever before, falling interest/mortgage rates, creative financing, etc. 

As to the latter – creative financing – many people who have purchased homes in the last several years will not be able to keep them.  In fact, many people who should never have been able to qualify for mortgages have been defaulting on them for over a year now.  According to data from the Fed and Freddie Mac, residential mortgage delinquency rates began to rise in the first half of 2005 and have accelerated steadily ever since.  This trend will only get worse if interest rates continue to rise.  The housing bears and the gloom-and-doom crowd are quick to point this out.

But what the housing bears fail to recognize is that while one segment of the homeowner population will be defaulting on their loans, vastly greater numbers of Americans are enjoying the financial rewards of the huge appreciation in value of their homes over the last decade or longer.  Their personal balance sheets – including their home equity – are in the strongest position ever.  Secondly, as the economy slows down, interest rates should peak and turn at least modestly lower over the next 6-12 months.

The most likely scenario is that the current retrenchment in housing prices and sales is likely to last longer than in previous cycles, largely because the boom phase of the cycle was so long and overextended due to creative financing.  As a result, it will take longer to work off the excesses of the past several years.  Home prices are likely to soften further in most areas over the next year or so as the economy cools down for several more quarters.  But barring any major surprises, we are not likely looking at home prices falling by 30-50% as in some previous cycles.

BCA’s Latest Analysis & Forecasts

For the last several months, The Bank Credit Analyst has been predicting that the US economy would soften in the second half of the year, and that we would see several quarters of “below-trend” growth in GDP.  Below-trend in this case means something less than 3% in GDP.  As noted above, we already have confirmation of this forecast since GDP softened to an annual growth rate of 2.5% in the 2Q.  BCA continues to forecast another 2-3 quarters of below-trend growth lasting into 2007.

BCA continues to maintain that a recession is not likely in the next year, barring some major surprise.  The editors at BCA believe that as the economy shows clearer signs of slowing down, inflation will cool and interest rates will peak.  As they have maintained all year, they do not believe the US economy is headed for a recession over the next year for a variety of underlying reasons and statistics, which are too detailed to go into here due to space limitations.

On a multi-year basis, BCA continues to believe the US remains in a long-term, technology-led economic “long-wave upturn,” which began in the mid-1990s.  As predicted by BCA back in the 1990s, this cycle has been highlighted by stronger than expected growth on the upside and shallower and shorter periods on the downside.  BCA still maintains that we have at least several more years to go in this long-wave cycle before we hit a major recession and a potential financial crisis.

Back to the present, with regard to Fed policy, the BCA editors believe the Fed has already gone far enough, and should use the latest weaker than expected GDP report as a reason not to raise rates again at the August 8 FOMC meeting.  BCA acknowledges, however, that the FOMC may feel compelled to hike rates one more time, but they are adamant that an August hike should be the last one.  They say: “The Fed’s forecast that the economy is headed for a period of below-trend growth is an acknowledgement that Fed policy has tightened by enough.”

As usual, the editors at BCA offer forecasts and advice on the major investment markets in their latest August report which became available online to subscribers last Friday.  Let’s start with the equity markets, since this is the area of most interest to investors, and because BCA offers some very interesting analysis.

After churning sideways to higher in the first several months of the year, the major equity indexes turned sharply lower in mid-May.  As always when there is a market reversal (if we can call it that), there are a variety of reasons cited as the cause.  In the latest case, the two main culprits seem to be the outlook for a slowdown in the economy and, more importantly as it pertains to equities, the likelihood that corporate profits will shrink, perhaps significantly, over the next 6-12 months.  But here, too, BCA suggests this isn’t all bad news and recommends that investors should be looking for buying opportunities in equities.  Let me explain.

BCA: Stocks Should Rise Even If Profits Decline

Many market analysts who have turned bearish since the equity downturn began in May point to statistics showing that US corporate profits, as a share of overall GDP, are at post-WWII highs.  The presumption is that with profits at these levels, and with the economy on track to slow down, then there is nowhere for profits to go but down.  In following, if profits are set to decline, then the broad markets are almost certain to follow.  Thus, the increasingly bearish mood of late.

But as usual, BCA has a different view of the equity markets.  BCA begins its analysis by examining current corporate profit levels, not as a percentage of overall GDP, but as a percentage of corporate sector GDP.  There is a big difference between corporate sector GDP and overall GDP, which includes consumer and government spending, exports, etc.

As a percentage of corporate sector GDP, current profit margins are still well below their historical highs seen in the 1950s and 1960s when the US economy was in a similar long-wave upturn.  Based on this historical perspective, BCA believes that corporate profits will hold up surprisingly well even as the economy continues in a relatively slow period over the next 6-12 months.  BCA notes the following:

“The performance of the U.S. corporate sector has been spectacular during the last several years. There has been a record of 16 consecutive quarters of double-digit annual growth in S&P 500 operating earnings, with average gains of 20%. Analysts expect 12% annual earnings growth to be reported for the second quarter of this year, and 14.5% for the second half.

Improved profitability has allowed companies to rebuild balance sheets with the result that the corporate sector’s overall financial position is the best it has been in a long time… Moreover, it is very much a global phenomenon, with buoyant earnings in all the major regions. This is consistent with our view that a technology-led long-wave upturn has been in place in the U.S. during the last decade, and other regions are now joining in.” 

So it is clear that BCA is not among the current Wall Street crowd which is predicting that corporate profits will fall off a cliff now that it is clear the US economy is in a slowdown. Even if profit margins should decline later this year or in the first half of next year, BCA points out how such a decline could actually be positive for equities:

“At face value, a decline in profit margins would seem unambiguously bearish for stocks. However, stocks have performed remarkably well during periods of margin compression over the last 20 years or so. This is because lower inflation and interest rates have boosted market multiples, providing a powerful offset to weaker earnings.”

BCA concludes that US equities are likely to deliver attractive returns, relative to other traditional investments, over the next several years in the context of their continued long-wave upturn economic forecast.  BCA continues to recommend slightly above-average weightings of equities, and the editors expect to advise moving to a fully-invested position in the next couple of months when it is clear that the Fed has put the rate hiking cycle on hold.

I should point out that the editors at BCA are not naïve in their optimism and recognize that the crux of their forecast is the assumption that inflation will recede as the economy continues to slow down.  If that doesn’t happen, and inflation continues to rise, then the editors readily admit that their forecast will be wrong.  Of course, it rarely pays to bet against BCA.

[Editor’s Note:  Please keep in mind that whenever I attempt to summarize BCA’s views in these pages, my observations represent only a very limited overview of their analysis.  It is most difficult to summarize 40 or so pages of discussion, analysis, charts and recommendations in only a few paragraphs.  This is why I encourage readers to subscribe to BCA on your own.  While the basic monthly service is not cheap, it is more than worth the subscription price.  For more information, go to www.bcaresearch.com.] 

Conclusions – No Recession But More Volatile Markets
    
(followed by an update on the Mid-term Elections)

We can stop wondering now – the economy has clearly slowed down, as evidenced by last Friday’s GDP report showing growth of only 2.5% (annual rate) in the 2Q, which was well below pre-report estimates.  Initially, stocks and bonds welcomed the report showing that the economy has slowed down, taking that as a signal that the Fed would finally take a breather.  Yet the inflation numbers in the latest GDP report and the CPI do not leave investors with a similar sense of comfort, and it remains to be seen what the Fed will do at the FOMC policy meeting next Tuesday.

The latest GDP report also sparked a new wave of recession forecasts.  What else is new?  Let us keep in mind that 2.5% growth in GDP does not equal a recession, and US economic growth has averaged just over 4% for the first half of the year.  In addition to the GDP report last Friday, the latest economic reports do not support the case for a recession anytime soon as discussed above.  BCA agrees.

BCA also presents a case this month for why the major equity markets could do reasonably well in the next couple of years, even in the face of a slower US economy, and even if corporate profit margins shrink modestly.  While I agree with BCA’s analysis (as usual), I would argue that the stock markets will continue to be very volatile in the months ahead, with some large moves in both directions, which will remain unsettling to most investors.

In addition to domestic issues such as Fed policy and inflation, the equity (and bond) markets are likely to remain quite volatile due to various unsettling international issues such as oil prices, the war in the Middle East, terrorism, etc.  Any of these issues could throw a wrench into the mix at any time.  I hope BCA is correct that the stock markets will deliver respectable returns over the next couple of years as the US economy advances in their “long-wave upturn” cycle.  But the various market risks continue to mount as BCA readily admits. 

This is why I continually advocate professional money managers who use active management strategies which include the flexibility to exit the markets and move to cash (partially or fully) as need be, and/or to “hedge” long positions should major negative developments occur.

Likewise, if you invest primarily in mutual funds, I suggest you check out our “Absolute Return Portfolios” which are made up of carefully selected mutual funds that are designed to deliver positive returns in various types of market environments.  We have three different Absolute Return Portfolios of mutual funds which range from moderate to aggressive in terms of risk/reward profiles.  The minimum investment is only $10,000 to invest in any one of our Absolute Return Portfolios.

If you have questions about any of the investment programs we offer at my company, or if you have questions about your existing portfolio, you can always e-mail us at mail@profutures.com or give one of our Investor Representatives a call at 800-348-3601.  We are happy to talk with you free of charge with no obligation whatsoever.

The Latest Mid-term Election Survey & Analysis

It’s been several months since I’ve discussed politics at any length, partly because I have been generally fed-up with the political scene for the last year or so, and partly because there hasn’t been a whole lot of substance on which to comment.  Yet with the mid-term elections drawing near, I suppose it’s time to start paying a little closer attention.

For much of the last year, the media has doted on President Bush’s paltry job approval numbers and various polls showing that the Democrats are likely to gain seats in both the House and the Senate in November.  The media would have us believe that the Democrats will win enough seats to retake majority control of both houses of Congress in the mid-term elections.  While things don’t look good for the Republicans in the fall, the latest comprehensive political poll has some interesting findings.

One of the most widely followed political polls is the so-called “Battleground States Poll” conducted by Zogby Interactive.  Zogby conducts in-depth polling in those states where the races are expected to be close, or in which incumbents currently look to be unseated.  The latest Zogby poll results were released on July 24 and covered contested Senate and gubernatorial races this coming November in the following states: AZ, AK, CA, CO, FL, GA, IL, IA, MA, MD, MI, MN, NV, NY, OH, OR, PA, TX and WI.      

Let’s start with the Senate.  Contrary to what we hear in the media, the Republicans remain on-track to hold a narrow majority in the Senate according to the latest Zogby polls in 17 of the 19 Battleground states.  The latest results were roughly unchanged from the results of the most recent Zogby polls in June.  Following the latest polls in July, Zogby concludes: “Taking into account the 40 Republican seats not up for re-election and seven that weren't included in the polling because Republicans are expected to win handily, Republicans would hold 52 seats [in the Senate].”

As for the gubernatorial races, the Democrats’ chances look much better.  “Taking into account governorships that aren't up for re-election and those that weren't included in the polling because the incumbent party is widely expected to remain in power, the Democrats would hold 28 governorships and Republicans 20, if the results on Election Day match the latest polling.”  Thus, the balance of power at the gubernatorial level could indeed switch back to the Democrats in November based on the latest Zogby polling data.

In its latest round of polling, Zogby did not canvas the many contested races in the House of Representatives this fall, but several other polling services have done so.  In the House, as in the Senate and state governorships, the Democrats look to gain seats.  Looking at various polls, I would sum up the current outlook for the House mid-term elections this fall as follows.

Based on the so-called “Generic Ballot” and other polls, if the elections for the House of Representatives were held today, after examining the competitive races, the Democrats would gain seven seats, the GOP would lose six seats, and the Independents would lose one.

If the election were to go that way, the House in 2007 would be: 226 Republican, 209 Democrat and 0 Independent.  Again, this is based on the current outlook and the latest polling data, which we all know can change.  Also, there are still numerous seats on the GOP side that could shift toward the Democrats between now and November.  Even so, it seems unlikely that the Democrats will be able to take majority control of the House in the mid-term elections.

While things could change, for now it looks like the Republicans will hold the Senate and the House in November, while the Democrats are likely to gain the edge in governorships.  While the Democrats look to gain seats all the way around, it will not be the overthrow the media had hoped for.  Things can change, of course, so we’ll revisit the political scene again in the months ahead.  

Very best regards,

Gary D. Halbert

 

SPECIAL ARTICLES:

Why the U.S. won’t face the truth in the Middle East (a very good read).
http://www.realclearpolitics.com/articles/2006/08/irans_strategy_is_crudely_obvi.html

The consequences of an Israeli defeat would be ugly.
http://www.opinionjournal.com/editorial/feature.html?id=110008735

Whose side is the New York Times On?  An Endorsement of Defeat
http://www.investors.com/editorial/IBDArticles.asp?artsec=20&artnum=1&issue=200607


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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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