On The Economy, The Fed & President Obama

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
July 29, 2008

IN THIS ISSUE:

1. Economy Holding Up Better Than Expected

2. Consumer Spending Remains Strong

3. The Fed In A Policy Box

4. Obama Acts As If He’s Already The President

5. John McCain’s Electoral Mountain

6. The Vice Presidential Sweepstakes

Introduction

If you talk to people on the street just about anywhere in the US, you find there is a broad consensus that the US economy is well into a recession at this point. Yet the US economy is holding up better than expected. 1Q GDP was revised upward once again in the final report at the end of June. This Thursday, we get the Commerce Department’s first estimate of 2Q GDP, and the pre-report consensus may surprise you. We will look at this and more economic indicators below.

Meanwhile, the Federal Reserve finds itself in an increasingly uncomfortable position. It has repeatedly lowered short-term interest rates over the last 12-18 months in an effort to combat the negative consequences of the housing slump, the sub-prime mortgage crisis and the resulting credit crunch. In recent months, however, even with the economy slowing down, inflation is on the rise. Now the Fed is in a dilemma – keep rates low to help the economy or raise rates to head off inflation and risk a potentially serious recession later on. We will discuss this in detail below.

Finally, we take a look at the presidential race and my latest thoughts about Barack Obama who is acting like he is already the president-elect, just waiting to occupy the White House in January. This man has to be the most arrogant presidential candidate in my adult lifetime. This would seem surprising given that his political and policy positions are extremely liberal and his background is suspect. Despite that, he may well be our next president.

My Obama misgivings aside, we will look at the political landscape as it seems to stand now – which states are likely to go to Obama and which are likely to go to McCain – and most importantly, the “battleground states” that could still tip either way. This should be a lively discussion all the way around, so let’s jump in.

Economy Holding Up Better Than Expected

Whether you are a conservative, a liberal or somewhere in between, I trust you realize that the Democrats and their accomplices in the media want you to believe that the US economy is in a serious recession and, of course, it is all the fault of President Bush. Likewise, they want you to believe that soaring oil, gasoline and energy prices are the direct result of Bush and Cheney and Big Oil lining their pockets at our expense.

There is no debate on whether the US economy is in a slump – we can all agree on that. Yet the US economy is holding up better than even I have expected in light of the housing slump and the credit crisis. But you will not hear this in the mainstream media. They want the American people in a foul mood, at least until after the election. Despite that, let’s look at the latest economic reports, and you can decide for yourself. Here we go.

We start with the latest figures on Gross Domestic Product, the bellwether indicator of the trend in the economy. In its advance report, the Commerce Department estimated 1Q GDP at an anemic +0.6% annual rate of growth. In its second report, the government raised its GDP estimate to +0.9% for the 1Q. And in its final report in late June, the Commerce Department raised its final 1Q GDP number to +1.0%.

What, you didn’t hear this reported in the media? Not surprising. +1.0% is nowhere near recession levels. So, what is likely in store for the 2Q? The Commerce Department’s first estimate of 2Q GDP will be released this Thursday (July 31). Remember that most analysts, your editor included, have previously predicted that GDP would fall into negative growth territory in the 2Q of this year.

But the pre-report estimates suggest yet another surprise – GDP may have outperformed yet again in the 2Q ended June 30. The consensus estimate is that 2Q GDP rose 1.8%. Where is that recession, may I ask? Here are some of the pre-report estimates on 2Q GDP. Morgan Stanley estimates that 2Q GDP rose 2.2%, well above the consensus estimate. Another source I follow, Macroeconomic Advisers (www.macroadvisers.com), now predicts that 2Q GDP will come in at a surprising +2.6%. If so, that will be another big surprise.

Macroeconomic Advisors also predicts that the US economy will grow by 1.4% in the 3Q. I don’t know if they will be correct, but if they are remotely in the ballpark, the media’s predictions of a recession this year are out the window.

The point is, we are not in a recession now, as defined by two consecutive quarters of negative GDP. Certainly, there are parts of the US that are experiencing a recession in terms of job losses and the drop in home values. Yet there are other parts of the country where the economy remains strong and home prices and sales remain vibrant, such as where I live in Austin, Texas.

Consumer Spending Remains Strong

The GDP numbers simply do not support arguments that we are in a recession. But what about other reports? Let’s quickly go through the list of recent economic reports. Let me warn you in advance that more of the recent reports have been positive than negative. I’m sure this will come as a surprise, based on what you hear in the media.

The Index of Leading Economic Indicators (LEI), one of my favorite reports, was down –0.1% for June, following rises of a similar amount in April and May. FYI, the LEI has not moved more than 0.2% either way since the first of the year, which is an indication of an economy that is essentially directionless, but not headed into a recession.

It is widely agreed that consumer spending makes up apprx. 70% of GDP. Admittedly, continued strong consumer spending has astounded not only me but most other analysts in the marketplace for quite a while now. The latest data bear this out. Retail sales were up 0.1% in June, following a rise of 0.8% in May. These gains over the last two months came despite a continued drop in consumer confidence.

As I have pointed out often over the last year, US consumers continue to spend despite the drop in confidence and rising consumer debt levels. Several readers have asked me to explain this phenomenon. I have several theories I could advance, but space does not permit, so here is my short answer.

The media has blatantly contributed to the plunge in consumer confidence, but that has not translated into a nationwide plunge in jobs. The labor markets continue to be relatively firm. The unemployment rate remains historically low at 5.5%, although I expect it to rise to 5.6-5.7% for July. Meanwhile, personal income has continued to go up month after month. So most Americans are doing OK in their jobs, and they continue to spend on the things we all spend our money on, which keeps the economy from falling into a recession.

Other Economic Indicators Are Mixed

Here we go with the other recent reports. First and foremost, consumer confidence continues to plunge month after month. Yet consumer spending remains firm as discussed above. Take retail sales, for example. Retail sales rose 0.1% in June following a surprising rise of 0.8% in May. According to the Commerce Department, personal consumption expenditures rose 1.1% in the 1Q, to the surprise of many. Personal spending rose another 0.8% in May according to the latest report. Translation: the economy is in a slump, but it is a minor one and most consumers have not substantially changed their lifestyles – at least not yet.

The latest durable goods orders report for June released last Friday was significantly stronger than expected, rising 0.8% when the consensus was for a decline of 0.3%. The Commerce Department also revised its May durable goods report from a negative to +0.1%. Durable goods are generally long-lasting, higher priced items.

In other reports, industrial production rose 0.5% in June, following a decline of 0.2% in May. The ISM manufacturing index rose modestly to 50.2 in June from 49.6 in May. On the other side, the unemployment rate remained at 5.5% in June. Advance reports suggest the unemployment rate may rise to near 6% by the end of this year.

On the housing front, most reports remain negative, although a few indicators suggest the worst may be over. For example, housing starts and new building permits actually rose modestly in June. Yet sales of new and existing homes continued to fall. Pending home sales fell in May (latest data available), which is good, but is hardly a trend. It remains to be seen what happens just ahead with home prices, but it would seem that a bottom on the national level may finally be in sight by the end of this year.

On the inflation front, indicators are turning higher, or so it would seem. The Consumer Price Index for June was up 1.1% year over year, and the “core” rate was up 0.3%. The Producer Price Index (wholesale prices) was up for June 1.8%, and the core rate was up 0.2%, minus food and energy.

It is increasingly hard to separate the headline inflation rates from the ‘core’ rates which exclude food and energy. It will be interesting to see how the government adapts its inflation reports in coming months to reflect this changing dynamic, if in fact they do.

The Fed In A Policy Box

Fed Chairman Ben Bernanke and his fellow members of the Fed Open Market Committee (FOMC) that sets interest rates are becoming increasingly concerned about rising inflation rates. Although the Fed has long been believed to focus on the core rate of inflation (minus food and energy), there is no doubt that Bernanke & Company are closely monitoring headline inflation as well. Bernanke made the following remarks in a speech on June 3:

“The possibility that commodity prices will continue to rise is an important risk to the inflation forecast. Another significant upside risk to inflation is that high headline inflation, if sustained, might lead the public to expect higher long-term inflation rates, an expectation that could ultimately become self-confirming. The Federal Reserve's mandate is to foster maximum sustainable employment and price stability. To achieve these goals, we must also support the return of financial markets to more normal functioning… For now, policy seems well positioned to promote moderate growth and price stability over time. We will, of course, be watching the evolving situation closely and are prepared to act as needed to meet our dual mandate.”

Those remarks delivered at an international monetary conference seemed to suggest that Bernanke is content to keep the Fed Funds rate at 2%, at least for the time being. However, there is believed to be a growing dissent among certain other members of the FOMC. The last FOMC meeting was on June 24-25 when the Fed once again elected to leave the Fed Funds rate at 2%. The FOMC policy statement included the following language:

“The Committee expects inflation to moderate later this year and next year. However, in light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remains high…

Although downside risks to [economic] growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.”

These policy statements are carefully scrutinized, and there is little doubt that the Fed is increasingly concerned about inflation. The question is, will the Fed raise short-term rates at a time when the economy is struggling and the credit crunch is still far from over? The interest rate futures markets believe the Fed will raise rates at least once before the end of the year. My best sources, however, believe the Fed will not raise rates before the end of the year.

The next FOMC policy meeting will be held on August 5.

Do Most Americans Really Know Barack Obama?

To the surprise of most conservatives, Senator Barack Obama continues to hold a lead over Senator John McCain in most of the national tracking polls, although McCain has made some gains over the last week or two as Obama went on his global “fact-finding” tour. Most conservatives are astonished at how many Americans have jumped on the Obama bandwagon, especially given his liberal positions on so many issues, his lack of experience and his questionable background.

Let’s start with the questionable background. We are told that Obama served as a “community organizer” in Chicago for ACORN (the Association of Community Organizations for Reform Now), which is one of the largest radical groups in America. You can easily check this out on the Internet. Next, there are Obama’s ties to now-convicted felon, Tony Rezko. Rezko, a Chicago mover and shaker, was one of Obama’s earliest supporters. After Obama was elected to the Senate in 2006, he and Rezko were involved in a questionable real estate transaction involving the purchase of Obama’s mansion in Chicago. Obama has since admitted it was a mistake.

Then there is the issue of Obama’s former minister of 20 years, Jeremiah Wright, who hit the national spotlight recently with his outrageous sermons. Wright also has a close relationship with and has praised Louis Farrakhan, who is the Supreme Minister of the Nation of Islam and an outspoken anti-Semite.

In addition to his questionable background, there are his various liberal policy positions and votes. Obama has been rated “the most liberal Senator in Congress” by National Review, a prominent conservative think tank in Washington. Obama is pro-abortion and pro-gun control. He will raise income taxes, especially on those making $250,000 or more a year, and he says he will increase the capital gains tax (not good for the stock markets).

He vows to nationalize health care, which in my view is one of the scariest things about Obama. He is opposed to increased offshore drilling for oil and natural gas – ANWR would definitely not be allowed. He is a global warming enthusiast. He opposed the war in Iraq. He refuses to admit that the “surge” in Iraq has worked, even after his latest visit there. And the list goes on.

Then there is the critical question of the Supreme Court. With the advanced ages of several current Justices, it is very likely that Obama will get to nominate at least two Supreme Court justices in his first term should he be elected. He could well nominate another one or two should he win a second term.

As discussed at length in my July 1, 2008 E-Letter, the Supreme Court is fairly balanced at present with four generally conservative Justices and four generally liberal ones, with one swing vote in Anthony Kennedy. Depending on which Justices retire in the next 4-8 years, Obama could swing the court significantly to the liberal side. And with the Democrats firmly in control of the Senate, you can bet Obama’s Supreme Court nominees will be approved quickly.

Obama Acts As If He’s Already The President

Despite the negatives noted above, the mainstream media fawns over Obama’s every word and refuses, for the most part, to write anything negative about the man – past or present. The ultimate proof of this was his latest overseas trip in which the evening news anchors from ABC, CBS and NBC all jumped at the chance to accompany Obama on his global junket.

Actually, I think Obama hurt himself on his foreign trip by talking and negotiating with foreign leaders as if he is already the President-elect. Excuse me, but we haven’t voted yet! Not that I care to admit it, but I have marveled at Obama’s confidence (at least when he has a teleprompter). However, his ill-advised discussions with foreign leaders now make me believe that he is one of the most arrogant politicians I have ever seen.

Given all of the above, why is Obama leading in the polls to become our next Commander-In-Chief? Much of it, I believe, is “Bush Fatigue.” Liberals and the media always hated Bush. Everything in the world that is wrong is Bush’s fault. Many conservatives have turned against President Bush as well – he has disappointed us on many occasions. Unfortunately, many conservatives don’t like McCain and may simply sit out this election, which is effectively a vote for Obama.

It is my belief that many Obama supporters are really just anti-Bush voters who simply want someone in the White House that is not the GOP candidate. That, in my view, is why many Obama supporters have dismissed (or failed to investigate) his questionable past and his liberal policy positions.

I have no doubt that I will receive many scathing e-mails in response to the analysis above from our more liberal readers. But take heart, Obama supporters! The following state-by-state electoral analysis will be sure to warm your hearts. I’ve asked my associate Spencer Wright to review the latest state polls and crunch the electoral numbers. Unfortunately, it does not look very good for John McCain. Take it away Spencer.

John McCain’s Electoral Mountain

National tracking polls have recently narrowed, thus putting the contest between McCain and Obama close to the margin of error as of last week. In fact McCain is enjoying a rather healthy rise in public opinion. In the face of the Obama World Tour 2008, this is very encouraging news. To say nothing of a very real dose of Bush Fatigue throughout the country combined with rising energy prices and the poor economy. So, all things considered, the McCain campaign should be thrilled with the week they have had. Indeed, ANY Republican candidate would struggle in this environment, although it does not help matters that McCain is viewed by many as a weak candidate.

It is important to keep in mind that at this stage most polls are reflecting the views of partisans who do not pick the president. It has been the soft middle of American politics – the so-called “swing voters” - that have determined our president since 1988. And those that comprise the middle generally are tuned out until the party conventions, which is why the conventions have become glitzy five-day infomercials that normally give each candidate a nice bounce in the polls just afterward.

That is why, at this pre-convention stage, the national tracking polls are of marginal value, whereas looking at the individual state polling numbers is a much better way to get a read on the potential outcome. I am not going to bother looking at states that are solidly for McCain or Obama as there is no point. Instead, let’s look at the handful of “battleground” states that will determine the outcome of the election.

The battleground states currently are: FL, OH, MI, NC, VA, IN, MO, CO, NM, NV and NH. This leaves Obama with a solid 238 electoral votes and McCain with a solid 163 electoral votes, leaving the 11 battlegrounds to account for a total of 137 electoral votes. Already you can see the path to 270 is much easier for Obama than McCain, as he holds a 75 electoral vote lead in solid states.

Here’s my list of where the battleground states stand based on the RealClearPolitics averages. This may differ slightly from some that you see on TV, but I think this is where the race is now. (Note that “EV” stands for Electoral Votes.)

FL (27 EV): Florida was looking like a McCain stronghold until recently. Obama has made substantial gains in the state over the last month. Current Standing: Obama 45.8% / McCain 45.8%. FL is a definite ‘must win’ for McCain.

OH (20 EV): Ohio is the battleground of battlegrounds, and it has been hard hit by the recent economic downturn. Bush won the state by thin margins in 2000 and 2004. Current Standing: Obama 46% / McCain 45%. Ohio is a ‘must win’ for McCain.

MI (17 EV): Like Ohio, Michigan has been hard hit by the recent economic slump. Add to that its history of voting Democrat across the board from 1992 on and you get a tough landscape for McCain, although recent Democrat victories in the state have been narrow. Current Standing: Obama 46% / McCain 42%. This is a ‘must win’ state for Obama.

NC (15 EV): North Carolina is yet another state that leans Republican and should not be this close, another indication of how McCain is doing poorly with the base. Current Standing: Obama 43% / McCain 47%. NC is another ‘must win’ for McCain.

VA (13 EV): Virginia is another state that really should not be in contention. While VA went for George Bush in 2000 and 2004, it has been trending Democrat over the past 12 years. Current Standing: Obama 47% / McCain 46%. VA is ‘must win’ for McCain.

IN (11 EV): Indiana should not be a battleground state since this state hasn’t voted for a Democrat in almost 40 years. This is a sign of McCain’s weakness with the GOP base. Current Standing: Obama 47% / McCain 46.5%. IN is a ‘must win’ for McCain.

MO (11 EV): Missouri has been in the GOP portfolio more often than not over the last 40 years, voting for a Democrat only three times over the last 10 cycles. Yet the polls are currently very tight in this Midwest bellwether state. Current Standing: Obama 45% / McCain 47%. MO is a ‘must win’ for McCain.

CO (9 EV): Colorado voted for Bush twice but by fairly small margins. The Democrats are convinced that it can be flipped. Look for lots of action in this state. Current Standing: Obama 47% / McCain 45%. CO is a ‘must win’ for Obama. More on Colorado below.

NM (5 EV): New Mexico split over the last two general elections going narrowly for Gore and then narrowly for Bush. This is another western state that the Democrats believe they can take. Democratic Governor Bill Richardson is very popular and has endorsed Obama and may be in the running for the VP nod. Current Standing: Obama 49% / McCain 43%. NM is a ‘must win’ for Obama.

NV (5 EV): Nevada voted for Clinton twice and Bush twice, but never by large margins. Mark this as the third western state the Democrats think they can capture. The YuccaMountain nuclear waste disposal area is a big hot button issue. Current Standing: Obama 45% / McCain 43%. NV is a ‘must win’ for Obama.

NH (4 EV): New Hampshire is the rare New England state that does actually vote for a Republican now and then. It voted for Bush in 2000. McCain is very popular in the state, which is why the polls remain close. Current Standing: Obama 44% / McCain 43%. NH is a ‘must win’ for Obama.

As noted at the beginning of this state-by-state analysis, Obama has a large lead over McCain in the electoral vote based on the current polls. Thus, you may be wondering why, if Obama already has a built in 75 EV lead, does he need to win any of the “must win” states marked for him? Well, those states represent Obama’s path of least resistance to the magic 270 EV total needed to win.

Let’s say, for example, that McCain manages to poach MI and salvage OH, VA, MO, NC and FL – states that Republicans normally have a good chance in. Based on current polls, that would be a good showing for McCain. However, Obama can still win by carrying NH, NM, CO and NV. That would give him 272 EV vs. 266 EV for McCain.

Fortunately, I have it from a good source on the ground that McCain is surging in Colorado, with its nine electoral votes, and has pulled to even with Obama in the last week. Assuming McCain carries the states he is expected to – which is a huge assumption – this race could ultimately come down to only one or two key states. We will revisit the standings after the Democratic convention, and again after the GOP convention.

The Vice Presidential Sweepstakes

McCain’s biggest problem of late is that he can’t get in the news. Obama, with his World Tour, has dominated the news cycles. Yet despite Obama sucking all of the oxygen out of the room, McCain has closed the gap in the national tracking polls to close to the margin of error. But for McCain to get back in the news, he has to do something big.

There is rampant speculation that McCain is on the verge of making his VP announcement to get back into the spotlight. Some believe this would be a good idea as it would not only build upon recent gains, but would shift the media attention from Obama to McCain, at least for a few days. Others like Karl Rove advise McCain to announce his VP choice only after Obama announces his. We’ll see.

Of course the size of the McCain VP bounce will depend on who he picks. In my opinion he has three basic options for his running-mate: 1) base; 2) buzz; and 3) boring. He could select Mitt Romney to shore up the GOP base; he could pick Louisiana governor Bobby Jindahl, a young rising star in the GOP, which would create a real buzz; or he can pick someone boring like his old friend Tim Pawlenty, the governor of Minnesota.

Gary and I firmly believe that Mitt Romney is the best choice if McCain is to have any chance to win. Romney could solidify the GOP base and would certainly help McCain in states like Virginia, North Carolina, Ohio, Indiana, Florida and certainly Michigan where his father was a very popular governor. The problem is, McCain doesn’t like Romney. Hopefully, his advisors are urging him to pick Romney anyway. We feel that if he picks Jindahl or Pawlenty or some other lightweight, it will be a sign that McCain doesn’t think he can win.

And what about Obama? Rumor has it he will also announce any day now. The Democratic National Convention begins on August 25, and Obama should make his choice very soon. Unlike McCain, Obama will likely make his VP pick based purely on two factors: experience and gravitas. Obama is believed to be considering three possible VP choices (in no particular order): 1) former Georgia Senator Sam Nunn; 2) Virginia Governor Tim Kaine; and 3) NM Governor Bill Richardson, who we consider a distant third.

What about Hillary? Gary and I believe that Obama would only choose Hillary if he was falling down in the polls. We could be wrong, of course, but we don’t see Obama opting to take on the Clintons’ baggage, and the chance that he could be upstaged by either Bill or Hillary. As noted above, Obama still has a lead in the polls. Thus, assuming Obama announces his VP choice before the convention, we do not expect it to be Hillary.

Sam Nunn would seem an unlikely pick because he is a conservative Democrat. However, Nunn is a political heavyweight, even though he retired from the Senate in 1996. On the one hand, conservatives might hope that Obama picks Nunn who might temper Obama’s liberalism. On the other hand, I think an Obama-Nunn ticket would be virtually unbeatable.

That’s it for the state electoral analysis and my take on the VP sweepstakes. Back to you, Gary.

Conclusions – Pass This Along

Thanks, Spencer. As noted previously, this is one of the more interesting presidential elections in some time. This is one of the most important presidential elections, in that more is at stake than in a long time. Obama is arguably the most liberal presidential candidate to get the Democratic nomination in a generation or more, yet many Americans who are going to vote for him do not know this. Unfortunately, for many, it is simply “anyone but Bush and the GOP.”

Feel free to forward this E-Letter to as many people as you wish, in whole or in part. Investors in particular need to know where Obama stands, because I do not think he will be good for the markets. Senator McCain was not my choice for the GOP nominee, but conservatives need to come out and support him.

Very best regards,

Gary D. Halbert

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