On the Economy & the Fed - Now What?
FORECASTS & TRENDS E-LETTER
August 30, 2011
IN THIS ISSUE:
1. Bernanke’s Speech at Jackson Hole
2. The Economy Continues to Disappoint
3. Has the CBO Become Irrelevant?
4. Welcome to Stagflation
5. Stock Market Mayhem!
We touch on several bases in today’s letter. We begin with Fed Chairman Ben Bernanke’s key speech at the Fed symposium in Jackson Hole, Wyoming last Friday, which proved to be a yawner despite all the anticipation beforehand. Next, we look at last Friday’s disappointing GDP report which was revised lower, along with other recent economic reports.
Following that, we look at the latest long-term budget forecasts from the Congressional Budget Office. As I will discuss below, the CBO uses so many optimistic assumptions in these forecasts that one wonders if they are even relevant anymore. In any case, I’ll give you the latest numbers.
Next, I make the case that the US economy has now drifted once again into “stagflation” – defined as slow growth and rising inflation. Expect to hear more references to stagflation in the days and weeks just ahead, but you heard it here first. Finally, we look at the latest chaos in the stock markets.
It’s a lot to cover in one E-Letter, but I think you’ll find it all interesting. As always your comments and suggestions are welcome.
Bernanke’s Speech at Jackson Hole
Practically the whole world was listening as Fed Chairman Ben Bernanke spoke at the annual Fed symposium in Jackson Hole, Wyoming last Friday. For much of last week, there was great speculation as to whether or not Bernanke would hint of yet another round of “quantitative easing” or QE3. But by the time Bernanke actually spoke, most analysts agreed that QE3 was probably not in the cards.
As it turns out, Bernanke didn’t announce anything new. The stock markets fell immediately after the speech last Friday but recovered shortly thereafter and closed higher on the day. Bernanke referred to the Fed’s action earlier in the month when the FOMC vowed to keep short-term interest rates near zero until at least mid-2013, but that was old news.
Bernanke acknowledged that the economy has slowed down more than expected this year, but he maintained his view that near record low interest rates will promote economic growth over time. He also hinted that Congress may need to act to stimulate hiring and growth, but he did not make any specific suggestions. Other than that, the much anticipated speech was pretty much a non-event.
The Economy Continues to Disappoint
Economic news of late has continued to be mostly disappointing. Last Friday’s 2Q GDP report was revised downward to 1.0% (annual rate) from the previous estimate of 1.3%. That followed growth of only 0.4% in the 1Q, so the economy only gained 0.7% for the first half of the year, which was well below most expectations coming into this year.
Economists pretty much across the board have slashed their estimates of GDP in the second half of the year, with most forecasting growth of around 1%. Forecasts for 2012 growth are generally only in the 1-2% range, down from 3-4% predicted earlier this year.
The big question now is whether or not the economy has slipped into a double-dip recession. Technically speaking, the answer is no since a recession is typically identified as two or more back-to-back quarters of negative growth in GDP. We haven’t seen that yet, but if the 3Q and 4Q turn out to be negative, the National Bureau of Economic Research will declare that a recession officially began around the middle of this year.
Unfortunately, we won’t know that until late January of next year when the first estimate of 4Q GDP is released by the Commerce Department. While I’m not predicting that we have sunk into a recession in the 3Q – we just don’t know yet – but that hasn’t stopped a growing number of forecasters from declaring that we are in a new recession. And they could be correct.
The Thomson Reuters/University of Michigan index of consumer sentiment plunged to 54.9 from 63.7 the prior month. That was the lowest reading in 31 years, and was sharply lower than the pre-report consensus of 62. The big decline in consumer sentiment came just after the largest one-week slump in stocks since 2008. This is a very bad sign given that consumer spending accounts for apprx. 70% of GDP.
Just this morning, the Consumer Confidence Index plunged to 44.5 in August from 59.2 in July. It was the lowest reading since April 2009 and was significantly lower than the pre-report consensus. The Conference Board cited the debt ceiling debacle and the credit downgrade to AA as major factors in the sharp decline in the index. This report is a strong indication that the economy is falling into a double-dip recession.
On August 18, the Philadelphia Federal Reserve Bank’s index of economic activity in the mid-Atlantic region plummeted to a negative 30.7, down from a positive 3.2 in July and the lowest since a negative 30.8 reading in March 2009 -- in the depths of the last recession. The index measures various aspects of business activity in the region, including new orders received by companies, shipments of goods and employment trends.
Economists were stunned at the unexpected plunge in the index, and the Dow Jones promptly tanked almost 420 points (-3.7%) on the day. Numerous economists and analysts noted that previous declines in the Philly Fed index to August’s levels have only been observed in or immediately prior to recessions, with the exception of a brief period in 1995.
On the housing front, all of the latest reports were disappointing. New and existing home sales were down in July, as were housing starts and building permits. Unemployment news wasn’t any better. Weekly claims for unemployment benefits jumped back above 400,000 in the middle two weeks of August. The unemployment rate for August is expected to remain at 9.1% when it is released this Friday.
Fortunately, not all the economic news of late was bad. The Index of Leading Economic Indicators (LEI) for July was a little better than expected at +0.5%. Yet a closer look at the report revealed that most of the increase came from a drop in interest rates, and several internal components showed greater weakness in the economy. Durable goods orders rose unexpectedly by 4% in July. And consumer spending rose more than expected in July, up 0.8%, thanks largely to back-to-school buying.
Has the CBO Become Irrelevant?
The Congressional Budget Office updated its long-term forecasts for the US economy, deficits, national debt, etc. last week following the debt ceiling increase, and some analysts found the report encouraging. Encouraging?? I’d call it drinking the CBO’s Kool-Aid! The thing you must understand about these 10-year CBO reports is that they include a lot of assumptions, and most are overly optimistic in my opinion and that of many others.
For example, the CBO assumes that the economy will expand every year for the next decade, with no recessions. Never mind that we may already be in a double-dip recession. I know of no one other than the CBO and the Obama administration that believes we will get through the next decade without a recession.
Specifically, the CBO forecasts economic growth of 2.3% for fiscal 2011, 2.7% for FY2012 and 3.7% for FY2013-2016. Only the most optimistic economists have GDP estimates this high. The CBO projects that the US unemployment rate will fall to 8.9% by the end of this year, but will remain above 8% until at least the end of 2014. They might actually be about right on this projection, but that level of unemployment doesn’t square with their rosy forecasts for economic growth.
The CBO also assumes that the government will succeed in cutting federal spending by $2.5 trillion over the next 10 years as prescribed by the debt ceiling deal. This assumption is made even before the congressional Joint Committee to make these cuts gets started.
The CBO also assumes that all of the Bush tax cuts will expire at the end of 2012, but even President Obama is not talking about eliminating all of the Bush tax cuts at the end of next year. For these reasons and others, the CBO’s long-term forecasts don’t carry nearly as much weight as in years past.
The problematic assumptions aside, the CBO forecasts that the federal budget deficit for fiscal 2011 will be $1.3 trillion or 8.5% of GDP. This is down slightly from the fiscal 2010 deficit but is still the third largest deficit in our nation’s history, all of which have occurred on Obama’s watch.
The CBO’s forecasts, projections and assumptions noted above are included in the agency’s so-called “Extended Baseline Scenario.” The CBO has another set of projections that are referred to as the “Alternative Fiscal Scenario.” This scenario includes some different assumptions including a long-term extension of the Bush tax cuts beyond 2012, limiting the alternative minimum tax, that federal revenues remain at their historical average of 18% of GDP, etc.
Under those assumptions, federal debt would grow much more rapidly than under the Extended-Baseline Scenario. With significantly lower revenues and higher outlays, debt held by the public would exceed 100% of GDP by 2021. After that, the growing imbalance between revenues and spending, combined with spiraling interest payments, would swiftly push debt to higher and higher levels. Debt as a share of GDP would exceed its historical peak of 109% (post WWII) by 2023 and would approach 190% by 2035. Clearly, this is an unsustainable path.
The CBO notes: “Many budget analysts believe that the alternative fiscal scenario presents a more realistic picture of the nation’s underlying fiscal policies than the extended-baseline scenario does. The explosive path of federal debt under the alternative fiscal scenario underscores the need for large and rapid policy changes to put the nation on a sustainable fiscal course.” No kidding!
Welcome to Stagflation
Stagflation is a term that became common in the US in the 1970s when inflation was rising significantly while economic growth was slow. As best we can tell the term stagflation was first used in Britain in 1965. It was first used in the US when President Nixon imposed wage and price controls in August 1971 and again in 1973 during the oil crisis. The term was widely used in the late 1970s during the Carter administration.
Expect to hear more references to stagflation in the days and weeks just ahead. Earlier this month, we learned that the US economy grew at a very anemic rate of only 0.4% in the 1Q and 1.0% in the 2Q, both well below most economists’ expectations. Unemployment remains above 9%. With the latest meltdown in the stock markets, most forecasters now believe the economy won’t grow much above 2% in the second half of this year, if that.
Meanwhile, inflation is creeping higher. “Creeping” may not be the appropriate description since wholesale prices are actually soaring as I will discuss below. The Consumer Price Index rose more than expected in July, up 0.5%, versus the pre-report consensus for an increase of just 0.2%. For the 12 months ended in July, the CPI rose 3.6%. This is well above the Fed’s target of around 2%.
Wholesale prices have jumped by twice that amount over the last year. The Producer Price Index rose 0.2% in July, about in line with expectations. However, the PPI jumped a whopping 7.2% over the last 12 months. Increases in wholesale prices lead to subsequent increases in consumer prices. The increases this year have been most notable in energy and food prices. Stagflation is definitely back, as I predicted in these pages a year ago.
Note: The chart above does not include the latest CPI data for July which shows consumer prices rising at an annual rate of 3.6% as noted above.
As the chart illustrates, wholesale and consumer prices have risen rather dramatically since the end of the recession (shaded area). Yet most economists believe that the US remains in a deflationary period overall, what with the continued deleveraging in the housing markets and high unemployment. What they really mean is that credit remains very tight.
On one hand, rising prices are bad news for consumers; on the other hand, this may actually be good news for the Fed. The Fed implemented QE1 and QE2 in an effort to head off deflation.The recent increase in the producer and consumer price indexes may be an indication that the Federal Reserve’s policies are starting to work. However, the lack of economic growth at a time when inflation is increasing is not what the Federal Reserve wanted. They wanted both economic growth and higher prices, but what they are getting is higher prices and very little growth.
Stock Market Mayhem!
There are times when you hope your predictions don’t come true, and that has certainly been the case for me in the last several weeks. In my July 19 E-Letter, “Why Greece Matters to You and Me,” I printed the chart below of the S&P 500 futures, with the following warning:
“If the situation in Europe deteriorates further, I think it could be quite bearish for equities, both in the US and Europe. The last time that happened, stocks lost half their value on average in just over a year. Despite what happens in Europe, US stocks have picked an ugly spot to turn sideways to slightly lower. The S&P 500 Index has heavy overhead resistance at 1400 and above. Technically speaking, this is not a good level to stall.”
In that same E-Letter I warned: “… we are very likely facing another global financial crisis that could be sparked if Greece defaults on its debt. If this happens, I would expect the US stock markets to plunge again, perhaps as they did in 2008. And this could happen at any time. Most US investors are NOT prepared for this scenario and believe that US equity prices will remain in a bull market for the balance of this year and next.” [Emphasis added, GDH.]
We all know what has happened since. The S&P 500 plunged from near 1,350 to near 1,100 or an 18% loss in less than two weeks. On some days, the Dow Jones fell by 400-500 points. And we may not be done yet.
In the updated weekly chart of the S&P 500 below, you can see that the market fell from a classic “head-and-shoulders” chart formation that has been developing all year. In the chart below, you can see the left shoulder peak in February, followed by the slightly higher peak (head) in late April, and the right shoulder peak in late July.
The stock markets have recovered somewhat from the recent plunge but the major trend remains down, in my opinion. I continue to believe that the equity markets will be most affected by the developments in the European debt crisis. The markets rallied strongly on Monday due to news that two Greek banks had merged, but the merger of two weak banks does not make a strong one.
The problems in Europe have not changed and it remains to be seen whether Germany will agree to take on the debt of the periphery nations, as well as Italy and Spain, vis-à-vis the creation of a new Eurobond. This is far from settled, and I believe there will be more bad news out of the Eurozone.
As discussed above, the US may be entering a double-dip recession, but we may not know for sure for a while. This uncertainty plus the continued problems in Europe are likely to keep pressure on US stocks for at least the next few months if not longer.
If the latest plunge in the stock markets has you rethinking your own portfolio, I invite you to call us at 800-348-3601 and speak with one of my experienced Investment Consultants. We can help you diversify your portfolio with the goal of limiting risks. Think about it.
Very best regards,
Gary D. Halbert
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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.