Friday, March 11, 2011

On the Mend, UCLA Anderson Forecast, March 2011

The U.S. economy is getting better. Slowly, in fits and starts, real GDP is growing and employment is increasing. We are forecasting real GDP growth of 3.8% in the current quarter and through 2013 the economy will grow at a 3% clip. In this environment payroll employment will increase at a pace of 1.9 million in 2011, 2.6 million in 2012 and 3.0 million in 2013. Nevertheless, because employment fell so far dsuring the recession, that growth will be insufficient to saurpass the employment peak reach in the first quarter of 2008.

Although the reported unemployment rate dropped to a recent low of 9.0% in January 2011, we believe the data was partially the result of a statistical anomaly caused by an unusually large decline in the labor force. Hence the unemployment rate will rise initially rise modestly in the second quarter before beginning a welcome decline to below 8% by the end of 2013. Implicit in our forecast is that oil supplied won't be disrupted by the turmoil that recently appeared throughout the Middle East.

Growth Drivers - Equipment and Software, Exports and Autos

The economy is being propelled higher by strong increases in corporate spending on equipment and software. The fuel for this spending is coming from extraordinarily low interest rates, a rapidly recovering stock market and investment incentives coming out of Washington D.C.. Indeed independent of policy, investment is being spurred by technological innovation in wireless and cloud computing along with new natural gas drilling technologies that are reshaping the Nation's energy map. As a result the real business investment share of GDP will increase from 12.8% in 2010 to 15.4% in 2013.

The capital spending surge is being reinforced by a much imporved export picture. The newly emerging economies of Asia are not only exporting to the United States, but are also importing American made airliners, machinery, medical devices and farm products, for example. Adding impetus to the export boom has been the weaker dollar which makes American exports more competitive in international markets. As a result real exports are on track to grow at an 8.5-9% pace over the next three years.

After suffering its worst collapse since the Great Depression, the motor vehicle industry is on the mend. Recall that automobile sales declined by 38% from 16.9 million units in 2005 to 10.4 million units in 2009. Sales rebounded to 11.5 million units in 2010 and now appear to be on the road to near 16 million units by late 2013. For the Detroit portion of the industry that appeared to be near death, this is a remarkable recovery. A key factor driving the automobile recovery is the fact that cars wear out and have to be replaced and with normalized replacement demand to be reckoned to be on the order of 13 million units a year,meeting pent-up demand has become a decisive factor. Just as in the case of corporate investment, automobile demand is being spurred by low interest rates and imporved stock prices along with a much imporved product line.

The Laggards: Housing (for now) and State and Local Government

Unlike automobiles, it takes a long time for housing to wear out. Housing continues to wallow in its modern day depression as low interest rates are being more than canceled out by the glut of new product created during the bubble years of 2004-2007, the tidal wave of foreclosures and increased credit standards being imposed by lenders. Moreover hte reemergence of real cash down payments in the housing finance system has offset the 30% decline in prices. Indeed fears of a further ratcheting down in prices along with the shock of witnessing an unprecedented collapse in the price structure have kept buyers out of the market. Put simply the investment value of home ownership has declined. Furthermore the usual factors associated with housing weakness of tepid job growth and high unemployment are suppressing demand.

As a result we are forecasting only a modest recovery in housing starts this year to 658,000 units up from 586,000 units in 2010. Thereafter, as the employment situation improves, we forecast that housing starts will exceed one million units in 2012 and approach 1.5 million units in 2013 as pent-up demand offsets rising interest rates. Remember as strongas this recovery appears, a run-rate of 1.5 million units represents demographic demand and no more. As an aside, we anticipate that multi-family construction will recover more rapidly as the glut of housing in fringe areas supresses new single-family construction in the exurbs.

As w have noted many times in the past, state and local government is undergoing a fundamental restructuring analagous to what happened in the manufacturing sector over the past 40 years. Simply put, promises were made with respect to public employee pension and post-retirement health benefits that have become financially infeasible. With state and local budgets being drained by employee benefits and the ever-growing Medicaid program, there are insufficient funds available to fund the remainder of government such as education, environmental, public safety and recreation programs. Thus even as tax receipts improve, state and local budgets will continue to be squeezed triggering new rounds of employee cutbacks, furloughs and pay cuts. As we have seen in other sectors of the economy, this process will take a long time and it will be accompanied by highly publicized "flashpoints" such as last month's dispute in Wisconsin over pensions and union bargaining issues.

A Whiff of Inflation

Although inflation has been quiescent and as recenmtly as November the Fed seemed to be more worried about deflation, there is now a whiff of inflation in the air. Commodity prices have rocketed higher with corn and wheat up about 60% from a year ago levels and with even greater advances for for iron ore, up 78% and cotton up 130%. Oil prices- up until the Libyan crisis spike- were still up 20% from the year ago level and for no apparent reason the European Brent market has consistently traded at an unpcredented $15 premium over the U.S. West Texas benchmark. It appears that aside from fueling the stock market, the Fed's quantitative easing policy has lit a fire under commodity prices.

Perhaps more important, under the radar apartment rents are rising as would be homeowners remain renters. Several of the larger apartment owning real estate investment trusts(REITs) are reporting year-over-year rent increases on the order of 2-3%, compared to the 1% reported in the official consumer price index. Historically REITs lead the official data by about six months. To be sure, renters represent only 36% of thepopulation, cash rents statistically enter into the owners' equivilent rent calculation that reflects the cost of homeownership. As a result, despite continued high unemployment, the core consumer price index on a sequential basis will hit the Fed's informal 2% target by mid-2012 and exceed it in 2013.

Higher Interest Rates Ahead

Since 2009 the Federal Reserve has been running an "emergency" Zero Interest Rate Policy (ZIRP). We anticipate that policy will be with us thoughout 2011 as the Fed remains more concerned about its employment madnate that its inflation mandate. However as the employment situation begins to improve and the inflation rate approaches their informal 2% target, the ZIRP policy will come to an end in early 2012. Before that eventuality the Fed will start unwinding its $600 billion quantitative easing program that is scheduled to end in May.

However, longer term interest rates will begin to antipate the change in policy. Perhaps as early as next quarter the 10-Year U.S. Treasury Bond will reach 4% and be on the road to a 5% yield by the end of 2013. Of course interest rates move far more violently that what are anticipated in econometric models, wo we won't be surprised to see a more dramatic move sooner. We note that from early November to early December 2010 the yield on the 10-year Treasury spiked from 2.5% to 3.5%.

The interest rate outlook is being exacerbated by the mega-Federal deficits as far as the eye can see. The Bowles-Simpson Deficit Reduction Commission offered a rough outline to partially alleviate the problem last December, but neither the President's budget nor the recent proposed cuts in discretionary nondefense spending bythe House Republicans come close to getting to the core of the issue. The big "elepahnts" in the room are the entitlement programs of Medicare and Social Security and until those programs are dealt with, the long run deficit outlook will be problematic. Remeber entitlements are the Federal equivilent of the state and local pension issue. Just to note our forecast assumes modest cuts in domestic discretionary outlays and defense along with increased taxation on high income earners in 2013. We have not, however, modeled in any significant entitlement reform.


Assuming the rolling crisis in the Middle East does not disrupt oil supplies, the economy is on the mend. Real GDP will be growing at a 3% clip over the next three years along with accelerating gains in empoyment. By the end of the forecast period in 2013, the unemployment rate will be below 8% and payroll employment will approach the prior peak. Along the way inflationary pressure will increase with both headline and core consumer price indicies exceeding 2% by mid-2012. That eventuality will bring with it an end to the ZIRP policy and 10-Year U.S. Treasury Bond yields will be at more nromal 4+% range.

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