Friday, March 30, 2012

"Curb Your Enthusiasm," UCLA Anderson Forecast, March 2012

With the economy creating 227,000 and 284,000
net new payroll jobs in February and January, respectively,
the employment situation is clearly improving.
Although that pace of job growth will not be sustainable
over the near-term, total employment is finally
climbing out of the gaping hole that was caused by
the recession of 2007-09. (See Figure 1) Concomitantly,
the unemployment rate improved from 9.0% in
October to 8.3% in February, but we expect it to fall
only modestly going forward as new entrants into the
long depressed labor force begin to seek work. (See
Figure 2)

We have argued elsewhere that the recent
improvement in the labor market and the consumer
economy has been, in part, driven by exceptionally
mild winter weather.2 In fact this past winter was the
fourth warmest on record with January and February
temperatures running between five and six degrees
warmer than last year.
Why is this important?

The seasonal adjustment factors used by government
statisticians take into account weather-related
impacts on the economy. Examples include slower
construction activity and plant closings caused by inclement
weather, as well as weaker retail sales caused
by the inability of consumers to brave sub-freezing
weather and snow to go out and shop. The Bureau
of Labor Statistics reported an unusually low number
of workers being kept from their jobs due to inclem-

Figure 1 Payroll Employment, 2005Q1-2014Q4

Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 2 Unemployment Rate, 2005Q1 – 2014Q4

Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

ent weather in February. Thus, with this winter being
almost balmy in the normally frigid Northeast and
Midwest, economic activity soared and the data was
put into overdrive by the normal seasonal factors that
are looking for depressed conditions.
Furthermore, the warmer temperatures -- along
with plummeting natural gas prices -- slashed home
heating bills on the order of 20%-40%, offsetting the
rise in gasoline prices. Thus, we suspect that once the
weather and the seasonal adjustment factors normalize
in March and April, the economic data won’t look
so ebullient.

Indeed, without the benefit of lower heating
costs, higher gasoline prices will begin to bite into
consumer spending. With oil prices staying over $100
a barrel and the global Brent price another $15-$20
higher, it seems highly likely that gasoline prices will
soon average over $4 a gallon. (See Figure 4) Of
course, over the near-term, oil prices will continue to
reflect political tensions caused by the Iranian nuclear

Unfortunately, the stronger employment data
are not appearing to translate into stronger overall
GDP growth. Indeed, it can be argued that part of the
recent gains in employment are in response to prior
growth, not expectations for future growth. After
growing at 3% in the fourth quarter, we are forecasting
real GDP growth to slow to around a 2% annual
rate for most of 2012, with the point estimate for the
first quarter at 2.0%. Growth is expected to improve
from that level in both 2013 and 2014. (See Figure 3)
Figure 4 West Texas Intermediate Oil,
2005Q1 - 2014Q4

Sources: Investors' Business Daily and UCLA Anderson Forecast
Figure 3 Real GDP Growth, 2005Q1 – 2014Q4

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 5 Real Equipment and Software Spending,
2005Q1 - 2014Q4

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Why is this happening?
Although the so-called “front end” consumer
portion of the economy seems to be doing better, the
“back end” business part of the economy is weakening.
Simply put, both investment and exports, which
led the economy earlier in the recovery, are now
slowing. (See Figures 5 and 6)

Europe in Recession

Europe is in recession. Euro-area real GDP declined
in the fourth quarter and is forecast to decline
by 0.5% this year. The recent Greek debt default/restructuring
highlighted the fiscal imbalances afflicting
Europe. Behind Greece, though not as troubled, stand
Portugal, Spain and Ireland. In response to the crisis,
the European Central Bank (ECB) embarked on a
massive quantitative easing program called the Long
Term Refinancing Operation (LTRO). In short, the
LTRO offers the European banks three year money at
very low rates. As a consequence, the ECB’s balance
sheet exploded. (See Figure 7)

With Europe accounting for roughly 20% of
U.S. and China exports, it is not surprising to see a
slowdown in this sector. As China and Asia slow as
well, U.S. exports weaken in those markets. Nevertheless,
the real risk coming out of Europe is not a
modest recession, but another financial crisis arising
out of the continent’s long-running imbalances. The
French presidential elections on April 22nd, might
renew the crisis if the less Eurocentric Francois Hollande,
who is now leading in the polls, defeats the
incumbent Nicolas Sarkozy.

Figure 6 Real Exports, 2005Q1 - 2014Q4

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 7 ECB Balance Sheet, 1999 - 2012, In Millions of Euros


The Fed and Housing

Like its ECB counterpart, the Fed continues to
flood the banking system with liquidity with a near
promise to keep interest rates at roughly zero through
mid-2014. Our sense is that the zero rate policy will
end somewhat sooner, in late 2013. (See Figure 8)
In addition, the Fed is undertaking an “operation
twist” designed to lower long-term rates and that
has allowed 30-year fixed rate mortgage interest
rates to plum depths to 4% and below. The low rate
policy will be enabled by less than 2% year-over-year
increases in the deflator for personal consumption
expenditures, the Fed’s preferred inflation gauge. (See
Figure 9)

To be sure, housing prices as measured by the
Case-Shiller Index recently dropped to a new cyclical
low, but our sense is that 2012 will represent the
low point in the housing price cycle. (See Figure 10)
Why? Employment is up, interest rates are very low,
incomes are gradually rising and the long-stalled
foreclosure logjam is breaking. Yes, credit standards
remain tight, but as the economy heals more buyers
will come into the market. Prodding them will
be rapid increases in apartment rents that are already

Figure 8 Federal Funds Rate vs. 10-Year U.S.
Treasury Bonds, 2005Q1 - 2014Q4

Sources: Federal Reserve Board and UCLA Anderson Forecast

Figure 9 Personal Consumption Expenditures
Deflator, 2005Q1 - 2014Q4

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 10 Case-Shiller House Price Index, 1988 - 2012

Source: Standard and Poor's

Figure 11 Housing Starts, 2005Q1 - 2014Q4

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

occurring. In more than a few markets, rents are up
between 5%-10% and in practically all markets real
rents are rising.

As a result, multi-family housing starts have
more than doubled off the bottom and single-family
starts are beginning to rebound as well. We estimate
that total housing starts this year will rise to 741,000
units up from 611,000 last year and will approach one
million units in 2013. (See Figure 11)

The Fiscal Train Wreck

Fiscal policy is inexorably headed for two train
wrecks, one in the short-run and the other in the longrun.
The short-run largely involves taxes. All of the
Bush era tax cuts expire at the end of the year along
with the payroll tax cut of the past two years. Should
all of the tax cuts expire at once along with some
mandatory spending cuts, the U.S. would be faced
with a $400 billion fiscal contraction, the biggest
since the end of World War II.

This looming uncertainty will hardly be a tonic
for economic activity in the second half of this year.
Just to note for modeling purposes, we are assuming
that a gradual phase out of most, but not all, of the tax
cuts will be approved after the election. And yes, this
is a heroic assumption.

The other train wreck is the long-run deterioration
in the fiscal condition of the United States. Even
with a heroic compromise, the U.S. faces mega-deficits
as far as the eye can see. (See Figure 12) Unless
the long-term entitlement programs of social security,
Medicare, Medicaid and perhaps “Obamacare” are
brought under control, there really isn’t any solution
to the long-term deficit. In our long-term outlook we
assume that the U.S. will muddle through. We caution,
however, sometimes the world isn’t so kind.

Figure 12 Federal Surplus/Deficit, FY2000 –FY2022

Sources: Office of Management and Budget


Although the employment outlook has decidedly improved, the growth outlook remains sluggish with 2% GDP growth likely for much of this year. The recent data has been favored by an unusually warm winter that brought forward economic activity that would normally have occurred in the spring.Thus, the weather effect along with higher gas prices and weak exports temper our enthusiasm for the balance of the year. Morevoer the looming expiration of all of the Bush era tax cuts and the payroll tax cut will elevate economic uncertainty in the second half of the year.

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