Friday, March 15, 2013

Slowly Ramping Up, UCLA Anderson Forecast, March 2013



After enduring the slowest postwar recovery on record, the economy is slowly beginning to ramp up. To be sure the acceleration will be more of a 2014 event, but the seeds are being sewn for real GDP growth to rise from the tepid 2% we have been used to to something more on the order of 3%. But this is still below the 4% - 6% growth rates associated with prior recoveries. Specifically, after growing at 2.2% in 2012, we are forecasting real GDP to advance 1.9% in 2013 and 2.8% and 3.1% in 2014 and 2015, respectively. (See Figure 1) Indeed, we anticipate the economy to achieve a sustained 3% growth rate starting in the second quarter of 2014. Along with the higher growth path we are also forecasting inflation in excess of 2% in 2014 and 2015 as the Fed’s extraordinary monetary policies catch up to a slow productivity growth economy.

Nevertheless, before we get to the accelerated growth we are forecasting, the economy has to overcome the headwinds coming from the $85 billion sequester in Federal spending over the next seven months ($1.2 trillion over 10 years), a recession in Europe, the impact of higher payroll taxes and higher taxes on upper income households and the payroll adjustments that business firms will make associated with the implementation of the Affordable Care Act. Because of the way the Affordable Care Act is structured, firms have incentives to convert full-time work to part-time work and for small firms to limit their headcount to 50 full time employees. As a result of these impediments, 2013 will represent the fourth year in a row of less than optimal 2% growth.

We assume the sequester issue will be resolved by another typical Washington compromise. Congress will likely respond to the near-term pain caused by the very quick and very arbitrary cuts in Federal programs that were passed by Congress and signed into law by the President in 2011 by coming up with a combination consisting of mostly long-term spending cuts in entitlements and some tax increases that will take effect in 2014. As a result of the sequester, growth will remain a slow 1.9% in the second quarter which temporarily spikes to 3.4% in the third quarter before dropping back to 2.5% in the fourth quarter. We fully realize this forecast outcome it too cute for our tastes, but that is the way it models out.

The recent revisions in the employment data highlighted the fact that the job situation was better than what we had thought. The economy gained an average 181,000 jobs a month in 2012 and we expect an equivalent gain in 2013 and acceleration to 200,000 jobs a month in 2014 and 220,000 in 2015. (See Figure 2) In this environment the demand we are forecasting the 

unemployment rate will gradually decline from the current 7.9% to 7.6% by yearend to 7.1% at the end of 2014 and to around 6.5% at the end of 2015. (See Figure3)


Growth will be buoyed by a rapidly recovering housing market and continued strength in light vehicle sales. Housing led the downturn; it is now leading the upturn. Housing starts totaled 781,000 units in 2012 up from 612,000 units in 2011. Because housing remains extremely affordable (low prices and low mortgage rates) for those who can obtain credit coupled with substantial pent-up demand, we are forecasting starts to exceed one million units this year and foresee further advances to 1.35 million units and 1.56 million units in 2014 and 2015, respectively. (See Figure 4) Although we are above consensus we do not view our forecast to be overly optimistic. After all, our 1.56 million unit forecast for 2015 is consistent with the historic 20-year average and with long run demographic demand. Where we differ with other forecasters is that we expect housing starts to normalize in 2015, they look for normalization in 2016.

Similarly, the recent strength in automobile sales is expected to continue. The fleet, on average, is 11 years old and onsumer balance sheets have been at least partially

repaired by the modest rebound in home prices and the surging stock market. Practically all of the household wealth destroyed during The Great Recession has been recouped. Light vehicle sales rebounded to 14.4 million units in 2012 up from 12.7 million units in 2011. We expect a further increase to 15.2 million units in 2013 and can easily visualize a 16 million unit year in 2015. (See Figure 5) Remember that will still be below the 16.1 million units sold in 2007.


Simply put, it is hard to export when your trading partners are in recession. Eurozone output shrank at a 2.4% annual rate in the fourth quarter of 2012. Japan contracted as well, albeit at a smaller 0.4% annual rate. With most forecasters looking for a very sluggish Europe in 2013, it is hard to visualize a rebound in U.S. export growth until 2014. Export growth rebounded a stunning 11.1% in 2010, but since then the growth rate has been on a decidedly downward track, dropping to a mere 2.5% in 2012. Although still positive, we forecast export growth to be a very low 1.5% in 2013 before rebounding to 5.3% and 5.8% in 2014 and 2015, respectively. (See Figure 6)

Adding additional risk to the forecast is the abrupt shift in Japanese monetary policy designed to end that country’s 20 year deflation. Concomitant with the change in policy, whether by design or not, has been a substantial decline in the exchange rate of the Yen. Since last fall

the Yen has been effectively devalued by 17%, thereby making Japanese goods far more competitive in global markets. Clearly this abrupt change in the exchange value of the Yen introduces a negative factor for the prospects for U.S. exports.

Another source of sluggishness in 2013 is the stalling in the investment in nonresidential structures. Specifically, the drop in natural gas prices lowered the investment in new wells and the completion of several major utility projects will cause growth in this sector to drop to essentially zero in 2013. However, a rebound in energy activity along with a marked increase in commercial construction will cause this sector to increase at 9.8% and 11.4% in 2014 and 2015 respectively. (See Figure 8)


To be sure, Federal purchases, thanks to significant declines in defense spending and more modest declines for civilian spending coming off the stimulus highs of 2010, are heading lower. (See Figure 9) Those reductions along with higher tax revenues coming in from the recent tax increases will cause the federal deficit to decline from $1.1 trillion in fiscal 2012 to about $860 billion in fiscal 2013 with further declines extending throughout the near-term forecast horizon. (See Figure 10)

However over the long-run, the scale of the Federal deficit is not a result of the federal purchases which fund defense, the FBI, the national parks, and the FDA, for example. And it is not the result of insufficient tax revenues because we forecast a return to a somewhat above average 19% share of GDP allocated to federal taxation.

Indeed, in the very long-run, according to the Congressional budget Office, by 2037 Medicare, Medicaid (including the Children’s Health Insurance Program) and Social Security will account for 16.6% of GDP swallowing over 80% of revenues. Of course, given our aging popula

tion a 20% share going forward maybe more appropriate. The real reason why the projected deficit starts expanding from $640 billion in 2019 and rises to $800 billion dollars in 2022 is entitlement spending and until that is controlled, no nominal deficit reduction package will work. Of course this and most all deficit projections naively assume no recession over the next decade.


Although inflation has remained quiescent we believe the economy is about to deliver more inflation than what policy makers now expect. To be sure, headline inflation will remain low for most of 2013, but core inflation will soon be running at a 2% annual rate and be well on the path to 3% in 2015. (See Figure 11) Why? We believe that the extraordinary monetary policy of the Federal Reserve is about to translate into higher prices as spot shortages of skilled labor put upward pressure on wages in an economy suffering from less than 1% a year productivity growth. (See Figure 12) Furthermore, inflation will be in part driven by the welcome rebound in housing prices as the owners’ equivalent rent calculation drives the consumer price index higher. We note that apartment rents reported by the publicly traded apartment Real Estate Investment Trusts are now increasing at a 4% pace and that rate of gain will soon find its way into the official price indices.

Fed policy has been nothing but extraordinary since the financial crisis began in August 2007. The Fed’s balance sheet has nearly quadrupled to over $3 trillion and it is on the road to $4 trillion if, and according to the minutes of the January Fed policy meeting that has become a bigger if, the $85 billion a month in asset purchases announced last fall continue throughout 2013. (See Figure 13) Although this policy has yet to show up as price inflation, the monetary kindling is certainly there to be ignited. We note that the potential for inflation is a new concern for us because until very recently we have been forecasting inflation to stay well within the bounds of the Fed’s target.

Along with massive asset purchases the Fed has targeted a zero interest rate policy since late 2008. We like others expect that policy to continue well into 2014. (See Figure 14) Unlike others and the official statements of the Fed we believe that policy will end in late 2014, and not continue on well into 2015. Simply put, the inflation we are envisioning will first show up in the long-term bond market and that will put pressure on the Fed to act sooner than what is now contemplated. Instead of waiting for the unemployment rate to drop to 6.5% before acting, we believe that as the unemployment rate approaches 7% with inflation rising, the Fed will begin to move away from its extraordinary monetary policy.


After overcoming a host of near-term hurdles coming from the sequester, recession in Europe, higher taxes and transition issues associated with the implementation of the Affordable Care Act, we believe that the economy is setting the stage to break out of the 2% growth path of the past four years and ramp up to a 3% growth pace in 2014. By the end of 2015, the unemployment rate will approximate 6.5%. The growth will come from the gradual removal and/or adjustment to the negative factors and continued strength in housing and automobile sales along with renewed growth in business construction and exports. Along the way inflation will pick up and that will challenge the Federal Reserve to rethink its zero interest rate policy in late 2014.


Saturday, March 9, 2013

My Letter to Barron's on MLPs, March 11

To the Editor:
I was disappointed in the cover story on "The New MLP Landscape" (Feb. 25) because it failed to discuss the most fundamental risk facing the sector. Practically, the sole reason that master limited partnerships exist is to game the tax code. Thus, any serious policy discussion involving business tax reform would have to include the role of MLPs, real-estate investment trusts, and large-scale limited liability corporations and partnerships. If corporate tax rates are to be lowered as they should be, the lost revenue will have to made up from somewhere.

Prudent MLP investors should keep a close eye on the congressional tax-writing committees.