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)

HOUSING AND CARS LEADING THE PARADE

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.

THE NEAR-TERM ANCHORS: EXPORTS AND BUSINESS STRUCTURES

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)

THE FISCAL TRAIN WRECK

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.

INFLATION AND THE FED

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.

CONCLUSION

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.

 

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.

My latest USNews Blog, "Obama's Liberal Vision is not Economically Viable," January 23, 2013

For the full article see the url below:

http://www.usnews.com/opinion/blogs/economic-intelligence/2013/01/23/obamas-liberal-vision-is-not-economically-viable

Post Mortem on the Tax Deal

After nearly two months of needless skirmishing the Congress and President Obama finally agreed on a tax compromise that could have been done at the outset. The final accord was pretty much along the lines of my November 7 post with called for tax increases for families making over $400,000 a year($450,000 enacted), a 20% dividend tax rate (enacted), elimination of all deductions save for charitable contributions for those earning over one million dollar a year (gradual phase out of exemptions and deductions for families making over $300,000 a year enacted) and a top rate of 37.5% (39.6% enacted). Why it took so long is a tribute to the dysfunction in the Capitol.

Of course nothing was done to solve the real fiscal issue facing our country which is runaway entitlement spending. The fundamentalists in the Democratic Party held the line here even unwilling to go along with a modest change in the indexing formula for social security. Just remember that that the Democratic Party's lack of interest in entitlement reform does not mean that entitlement reform is not interested in them. It will come and the longer we wait the more severe it will be.

Meantime I would note that there were a few adults in the room. Credit for the passage of the compromise should go to the much maligned House Speaker John Boehner, Senate Republican Leader Mitch McConnell, Vice President Joe Biden, and as much as I hate to admit it, House Minority Leader Nancy Pelosi. The cry babies in the room were House Republican Leader Eric Cantor and his acolytes who almost torpedoed the final deal and thereby prevented the Republican for taking credit for at least common sense partial compromise. Simply put, Cantor, doesn't know how to say "Yes". On Democratic side the cry baby was Sentate Majority Leader Harry Reid who simply refused to do what senators do, cut a deal.

"An Uneasy Look at Office Space Demand," UCLA Economic Letter, December 17, 2012

For the complete article see the URL below:

http://www.anderson.ucla.edu/Documents/areas/ctr/ziman/UCLA%20Economic%20Letter_Shulman_12-17-12.pdf

"Beyond the Cliff," UCLA Anderson Forecast, December 2012

As of this writing, the U.S. economy is hurtling towards the fiscal cliff. In short hand, the fiscal cliff is a colloquial expression describing the expiration of previously enacted tax cuts combined with some automatic spending cuts totaling about $600 billion (about 4% of the economy) that are scheduled to take effect in January 2013. Congress and President Obama will resolve it one way or another. Its resolution will be characterized as good, bad or ugly largely depending on the world view of the observer.

Just to remind you, the major elements of the fiscal cliff include automatic spending cuts next year of $78 billion, the elimination of $40 billion in emergency unemployment compensation benefits, and tax increases totaling more than $400 billion from an end to the:
• 1. Payroll Tax Cut - $126 Billion
• 2. 2001/2003 Tax Cut (Upper Income) – $56 billion
• 3. 2001/2003 Tax Cut (Middle/Low Income) - $136 billion
• 4. Alternative Minimum Tax Fix - $103 billion
Because we don’t know what the final resolution will be we are assuming for forecasting purposes, despite the current furor, a "benign" compromise where spending is reduced and taxes are increased in a phased in manner over the next few years. From the point of view of the near-term economic environment modest growth continues, but an agreement on the cliff will be far from a solution to the long-term fiscal deficits facing the U.S. economy.

If Congress and the President fail to compromise, then, according to the Congressional Budget Office, the economy will fall back into recession with unemployment rate returning to 9% late next year. In general we agree with that assessment. In this report we look beyond the cliff.

Even assuming a benign resolution to the fiscal cliff and after taking into account the recent upward revision to the third quarter GDP data, the near-term outlook for the U.S. economy continues to be characterized by modest growth. Specifically, we are forecasting that real GDP will increase at an annual rate of only 0.7% in the current quarter and sub-2% growth in 2013s first half. (See Figure 1)

Thereafter, we can visualize growth accelerating to a run rate in excess of 3% in 2014. In this environment the unemployment rate will remain close to 8% in 2013, but decline to 7.2% by the end of 2014. (See Figure 2) Although this reduction in unemployment appears modest, we are forecasting job growth onthe order of 160,000 a month in 2013 and 200,000 a month in 2014. (See Figure 3) Not great, but a small improvement from recent years.

Why will growth be so tepid even after a fiscal cliff deal?

Deal or no deal the U.S. economy is being buffeted by economic weakness abroad. Europe and Japan are in recession and Brazil, China, and India are slowing. Simply put, the export growth engine is stalling; more on that later.

Furthermore, Hurricane Sandy has severely disrupted the economy of the Mid-Atlantic States thereby reducing output over the near-term. To be sure, measured GDP next year will be boosted later
Figure 3 Payroll Employment, 2005Q1 -2014Q4
Figure 1 Real GDP Growth, 2005Q1 -2014Q4F


Figure 2 Unemployment Rate, 2005Q1 – 2014Q4F
 

by rebuilding efforts, but make no mistake, wealth destruction is hardly an economic positive. Finally, the tax increases and spending cuts coming out of any fiscal deal will weigh on economic activity. It remains to be seen that a deal will engender sufficient euphoria to boost the economic outlook as so many commentators are currently arguing.

Fiscal Imbalances Remain



The most important thing to understand about the fiscal cliff and the long-term deficit negotiations accompanying it is that both parties have much higher priorities than deficit reduction. If President Obama really cared about the deficit he would never have created the new healthcare entitlement or alternatively he would delay its implementation a few years and use the revenue to reduce the deficit. Similarly, there was nary a tax increase in the Ryan Budget passed by the House Republicans. To emphasize the point neither President Obama nor Speaker John Boehner endorsed the bipartisan Simpson-Bowles Commission recommendations. Any serious attempt to reign in the deficit requires both tax increases on more than just the high income earners and more than modest entitlement reductions, especially in Medicare and Medicaid programs. As a result, we continue to forecast high deficits over the next decade. (See Figure 4)

The current impasse involving the fiscal cliff and the on-going structural deficit of the United States has not gone unnoticed by the global credit markets. Forget the Standard & Poor’s down grade last year, look at the credit default swap market. In early November, it was cheaper to insure against default corporate credits such as Chevron, Google, Johnson & Johnson and Wal-Mart than the United States of America.1 Simply put, high-quality corporates have become the new sovereigns.

Furthermore, the current deficit is understated as result of the extraordinary aggressive monetary policies of the Federal Reserve. A zero interest rate policy does wonders for the interest expense line on the federal budget. In essence, the Federal Reserve has enabled the high deficit policies implicitly endorsed by both political parties. In defense, the Fed has argued were it not for their policies the deficit would be much higher because the economy would have been much weaker.
Figure 4 Federal Surplus/Defecit,
FY 2000 - FY 2022
Figure 5 Federal Funds Rate vs. Yield on 10-Year U.S. Treasury Bonds, 2005Q1 - 2012Q4F




Nevertheless, we anticipate that the current zero interest rate policy will continue until late 2014. (See Figure 5) In contrast, we note that the Fed has signaled that the current policy will continue until mid-2015. We base our view on the premise that the bond market will begin to sense more inflationary pressures in the economy in 2014 than the Fed now contemplates.

Front End Strength Offset by Back End Weakness



In contrast to the typical business cycle, the recent recovery has been characterized by strength in the back end of the economy, business investment and exports, and weakness in the front end, consumer spending and housing. Now with the recovery more than three years old, the business side of the economy and exports are weakening and housing is gaining strength. In fact ,the late arrival of the traditionally early pickup in the housing market has become the leading source of strength.

Led by gains in multi-family construction housing starts are expected to increase from 612,000 units in 2011 to 768,000 units this year. Further increases to 991,000 units and 1.34 million units are anticipated in 2013 and 2014, respectively. (See Figure 6) Indeed, by the end of 2014 housing starts are expected to run at an annual rate of 1.45 million units. We do not believe our forecast for housing starts to be aggressive because from 1990 – 2007 housing starts averaged about 1.5 million units a year.

After expanding at an 11% clip, the growth rate in real investment in equipment and software will decline to 6.8% this year and is projected to slow again to 5.6% in 2013. (See Figure 7) Essentially, the early cycle rebound in equipment and software spending represented a rebound from the freezing up of capital spending by businesses in response to the credit crisis of 2008. Similarly, business investment in structures, which never really recovered from the recession, appears to be stalling out with essentially zero growth expected for 2013. (See Figure 8) What’s happening here is a temporary reduction in natural gas drilling
Figure 6 Housing Starts, 2005 – 2014F, Annual Data
Figure 7 Real Investment in Equipment and Software, 2005 – 2014F, Annual Data

 
 

in response to falling prices and the completion of several major utility projects. By 2014 this sector will be growing briskly as the construction of office buildings and shopping centers rebounds and natural gas drilling responds to an improved pricing environment.

Over the longer run, energy development has the potential to transform the U.S. economy. For example, the International Energy Agency believes that the U.S. will become the world’s largest oil producer, surpassing Saudi Arabia, by 2020.2 Furthermore natural gas production is surging as the U.S. is forecast to surpass Russia as the world’s leading producer by 2015. So much so that natural gas boilers now account for 31% of U.S. electricity production compared to 24% a year ago.

Much of the increased production is the result of hydraulic fracturing, a process involving the use of a mixture of highly pressurized water with sand and chemicals that has the ability to unlock hydrocarbon reserves in hitherto inaccessible shale formations. This new technology has triggered an energy boom in Pennsylvania and Ohio and it has transformed North Dakota into a leading energy producing state. In fact, the Bakkan Shale in North Dakota appears to have the equivalent oil reserves of two Prudhoe Bays (Alaska’s largest field).

The oil and gas boom is fueling an industrial revival in the Midwest and the Gulf Coast as low cost feed stocks have made the U.S. the low cost producer in a host of petro-chemicals and fertilizer. New plants have been announced in Pennsylvania, Louisiana and Texas. Moreover, the once nearly dead steel town of Youngstown, Ohio is being revived with the manufacture of steel pipe and drilling equipment.

To be sure the boom is not without its critics. Hydraulic fracturing is water intensive and there are several pollution-related questions involving the chemicals used in the process. A major test will come in California where the vast Monterey/Santos Shale (Kern and Los Angeles Counties) is just beginning to be opened for development. A critical question will be the attitude of the state and federal regulators towards this activity. Although much of the energy-related spending will occur beyond our forecast horizon, it
Figure 9 Real Exports, 2005 – 2014F, Annual Data
Figure 8 Real Investment in Business Structures, 2005 – 2014F, Annual Data

 

does offer the prospect of a better economic environment later in the decade. It is ironic that the Obama Administration came to power in 2009 on a platform of alternative energy and that it is now presiding over a major boom in conventional hydrocarbon production.

Meantime, while we await the energy boom that is to come, real exports are decidedly slowing. After increasing at an 11.1% annual rate in 2010, growth slowed to 6.7% in 2011 and will only be 3.3% this year. (See Figure 9) Simply put, it is very hard to grow exports with Europe and Japan in recession and much of the rest of the world in a slowdown. Recall that for several years we have believed that the U.S. growth engine would be exports. That engine is now sputtering, but with rising domestic energy production, at least import growth is slowing even faster than exports.

Inflation: Cold Now, Simmering Later


Although inflation certainly is not a problem today, with gradual but accelerating economic growth and the lagged effect of the extraordinary monetary ease of the Fed, it could very well become an issue in late 2014. Put bluntly, the Fed wants a temporary increase in inflation to lower real interest rates. It believes such a policy will speed up the recovery. With the Federal Funds rate set at zero the only way it can lower real interest rates is by increasing the inflation rate. Because capacity utilization remains low and unemployment and under-employment remains high, it is likely that inflation will stay low in 2013, but we surmise that inflationary pressures will build far quicker than the Fed now thinks and that inflation will be running above their target 2% rate in 2014. (See Figure 10) One source of the inflation will come from rising apartment rents (already happening) and the interaction of higher rents and housing prices on the owners’ equivalent rent calculation in the various price indices.

Conclusion


Looking beyond the fiscal cliff debate, we forecast that the economy will be growing at less than a 2% annual rate through mid-year 2013. Thereafter we expect growth to pick up and to exceed 3% for most of 2014 with housing activity leading the way. In this environment unemployment will stay close to the current 7.9% rate in 2013, but gradually decline to 7.2% by the end of 2014. Towards the end of the forecast period we expect that inflation will be running above the Fed’s 2% target that will bring to an end the zero interest rate policy that has been with us since late 2008.
Endnotes 1. See Goodman Lawrence, "Better Borrowers than Uncle Sam," Center for Financial Stability, November 13, 2012.
2. See Faucon, Benoit and Keith Johnson, "U.S. Redraws World Oil Map," The Wall Street Journal, November 13, 2012, p.1

My Appearance on CNBC, November 19, 2012

See the url below:

http://video.cnbc.com/gallery/?video=3000129907&play=1