More Of The Same

More Of The Same

by Scott Brown, Chief Economist, Raymond James

November 1 – November 5, 2010

Real GDP rose about as expected in the third quarter. Details were mixed, but remained consistent with the view that the pace of growth, while still positive, is subpar – far below a rate that would be associated with a significant reduction in unemployment. What to expect from here? More of the same, most likely. The economy continues to face a number of serious headwinds, but the recovery is likely to remain on track.

It was the best of times, it was the worst of times. The good news is that the recovery, which began in June 2009, has continued. The economy is growing. The bad news is that it’s not growing fast enough. We need to see real GDP growth on the order of 4%, 5%, or 6% to put much of a dent in the unemployment rate. Real GDP rose 3.1% over the four quarters ending 3Q10, but a good chunk of that was an inventory rebound. Imports have a negative sign in the GDP calculations, and higher imports in the last two quarters have subtracted significantly from overall GDP growth. Domestic Final Sales (GDP less net exports and the change in inventories) rose 2.1% y/y, better in the last two quarters (a 3.4% annual rate) than in the previous two quarters (+0.8%).

So what’s holding the recovery back? In a typical business cycle, the Fed raises short-term interest rates to cool inflation pressures, often leading to a downturn in the overall economy (a recession). The Fed then lowers interest rates and the economy recovers. However, the current downturn was not caused by higher interest rates. In turn, a reduction in interest rates should not be expected to turn things around right away. Recessions that are caused by financial crises tend to be long and severe – the recoveries tend to be very gradual. Simply put, it takes time to repair household and business balance sheets. That process is well underway, but it is far from over. Plenty of cash lying around, but there is still a crisis of confidence.

Residential housing problems clearly remain. Delinquencies and foreclosures are likely to remain elevated for some time. Residential homebuilding is a fairly small part of the overall economy (normally about 4.5% of GDP, it rose to a little over 6% of GDP during the boom, and is now about 2.5% of GDP). During the previous decade, many households extracted equity as home values were rising. Some of that went to home improvements, some went to pay down other forms of debt, and some was simply spent (boosting consumer spending and helping to offset a negative drag from higher gasoline prices). That game is over. Consumer spending is now back to being driven mostly by job growth, which hasn’t been spectacular.

The personal savings rate is a flawed statistic, subject to large revisions, but recent figures suggest that households are saving more than they were before the financial crisis (or equivalently, are paying down debt). The increase in savings made the downturn more severe than it would have been otherwise (since one person’s spending is another person’s income). It remains unclear whether the savings rate will settle where it is, decrease somewhat, or head higher.

The business outlook is mixed. Corporate profits have rebounded in the economic recovery, helping to fuel spending on business equipment and software – but not new hiring. Smaller firms are still subject to tight credit and we normally look to the smaller, newer firms to account for a lot of the job growth during an expansion. That’s not happening currently.

Many investors are likely to be encouraged by the election results this week. However, gridlock in Washington means that little is likely to get done in the near term. While austerity is well meant, history shows that raising taxes in a soft recovery is a bad idea. Will there be a compromise on taxes before the end of the year? It’s hard to say, but the uncertainty will remain a negative for the economy and for the markets. Higher taxes may dampen growth, but growth should stay positive in 2011.

Copyright (c) Raymond James