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Stimulative stance has accelerated spending...
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Second quarter gross domestic product (GDP) growth rates were recently revised
up from earlier estimates to an annual rate of 3.3%. We
anticipate real GDP growth in the second half of 2003 to approximate 4.5%
at an annual rate. This is a pace above the economy’s long-term growth
potential. Private spending, consumer spending and business
fixed investment, the prime beneficiaries of the last round of tax cuts,
has been the recipient of the most stimulative financial conditions in the
US in the past two decades. The strength of consumer expenditures is impressive;
personal consumption expenditures have risen at an annual rate of over 6.0%
during the past three months. In the business sector, new orders for non-defense
capital goods, excluding aircraft, have risen at an annual rate of 15.0%,
in the past three months. |
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... but the state of the states may partially offset
stimulus.
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How will growing state budget deficits impact the positive effect of Federal
stimulus packages, given that current state deficits are deeper than they
have been for the past fifty years? In an effort to comply with mandatory
budget balancing, states are turning to spending cuts, and higher taxes
and fees. So far, of the 21 states with budgets
signed into law for the fiscal year that began in July 2003, Americans will
pay $4.3 billion in new taxes and $2.3 billion in new fees. Another $14
billion in proposed taxes and $2.4 billion in possible fees remain on the
table in 29 states, including some of the most expensive proposals in states
such as Pennsylvania, California and Connecticut. Some Americans
will pay more to their state than they get back from Washington, and some
will come out ahead, depending on where they live and their habits. Smokers,
drinkers and gamblers are top targets, along with motorists and traffic
offenders. |
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Concerns about inflation versus deflation continue.
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Deflation has been a significant concern for the Federal Reserve Board (Fed)
and the current Administration. The fundamentals for pricing continue to
gradually improve, despite measures of core consumer inflation drifting
toward the lower end of the Fed’s presumed 1.0% to 2.0% range. In previous
periods of economic expansion, a pace of growth in excess of the economy’s
long-term growth potential has typically resulted in the Fed raising short-term
interest rates to more normal levels from those that prevail in a recession
or in the very early stages of economic recovery. Judging by federal funds
rate futures, financial markets expect the Fed to commence that process
after the Presidential election, late next year. The
situation facing the Fed at the moment, however, has no close historical
precedents. Inflation has been brought down to an unusually low rate of
barely over 1.0%, and inflation expectations have been anchored by a strong
commitment from the Fed to maintain price stability. |
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Concern about federal deficit looms largest.
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A deeper concern to the Administration, and indeed, all political factions,
is the current budget deficit. The Iraqi occupation has pushed the deficit
to the forefront of discussion with sudden force, with the information that
next year the occupation will cost another $87 billion. The US must guard
against the potentially dangerous situation of allowing the current account
deficit to grow too high as a percentage of the GDP. Traditional economic
theory says that under these circumstances, foreign investors may become
wary of seeing our nation become too leveraged. At
a certain point, investing in our country becomes risky, and in order to
maintain foreign investment, we must either increase interest rates or weaken
the strength of our currency. Both of those measures have dampening effects
on our economy. In 2000, a study by the Fed showed that the point at which
these effects may occur is at 5.0% of the GDP. As is stands, the current
account deficit is 5.1% of GDP. However, an improving economy,
by virtue of tax cuts, government spending, and a better business environment
should reduce the national debt. |
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Increase in interest rates causes volatility, raises
questions about the housing market.
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The remarkable run in the US bond market began to turn early in the summer
and rattled many investors. The nervous bond market that caused a rise in
mortgage interest rates has calmed a bit, as rates have retraced from the
summer months. The interim increase in mortgage
interest rates has yet to take its full toll on home-building activity,
which has been among the strongest of US industries for the past three years.
US existing home sales remain strong as well, with robust reports for the
summer months expected to continue. The increase in rates did cool the hot
refinancing frenzy; however, with rates trending lower, this sector should
rekindle. The equity extracted from the mortgage market through cashout
refinancing and sales of existing homes has provided an important support
for home improvement expenditures and other consumer outlays, however, this
support may taper off. |
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Despite these concerns, the question now is not of
recovery, but how sturdy and long-lasting will the recovery be?
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Corporate profits should increase as the economy shows rebounding strength
that began late last year and is accelerating into the second half of 2003.
The translation effects of a weaker dollar
and lower interest expense have generated strong earnings gains in 2003.
Firms will continue to manage inventories carefully, with inventory investment
one of the few sectors of the private economy that is not yet contributing
to growth. In fact, business inventories have been falling during the current
economic expansion. If the economy continues to grow, rebuilding inventories
would result in the need to expand hiring, further accelerating the economic
recovery. The earnings recovery will nurture capital spending, with the
replacement of aging equipment being the leading driver, followed by the
search for even-higher productivity gains. |
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Deterrents to improving profit margins will be in the form of:
- Increased corporate defined-benefit
pension contributions to address the “asset-liability mismatch”;
- Expensing of nonqualified
stock options; and
- Increases in the cost of
employer-provided healthcare benefits despite efforts to control these
costs.
Productivity is on the rise,
and the September report on employment came in unexpectedly strong. To
date, the recovery had been essentially jobless, with non-farm payrolls
declining since January. September figures now show us that non-farm payroll
jobs increased by 57,000 people, beating the consensus of 25,000 job losses.
Although the current pace of projected GDP growth is above the economy’s
long-term growth potential, which we feel will lead to a stronger economy
in 2004, the high level of unemployment has been a drag on the economy.
A study shows that since 1960, the median
lag time for unemployment figures to improve following the start of a
recovery is fourteen months. It is too soon to tell what effects globalization
and free trade will have on job losses in the US if the unemployment situation
is chronic, and there is not yet sufficient or meaningful evidence that
the US is experiencing permanent job losses. While there
may be some sectors that are hurt as a result of outsourcing of work abroad,
particularly in the manufacturing and some service sectors, the practicality
of keeping jobs in the US as well as the gains in productivity and security
will weigh heavily on the outsourcing decision.
We feel that in the near term,
the economy will remain somewhat sluggish, particularly in the labor markets.
The projections for job growth for the next six months, while still an
improvement, are historically weak. However, the fundamentals of historically
low short and long-term interest rates combined with consumer and business
spending will provide the support for a sustainable recovery.
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