WEEKLY ECONOMIC COMMENTARY
Stone & McCarthy Research Associates
WEEK OF MAY 21, 2012
If the financial markets like to climb a “wall of worry”, as
pundits claim, they are having a field day. Like a bad penny, the Greek debt
crisis continues to be a recurring nightmare for investors, with no endgame in
sight. The odds of an eventual exit of Greece from the euro zone are climbing
steadily, and experts have spent the past several weeks debating what the
ramifications would be. Some believe the aftereffects can be contained while
others fear a domino effect, with weaker members of the EU becoming victims of
contagion. One thing is clear: The cracks are clearly showing up on the
political front, spurring election upheavals in Greece, France and yes, even
Germany, the bulwark of fiscal austerity.
Clearly, the European fear factor is taking a toll on the
stock market, where prices have fallen by more than 7 percent so far in May. But
investors have more on their plate than just the European debt crisis. Although
it is still early in the game, a homegrown crisis on the fiscal front is
starting to brew as the national debt moves closer to its upper limit. In a speech
earlier this week, House Speaker Boehner said that when the time comes to raise
the debt ceiling again, he would insist on "my simple principle of cuts and
reforms greater than the debt limit increase." According to some members of the
Washington punditry, Boehner's comments were aimed more at members of his own
party, and were designed primarily to ensure that he keeps his job as Speaker,
assuming Republicans retain control of the House after the election.
Who
knows for sure? One thing that is clear, however, is that Treasury will hit the
current debt ceiling later this year. And it's hard to imagine that the debt
ceiling won't get tied up in battles related to the "fiscal cliff" looming at
the end of the year. As Boehner noted in his speech "it's an action-forcing
event in a town that has become infamous for inaction.” There is probably a
small chance that Republicans and Democrats agree before the election to defer
action on taxes and spending cuts until the new Congress and Administration
convene next year. That could be done with temporary measures that avoid the
cliff -- for example, current tax rates could be extended for the first few
months of 2013. If last year's experience is any guide, however, we shouldn't
hold out much hope that Congress will take the least disruptive course. Either
way, the debt ceiling will have to be increased -- probably by the end of
January.
We have prepared a preliminary forecast for when Treasury will violate the
current $16.394 trillion debt ceiling. As of May 15, it had $720 billion in room
left under the limit. Based on our projections, Treasury would hit the debt
ceiling at the end of November, with the settlement of 2-, 5- and 7-year note
auctions. If our projections are accurate, the administration would have to
resort to its special measures to create more room under the debt ceiling
starting in December. Those measures would provide Treasury with about $250
billion in extra borrowing authority, which we think would be sufficient for
about two months. However, you can be sure that Republicans will shine the
public spotlight on such budgetary shenanigans, intensifying the fiscal debate
in the months leading up to the elections.
The
risk is that businesses will defer spending and hiring until a clearer picture
of how fiscal policy will impact the economy in 2013 emerges. If nothing is done
and the economy bears the full brunt of the looming $8 trillion fiscal cliff
(i.e. allowing all of the Bush and Obama tax cuts to expire, extended
unemployment benefits to run out and mandated spending cuts to take place), as
much as 5 percent of GDP could be at stake, which would surely put the recovery
at risk. Such an irresponsible policy is not likely to happen, of course, and
the business community will probably take the fiscal debate in stride, albeit
operate with more caution than it otherwise would. Even the Federal Reserve took
note in its latest FOMC meeting (according to the minutes released this week) of
the downside risks that uncertainty over fiscal policy pose to the economy.
That said, amidst the prospective headwinds from the Greek debt crisis and
the U.S. fiscal cliff, the economy is shaping up to be a beacon of light over
the near term. Indeed, there has been a subtle shift in perceptions over growth
prospects during the past few weeks. Yes, the revised estimate for the first
quarter will probably result in a lower growth rate than the initial tally of
2.2 made last month. But the downshift is not spilling over into the second
quarter. Indeed, the outlook for the April-June period has brightened somewhat,
thanks to robust figures on production and better than expected reports on
housing and consumer spending.
The most promising development was the muscular 1.1 percent increase in
industrial production for April reported this week, matching the strongest
monthly gain in nearly two years. While the auto industry was the main
sparkplug, production gains were spread over a wide array of sectors, with
sizeable increases by producers of computers and electronic products as well as
business equipment and furniture. But automakers were the stars of the show last
month, stepping up output by 3.9 percent. Nor is this a one-off event, as auto
output has been a major growth driver since the year began, accounting for fully
one-half of the 2.2 percent growth rate in the first quarter. The auto
contribution stayed high as the second quarter got underway. Indeed, auto
assemblies in April hit a 10.78 million annual rate, the highest since August of
2007.
Keep
in mind that the auto industry has long tentacles that ignite increased activity
across a broad swath of other industries – from makers of steel and glass who
benefit from higher vehicle output, to truck haulers that transport the vehicles
to their retail destinations to mom and pop stores around local dealerships that
welcome more customers when traffic at showrooms increase. The National
Association of manufacturers estimates that each dollar spent in the auto
industry generates $2.02 of additional revenue for the overall economy. The open
question is whether the revival in auto output reflects a genuine upswing in
demand or is mainly a belated rebound from the extremely depressed sales during
the 18-month recession that began in December 2007. The encouraging news is that
there is potentially more room to grow; while the sales pace this year has risen
to a 14.5 million annual rate, up from 10.4 million in 2009, it remains well
below the 16.7 million pre-recession average that prevailed from 2002 through
2007.
But for the ramp up in production to be sustained, it needs support from the
demand side. Clearly, the slowdown in job creation in April – the 115 thousand
increase in nonfarm payrolls was the weakest in six months – is not a positive
omen for continued sales of big-ticket items. But the labor market shows every
sign of staying on a steadily improving path, as manifested by the
ever-shrinking number of people filing for jobless benefits and a significant
increase in job openings. The consensus estimate is for a meaningful rebound in
job growth in May to about 175 thousand. As it is, households are not cutting
back expenditures to any significant extent. While retail sales eked out a much
smaller gain of 0.1 percent in April than the sturdy 0.7 percent gain posted in
March, the early Easter holiday skewed the results by pulling forward sales of
apparel and clothing as well as other goods at department stores usually
associated with the holiday.
The
more relevant perspective would be to average March and April results to smooth
out the holiday distortion. What this shows is that the surprisingly strong 2.9
percent gain in real consumption expenditures registered during the first
quarter was not entirely a fluke linked to the abnormally warm winter, as most
economists surmised. To be sure, April is only the first month of the quarter,
but there was enough momentum implied by the retail sales report to support a
2.5 percent consumption increase for the second quarter. If that turns out to be
the case, the weather-related payback will be much less than expected a few
weeks ago. Even more promising is that households are set to enjoy a nice boost
to discretionary incomes from the astonishing plunge in oil prices over the past
several weeks, foreshadowing lower gasoline prices. Prices at the pump have
fallen for six consecutive weeks, and another drop is baked in for this week as
well. On Friday, crude oil prices slid to below $92/gallon, more than $8 less
than a year ago.
Finally, there are more signs that the long-ailing housing sector is turning
the corner. Starts posted a solid 2.6 percent increase in April to a 717
thousand annual rate, and revisions to past data show more strength this year
than previously thought. Builders are more optimistic about future activity –
the homebuilder’s sentiment index hit a five-year high in May – mortgage
delinquencies are falling and home prices in many regions are stabilizing or
even rising. Make no mistake, the industry is far from healthy – the normal pace
of starts is over 1 million units and the foreclosure pipeline is still huge.
But the sector is no longer as much of a drag on the overall economy as it had
been over the past five years, and construction workers are actually finding
jobs. The question is whether the economy can stay on its firmer footing in the
face of gathering storms from overseas that is clearly roiling the financial
markets and has the capacity to undermine consumer and business confidence.
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