Economic Outlook

Insights on the economy’s next moves…

GDP: 3.0% pace in ’18, up from 2.3% in ’17
JOBS: Big job gains will continue, but reflect a strong economy
INTEREST RATES: 10-year T-notes at 3.3% by end ’18
INFLATION: 2.6% in ’18, up from 2.1% in ’17
BUSINESS SPENDING: Up 7% in ’18, boosted by expanded tax breaks
ENERGY: Crude trading from $60 to $65 per barrel in June
HOUSING: Price growth: 5.0% by end of ’18
RETAIL SALES: Growing 4.7% in ’18 (excluding gas)
TRADE DEFICIT: Widening 5%-6% in ’18

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Economic Outlooks

GDP

By David Payne [Last updated: June 27, 2014]

Look for the economy to pick up speed in the second half of 2014, with GDP rising at about a 3% annualized rate as the expansion cycle matures and hindrances to growth ease. Given the dismal first quarter (a -2.9% growth rate) and the likelihood that higher food and energy prices will dampen growth in the second quarter, GDP is likely to rack up only about 1.5% growth for the whole of 2014. The second- quarter GDP gain is likely to total about 2.5% (annualized).

The stage is set for much improved performance, however. Disposable income adjusted for inflation grew at a healthy 3.0% annualized rate in January through May. Consumer confidence has bounced back, climbing above its 2013 peak, and is now at its highest level since before the recession. Motor vehicle sales in May hit their highest level in eight years. And an index of manufacturing purchasing managers’ activity points to strongly expanding output. Plus, hiring is on the rise, new unemployment claims have been running at a very low rate in May and June, and retail sales have rebounded.

What’s more, there’s still a chance that growth will accelerate more dramatically in the second half of the year. Consumer spending and confidence remain way below what would be considered normal levels by the standards of past economic expansions. As job growth returns and consumers feel more secure, more robust income and spending increases may well be triggered, pushing second-half growth over the expected 3% pace. While that happening in what remains of this year is an outside chance, it’s a good bet that in 2015 such a virtuous cycle will kick in.

As for the sharp first-quarter slowdown, it isn’t quite as disheartening as it first appears. The decline doesn’t indicate a systemic weakness, and there may even be some offsetting upward bounces yet to come. Weather depressed consumption of goods and housing. Both exports, especially to China, and business investment in aircraft and computers surged at the end of 2013, and a partial pullback in those areas was to be expected. Unsustainably strong business stockpiling of inventories last year returned to a more normal rate. And finally, odds are uncertainty about the introduction of Obamacare contributed to the decline in health care spending in the first quarter. Higher enrollments will eventually turn into spending gains.

Dept. of Commerce: GDP Data

Employment

By David Payne [Last updated: June 6, 2014]

A healthy net gain of 217,000 jobs in May confirms our expectation of a faster hiring pace in the latter half of 2014. By year-end, monthly job creation should be running at about 230,000 a month, with a total of 2.6 million workers added to payrolls over the year. Monthly gains so far this year have averaged 214,000 a month.

Don’t expect much improvement in the unemployment rate, however. Although the 6.3% in April and May are the lowest since 2008, the pickup in hiring is spurring an increase in the labor force, as more would-be workers are encouraged to once again start looking for jobs. In May more people joined (or rejoined) the labor force than found jobs. The fact is, there’s an awful lot of slack remaining in the labor market. The labor force participation rate is still a very low 62.8%. So even as hiring climbs, the unemployment rate will stagnate, or even possibly climb for a month or two.

It’s good news, too, that gains were spread broadly across most private industries, with only modest declines registered in a handful of industries, including banking, electronics, retail, motion pictures, and food and clothing manufacturing. Although federal and state government employment continued to decline, local governments boosted hiring. Temporary employment, which tends to lead employment in other sectors, continued to grow. Overtime hours of manufacturing workers, which also tends to lead employment, rose in May.

Note too, that wages are picking up — a major plus for consumer spending. Pay of non-supervisory workers — 83% of the workforce — increased 2.4% over the past twelve months, the largest increase in over three years. Because such workers are at the lower end of the pay scale and a higher percentage of their pay is spent quickly, the jump in wages tends to have a faster impact on consumer demand and economic growth than an increase in the earnings of supervisors.

Dept. of Labor: Employment Data

Interest Rates

By David Payne [Last updated: June 27, 2014]

10-year Treasury rates will rise slowly to 3.0% by the end of 2014, hovering a few tenths of a percentage point lower than that for most of the year. Bond demand has held up well, as the Federal Reserve ratchets down its massive bond buying program and concerns about the effect of the so-called taper are no longer influencing interest rates. Rates are likely to be most responsive now to reports indicating the strength of the economy, as investors try to anticipate the timing of Fed tightening in mid- to late 2015.

Fed Chair Janet Yellen has so far indicated a strong pro-growth stance, primarily based on concerns about full recovery in the labor market. That would suggest that the Fed will hold off raising short-term interest rates this year, even as GDP growth rebounds after a dreadful first quarter and strengthens further in the second half of 2014. At some point in 2015, the Fed will have to tighten policy, however, and long-term Treasury bond rates will start to rise when investors begin to sense some stirring by policymakers.

Don’t be surprised to see rates jump by half a percentage point when that happens — probably in early 2015. Similar nervousness jolted rates higher in mid-2013, when it became clear that the Fed would soon reduce its monthly bond buying binge. But just as rates stabilized once the taper actually began, anxiety will fade and rate hikes will moderate once investors absorb the initial adjustment. By the end of 2015, figure on rates in the neighborhood of 3.7%.

Rates in the two- to seven-year maturity range have picked up a tenth or two in the past month as nervousness about Fed policy picked up just a bit. So far, there has been little effect on 10-, 20- and 30-year bonds.

The rate for 30-year mortgages — now around 4.2% — will likewise edge slowly up to 4.5% by the end of 2014, and follow the Treasury bond rate in its jump up in early 2015, ending next year around 5.25%. This is low by historical standards, but the effect of higher home prices on affordability will likely mean that we will never return to the historical average, unless there is a bout of general inflation.

Federal Open Market Committee

Inflation

By David Payne [Last updated: June 25, 2014]

Inflation is headed higher, hitting 2.4% over the year, largely because of a surge in food and energy costs. The tab for putting the family dinner on the table is up sharply. Prices for pork have increased because of an outbreak of a virus that’s reducing supplies, and beef has risen as a result of herds culled in the wake of last year’s drought. Plus an ongoing drought in California is boosting prices for a variety of fresh fruits and vegetables. By May, the annualized rate for the first five months of the year had climbed to 2.5%. We should, however, see a slight easing of monthly increases by the end of the year as food prices other than for meat settle down. Pressure should remain on beef, pork and chicken prices for some time to come because it takes time to build up stock. Meanwhile, gasoline prices are likely to pick up in coming months as political turmoil in the Middle East spooks traders, pushing crude oil prices higher. In the early months of the year, the harsh winter led to price hikes for natural gas and electricity.

Excluding those two volatile categories, however, the Consumer Price Index is likely to rise a more moderate 2.1%, measuring from December 2013 to December 2014. That core rate, which is considered a better reflection of underlying systemic inflation, rose at a 2.3% clip (annualized) in the first five months of 2014, up from a 1.7% rate in 2013. The core rate should settle down to a 2% average in the second half of 2014.

Slightly greater than expected consumer price increases in May aren’t necessarily cause for concern. Isolated blips in monthly prices — such as those seen in May for food, energy, housing and medical care — are common. If, however, June or July price increases are also surprisingly large, that may indicate a stronger, and more troublesome, upward trend than we now anticipate.

Dept. of Labor: Inflation Data

Business Spending

By Glenn Somerville [Last updated: July 1, 2014]

Business investment spending is perking up, helping to lead the economy out of a steep slump at the start of the year. A capital spending increase in the range of 4.5% to 5% is in the works this year. While it’s not soaring growth, it’s nonetheless a nice improvement from the paltry 1.5% spending gain of 2013. The improvement is both much needed and overdue. Fortunately, it should continue: We look for business spending next year to finally return to the 6% gain that it registered in 2012.

Companies are starting to add to capacity as the economy rebounds from the sharpest first-quarter contraction since the recession five years ago. Sales and orders for new cars are climbing, and home sales are strong, which will help keep manufacturing industries on track for more-vigorous expansion in the second half of the year. Corporate planners considering borrowing for expansion are well aware that current low interest rates won’t last forever. That should help bring forward some project spending. Core capital goods orders, which exclude aircraft and are taken as a proxy for business investment, climbed by 0.7% in May after declining 1.1% in April. Shipments of finished capital goods followed the same pattern, regaining strength in May after an April lapse.

The U.S. economy’s recovery from the severe downturn of 2008 and 2009 remains slower paced than after past recessions, at about half the rate recorded for other recoveries since World War II. That makes companies cautious about making capital expenditures. Though they’re more willing to spend on automation equipment to increase production without adding to payrolls, they’re still especially reluctant to spend on buildings and even on information processing equipment, including computers. It is easier to fine-tune automated equipment to match variations in customer demand than it is to guess about when to start building a new factory that may saddle a company with productive capacity it ends up not using. The other key factor restraining investment growth is knowledge that consumer purchasing power is strained. Wage and salary growth since the recession has averaged about 2%, too little to fuel robust demand that would call for a surge in business investment.

Census Bureau: Durable Goods ReportCensus Bureau: Business InventoriesCensus Bureau: Construction Activity

Energy

By Jim Patterson [Last updated: June 27, 2014]

Calm returns to natural gas markets, with the benchmark U.S. price falling to $4.41 per million British thermal units as traders react to another big jump in gas supplies and relatively mild weather forecasts. We expect supplies of gas held in underground storage to keep gaining, holding gas prices in a trading range of $4 to $4.50 over the summer. However, any protracted heat wave would likely cause a quick price spurt, as use of air conditioners use ramps up and power plants burn extra gas to meet the demand for electricity.

The oil market remains on edge, though, unsure what direction violence in Iraq will take next. Crude exports from Iraq’s oil-rich south have not been disrupted by heavy fighting to the north. But the situation remains unstable and could escalate quickly with little warning. So West Texas Intermediate (WTI), the U.S. crude benchmark, continues to trade near $106 per barrel, largely unchanged from a week ago. With little prospect of a return to normality in Iraq, we expect prices to stay close to that level for much of the summer.

Gasoline prices are following crude’s lead, holding at fairly high levels but not surging. At $3.68 per gallon, regular unleaded is up a fraction of a penny from a week ago, and hovering near its high for the year. We look for gasoline to creep higher, to about $3.70 in coming days. Diesel is also largely treading water, at $3.91 per gallon. That’s up a penny from a week ago. Odds are diesel won’t move much up or down in coming weeks.

Dept. of Energy: Price Statistics

Housing

Last updated: July 3, 2014

More expansion is ahead for the housing market during the second half of 2014, after a miserable first quarter but a strong recovery in the second quarter. Both building starts and sales (new and existing) will show additional growth.

For existing-home sales, in particular, the latter half of the year is looking more promising, with the annualized pace of monthly sales picking up to about 5.3 million. That will follow a pace of just 4.7 million in the first half, after brutal winter weather hammered first-quarter sales. Though a big rebound in May sales and growth in the second half will help, that still spells a 1.5% decline in total sales for the year. Head winds include rising home values, slim wage gains, tighter mortgage lending, fewer first-time buyers and less interest from investors. Existing-home sales rose 8.9% in 2013.

After a whopping 18.6% jump in the annualized pace of monthly new-home sales in May, growth will continue, but at a more modest pace for the rest of the year, notwithstanding the usual ebb and flow. By December, we expect the pace of sales to be 3% faster than in May, bringing total new-home sales for the year to about 483,000. That’s a healthy 12% increase over the 2013 total, but more modest than the 17% gain racked up last year and the 20% jump seen in 2012. New homes are staying on the market for an average of just 3.3 months before being sold, still far below the 5.5-month average of the past 30 years.

2014 building starts are likely to total about 1.03 million this year — an 11% jump from 2013 starts. The rebound from weather-battered low starts in the first quarter came in April, when starts jumped sharply. Thus, a 6.5% decline in May doesn’t signify a softening, and we expect the number of starts to accelerate again in the latter half of the year, as the economy strengthens and building conditions become more favorable.

As for home values, slower sales will moderate the recent strong pace of gains, as will any increase in interest rates later this year. On average, figure on about a 4% gain nationwide for 2014.

Dept. of Commerce: New-Home SalesNational Assn. of Realtors: Existing-Home SalesDept. of Commerce: Housing Starts

Retail

By Gillian B. White [Last updated: June 23, 2014]

Look for retail sales growth to slow slightly in the second half of this year, as the torrid pace of motor vehicle sales cools a bit. Retail sales of most goods, however — from cakes to consumer electronics — will actually see a small pickup as the economy improves (which will bring positive job numbers, climbing consumer confidence and a likely 4% jump in personal income). What’s more, for the year as a whole, retail sales will likely gain 4%, climbing a bit more swiftly than at last year’s 3.5% pace of growth.

Overall, look for car and light-truck sales to average 16.3 million units this year, up from 15.6 million last year and the best showing for the industry since 2007. Indeed, sales are approaching the average for autos in the years just preceding the recession — about 16.6 million a year.

For the most part, growth in May was lackluster — an increase of just 0.3% — though April sales figures were stronger than first estimated and were revised upward significantly. Building supply and garden equipment stores saw significant gains in May as steadily warm weather encouraged Americans to shop for supplies related to construction, landscaping, gardening and a host of other outdoor activities. Moreover, a strong showing by autos, which climbed 1.4% in May, may mean that many households used up their monthly discretionary budget on down payments, rather than purchases of clothing or dinners out, causing temporary slumps in some spending categories.

Dept. of Commerce: Retail Data

Trade

By Glenn Somerville [Last updated: June 6, 2014]

A strengthening U.S. economy is drawing in more imports and will likely halt recent progress in shrinking the annual trade deficit. The problem is that the rest of the global economy is growing so sluggishly that prospects for boosting U.S. exports are less promising now than they were earlier this year. As a result, the full-year shortfall between exports and imports is unlikely to change from last year: about $476 billion. In 2013, the gap narrowed by 11%. Nonetheless, rising imports reflect growing consumer and business confidence, likely to mean more household and business spending that in turn bodes well for economic growth

A 6.9% increase in the trade deficit in March is illustrative. The deficit hit a two-year monthly high of $47.2 billion. Some of the jump was merely a snapback from the economic slowdown, resulting from severe weather, that walloped the country at the start of 2014. But buyers also splurged on imported consumer goods and foreign-made cars. Imports of industrial supplies climbed as well. In addition, March exports declined, albeit very slightly–by 0.2%. Indeed, slower growth in China, Europe and elsewhere is likely to continue to restrain overseas sales, which will in turn dampen second-quarter U.S. GDP performance. April exports to the European Union, China and Japan all dipped from March levels.

One bright spot remains: growing volumes of petroleum exports, as energy exploration and development continue to expand in the United States. Petroleum import needs are shrinking month by month as domestic production climbs. By the end of this decade, the United States should be a net exporter. Exports of petroleum in April climbed by $355 million to $11.82 billion, while imports were down $666 million to $29.83 billion for the lowest monthly total since mid-2013.

Dept. of Commerce: Trade Data

The Capitalist’s Dilemma

In The Capitalist’s Dilemma, Clayton Christensen and Derek van Bever introduce a powerful new theory which works to explain the relative paucity of growth in developed economies … The authors draw a causal relationship between the mis-application of capital in pursuit of innovation and the failure to grow.[1]

In particular, they observe that capital is allocated toward the type of innovation(s) which increase efficiency or performance, and not toward(s) those means which create markets (and hence long-term growth and jobs). This itself they argue is caused by a prioritization and rewarding of “performance ratios” rather than cash flows, and that that in itself … is due to a perversion of the purpose of the firm.[2]

For this statement of causality to be confirmed, one needs to observe whether it predicts measurable phenomena. For instance/starters, do companies which create markets apply capital toward market-creating innovations, or do companies which create value through efficiencies or performance improvements hoard abundant capital …

Notes:

1. and, indirectly, in the increase in inequality and hence the destabilization of socio-political institutions. [↩]
2. That being the creation of customers, and not shareholder returns. [↩]

HBR’s Synopsis

Sixty months after the 2008 recession ended, the economy was still sputtering, producing disappointing growth and job numbers. Corporations seemed stuck: Despite low interest rates, they were sitting on massive piles of cash and failing to invest in new initiatives. In this article, a leading innovation expert and his HBS colleague explore the reasons for this sluggishness. The crux of the problem, they say, is that investments in different types of innovation have different effects on growth but are all evaluated using the same (flawed) metrics. “Performance-improving innovations,” which replace old products with better models, and “efficiency innovations,” which lower costs, don’t produce many jobs. (Indeed, efficiency innovations eliminate them.) “Market-creating innovations,” which transform products so radically they create a new class of consumer, do generate jobs for their originators and for the economy. But the assessment metrics that financial markets–and companies–use always show efficiency and performance-improving innovations to be better opportunities. This is the capitalist’s dilemma: Doing the right thing for long-term prosperity is the wrong thing for investors, according to the tools that guide investments. Those tools, however, are based on an unexamined assumption: that capital is scarce, and that performance should be assessed by how efficiently companies use it. The truth is, capital is no longer scarce, and our tools need to catch up to that reality.

Genius of the AND

The Genius of the AND

First, leaders of endurung great companies are comfortable with paradox i.e., having the ability to embrace two opposed ideas in the mind at the same time. Second, they don’t oppress themselves with the “Tyranny of the OR” e.g., to believe that things must be either A OR B, but not both. The best leaders liberate themselves with the Genius of the AND—the ability to embrace both extremes of a number of dimensions at the same time. In the words of F. Scott Fitzgerald, “The test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.”

Some Genius of the AND examples:

Disciplined And Creative
Empirical validation And Bold moves
Prudence And BHAGs (Big Harry Audacious Goals)
Paranoid And Courageous
Ferociously ambitious And Not egocentric
Severe performance standards, no excuses And Never going too far, able to hold back
On a 20 Mile March And Fire bullets, then cannonballs
Threshold innovation And One fad behind
Cannot predict the future And Prepred for what they cannot predict
Go slow when they can And Go fast when they must
Disciplined thought And Decisive action
Zoom out And Zoom in
Adhering to a SMaC recipe And Amending a SMaC recipe (Specific, Methodical, Consistent)
Consistency And Change
Never count on luck And Get a high ROL when luck comes