It’s important to account for factors, which may help unlock the macro puzzle in the months ahead. In my bi-annual macro outlooks, I specifically include a sub-section named “Keeping An Eye Out”. In it I list what I believe will be important ingredients in accurately forecasting the macro picture in the quarters ahead. My latest outlook can be found here. This research is designed as an addendum to my latest (Mid-year) outlook and therefore may seem a little choppy in its presentation. I suggest reading it along with my latest outlook. Factor cited here will contribute to my updated thesis due in the beginning of 2012.
Monetary Policy: There are several factors that I’m focusing on to help me anticipate a shift in monetary policy. A dose of monetary stimulus has the potential to significantly alter the financial market landscape; therefore I currently regard this facet of the macro outlook as one of the more important ones in determining the near-term behavior of financial markets (and the economy?).
Overall, inflation has become a weakening impediment for the Fed to initiate another round of monetary stimulus, though it still remains one. Headline and Core CPI indicators remain warm with headline CPI near the upper-end of the historical range and core CPI right at the Fed’s target level. Continued reports of rising rents will likely support the core rate for the remainder of the year, however, headline CPI may begin to cool as lower gas prices begin to trickle down to the consumer. With respect to gas prices, while they have come down, they remain significantly elevated when compared to when the Fed announced QE2, currently at $3.45 vs. $2.71 in 2010. I believe that they remain the single largest impediment for the Fed to justify initiating another QE experiment as more stimulus would likely push oil above the $100/barrel. The result may be a further decline in consumer confidence as well as consumption growth, similar to what transpired in the second quarter of this year. Inflation expectations as per the Conference Board and University of Michigan consumer surveys have shown a small dichotomy the past few months, with the former showing persistent stickiness at the 5.7-6.1% range from May-September ‘11 (2010 QE2 = 5.0%) and the latter falling from 4.1% in May ‘11 to 2.7% (2010 = 2.5%) in September. The University of Michigan survey is indeed giving the green light for additional easing, while the Conference Board is not quite there yet. Taken together, they signal that further easing is possible in the near-term. The market’s expectations of inflation, represented by the 5 and 10-year breakevens, are slowly pointing to more wiggle room for the Fed. While both these metrics remain largely unchanged from when I last reviewed them, they are currently in a clear downtrend. Both peaked in April and have fallen 25% and 17% respectably.
Perhaps the strongest indicator in favor for additional monetary stimulus lies in recent Fed speeches. Janet Yellen, Charles Evans, Eric Rosengren, and William Dudley all expressed the need for additional measures, with Evans proposing setting a target unemployment rate and easing until such goal is achieved. There’s even talk now of setting a nominal GDP target. However, the probability for action this coming week (November 1-2) remains relatively low. What will be interesting to see are the updated forecasts of the FOMC members with regards to Unemployment and Inflation.
My sense is that many at the Fed are quite worried with what’s going on in Europe and recently China. Should a strong exogenous shock emanate from either of these regions, QE3 would follow soon thereafter. Notice how Mrs. Yellen stated, “the potential for such adverse financial developments to derail the recovery, in my view, pose a significant downside risk to the outlook”.
Overall, It looks to me that that inflation still hinders the ability of the Fed to take action. There’s a good chance that the November 1-2 meeting will be a non-event in terms of any monetary stimulus announcement. However it is becoming more probable that December or January 2012 will see some sort of action… excluding any significant deterioration in the global economy before then. Should a negative shock from Europe or China occur, then QE3 would come very soon afterwards. The outlook for monetary stimulus is clouded due to the “global economy wildcard”. Unfortunately officials continue to pursue this myopic strategy, one that has been more of a detriment than a help to the economy. The probability of unforeseen long-term effects continues to grow. A glaring example lies in the resiliency of the oil market. Brent crude remains near the $95/barrel mark despite many unknowns in the macro picture. Continued QE along with future supply shocks will help elevate the essential commodity at historically high prices over the longer-term. In the medium-term though, pursuing further monetary stimulus could result in a decent tradable multi-week/month equity rally in 2012 (similar to 2H 2010), especially if it comes paired with fiscal stimulus.
Global Economy/Trade: Currently events in transpiring throughout the global economy have the most potential in dictating the near and medium-term direction of our financial markets; therefore I currently regard this aspect of the macro outlook as the most important. Unfortunately, the news isn’t very positive.
Eurozone officials have just unleashed a multi-pronged rescue package aimed at stabilizing the sovereign bond market as well as the region’s banks. The result remains unclear. While markets rallied strongly immediately following the announcement, there is an elevated level of “execution risk”. The following couple of weeks will be very important for the global economy. Will investors deem the package appropriate? Will leaders be able to execute? The global recovery has come down to this binary and critical variable. While in my outlook I had mentioned that the Spanish 10-yr was the indicator to watch, my eyes have recently shifted to the Italian 10-yr (and possibly the French 10-yr OAT). In the immediate aftermath of the rescue announcement, I am very concerned that the Italian 10-yr yield hasn’t fallen, in fact it’s risen! Surprisingly, the Euro has held in there, moving higher to meet its 200-day moving average as of late (not counting tonight’s plunge). In an effort to stay objective, I must cite this as a positive for the region. In my view however, the package will prove to be insufficient to withstand a deepening recession throughout the territory. Furthermore, it only kicks the can down the road; it isn’t the comprehensive solution markets were looking for. Lamentably, continuing to “kick the can down the road” risks exacerbating what is a dangerous and nascent sense of nationalism. This sentiment is clearly seeping into the psyche of citizens in peripheral countries undergoing what I deem as a depression due to austerity measures. For a more detailed and current review of these factors please see here, here, here, and here (Bearish Point #3).
China inflation metrics are finally subsiding, albeit from still elevated levels. Inflation has proven to be stickier than many bulls expected. For the time being, policy officials remain committed to battling inflation; though they have signaled that policy will be “fine-tuned”. Given the sluggish nature of the global economy, the increasing probability of declining inflation is becoming important enough to consider better odds of some sort of policy easing in mid to late 2012 (earlier if we have a negative surprise from the Eurozone). For the time being though, we still have reports of protests not only from elevated inflation, but also from falling housing prices.
While I didn’t mention any indicators to “keep an eye out” for regarding China’s property market (though I did mention the rising likelihood of a property bubble popping as early as 2010), news out of this sector is very disheartening for the bullish investor. A prudent investor would need to follow news bits coming out of the sector very carefully and frequently in my humble opinion.
While the Yuan has been appreciating at a roughly 5.5% annualized rate, which I argue is a needed and continuous step to proceed with the global economic restructuring, news of hard times for exporters is pressuring authorities to temper the gains, in line with what I expected. Furthermore, diplomatic relations between the U.S. and China have become a bit rocky with Congress recently approving currency legislation despite China’s objections that rebalancing has progressed markedly. This has put China in a very difficult position. While the outlook regarding a resurgence in protectionism remains clouded, political posturing for the 2012 presidential election may result in some dicey moments for global trade in the months ahead. Romney has said on the record that he would classify China as a currency manipulator, which would open a can of “tariff and quota” worms.
Over the longer-term, China is making progress in enacting social safety nets, which I see as an important step in effectively unlocking the massive pent-up demand in the country. Progress here will undoubtedly have widespread repercussions in regards to the global economic outlook. Increased exports and job creation would dominate my outlook for the U.S economy. However, a noticeable impact from these policies remains far off.
Overall, the global economy is in danger of an acute negative surprise from Europe and China. The following days and weeks will be very important for global recovery. So far the news isn’t positive and the probability of a negative surprise from either country is alarmingly high. Should a negative outcome be averted in both Europe and China, then the medium-term outlook would probably involve continued slowing in the global economy but with a good chance of stabilization sometime in 2012. Two primary downside risks should be monitored: a flare up in protectionism and/or an intensification of unrest in China. Over the longer-term, the continued progress of enacting social safety nets in China supports my secular bullish thesis for the rise of the Chinese consumer. However, as with any long-term outlook, there are many potential potholes along the way.
U.S Inflation: Inflation remains an important component in dictating when the Fed may proceed with another round of monetary stimulus. Therefore, it is also an important piece of the macro puzzle.
An increasing risk of a negative outcome, particularly from Europe, leads me to consider a possible deflationary shock in the near-term as an important factor in my portfolio construction. Furthermore, recent news out of China remains underwhelming from a bullish standpoint and is increasingly becoming a short-term risk vs. a medium-term risk as postulated in my mid-year outlook. A slowdown in aggregate demand from the communist nation is beginning to affect commodity inventories and prices.
As I expected, higher CPI readings during the second half of the year have put the Fed in an interesting predicament with regards to administering QE3. An unexpected development, however, lies in the Fed’s consideration of changing their dual mandate strategy, with an increased penchant for targeting the unemployment rate over inflation readings as espoused by Mr. Evans. This bears watching, as it would portray greater tolerance for inflation and somewhat reduce the factor’s importance in determining the future direction of monetary policy.
On the “job market” front we have more of the same environment that has characterized this recovery, sluggish growth with low expectations for wage growth. The ability of the consumer to withstand continued inflation remains restricted if tepid growth in real wages is any indication. Wages have lagged inflation due to a glaring characteristic of the 2007-2009 recession, an increase in the structural rate of unemployment. A high supply of workers remains a critical issue for the economy.
Overall, most ingredients that I believe should dictate the future direction of inflation continue to signal a period of “disinflation” with the risk of a deflationary shock should the Eurozone or China falter in the near to medium-term 0-12 months). However, over the longer-term (1+ yrs), the risk of inflation is increasing due the Fed’s myopic strategy of resorting to monetary stimulus every time the economy seems to be slowing. Couple this policy with increasing evidence of a manufacturing renaissance in the U.S. as “re-shoring” gains momentum (prompting job creation) and an inevitable scarcity of raw material supply (due to China’s secular growth) and you have a long-term scenario of elevated commodity prices, and increasing interest rates. I’m beginning to see a flicker of light in what remains a long disinflationary/deflationary tunnel.
U.S Government Policy: As I expected as early as February, progress towards enacting another stimulus package has been halted by deadlock between Democrats and Republicans. My thesis of “Political Frugality” remains in place given that bickering continues over what’s the best prescription for our ailing economy. “Recognition Lag” remains an elevated risk for a double-dip recession in the short to medium-term. Consequently, I deem near-term U.S. Government policy of heighted importance in the macro outlook.
Perhaps the largest factor that may lead to further short-term stimulus comes from the near-term direction of the global economy. As I reviewed previously, this risk is extraordinarily high. A negative surprise in either the Eurozone or China would precipitate an accelerated fiscal response in my view. Continued Republican opposition would be seen as detrimental towards shielding the U.S. economy from a global slowdown.
Should we avoid a downturn in global growth, the U.S. economy would likely remain in a slow growth pattern resulting in job creation lagging population growth. The unemployment rate would remain elevated. I had hypothesized earlier (note: not as part of my official outlook just yet) that we could see a strong push for more fiscal stimulus in the coming weeks/months. I am growing more confident in this outcome when I read recent political news stories (here, here, and here). An unexpected wrinkle further supports my sentiment, the Occupy Wall Street Movement. Certainly an environment of class warfare is developing and is creating a political motivation to advance stimulus proposals, seen as a way to help the “bottom 99%”. Finally, the Fed has publicly become more supportive for fiscal stimulus (I actually see it as a necessity for an effective monetary stimulus package).
Overall, the political and economic environment is more accommodative for additional fiscal stimulus sometime in 2012 and I will likely include it as an upside risk for my 2012 outlook. Political backing for additional stimulus is slowly gaining momentum as our economic malaise continues. By continuing to reject any stimulus proposal, the Republican party is putting itself between a rock and hard spot in my view. Political Frugality may take a rear seat in 2012.
U.S Industrial Production: While we have recently seen a dichotomy between PMI surveys (lower) and industrial production data (stable to higher), when taken together, Manufacturing activity currently remains in growth mode. While industrial production is obviously important to the U.S. economy, I currently do not regard it as an important impetus capable of profoundly altering the bigger macroeconomic picture. I see it more as a coincident indicator, if that makes any sense.
Factors that I’m looking at in determining the direction of industrial production begin with end demand in the U.S., Europe, and China. To that end, the news points to increasing downside risk. In the U.S., the ECRI leading index has been flagging a slowdown, accentuated by Lakshman Achuthan’s bold call for an oncoming recession. Moreover, another leading indicator, specifically gauging the future growth potential for the manufacturing sector, is also flagging a significant slowdown. While the Pulse of Commerce Index is still in its infancy and has yet to successfully forewarn of an oncoming contraction in manufacturing, it supports the ECRI assessment. The risk of a slowdown in the U.S. is a heightened probability, especially when factoring transpiring events in the Eurozone and China. Given that global growth has been a positive factor for our manufacturing sector, any slowdown here will more than likely affect the sector’s prospects.
In the longer-term (1+ yrs), a manufacturing renaissance is increasing in probability as “re-shoring” picks up momentum. Furthermore, the advent of natural gas and shale is a new factor, which has recently caught my attention. Another supportive ingredient for a bullish view lies in China. Continued progress on implementing a comprehensive social safety net will pay dividends for manufacturers at home as untapped demand increases. I’m usually not keen on pointing out a specific investment given that I’m a macro guy, but I’d seriously consider “putting my hands up for Detroit”. Real estate there fits my definition of a secular bear market trough, a hopelessness and hate for an asset class (contrary to the equity market). If I had long-term investment staying power (10 yrs+), I’d be carefully analyzing real-estate investment opportunities in the city.
U.S Service Sector: My sentiment with regards to the U.S. service sector tightly fits with manufacturing. The sector in growth mode, however, it remains sluggish.
End-demand remains of the upmost importance. As an addendum, the U.S. dollar has recently seen support and may be on the cusp of a sustained weekly uptrend, particularly if the twin towers of negative global risk (Europe and China) come to a negative solution.
Job Market: Conditions in the job market have remained mostly inline with my outlook. Growth remains tepid and there are signs that it has begun to stall (Gallup Poll of Job Creation, and consumer sentiment surveys). While I generally see job creation as a coincident factor for the macro outlook, it is extremely important not only from an economic aspect but from a social aspect as well (my clear acknowledgment of the importance of the Occupy (Name the City) movement). A healthy job market remains a pivotal cog in a self-sustaining recovery as well as improvement in living standards.
Prospects for renewed growth remain grim. Leading indicators such as the Conference Board Employment Trends Index and the ECRI leading indicators point to formidable hurdles for above average growth in the months ahead. The JOLT survey has shown some healing but little in the way of significant improvement.
Tying in with my government outlook, I see the prospect for another stimulus package increasing sometime in the short to medium-term. This is a developing positive for the job market. While we currently see continued deadlock in our legislative branch, I believe that the increasing eminence of the Occupy Wall Street movement will more than likely light a fire under Congress’s ass. At the risk of sounding like a tape-recorder, the near-term probability of immediate stimulus would rise should the global economy take a negative turn. Looking ahead, I sincerely hope that the next stimulus will be more geared towards our long-term prosperity (ie. one focused on a re-tooling of our workforce, coupled with a “Made in America” infrastructure stimulus).
Consumption/Borrowing: While I cited in my Beg. 2011 outlook that the advent of higher commodity prices in the first half of the year could be the straw that breaks the vulnerable consumer’s back (citing this event as a high probability), consumption growth was able to hang in and overall outperformed my expectations in Q3. The sector’s performance was clearly a bullish factor for Q3 GDP growth, contributing 1.73% in what was its strongest performance for the year. I would point out though that higher commodity process did indeed have a negative effect as I forecasted in the beginning of the year and it was a very very close call. Consumption added 0.49% in Q2, in what was the lowest growth rate since Q4 2009. I did compensate for this “over-bearishness” in my Mid-year outlook by stating that the sector remained in growth mode. In the grand scheme of things, I still consider the sector’s performance as largely in line with my general long-term outlook; continued tepid growth translating to an elevated vulnerability to significant downside surprises. Similar to the manufacturing and service industries, I view consumption a coincident macro factor; however, it is clearly the most important one for the domestic economy. So what am I keeping an eye out for?
Obviously, front and center is the increased negative risk for souring global economy growth (Europe and China). Deterioration on this front would greatly increase the odds of contraction in the first half of 2012.
On the bright side, we are seeing a decline in gas prices, which based on Q3 performance is clearly a productive medicine. It will be important for this trend to continue in order to have a potential upside surprise in 2012 (ie. Please FOMC, no more QE). I should mention a paradox that has developed in the past few months. Consumer confidence has lagged spending in remarkable fashion. Why? I’m still scratching my head on that outcome. Consumer confidence as an indicator for potential spending patterns has fallen in importance in my opinion.
Continuing in the medium-term, you have the current state of deadlock in Washington acting as a psychological headwind for business confidence. On the positive side though, I’m beginning to expect a renewed political surge for fiscal stimulus in the shorter-term (0-6 months). This should help in the coming quarters.
Finally we need to examine the current state of the consumer’s balance sheet, beginning with its largest asset: a home. The housing market remains in a deep funk. The best we can expect on this front is price stabilization. I’m not very confident on this outcome either over the short to medium-term; particularly when looking the state of the job market, not to mention the supply situation. Housing will continue to act as a persistent headwind on consumption. The potential for further declines in home prices is significant, which would lead to an increasing headwind for consumption and psyche.
One could choose two ways to interpret the consumer’s savings rate. On the bullish side, a decline may signify increased confidence in the economic outlook and little need for deleveraging. This view is very difficult to accept in my opinion given that consumer surveys are extremely negative. On the bearish end, which makes more sense to me, it can be seen as a depleting “consumption-growth battery”. Given that the savings rate is the lowest since late 2007, this battery is dangerously low. With real wage growth stagnant, how will consumption growth continue? Trust me, I’m trying to look at things in an objective fashion, but this isn’t very positive news. With all this negativity, I need to end with a bullish tidbit: the Household Debt to Disposable Income Ratio is coming down to more sustainable levels and is a growing bullish factor.
Overall, on the bullish end, the consumer has definitely shown its resiliency in previous months (outperforming my expectations). The Household debt to Disposable Income Ratio has come down to more sustainable levels. Gas prices have been declining. While I am speculating with this bullish tidbit; we have an increasing probability for fiscal stimulus in 2012. Conversely, on the bearish end we have a clear and present danger in a downward surprise in global growth. We also have a low “consumption battery” (savings rate). We have sluggish home prices. Finally, wage and job growth remain tepid. Trying to take all these indicators and tie them into one conclusion is challenging. In my view the sector’s short and medium-term prospects remain extremely clouded with a more intense bearish tilt compared to my mid-year forecast.
Consumer Confidence: My outlook has been spot on with regards to consumer confidence. As expected, increased market volatility due to Eurozone jitters has affected consumer confidence in a negative fashion, particularly for the affluent consumer who has much of his/her wealth in financial markets. As noted in the previous section, perhaps this macro factor has lost some of its predictive luster given the large dichotomy between it and consumption trends.
The Eurozone remains a factor I’m closely watching. News on that front is negative. The potential for further declines in confidence in the short to medium-term is probable if we have a negative surprise both the Eurozone and/or China.
The labor market remains challenged. This has clearly manifested itself in confidence. On the labor market front, as previously reviewed, strong growth doesn’t seem to be coming anytime soon. From a bullish view, prospects of a fiscal stimulus may result in an upside surprise in 2012.
Finally with regards to housing, please see below…
Housing: As expected, housing has remained it a deep funk since 2006. While home prices have resumed their decline, I must admit that they have been rather resilient. I believe that this sector will eventually become a key leading macro factor in the long-term.
In the short-term, recent levels of the MBA mortgage purchase applications index (hovering near 1996 levels) serve to reinforce how poor the demand side is for housing. Pair this with a tepid job market and you have a situation where further price declines are probable in the quarters ahead. My confidence for an upside surprise remains limited, however, I will be keeping an eye out for positive news from the latest HAMP modifications. While much of the feedback I’ve read has been negative, I will let the market dictate the result and will remain open to a possible surprise come the next home-buying season.
In the longer-term, the homeownership rate remains rather high when considering a need for “mean-reversion” (ie. It has a ways to go).