By Christopher Bremer, Director, Private Client Services Portfolio Management
Northwestern Mutual Wealth Management Company
Since the Great Recession ended, the U.S. economy hasn’t been able to gain traction and achieve a true recovery that would bring unemployment down and set the economy on a path to sustainable growth. While there is no guarantee that 2013 will finally mean the end of the low-growth, high-unemployment economy that has been the norm for the past three years, there are encouraging signs.
Underpinning the global economy are the significant central bank easing initiatives, meaning that across most of the world, interest rates should remain fairly low through 2013. And because inflationary pressures are also low, central bankers have room to follow this policy and even ease further should economic conditions fail to improve.
Consumers and businesses have spent the last few years deleveraging, a process that may not yet be concluded. Regardless of whether it is, both households and businesses are in a better position to contribute to economic growth in 2013 than in previous years. Households are feeling wealthier due to increased home values, lower unemployment rates and deleveraging. Businesses are enjoying record profits as lending standards are set to loosen a bit, which could mean more business investment next year.
All that being said, the economy still has to navigate through a significant amount of uncertainty. As of this writing, the fiscal cliff has yet to be resolved. In addition to domestic political risk, there is still significant political risk in Europe. European leaders have yet to implement structural reforms that will pave the way for a politically and economically united Europe, and the countries on the periphery that have received bailout funds are still staggering under high loads of debt amid shrinking economies. In addition, emerging markets, while still growing more rapidly than developed markets, are slowing from their prior rapid growth pace, impacting the overall global macro economic picture.
While there is no way to know how the U.S. economy will perform in 2013, the best guess from economists is another year of moderate growth, with the second half growing faster than the first half. Absent a political shock, the positive forces that are present in the U.S. economy may be setting the stage for higher growth rates and a further decline in unemployment in 2014. Many of the trends we are seeing – low interest rates, an improved housing market and improved business and consumer spending – have the potential to build on each other in a positive way, ultimately paving the way for higher economic growth later this year and going forward.
In this month’s commentary, we’ll take a look back at 2012 through the lens of trends into 2013 and what those might mean for the economy. We’ll also examine the roles that monetary easing, deleveraging, the housing market, consumer and business spending and inflation are likely to play in the economy this year.
The impact of the Federal Reserve’s accommodative monetary policy stance on the economy can’t be underestimated. For six and a half years, the Fed has maintained a zero interest rate policy that it is committed to continuing through next year. By keeping interest rates near zero, the Fed encouraged business investment and has supported the housing market. That support for the housing market is poised to pay off this year, as more new homes are likely to be built and deleveraged consumers, more confident about the job market, feel comfortable enough to move. Businesses, with record profits, can also invest in capital improvement projects at low interest rates, which could also help spur employment. The Fed is hopeful that as housing prices stabilize and increase, banks will be more willing to lend, leading to an increase in consumer and business sentiment, which will lead to more willingness to spend.
Accommodative monetary policy is also the rule of the day across the globe, as 40 countries have implemented easy money policies via 300 global policy initiatives, according to ISI Group. Such policies have reduced economic systemic risk over the past several years.
Supporting employment has been a major goal of the Fed’s low interest rate policy. The Fed has a stated goal of 6.5 percent unemployment. To get there by the end of this year from the current unemployment rate of 7.7 percent, the economy would have to create a total of 3.2 million jobs, or 270,000 jobs a month. That’s a pretty steep increase from the current rate of approximately 150,000 jobs a month.
Whenever the economy does reach that target, the Fed would presumably back off on its monetary policy easing, which would mean interest rates would start to increase from their current rock-bottom lows. At that point, the Fed will begin to remove liquidity from the economy, and interest rates would increase. While the Fed has not laid out a plan for exactly how that would occur, it would likely reduce liquidity gradually, meaning interest rates would also increase gradually.
Economists are rightly preoccupied with inflation because consumer spending is so critical to the economy that inflationary pressures could easily constrain consumer spending, diverting more spending toward coping with increasing prices than other areas (Fig. 1). Fortunately, inflation, which has been seen as a risk of loose monetary policy for years, remains tame. Lower inflation, which benefitted consumers in 2012 by providing them with more cash flow, looks to continue into this year. Last year, inflation fell to pre-Quantitative Easing levels.
Another positive trend at the end of 2012 was falling food and energy costs. In November, consumer prices dropped by .3 percent, and gas prices led the decline with a fall of 7.4 percent from the previous month. As a lower percentage of their incomes go toward food and energy, consumers have more discretionary income to spend. If food and energy inflation remain moderate or even fall in 2013, that could free up additional discretionary spending into the economy and stimulate further growth. However, there is always a possibility that inflation will return; the most likely area for a re-emergence is in emerging markets, which are more subject to volatile pricing due to their commodity-based economies.
Following the housing boom and bust that contributed to the Great Recessions, American consumers and businesses have been on a deleveraging quest. Many homeowners are still underwater with their home values; others have paid down credit cards, student loan and other debt. Businesses have also delevered and, like consumers, are in a position to begin spending more to contribute to economic growth.
Although it is likely that consumers have not completely worked through the deleveraging cycle that began in 2007, deleveraging will likely be less of a factor in 2013 than it was in 2012 and in previous years. Household debt service burdens are falling to all-time lows as a result of lower debt levels, rock bottom interest rates and refinancing activity (Fig. 2). Consumer borrowing is unlikely to rise in 2013, as bank underwriting standards are still tight for all but the most qualified borrowers.
Consumer savings rates are continuing to rise, which is a positive trend for consumer balance sheets but could be a negative for the economy if it inhibits consumer spending. However, gross domestic product (GDP) is growing faster than credit growth. If this trend continues at the pace of the past four quarters, private debt to GDP ratios will be back to historically normal levels within a decade. Many economic models, including the Fed models, don’t take consumer deleveraging into consideration, which may distort them.
Businesses, in particular, are in a good position to spend. Not only have they paid down debt, but also any debt they have assumed is at extremely low interest rates. Plus, many have cut down on their expenses, including labor costs, which are unchanged since the recession began.
The housing market, long a drag on U.S. economic growth, became a positive contributor to economic growth in 2012 and is likely to continue to gain momentum this year. A number of positive signs, including growth in housing starts, home sales, building permits issued and home prices, are building on each other.
Homebuilder confidence, an important metric of builder optimism about the economy, has risen for eight months in a row and is on the brink of turning positive. The National Association of Home Builders Monthly Index hasn’t risen above 50 since April 2006; a reading above 50 indicates that the majority of builders surveyed view the building sales climate positively. The index was just below that mark in November.
One of the Fed’s primary motivators in its low interest rate policies has been its support of the housing market. Previously, those efforts kept the housing market from falling into a deeper hole; this year, those efforts are likely to bear more fruit in terms of a positive impact on the economy.
Consumers are at a point where they are more confident due to falling unemployment rates and lower food and energy inflation, which could act as a further spur to home buying. In addition, household formation is rising as young people who have lived with their parents are moving out and either renting apartments or homes or buying their own homes – another positive for the housing market.
If businesses and consumers remain confident and act on that confidence by spending on big-ticket items, that could spur economic growth above the anemic rates of the past few years. For consumers, that spending is most likely to occur around housing and cars. Research firm R.L. Polk reports that the average age of all U.S. vehicles in operation is at a record high (Fig. 3), indicating there may be a pent-up demand for new cars, especially in light of all the destruction of vehicles involved in Super Storm Sandy.
In addition, consumer retail sales are holding up during the critical holiday season; the November retail sales report came in at .3 percent, which is especially significant given the impact of Sandy, which impeded sales in the Northeast. The biggest gainers in November were electronics and online retailers.
For businesses intent on remaining profitable or increasing profitability, business investment is necessary after years of operating leanly. The resolution of political uncertainty around the fiscal cliff, combined with record corporate profits, could provide the incentive for corporations to invest in capital equipment and technology, boosting employment.
With a confluence of economic factors seemingly responsible for the positive trend in the economy, it makes sense to follow these for some indications of how the economy will fare this year. Housing starts, builder confidence, housing prices and existing home sales are all important metrics related to the housing market. If those continue to improve or at least not deteriorate, that will support a decent rate of economic growth this year. Consumer spending, as seen in retail sales numbers, is another important metric to monitor.
Inflation is such a foundational metric for the overall economy that it bears watching. While the Fed is willing to tolerate higher inflation, high inflation in general is not a positive for the economy. So the trends in the Consumer Price Index are important to get a feel for how inflation is trending.
Keep an eye out for exogenous risks to the economy, such as violence in the Middle East, rising bond yields in Europe and inflation spikes in emerging markets. We’re monitoring these, as we think they still pose significant threats to a fragile recovery in the United States.
While the economy is on a stronger footing than it was this time last year, there isn’t a consensus that it’s about to break out on the upside, nor is a recession likely. Economists surveyed by the Wall Street Journal predict a GDP rate of 2.3 percent next year. They assess the risks of recession and the chance of growth at or about 3 percent at exactly the same likelihood: 24 percent.
The fact that the economy is operating from a broader base of growth than it did previously is another reason that a recession is less likely. With the housing market in full recovery mode, interest rates low and inflation tame, the economy is in a better place than this time last year.
Christopher Bremer is the Director, Private Client Services Portfolio Management with the Northwestern Mutual Wealth Management Company. The opinions expressed are those of Christopher Bremer as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.
Northwestern Mutual Wealth Management Company, Milwaukee, WI is a subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and a limited purpose federal savings bank authorized to offer a range of financial planning, trust, fiduciary, investment advisory and investment management products and services. Securities are offered by Northwestern Mutual Investment Services, LLC, subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC.
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The National Association of Home Builders (NAHB) is a trade association that helps promote the policies that make housing a national priority. The NAHB services its members, the housing industry and the public at large.
The U.S. Department of Labor Consumer Price Indexes (CPI) program produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services.