Outlook and Market Review - Third Quarter 2011

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Summary: 

In the first revision of third quarter GDP, the Bureau of Economic Analysis announced that the U.S. economy grew at only 2% in the third quarter.  For the year, the real GDP growth was 1.5%, which is well below normal growth in the third year of an expansion.  Consumers led the way in the third quarter but spending was not supported by increased disposable income, resulting in a declining saving rate.  While delevering has created room for consumers to spend, the rate of spending relative to income in the third quarter is not sustainable.  Unemployment remains at 9% but labor markets are positioned to improve as we move into 2012.  First claims for unemployment in recent weeks dropped below the 400,000 benchmark that is often used to measure the health of labor market.  Job creation is slow for now but unit labor costs have continued to decline to set the stage for more hiring. Inflation eased in the third quarter after picking up earlier in the year.  The personal consumption expenditure index has moved back in the range of acceptable inflation.  Nevertheless, the misery index, calculated as the sum of the unemployment rate and the inflation rate, is higher than it was during the financial crisis and 2008-2009 recession.  The misery index is at its highest point since the early 1980s.

Financial markets continue to be very volatile as both internal and external threats to the U.S. economy build.  Europe is facing a recession with a mounting crisis over the ability and willingness to maintain the Euro through bailouts of Eurozone countries.  Greece, Italy, Spain, Belgium, and Portugal all appear to need help at this point.  A tipping point is approaching where any solution will require more aggressive demands for fiscal policy integration in addition to existing monetary policy integration.  This will be contentious and difficult to achieve in the short run.  Overall, the European economies are weakening, reflected by recent declines in the Purchase Managers Index (PMI).  Yields are rising and talk of a potential downgrade of France’s bond rating is picking up.  Europe is not the only global problem area for the U.S.  The PMI of China is weakening as the government is trying to achieve a soft landing from an over-heated economy.  U.S. exports will take a substantial hit if both Europe and China have much lower growth.  The Middle East will continue to be a concern with unknown shifts in the balance of power for countries where leadership was toppled.  Worse yet, the Iranian nuclear program backed by China and the Soviet Union creates the possibility of pre-emptive strikes by Israel and major disruption of oil supplies.

Internal threats to the U.S. economy are also serious.  Fiscal policy will become a drag on the economy as automatic spending cuts kick in due to the failure of the “Super Committee” to structure a long run plan for deficit reduction.  While the debate over higher taxes relative to spending cuts continues, no progress has been made on fundamental problems in entitlement programs and tax reform. The total national debt now exceeds 15 trillion with annual deficits that are approximately 10% of GDP.  These underlying conditions and ineffectiveness of the 2009 one trillion dollar stimulus package make it unlikely that a “jobs bill” with a temporary stimulus of approximately 400 billion will have a serious chance of passing.  

Fourth quarter GDP will get a boost from inventory investment and consumers are likely to carry forward strong spending in the third quarter into the fourth quarter.  Government will be a drag on GDP but business spending should pick up to take advantage of tax laws ending in 2011.  Net exports are not likely to help GDP as much as in the third quarter.  Without major unexpected shocks, GDP growth is likely to be in the range of 2% to 2.5%. Inflation has moderated and will remain in the 2.5% range unless there are key shocks to energy prices.  The Fed will help keep interest rates down with a flatter yield curve.  The Fed is likely to step up purchases of Mortgage Backed Securities in 2012 to lower the spread between Mortgage rates and Treasury rates.  The inability of fiscal policy to provide stimulus to the economy will make it likely that the Fed uses monetary expansion in 2012.