2011 Q2 Review - Economy Outlook

The data caused me to reduce my full-year GDP growth estimate from 3.5% in my last quarterly report to a range of 2.5% to 3.0%. Inflation for the year is still likely to be around 3%, though that rate is clearly moderating now. I still think monthly private-sector employment growth of 200,000 (or about 2% annualized) remains a real possibility, though the 250,000 number I had hoped for looks like a bit of a stretch. Given a combination of labor force drop-outs and these better employment numbers, I still believe that the unemployment rate can fall below 8.5% by the end of this year.

Slower Economy Leads Investors to More Defensive Stocks

Slowing growth showed up in this quarter's stock data as health care and utilities--heretofore poor performers--were the best performers, as investors flocked to more defensive sectors. Meanwhile commodities and tech stocks, which had led the market, trailed far behind in the quarterly performance derby. The popping of the commodity bubble and a greater fear of risk assets contributed to the underperformance.

Special Factors Hit the Economy Hard, But There Are Fundamental Concerns, Too

The economic slowdown appears to be partially due to several one-time factors that should reverse themselves (earthquakes, tornadoes, and gasoline prices) in the second half. However, some fundamental factors are contributing to the softness as well.

I believe the root cause of the current slowdown in economic growth was a slowing in real hourly wage growth. Given that the consumer represents over 70% of the economy and that consumer incomes come primarily from wages, the hourly wage data can provide important clues about consumer spending capabilities. Real hourly wages began slowing in February and moved into negative territory in May, when computed on a three-month moving average basis. Real hourly wage growth is calculated by taking wage growth and adjusting for the effects of inflation.

Actual hourly wages before inflation have been stuck in a very narrow range of 2%-2.3% for over a year; meanwhile, inflation has moved from about 1.1% to 2.2%, putting the consumer behind the eight ball.

The good news is that I expect inflation to moderate in the months ahead, which should put the consumer back on top. Gasoline prices have fallen from almost $4 per gallon to around $3.60, a 10% decline in just a matter of weeks (see more on gas prices below). As detailed by our consumer team, food prices are also in the process of peaking. Wholesale crude food prices are off significantly for three months in a row. Auto prices, which have also been a major bugaboo, should begin to back off as the Japanese auto manufacturers bring major chunks of capacity back online over the next several weeks.

Besides the real wage growth issue, which appears as if it could subside, a number of anomalies rocked the economy during the quarter. In fact, it's a bit surprising to me that the economy has held up as well as it has given a surprisingly long list of negatives. The list includes major supply chain issues related to the Japanese earthquake, sky-high gasoline prices resulting from unrest in the Middle East, and weather so chilly and stormy as to disrupt normal seasonal buying patterns.

Looking for Clues in All the Wrong Places

The market is currently focusing on both manufacturing data and commodity prices as key indicators of economic direction. At different parts of the recovery, especially economic bottoms, these can be important indicators, but perhaps less so at other times. For example the three-month moving average of the National ISM Purchasing Managers' Survey was a great and early predictor of the current recovery. However, this indicator tends to be hyperactive at tops. During the 1990s this indicator fell below 50 (anything below 50 is generally considered indicative of a slowing) on three separate occasions, and no recession followed, before making its fourth plunge right at the end of the decade that did finally lead to a recession.

Attempts to keep inventories in line with demand lead to a lot of over- and under-shooting in the manufacturing sector. And keep in mind that manufacturing employment represents less than 10% of U.S. employment. Some of the weaker purchasing managers' reports did indeed lead declines to softer industrial production, but strengths in other sectors of the economy offset some of the weakness in the smallish manufacturing sector.

The most important point to remember is that manufacturing is driven by consumers and not vice versa. Manufacturers aren't going to produce goods for the fun of it. They can only react to what consumers are demanding. Therefore, keeping an eye on consumers is the key to determining the direction of the economy.

Interpreting commodity prices in relation to the economy can get really tricky, too. Right now, commodities can seem to do no right. Prices go too high, and the market frets that the consumer will have nothing left to spend after paying up for commodities, especially gasoline. Prices fall too far, and the market interprets it as a great secret indicator of economic weakness.

At the moment, I believe that recently falling commodity prices are a really good thing. As I noted above, high inflation, which has been driven almost entirely by commodities, has been the biggest threat to consumer spending. Therefore, a fall in commodity prices (as described in more detail in many of our sector updates) should free up more cash for goods and services produced in the United States. However, falling commodities probably do mean at least some weakening in the manufacturing sector.

The Healing Process Should Continue, but Slowly

This quarter's report is perhaps a bit more short-term oriented and tactical than I am accustomed to. However, I think it's best to identify the short-term problems front and center so they lose some of their panic power.

The economy is still operating close enough to the edge that we have the capability of scaring ourselves into another recession. Another bad geopolitical event combined with a little old-fashioned panic could indeed sink this recovery.

But as bad as the numbers will look over the next month or two, there are some hopeful signs just down the road. Longer term, I am convinced that decent productivity growth, favorable demographics, and a sustained real estate recovery beginning in 2012 could drive the economy forward for some time. That is, if the politicians don't mess it up.

Robert Johnson, CFA, is associate director of economic analysis with Morningstar.

This is an edited version. The article originated from Morningstar.com.