Saturday, April 02, 2011

Guest Post: First Quarter Economic Update by Dorothy Jaworski

The World Around Us

World events are impacting our markets. Unrest in the Middle East has already changed governments in Tunisia and Egypt. Protests and internal fighting in Libya have led to an international coalition bombing the country in order to establish a “no-fly” zone. Saudi Arabia and Bahrain also face protests. Triple tragedies in Japan from the 9.0 magnitude earthquake, the giant tsunami, and the ongoing nuclear emergencies have us all unsettled.

Moody’s Rating Service never sleeps and has downgraded the debt of Spain, Greece, and yes, Japan. Oil prices keep rising and we’ve seen a 15% increase in gas prices since year end 2010. So far, about half of the positive economic impact of the surprise 2% reduction in social security taxes and small business tax cuts are gone because of higher gas prices. It may not take long before the remainder is gone, too.

It is no surprise then that the confluence of these events chipped away at the stock market rally and set into motion the inevitable correction. Stock markets had been rallying nicely since the Federal Reserve unveiled their $600 million quantitative easing program, commonly known as “QE2,” in November. Actually, stock markets are up nearly 100% since the Fed was in the midst of their first quantitative easing program in early 2009. One of the Fed’s QE2 goals, as stated by Chairman Bernanke, was to improve the stock market. In that, it has succeeded.

But the other stated goal was to keep longer term interest rates low or push them lower; this has not been accomplished. The bond markets had other ideas, selling off continuously since November, until three year through ten year Treasury yields had risen by over 100 basis points, peaking at increases of 130 to 140 basis points over November levels. It was not until stocks began to correct in early March that rates began to fall some-what, or about 25 basis points, as investors bought Treasuries and other bonds in a flight to quality because of all the uncertainty in the world.

Fundamentally, stocks should continue to do well in this, the third year of the rally. Corporate profits are strong and companies are sitting on a $2 trillion stockpile of cash. Mergers and acquisitions are continuing at a brisk pace. Prospects for economic growth are gradually improving, with 3% to 3.5% expected this year, and consumer and business confidence has been rising. The S&P 500 forward price-earnings ratio of 13.5 times is well below the historical norm of 15.5 times, so there is room to continue the upward trend, if world events cooperate, that is.

The Missing People

I usually do not obsess over economic data but I have been trying to figure out why the unemployment rate managed to drop from 9.8% to 8.9% in just three months, without a commensurate improvement in the number of jobs created. There has not been a drop of this magnitude in the unemployment rate in so short a time since 1958, when I was an infant. So, let’s look at some of the recent numbers and you will probably join me in asking “Where are the missing people?”

Payroll employment rose by 407,000 in the past three months, or an average of 135,000. Household employment, which incorporates the self-employed, rose by 664,000, or an average of 221,000.

Now, let’s look at the other data: Over the past three months, the number of people reported as unemployed has dropped by 1,028,000, the pool of available workers dropped by 1,206,000, and the total labor force dropped by 704,000. Where are these people, when there were not enough jobs created to account for the drop in unemployed persons? Why are they missing? If they didn’t get jobs, where are they?

We are creating average monthly payroll growth of 135,000 and household growth of 221,000, or barely enough to absorb new entrants into the workplace, and we are supposed to believe that the ranks of the unemployed dropped by over a million and the unemployment rate has miraculously dropped by nearly 1%! Ridiculous!

Growth for 2011

Economists were stampeding over each other to raise their GDP forecasts to 3.5% from 3.0% for 2011 earlier this year after the surprise tax cuts for consumers and businesses. Even the Federal Reserve raised their forecast range to 3.4% to 3.9% from the prior 3.0% to 3.6%. Then they all got another surprise from surging oil prices (currently over $100 per barrel) and gas prices (currently up almost 50 cents from the end of 2010), so the higher growth projections may have been a bit premature. At this point, we will probably see the originally projected 3%, given the still rising oil and gas prices, high unemployment, higher interest rates, and still weak housing markets.

To put this 3% growth rate into perspective, it would be only slightly better than 2010’s rate of 2.7% and equal to the average rate of GDP growth from 2000 to 2004. But 3% is tremendously above the recent average between 2005 and 2009 of 1.0%. We long for the glory days of the 1990s, when the average growth rate for the decade was 3.8%.

But, dream on, because the long term historical average is 3.2% since World War II, so we are close to average. I will note that GDP for 4Q10 was a record $14.86 trillion (annualized basis), which is above the prior record set in 4Q07. Consumers, businesses, and governments – state and local – are improving slowly. Very slowly. Enough to keep the Fed on hold with short term interest rates near zero – until unemployment falls from today’s high levels – from real job creation not just missing people.

Putting It All Together

Since my NCAA bracket did not turn out too well – I had Temple, Pitt, and Syracuse among others – I am forced to focus on the rest of the madness in the world. It really is true that our markets are closely tied to what is happening elsewhere and not always what is happening at home. Other than protests and natural disasters, there is one theme that has been garnering attention – that of soaring food and energy prices.

Some of the Middle East protests are in response to higher food prices, which, according to the IMF, are setting new records. So far, these dramatic price rises have not worked their way permanently into the prices of other goods and services. That is because our economic recovery is still fragile and increases in prices may not be sustainable.

Consumers likely will pull back spending in response to high prices, leading to weakening economic growth. We count on the Federal Reserve to watch inflation developments closely and they are seeing excess capacity, high unemployment, low wage and salary gains, and continued weak housing markets.

Today’s issue is to reduce unemployment; tomorrow’s issue may well be fighting inflation. Expect the Fed to keep short term rates low for an “extended period” of time, just as they promise us each month. Expect the Fed to remain angry over the bond market’s reaction to their QE2 program. For all we know, they may be plotting QE3. Stay tuned!

Thanks for reading! DJ 03/21/11

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004.


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