|Monthly Economic Outlook - November 2010|
|Long Term Forecasts | Written by Wells Fargo Securities | Nov 10 10 16:48 GMT|
Monthly Economic Outlook - November 2010
The Economy Picks Up Steam
Economic recovery is again proving surprisingly resilient and has disappointed pessimists as growth expectations have improved. Better ISM reports and stronger-than-expected employment gains in October, along with upward revisions to previously published data, suggest income and spending should hold up well going into the key holiday shopping season and the New Year. Moreover, export data from the ISM report shows export demand strengthening, which should help offset any slowdown in domestic orders following the third quarter's huge build-up in inventories.
Our forecast calls for real GDP to rise at a 1.9 percent pace during the fourth quarter, which is roughly in line with the third quarter's growth. The composition should be markedly improved, however, with final demand strengthening from the third quarter's paltry 0.6 percent pace to a solid 2.9 percent pace in the fourth quarter. After surging $115.5 billion in Q3 inventories will likely climb less during the current period, resulting in the slightly smaller rise in real GDP.
Our forecast is based on the expectation Congress and the president will come to an agreement to extend the tax cuts along their current lines for at least two years. Congress will also likely agree on a relatively austere budget for fiscal 2011, and the incoming Congress has promised to make additional cuts to discretionary outlays. State and local budgets will also remain under intense pressure, which is one reason the Fed has chosen to move forward with its second quantitative ease.
A Little Less Uncertainty and a Little More Growth
This past month cleared up some of the uncertainty that has caused businesses to put off decisions on expanding or hiring more workers. Republican gains in the House and Senate increase the odds the tax cuts will be extended for everyone and also imply the pace of regulation will be somewhat less burdensome. Efforts to repeal or scale back healthcare reform and financial regulation will likely soften some key provisions in both, but overturning enacted laws will prove extremely difficult. The Election Day success of the Tea Party should also lead to more fiscal restraint, which may help curb the budget deficit but will also restrain government spending at all levels.
One day after the election the Federal Reserve announced plans to expand its balance sheet by $600 billion by purchasing Treasury notes with an average maturity of 5–6 years for the next eight months and would also continue to reinvest the proceeds of maturing securities. The announcement was roughly in line with expectations, including our own forecast, which had been calling for such a move since early May. The move also sent commodity prices soaring and stirred up an unexpectedly fierce firestorm overseas, just ahead of the G-20 meeting. The harsh criticism will make it more difficult for the Fed to do a follow up to QE2. Hopefully, QE3 will never need to sail.
Recent economic reports provide some reason to be optimistic. October's employment numbers were stronger than expected, with private-sector payrolls rising by 159,000 jobs in October and data for the prior two months revised up by a combined 93,000 jobs. Private-sector employers have added more than 100,000 jobs during each of the past four months and have added jobs in 11 of the past 12 months. Job gains have been fairly broad based in recent months, hours worked have increased and hiring in temporary services has turned up again. All are signs that hiring should remain solid in the months to come. We have slightly raised our expectations for job growth next year and look for an average of 135,000 jobs to be created each month in 2011, up from 91,000 this year.
The improved employment figures, along with the increased likelihood that the tax cuts will be extended for at least another couple of years, significantly reduce the downside risks to the economy over the next few months. Though optimism should be tempered due to exceptionally high unemployment and because workers are not returning to the labor force like they did in previous recoveries. Long-term unemployment remains particularly problematic, with the average duration of unemployment at 33.9 weeks and the median duration of unemployment at 21.2 weeks. Moreover, layoffs are still way too high, with recent weekly first-time unemployment claims stuck at around 450,000.
High unemployment will constrain the recoveries in consumer spending and housing, but both will improve. We look for consumer spending to rise 2.1 percent next year, up from 1.7 percent in 2010. Home sales and new home construction also look set to improve, but questions surrounding the disposition of foreclosed properties could push off a full recovery until late next year and create some downside risks in some areas.
Worries about inflation are a bit premature but are understandable given the Fed's massive stimulus program. One of the immediate impacts of QE2 was to weaken the dollar against other major currencies and raise commodity prices. Higher commodity prices will boost the Producer Price Index but should have less of an impact at the consumer level. Demand is simply not strong enough for businesses to pass their higher costs on to consumers, resulting in tighter profit margins, as is evident in an increasing number of earnings announcements for consumer products companies. As a result, companies will have to find new ways to cut costs, which will limit hiring and capital investment and spending.
Global Economic Activity Has Strengthened Recently
Recently released data suggest that growth in global economic activity, which slowed somewhat over the summer, has strengthened. This apparent acceleration in foreign economic output has led some central banks to tighten monetary policy. For example, the People's Bank of China hiked rates for the first time in three years a few weeks ago. Central banks in Australia and India, countries in which inflation is a bigger concern at present than insufficient economic growth, have tightened further in recent weeks.
Most economies in western Europe continue to expand as well. The United Kingdom posted a stronger-than-expected growth rate in the third quarter, and real GDP growth in the euro area appears to have held up reasonably well also. In contrast to the Federal Reserve, neither the Bank of England nor the European Central Bank have embarked on a second round of quantitative easing (QE), at least not yet. However, we suspect that the Bank of England will eventually undertake more QE as budget cutting by Her Majesty's government exerts headwinds on British economic growth. The ECB probably will not raise rates in the near term, but it is unlikely to approve more QE anytime soon either.
The dollar has depreciated over the past few weeks on the expectation that the Fed would increase the size of its QE program. With few other central banks willing to follow the Fed's lead at this time, it seems that further dollar depreciation is in store in the near term.
Global Economic Activity Has Strengthened Recently
After slowing since the spring, it appears that global economic growth may have strengthened somewhat in October. Indeed, many purchasing managers' indices, including those in the large economies of the United States, the Eurozone and China, rose in October (see graph on the front page). Obviously, one would not want to forecast a "V-shaped" global recovery based solely on a one-month rise in purchasing managers' indices. Indeed, we believe that the contractionary effects of fiscal consolidation in Europe and further deleveraging by American consumers will continue to exert headwinds on global GDP growth in 2011. That said, the PMI data for October help to support the notion that the global economy is not about to tip back into recession.
Economic growth in Asia generally remains very solid. The year-over-year growth rate in China slowed from 11.9 percent in the first quarter of 2010 to 9.6 percent in the third quarter. However, the Chinese manufacturing PMI has risen for two consecutive months, suggesting that the modest slowdown in China may be coming to an end, and the comparable index in India also rebounded in October (bottom chart).
The apparent acceleration in economic activity in conjunction with high or rising CPI inflation rates have led some central banks in the region to tighten monetary policy. The central bank in India has hiked rates by 150 bps since mid-March, and its counterpart in China raised its benchmark lending rate by 25 bps on Oct. 20. Further tightening by these central banks seems likely in the months ahead as they move to bring interest rates back to levels that are more appropriate for economies experiencing very rapid economic growth.
Economic activity in Europe also appears to have strengthened somewhat recently. The manufacturing PMIs in both the Eurozone and the United Kingdom rose in October (bottom chart). Strong economic growth in the third quarter - real GDP rose at an annualized rate of around 3 percent - and the apparent expansion of the economy in October may have caused the Bank of England to refrain from following the Fed down the path of more quantitative easing. That said, we think there is a better-than-even chance that the Monetary Policy Committee (MPC) eventually increases the size of its £200 billion QE program. We believe that the fiscal consolidation that is planned over the next few years will exert significant headwinds on British economic growth that will convince a majority of MPC members to support another round of QE next year. (See "Outlook for U.K. Growth Amid Budget Cutting," which is posted on our Web site).
Across the British Channel on the continent, it appears that economic activity in the euro area has held up fairly well thus far in the fourth quarter. Not only did the manufacturing and service sector PMIs in October remain well above the demarcation line that separates expansion from contraction, but it appears that loan growth is staring to strengthen again. In contrast to the Bank of England, which we think will eventually expand its asset purchase program, we believe the probability that the ECB increases the size of its very modest QE program is rather low. An untested program that would significantly increase the monetary base, namely a QE program, makes inflation-conscious policymakers at the ECB very nervous. In our view, the Eurozone would need to be slipping back into recession before the ECB even contemplated more QE. Although we expect that real GDP growth in the Eurozone will be sluggish next year as governments continue to slash budget deficit, we do not look for another downturn.
The dollar has depreciated over the past few weeks on the expectation that the Fed would increase the size of its QE program (bottom chart). With few other central banks willing to follow the Fed's lead at this time, it seems that further dollar depreciation is in store in the near term.
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