Wells Fargo Monthly Outlook

Wells Fargo Monthly Outlook
Commentary by Wells Fargo Securities, LLC Economics Group, 3/14/12

Resiliency but Now Much More Strength

Most economic indicators continue to show the recovery gaining momentum. Real GDP grew at a solid 3 percent annualized rate during the fourth quarter of last year, and 2012 has gotten off to a solid start. Nonfarm employment has risen an average of 244,000 jobs per month over the past three months, layoffs have slowed and consumer confidence has rebounded. Despite the improvement in the labor market, income growth remains relatively sluggish and consumer spending has started the year in a fairly weak position. Business fixed investment also looks to be a soft spot for the early part of the year, as shipments were likely accelerated into late 2011 to take advantage of more generous tax treatment.

Our current forecast calls for real GDP to grow at a 1.5 percent annual rate during the first quarter and for growth to average 1.9 percent over all of 2012. While those gains are exceptionally modest, the economy continues to show a great deal of resiliency to the continuing uncertainty surrounding the European sovereign debt crisis and domestic economic policy. Net exports are expected to be a drag on real GDP during the first half of the year and government outlays are expected to subtract from growth for at least the next two years. Private domestic demand is expected to grow a bit more rapidly, climbing at a 2.9 percent pace in the first quarter and 2.8 percent for all of 2012.

The resiliency in the private sector means the Federal Reserve will continue to walk softly. We believe we could see some additional mortgage backed securities purchases this spring but look for progressively tougher talk from the Fed after that.

International Overview

Global Economy: How Deep and Pronounced?

While it was not so obvious a decade ago, the importance of Chinese economic growth for the world economy is, today, almost undisputed. This is especially true for those economies for which production of commodities is important. That is, many of the high growth emerging markets depend on a strong performance of the Chinese economy to continue to achieve a strong economic performance of their own. This is the reason why last week’s announcement by the Chinese government that it was bringing down its target economic growth for the Chinese economy to 7.5 percent from 8 percent wreaked havoc on the commodity markets and its expectations on economic growth.

Thus, expect the global economy to follow the path the Chinese economy is following now that it is clear that the European economies are in recession or close to recession and the global economy will not be able to count on European growth to contribute to overall economic growth.

Furthermore, while the Greek sovereign debt deal seems to have closed a door that was threatening to increase instability in the world and financial markets, growth prospects for Greece are still not very positive. When Argentina defaulted on its debt in 2001-2002 the country had two advantages working for it to support a strong recovery in economic activity. First, the country’s currency depreciated by almost 80 percent, while commodity prices, which were depressed during the 1990s, started a process of price appreciation that remains almost intact today. Greece does not have either of these.

How Large of a Step Forward?

Real GDP ended 2011 on a relatively strong note and by most accounts, 2012 has gotten off to a strong start. Some of the most encouraging news has come from the labor market, where nonfarm payrolls have risen by an average of 244,000 per month over the past three months and the unemployment rate has fallen to 8.3 percent. Other employment data, ranging from weekly first-time unemployment claims to the Manpower and ADP employment surveys confirm that the labor market has firmed a bit, particularly in the private sector.

The weak underbelly of the recovery continues to be sluggish income growth and the massive destruction of household wealth from lower home prices and the 2008 financial crisis. Household wealth remains $8.4 trillion lower, with financial assets $3.0 trillion lower and the value of household real estate holdings $6.7 trillion below their respective pre-crisis levels.

Even with the recent improvement in hiring, income growth remains weak. Private sector average hourly earnings have risen just 1.6 percent over the past year, and inflation-adjusted disposable personal income is more or less flat over the same period on a per capita basis. The weak gains in hourly earnings and sluggish income growth in general have made it difficult for households to cope with soaring gasoline prices. As a result, consumer spending remains somewhat sluggish and is on track to rise at just a 1.5 percent pace in the first quarter.

Business fixed investment moderated considerably at the start of 2012 but the strong end to last year and big fleet purchases by rental car companies in January and February will be enough to keep investment outlays well into positive territory during the first quarter. Longer term, we have grown more cautious on investment outlays, as profit margins have come under pressure and weakening economies overseas have cut exports and political and regulatory uncertainty in the U.S.

have caused businesses to become more cautious. Low natural gas prices have also led to a sharp cutback in exploration activity, which had previously been a strong source of growth.

Slight Upside Risk to Inflation and Interest Rates

Higher food and energy prices will make it tougher for the Fed to meet its 2 percent inflation objective. By themselves, higher food and energy prices would not present much of a threat to overall inflation, as consumers would cut back spending elsewhere. Consumers caught a huge break this winter, however, as warmer-than-usual weather cut utility bills. Moreover, the extension of the temporary social security tax cut and prospect of additional quantitative ease mean that fiscal and monetary policy are offsetting some of the contractionary effect of higher food and energy costs, allowing them to rise even further. We suspect the Fed will toughen its rhetoric and adjust its timetable to begin to move away from its ultra-low interest rate policy over the course of this year, as private demand proves more resilient.

Resiliency Will Be Tested Later This Year

The economy’s ability to shrug off concerns about the European sovereign debt crisis and domestic economic policy will be rigorously tested later this year. While Greece’s debt worries have now been placed on the back burner, southern European issues will likely come to a head later this year. The domestic policy environment will also have to come to terms with worsening deficit projections and a possible credit rating downgrade later this summer. The debt ceiling will also need to be raised after the November elections. Finally, the presidential election will introduce more uncertainty into the policy front, with major tax changes scheduled to take effect at year-end and significant budget cuts slated for defense outlays and discretionary spending beginning January 2013.

Global Economy: How Deep and Pronounced?

Last month, we posed the question about the impending slowdown in economic activity across the world. However, at the same time, the U.S. economy seems to continue to decouple from the rest of the world and it is not clear how long this could last or if the U.S. consumer can keep the economy from following the rest of the world economies. In this environment, the Chinese government, on a move that surprised the markets, lowered its own target for economic growth from 8.0 percent to 7.5 percent. When this new target was released, markets became nervous, as if Chinese policymakers had been right on target with the country’s economic growth in previous years. The fact is that even as the Chinese economy had a target of 8.0 percent, that target was never achieved, as the country’s GDP grew more than the government’s target. It is true that lowering the target by 0.5 percent would tend to indicate that Chinese authorities would try to put forward policy measures to slow down economic activity in the coming years, but our contention is that, as it has been in the past, this target is hardly a number markets should be concerned about, as there is little the Chinese government can do to fine tune economic growth, as has been clear over the past several decades. Furthermore, the need to keep the Chinese economy from slowing down too much is almost a guarantee that the Chinese communist party will always try to “err” on the side of higher economic growth rather than lower economic growth. It is true that there is some news coming from the Chinese economy that is not reassuring, like all the chatter regarding an overheated or even bubble-like housing market. However, there are a number of different policies that Chinese authorities could enact to help support economic growth.

Having said this, China is the world’s second largest economy, and a sharp slowdown in China would have global ramifications, especially for those countries for which production of commodities is important. Thus, the economic slower growth that we project this year in China should exert some headwinds on economic growth in some of China’s main trading partners.