Friday, October 13, 2006

Autumn Chills the Goldilocks Economy

Autumn Chills the Goldilocks Economy
by Max Fraad Wolff

Max Fraad Wolff is a Doctoral Candidate in Economics at the University of Massachusetts, Amherst and editor of the website GlobalMacroScope.

Naturally, the passage of summer into autumn entails a chilling of the air. Less natural and more pronounced this year is the cooling of the macroeconomy. Profit and GDP growth, as well as, housing numbers and durable goods reports, point to falling temperatures. Fed rate hikes on pause and cooling commodity prices offer more evidence- if that were necessary. Thus far, the stock market’s response has been to heat up to August-like temperatures. Renewed geo-political risk suggested by recent events in Shanghai, Mexico City, Budapest and Bangkok be damned, the Dow is in record breaking mode. Could this be a sign of agreement with my cautionary thesis? The Dow is populated by larger more global and defensive firms with higher credit ratings than the S&P. Thus, some of its rise may be rotation from even more dangerous positions elsewhere in the US equity orbit.

Sadly, it seems clear that most are driven by the goldilocks outlook. This “understanding” became popular in 2002. According to the goldilocks story, we will artfully and profitably dodge inflation and recession as we hop from sweet spot to sweet spot. It is a mutant form of the new economy/new era conception popularized and universalized in the heady days of the late 1990’s. The US does not have to save; we can run huge external imbalances forever; the Fed can endlessly run expansionary monetary policy; there are no equity, bond, real estate bubbles; and we can have rapid growth without inflation. Goldilocks adherents believe this is being done as we thread the needle between various risks. How well does the macroeconomic data confirm this outlook?

Early winter would seem the correct analogy here. Housing starts, permits, mortgage applications, prices and housing company stock prices are down, foreclosures are up. Durable goods orders fell 0.5% in August, widely missing consensus forecast of a 0.5% increase. Bright spots were autos and defense spending, yet neither is likely to be a source of macroeconomic strength moving forward. Excluding transports, durable goods orders declined by 2.0%. The Mortgage Bankers Association (MBA) announced on September 22, 2006 that its seasonally adjusted index of mortgage applications declined 5% on the week despite half-year lows in listed mortgage rates. The 5% one week decline masked a more worrisome 21% year-over-year slide. Home sales declines in August were sharp in several vital and once hot markets. The California Association of Realtors (CAR) reported a 30% drop in sales for August 2006. This is the largest decline since 1982. The Florida Association of Realtors reported a 50% August decline in sales in Palm Beach County and a 6% fall in median home price there. The Massachusetts Association of Realtors revealed a 20% decline in sales and an 8% decline in median price. It is possible some of this weak performance is related to the total lack of growth and dynamism in personal income and spending growth. The September 29, 2006 Personal Incomes and Outlays release form the BEA reveals that August was a low point for wage growth and personal consumption expenditure. Only core inflation stayed strong. Earnings and spending growth were anemic while prices stayed high. This is the mirror image of goldilocks. August 2006 marks another month with a negative private savings rate (-.5%). [1] This has caused little concern, likely because consumption is a relatively unimportant 70% of US GDP.

The September 28, 2006 release of Q2 2006 GDP and national economic data has confirmed more skeptical outlooks and spurred hardened optimists to new levels of creativity. Consensus estimates from private sector economists of 2.8% GDP growth and advanced estimates of 2.9% growth were disappointed as the Commerce Department announced actual growth of 2.6%. The Fed-preferred price index for personal consumption expenditure- excluding food and energy- increased 2.9% in Q2 down from 3.0% in Q1. Thus, our present goldilocks economy most recently displayed a 3% drop in the rate of price increase and a 53% decline- quarter over quarter- in GDP growth. This must be why indexes are soaring and the soft landing, benign inflation environment expectation has become dominant! What of corporate profits, long a bright spot in our economy?

Profits from current production (corporate profits with inventory valuation and capital consumption adjustments) increased $22.7 billion in the second quarter, compared with an increase of $175.6 billion in the first quarter. Current-production cash flow (net cash flow with inventory valuation and capital consumption adjustments)--the internal funds available to corporations for investment--increased $1.1 billion in the second quarter, compared with an increase of $125.3 billion in the first.[2]

It is fair to say that the corporate profit picture is defined by deceleration in Q2. This was particularly true for non-financial corporations that underwent a rather profound reversal of profit fortunes across the quarter. Reported domestic profits for non-financial corporations dropped by $32.8 billion in Q2 on the heels of a strong $94.5 billion increase in Q1. The profit picture, while still a relative strong spot in the economy, is less hot than it has been. The most recent data, like the first cold winds of autumn, are a reminder that winter is approaching. Stagnant earnings, pressured private consumption, decelerating profit growth and robust price inflation are showing up in the macro data.

So we are left to ponder a widely popular consensus on the economy that is influencing equity performance. It runs as follows: eureka! The Fed has stopped tightening and the economy is still growing well and highly profitably. Of course growth and profitability are still in respectable shape- particularly the later. However, they have remarkably cooled of late. Much like rate increases. When rate increases slow we celebrate the end of inflation risk, despite the price change metrics reported. When GDP and profit numbers slow, we refocus on their strength in long run, global comparisons. Thus, the goldilocks consensus is sustained. The economy is not too hot, not too slow and just right!

Remember the Goldilocks story? Cool days and warm porridge lure Goldi into the bears’ house. There are two endings to the fairly tale. In the friendly version she wakes and flees in terror. In the harsher version she is eaten by the bears. Either way, advocates of the goldilocks economy may have much to learn from the fable they have invoked. Cooler data may be driving them to follow in goldilocks’ footsteps. It might be just right now, but there is trouble lurking in the near future! After all, the bears return in all the versions of the story.