The economy is growing once again, but the pace of growth has not been strong enough to generate enough job growth to make a serious dent in the unemployment rate. The unemployment rate actually increased to 9.8% in November, and the economy only added a total of 39,000 jobs.
There are, however, some significant signs that we are about to see better job growth in the future.
We have finally broken out to the downside of the “trading range” we were in for initial unemployment claims. Also, the JOLTS data for October showed a large increase in job openings. I suspect that the November jobs totals will be revised up when the December report is released, but even so it will still be a disappointing performance.
It is not just the total number of people out of work that matters, but also the number of long-term unemployed. The Great Recession was in a league of its own when it came to creating long-term unemployment. While off its June peak, then median duration of unemployment has been ticking back up in the last two months and now sits at 21.6 weeks. The highest the median had ever gotten prior to the Great Recession was 12.3 weeks.
Clearly, we still have a lot of work to do on the jobs front. While we will probably see a pick up in the pace of job creation in 2011 — perhaps getting up to an average of about 150,000 per month, up from 86,000 per month in the first 11 months of 2009. We will, however, probably see an increase in the participation rate. It is at 64.5%, the lowest level since November 1984, and down from 66.1% just before the financial meltdown. That would mean that progress on the unemployment rate will be much slower than progress on actual job creation.
“Low” vs. “High” Quality Growth
Too much of the economic growth that we saw in the second and third quarters was simply due to the rebuilding of inventories. That is very “low quality” growth. Looking forward to the fourth quarter and into 2011, it is likely that that portion of growth will fade, and possibly even start to reverse itself.
On the other hand, the two great drags on growth — housing and the trade deficit — are likely to go away, and might even turn into contributors to growth. To contribute to growth, we don’t need net exports to actually turn positive, as in running a trade surplus. We just need the size of the trade deficit to shrink. Even if it just stays at the horrible level it was at in the third quarter, it would stop subtracting from growth, and that alone would provide a major boost to the overall economy.
The October data suggests that it could do much more than that. A weak dollar would greatly help in that regard. It would make our exports cheaper to buyers abroad, and would make imports more expensive. Often it would not be just because the dollar was weak relative to the buyer’s country, but because a U.S. based company is competing with a company from a stronger currency based company. For example, at 90 yen to the dollar, a buyer in India might be indifferent between buying a bulldozer from either Caterpillar (CAT) or Komatsu, but at 80 yen to the dollar, the Caterpillar machine is “on sale” to the Indian buyer.
Just reversing the increase in the trade deficit we saw in the third quarter will help growth, but ultimately we need to go further than that and eventually start running a trade surplus. It is the trade deficit, not the budget deficit, which is directly responsible for the ever growing foreign indebtedness of the U.S. That, folks, is not a matter of opinion, it is an accounting identity.
I consider the trade deficit to be a far larger economic problem than the budget deficit, even though it gets a fraction of the ink the budget deficit does. While a decline in the dollar is desperately needed, it is not a slam dunk that it will happen in 2011. The reason is that the Euro, which is sort of the anti-dollar, faces problems which are just as severe as the dollar faces.
Still, I see the odds favoring a weaker dollar on a trade weighted basis over the course of 2011. In 2010 there was a very strong inverse correlation between the strength of the dollar and the strength of the stock market. I would expect that correlation to continue. The weaker the dollar, the better the stock market will do in 2011.
Trade Deficit & Our Addiction to Oil
A weak dollar will not solve the entire trade deficit problem. Too much of our trade deficit is simply due to our addiction to oil. Over the first 10 months of the year, $221 billion of the $421 billion (52.5%) total trade deficit was due to oil imports. As the dollar weakens, the price of oil tends to rise.
Unfortunately, the zeal to find ways to cut oil consumption has diminished relative to where it was just a few years ago when oil prices were pushing up against the $150 per barrel level. I was to aggressive in my oil price forecast last year, looking for oil prices to close out the year at around $100 a barrel. I’m going to risk making the same mistake again and call for oil prices to close out 2011 between $105 and $110. If they get much higher than that, then world wide growth would start to slow significantly, but the world economy can probably sustain those sorts of prices.
Over the medium-to-long term, moving towards more wind and solar seems to be the only viable solution. In the short term, we have more than ample supplies of natural gas, and the technology is well established to use it as a transportation fuel (where the vast bulk of oil consumption goes). We need to start making that transition as soon as possible. The reasons for doing so go far beyond just the trade deficit, but that reason alone should be more than enough. If left unchecked, the trade deficit will eventually lead to national bankruptcy.
The Housing Problem
Housing has been the other Achilles Heel of the economy. Traditionally it has been the locomotive that pulls the economy out of recessions, but this time around it has been derailed. Residential Investment was down to just 2.22% of the economy in the third quarter, from a high of 6.34% of the economy at the height of the bubble, and a long-term average of about 4.5% of the economy.
The six lowest months in history (back to 1963) for new home sales have been in the last six months. New home sales, normally about one sixth the level of existing home sales are running about one fifteenth the level of used home sales, and it is not as if existing home sales are particularly robust. Each new home built and sold generates a huge amount of economic activity. Unfortunately we still face a massive overhang of existing home inventory, and used homes are very good substitutes for new homes.
The high level of inventories relative to sales is putting renewed downward pressure on housing prices, although the decline in this second down-leg of housing prices is not likely to be as big as in the first down-leg in 2008. While the level of used home sales is not really that important, the prices of existing homes are extremely important.
Still there are some signs that the inventory is starting to be worked off. Housing is not yet ready to be a major contributor to economic growth, but if it can just stop being a drag. Eventually population growth and higher household formation will cause the inventory to be absorbed, and housing will get back on track.
When (not if) that happens, the economy will start to show much higher growth. Housing as a “non-negative” factor in the economy is probably a fourth quarter and first half of 2011 story. Housing as an actual positive contributor to growth is more likely a second half of 2011 and 2012 story.
The Fed’s Two Mandates
Economic policy has recently turned more stimulative. The Fed has two mandates: to promote full employment and to keep prices stable. Sometimes those goals are in conflict, but they are not now. Inflation is extremely tame, and there was a significant danger that we would topple into outright deflation — and deflation is a nasty disease.
Unemployment is clearly too high. Both sides are pointing to the need for an easier monetary policy. The Fed has spent all of its conventional ammo. The Fed Funds rate has been pegged near zero for two years now, and is likely to remain there for at least another year. It has thus had to resort to unconventional tools and launched a second round of quantitative easing, or the QE2. This has taken the risk of outright deflation off the table.
Core inflation is likely to stay under control in 2011, probably between 10% and 1.5%. Headline inflation will be higher than that, especially if the dollar weakens resulting in higher oil prices, but oil is a relatively small part of the overall CPI, so pencil in headline CPI inflation of about 2.0% for 2011.
The prospect of prices actually falling significantly was the only reason it would have made sense to own a 10-year Treasury note at less than 2.5%. The prospect of at least some positive inflation has pushed rates sharply higher since the QE2 was launched, overcoming the effect that the extra Fed buying pressure to push down rates. One of the key ways that QE2 will stimulate the economy is through putting downward pressure on the dollar and thus improving the trade deficit.
For awhile it looked like fiscal policy was on the verge of becoming deeply concretionary. The hymn that the GOP was singing on its way to victory was all about how nasty budget deficits are. Over the long term, they are right about that, but in the short term we actually need to be running a budget deficit.
Despite all the press, the fact is that the budget deficit has been trending down, not up (although it did tick up significantly in November). With the ARRA stimulus fading fast, all of the Bush tax cuts scheduled to expire, as well as the tax cuts that Obama pushed through as part of the ARRA, and unemployment benefits about to end, it looked like the budget deficit was on track to fall sharply in 2011 — but at the cost of a significant drag on the economy, one that could have been big enough to tip us back into a double-dip recession.
The Tax Deal
The deal the Obama cut with the GOP, and which just passed Congress, not only prevents fiscal contraction from occurring (which would have repeated FDR’s 1937 mistake) but actually adds new fiscal stimulus. This comes in the form of a one year 2% cut in the payroll tax.
While as a matter of accounting, I would have rather that the stimulus come out of the General Fund budget rather than Social Security, it will be a major shot in the arm for the economy. For someone earning $50,000 (roughly the median household income) that will mean an extra $1,000 in their pockets for 2011. That’s roughly equal to the increase the median family has seen in its pretax income over the last decade.
Where We Can Expect Growth
So on balance I think that growth will pick up in the U.S. in 2011. The world economy, most notably Asia and Latin America, should post higher growth than the U.S. The price of copper for example is now pushing $4.30 a pound, and that level points to very robust worldwide economic growth (ignore the forecasts made by “Dr. Copper” at your peril).
We are also moving into the third year of the presidential cycle, and the third year is almost always the best of the four for the stock market in the cycle. Corporate earnings are doing very well, and the third quarter earnings season was very strong. Earnings growth should continue at a solid pace through 2011 (about 12% for the S&P 500). Valuations, particularly relative to bonds, are still very reasonable, if not quite as compelling as they were a few months ago.
I think that we are unlikely to see either major P/E contraction of expansion in 2011, but if forced to pick, the risk is more of P/E expansion from current levels than contraction. My round number projection for the S&P at the end of 2011 is 1400, or up in line with earnings growth.
I would favor the more cyclical sectors and large dividend-paying firms. Technology, Industrials, Autos, Energy and Materials look attractive to me. I’m still a skeptic on the Financials and would underweight them, as well as Utilities and Staples, and would avoid the Construction sector, particularly in the first half of the year.
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