Maryland's Economy: There is Still Plenty of Reason for Concern, but the Reasons Have Changed

by Anirban Basu 15. April 2011

Focus Shifts from Growth to Inflation

Economy Now Enjoys Self-Sustaining Momentum

Coming into 2011, economists remained largely fixated on the inadequacy of demand for labor, housing, commercial real estate and other aspects of economic life. Economists have been busily pouring over reams of data regarding senior bank loan officer attitudes, consumer credit availability and other indicia of credit market thawing. The conventional wisdom has been that until banks begin lending more aggressively, the U.S. economy will continue to be lackluster and the recovery that began in mid-2009 will remain fragile.

With the first quarter now over, many of the principal economic concerns coming into the year have been largely addressed. For instance, demand is building. Retail sales are up 9.5 percent on a year-over-year basis through February. Overall consumer spending is up 2.5 percent with the purchase of durable goods up 11.9 percent on an inflation-adjusted basis. Adjusted for inflation, private nonresidential fixed investment was up 1.9 during the fourth quarter and 10.6 percent year-over-year.

Moody’s presently predicts that consumption will expand 3.3 percent in 2011, with motor vehicle sales rising 13.6 percent. Fixed investment is predicted to rise nearly 9.6 percent this year, with investment in equipment up 10.3 percent.

Foreign demand has also been strong. Despite a sea of troubles ranging from Portugal to Japan and engulfing Tunisia, Egypt, Libya, Greece, Yemen and Pakistan, the world increasingly looks to America for output. That is very encouraging. Since January 2010, U.S. exports are up 6.9 percent on a seasonally adjusted basis and 18.9 percent on a not seasonally adjusted basis, with sales to China, India and Brazil up 17.3 percent, 42.2 percent and 7.4 percent, respectively.

The accompanying increase in production has led to the emergence of a new trend in America: employment growth in manufacturing. For six months running, the number of manufacturing jobs in America is up on a year-over-year basis, with March 2011 industry employment totals 196,000 jobs above the corresponding month one year prior.

Employment growth has generally been accelerating in America. Nonfarm payroll employment increased by 216,000 in March according to the Bureau of Labor Statistics (BLS) and the nation’s unemployment ticked down to 8.8 percent. BLS observed job gains professional and business services, health care, leisure and hospitality and mining. However, the number of long-term unemployed (those jobless for 27 weeks or more) totaled 6.1 million in March and their share of the unemployed increased from 43.9 percent to 45.5 percent over the course of the month.

All of this positive economic news has allowed equity markets to bounce higher. At the beginning of the year, the Dow Jones Industrial Average stood at 11,577. By the end of March, the Index stood at 12,320 and as of this writing has risen above 12,400. The S&P 500 is up 6.0 percent since the beginning of the year. That’s simply remarkable in light of the tragedies in Japan, sovereign debt issues in Europe, civil war in Libya and oil prices that are now above $110 a barrel.

Inflationary Pressures Have Been Building

For months, we have been suggesting that it is still too soon to tell whether or not inflation will become problematic. Indeed, recent core inflation data (all components except food and energy) indicate that inflation remains mild. Through February, core inflation was running at a 0.2 percent monthly rate and 1.1 percent annual rate in America despite increases in medical care expenses (up 0.4% for the month and 2.9 percent year-over-year).

That said, inflationary buzzards have begun to circle. There are a number of factors that collectively conspire to support the emerging view that at some point later this year or in 2012 the U.S. Federal Reserve will begin to find it necessary to constrain inflationary pressures by reducing money supply growth and increasing short-term rates.

While much of the recent focus has been upon food and energy prices, commodity prices generally have been marching higher. For instance, steel and iron producer prices are up 16.8 percent through February on a year-over-year basis. Gold now stands at $1,471 a troy ounce, up 27.9 percent from a year ago. Cotton prices recently set a record at $2.11 a pound. Certain non-commodity prices have also been drifting higher, including airline fares, which are up 12.3 percent year-over-year through February.

What’s more, import prices are also up with a growing number of nations reporting widening inflationary issues. In India, inflation is up 18.9 percent year-to-date through February. In China, the corresponding statistic is 10.0 percent. In Mexico, consumer prices are up 10.8 percent through March. Presumably, this inflation will continue to be exported to America in the form of higher priced clothing, food and household items.

Thus far, many prices have been constrained due to productivity gains and the inability of producers to pass along input price increases (including those associated with oil prices) to consumers. But with the economy steadily improving, consumers are likely to face rising prices for many goods and services, and that will ultimately prompt the Federal Reserve to begin to meaningfully chip away at the massive monetary accommodation it has been providing to the economy in the wake of the financial crisis that gripped us in September of 2008 and the accompanying Great Recession.

Implications for Investors

It has been wonderful to be exposed to equities over the past two years. The Dow Jones Industrial Average is up roughly 92 percent since its March 9, 2009 intraday low. The simple laws of gravity suggest that at some point, some of these gains will be returned. But the specter of inflation is now becoming more apparent, with the primary implication being that the current interest rate environment is about to shift. That would impact the multiple on corporate earnings and therefore stock prices.

Emerging inflationary pressures render bond investing particularly challenging. Even in the absence of inflationary pressures, bond market fluctuations have been unusually difficult to predict. Sovereign and municipal debt issues have unnerved many investors and yields have been drifting higher on various forms of debt. As of this writing, the yield on the 10-year U.S. Treasury stands at 3.59 percent, up 41.3 percent from early November 2010.

On top of that, commodities have enjoyed a remarkable run as well. It is unlikely that this can continue in conjunction with an ongoing equity market rally. To put it in the simplest terms, something has got to give. Therefore, while underlying positive economic momentum implies that substantial exposure to equities remains sensible as we approach mid-year 2011, investors should be thinking about quick response strategies to a potential market correction that could be triggered by bad news regarding core inflation.

Anirban Basu is Chairman & CEO of Sage Policy Group, Inc., an economic and policy consulting firm in Baltimore, Maryland. Mr. Basu is one of the Mid-Atlantic region’s most recognizable economists, in part because of his consulting work on behalf of numerous clients, including prominent developers, bankers, brokerage houses, energy suppliers and law firms. On behalf of government agencies and non-profit organizations, Mr. Basu has written several high-profile economic development strategies, including co-authoring Baltimore City’s economic growth strategy. His opinions do not necessarily reflect the opinions and beliefs of 1st Mariner Bank.

Crystal Balls, Ouija Boards, and Basu? What's the 2011 Maryland Economic Prediction?

by Anirban Basu 27. January 2011

Equity Markets and Economy Have Turned for the Better

Why Economic Activity may not Accelerate as Dramatically as Expected this Year

A combination of ongoing stimulus and recent economic momentum has induced many economists to ratchet up their 2011 forecasts and there are plenty of reasons to be optimistic.  Consumer spending has been rising, with retail and food services sales up 7.7 percent between November 2009 and November 2010.  Auto sales have also been edging higher, including among America’s big three automakers.  The holiday shopping season was the best in several years.

It also helps that financial markets have been recovering.  On March 9th of 2009, the Dow Jones Industrial Average sank to 6,469.95 intraday.  As of this writing, it stands at well above 11,600.  Since financial market performance often foreshadows broader economic performance, the implication is that the economy is in for some better times ahead.

While it is true that 2011 is very likely to be a year a solid growth, it is possible that members of the dismal science have become a bit too optimistic in their projections in recent months.  There are (at least) ten factors that could act as speed governors on the U.S. economy this year.

  • Consumers tap their brakes

Though household spending was unexpectedly strong in 2010, in the absence of substantial income growth, this is unlikely to continue particularly if consumers are spooked by unemployment rates that still hover near double digits.  Many consumers may feel buyers’ remorse during this year’s first quarter as credit card statements tumble in.

  • Housing market recovery scrubs much of its speed 

The fear had been that once the first-time and move-up buyer tax credits expired, the housing market would begin to swoon.  That is precisely what happened, with existing home sales slumping since May and new home sales performing even more sluggishly.

  • Federal spending cuts diminish momentum 

Congress has not been as serious about deficit reduction since arguably the early 1990s.  Already, the newly-seated Congress is talking seriously about substantial cuts to discretionary spending, including within the Department of Defense budget.

  • State/local tax increases become a source of slippage

At least 46 states struggled with fiscal shortfalls when adopting budgets for the current fiscal year, which in most states began July 1st.  The collective budgetary gap for 2011 and 2012 is $260 billion.

  • The stimulus turbocharger cuts off

Though much of the $787 billion associated with the American Recovery and Reinvestment Act of 2009 has yet to be spent, by some point in 2011, the federal stimulus driver will begin to wind down, and that remains another reason to believe that another economic downturn could be headed our way.

  • European debt crisis is no formula for success

Greece, Portugal and Spain have all experienced debt downgrades.  Greek debt has now reached junk status.  Though members of the European Union have established a $1 billion bailout fun, there is still the possibility of a sovereign default going forward.  Nearly 100 European banks are being stress tested.

  • State and local government spending further deflates aggregate demand

Despite ongoing assistance from the federal government, it is clear that most state and local governments have begun to decelerate spending.  While there is something positive associated with the rationalization of spending levels, in the short-term the impact is negative including upon contractors.

  • Government spending cuts in other parts of the world puts global expansion into neutral 

At the most recent G-20 summit, nations from around the globe agreed to slash their deficits over time.  A number of countries in Europe, including Greece and Spain, have initiated austerity programs through a combination of tax increases and spending adjustments.  Not surprisingly, recent data indicate that global economic expansion is beginning to soften.

  • Bond market continues to fade

Bond traders have become increasingly unnerved by sovereign debt issues, growing fears of inflation and the temptation to leave fixed-income assets for equities.  If the bond market continues to experience outflows, interest rates could rise further, slowing economic progress in the process.  According to Barron’s, bond mutual funds redeemed nearly $15 billion in December, the heaviest outflow since October 2008.

  • Unemployment remains high and private job growth has not picked up sufficiently 

The key to sustained economic momentum is income growth.  With employment growth still lagging and with the public sector now retrenching, the prospects for a significant acceleration in wage/salary income growth next year are weak.

Looking Ahead

Despite these risks to the economic outlook, this year is shaping up to be a good one for the U.S. and Maryland economies.  The nation’s economy is positioned to expand at 3 percent or better adding an estimated 1.6 million jobs in the process.  Unemployment should be closer to 9 percent by the end of the current year.  Maryland is positioned to add more than 40,000 jobs this year, respectable performance by historic standards.

Based on that, more substantial exposure to equities appears warranted.  Though investors must always remain vigilant, there is now more transparency regarding the direction of the U.S. economy than there has been for several years, and that has been and likely will be good for stocks in general.

Anirban Basu is Chairman & CEO of Sage Policy Group, Inc., an economic and policy consulting firm in Baltimore, Maryland. Mr. Basu is one of the Mid-Atlantic region’s most recognizable economists, in part because of his consulting work on behalf of numerous clients, including prominent developers, bankers, brokerage houses, energy suppliers and law firms. On behalf of government agencies and non-profit organizations, Mr. Basu has written several high-profile economic development strategies, including co-authoring Baltimore City’s economic growth strategy. His opinions do not necessarily reflect the opinions and beliefs of 1st Mariner Bank.

Recovery Revs Up

by Anirban Basu 13. April 2010

Economy Expanding as Predicted, but Will the Run Last?

The nation has strung together two consecutive quarters of growth with 2009:Q4 annualized growth registering 5.6 percent (third estimate).  Employment is now expanding and the unemployment rate has been declining in recent months.  A close inspection of fourth quarter GDP reveals a promising shift away from pure dependence upon government spending to a broadening economic expansion.  Of central importance is the ongoing rebound in retail sales and in consumer confidence.  Year-over-year sales growth is now positive, though the comparison months were of course in the immediate aftermath of the financial crisis that began in September 2008.

Sage does not anticipate a brisk recovery as tight credit, an unsettled and unsettling federal policymaking environment, subdued expansion in various parts of the world including much of Europe, double-digit or near double-digit unemployment rates for months to come and the expectation that policy support for the economy will begin to wane within the next twelve months.

In fact, policy support will begin to wane well before the next twelve months.  As of this writing, Federal Reserve purchases of collateralized mortgage backed securities have been over for two days, which implies that the era of ultra-low mortgages may soon be coming to an end.  Moreover, rumors continue to circle both Freddie and Fannie, and with the federal guarantee of their balance sheets now explicit as opposed to implicit, there will likely be calls for Freddie and Fannie to slow down their purchases of mortgages.

One of the other reasons to believe in the sustainability of the nation’s nascent but weak recovery is the recent performance of financial markets.  On March 9, 2009, the Dow Jones Industrial Average reached a cyclical low 6,547.05 after dipping to an intraday low of 6,469.95.  Since that time, stock prices have enjoyed a roughly 75 percent retracement, replenishing wealth and signaling confidence in corporate earnings.

During the third quarter, roughly 5 in 6 large U.S. companies reported earnings that exceeded expectations.  Moreover, if U.S. stocks were valued at 15 times their expected 2011 earnings by the end of 2010, the S&P Index would be approaching 1,365, about 16 percent higher than the level at the time of this writing (1,178; April 1st, 2010 market close).  This implies even more wealth generation, which could be enough to allow for sustained economic momentum into and through 2011 despite expectations of rising interest rates and taxes at that time.  Fourth quarter GDP report was also consistent with the notion of rising profits and that may be just enough to keep the recovery going into and through 2011.

In many ways the recovery that began during the summer of 2009 is quite ordinary.  As with typical recoveries, financial markets first began to recover followed by GDP growth.    Now comes the final big piece in the puzzle:  job growth.

In January the nation gained 14,000 jobs (revised estimate) and then lost almost precisely that number of jobs one month later.  In March, the nation added 162,000, the first six-digit increase for the U.S. economy since November 2007.  Through March, unemployment has remained steady at 9.7 percent and may fall during the months ahead due to Census hiring.  However, Sage continues to expect that once Census jobs dissipate, unemployment will begin to expand again as more Americans rejoin the labor force.  Despite the recent employment momentum, underemployment issues remain elevated and there has been little sign of progress along that dimension.

Exhibit 1: National Nonfarm Employment Net Change, February 2006 – March2010

Looking Ahead

The last few months have been surprisingly good.  As of this writing, the Dow Jones has rebounded to around 10,900 on the Dow Jones Industrial Average (the Dow began the year at 10,430) and the S&P 500 at around 1,170, up from a 52-week low of 783.  That represents a 52-week retracement approaching 50 percent for the S&P.

Perhaps the most positive indicator of all is the recent expansion in exports, though exports dipped modestly in January.  Most economists seem to agree that massive growth in U.S. exports is required if the nation hopes to maintain current living standards or to improve upon them.  Our concerns revolve largely around the second half of 2010 and 2011.  As stimulus impact ebbs as interest rates rise and as past tax cuts lapse, the economy will become increasingly vulnerable.

Indeed, as we move through 2010, Sage is looking to a number of key economic variables to determine its 2011 forecast.  The first is the performance of financial markets, which have recently done more than a passable job in predicting the trajectory of the economy.  The Dow Jones

Industrial Average peaked at 14,164.53 on October 9th, 2007 before beginning what was then a slow, steady descent.  Two months later, the economy was in recession.  More recently, the market has been trending higher on low volatility.  Perceptions of risk have abated massively in recent weeks and if economic data continue to be strong and largely unidirectional the market liftoff could continue.

The second set of indicators relates to business investment.  Sage is particularly keen to observe increases in business investment that do not appear directly related to government spending.  Industries that appear best positioned to ramp up investment include exporters and energy suppliers, though still tight business credit will serve to limit the pace of investment expansion.

A third indicator will be bank lending.  As corporate profits expand and help repair balance sheets, Sage expects that bank purse strings will loosen.  Higher long-term interest rates, which are anticipated as the economy marches toward 2011, should help induce more rapid velocity of money.

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