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It Would Be So Much Easier To Be a Pessimist

Tue, Jan 29 2008, 15:06 GMT
by Mark Vitner

Wachovia

There is little wonder why economics is known as the dismal science. Pessimistic views on the economy almost always seem to garner far more headlines and attention than supposedly optimistic predictions of moderating economic growth. Judging from today’s headlines you would think that virtually every economist believes the U.S. economy is either heading for or is already in a recession. In fact, the latest Blue Chip Consensus shows economists rate the odds of a recession beginning in the next 12 months at just shy of 50 percent.

Our own forecast has the economy avoiding an outright downturn but it would be hard to label us as optimistic. We see economic activity essentially stalling out during the first half of this year before rebounding during the second half. Even projections of frustratingly sluggish economic growth are hard to defend against a torrent of reports on the deepening housing slump, mortgage-related write-downs, a disappointing holiday shopping season, and the relentless sell-off on Wall Street. If a recession is not a fait accompli we are expected to see near recession conditions in 2008.

Certainly, the easiest thing for economists to do in this environment is to adopt a pessimistic view. All one would have to do is take today's negative headlines and extrapolate them into the future. The housing slump continues to worsen, dragging down home values and household wealth, which trigger s a pullback in consumer spending and sends the U.S. economy into a deep recession.

There is little downside risk from taking this view. If events unfold the way they are laid out here, then a pessimist would look prescient. If the economy turned out to be stronger than projected, folks would be so relieved they would likely look past the mistake. If conditions turned out worse, at least they warned them that tough times were coming.

Our job is not to simply confirm our clients’ worst fears any more than it is to express our own sincere hopes for the future. Rather our job is to analyze all the relevant data. Use models when appropriate to quantify our opinions, and provide our managers, clients, and the public with our best estimates as to what is likely to happen with the economy. That is the way we have been doing this job for the past twenty-three years and the only way we know how to do it.

One of the problems with the pessimistic view is that it focuses too much attention on the areas doing poorly in the economy and too little on areas that are doing well. Make no mistake about it, 2008 will be challenging year. We face a mountain of mortgage rate resets, residential construction is plummeting, and household budgets are being stretched by slowing job growth and higher food and energy prices. That said, the economy is still growing. Employment is rising slowly and incomes are increasing faster than inflation.

December’s weaker than expected economic news poured even more fuel on the fire, beginning with the first major economic report, which was released the first business day of the year. The ISM manufacturing report, which measures the breadth of strength or weakness in the manufacturing sector, fell 3.1 points in December, to 47.4. This marks the first time the closely-watched index has fallen below the key 50 break-even level in eleven months and only the third time it has been below 50 in the past four and a half years.

Alarm bells went off again two days later when the December employment report noted only a meager 18,000-job gain in nonfarm payrolls and a 0.3 percentage point rise in the unemployment rate. Most other economic reports for the month also came in on the soft side, including data on factory orders, retail sales and housing. The weaker tone to the economic news helped support the sell-off in equities, which gained momentum until the Fed’s surprising three-quarter percentage point rate cut this past Tuesday.

While it may be easier to be a pessimist, it is almost certainly less profitable. There is an often cited parable that states the Chinese word for crisis can be broken in two words that mean both danger and opportunity. We see such an opportunity in the financial markets today. Stocks and bonds are priced for a recession that may not occur. Moreover, the disappointing run of economic news, that began with last month’s ISM report, may have been influenced by the weather, setting the stage for an unexpectedly good run of economic reports next month.

How could the weather disrupt the data so much? About the best explanation we can figure is that we have been talking about global warming for so long that we forgot what winter was like. We had an ice storm in early December, which impacted much of the Midwest, where much of the nation’s factory sector is centered. With the power out, production plummeted and deliveries were delayed. Since products were not produced or shipped as planned, new orders tanked. The lost production, however, also meant that order backlogs rose. Moreover, the temporary lapse in output gave producers no reason to reduce employment.

How does this scenario mesh with the actual data? Judge for yourself. The production series fell 4.6 points in December to 47.3. New orders tumbled nearly 7.0 points to 45.7. Unfilled orders, or order backlogs, rose 1.5 points to 43.0, while the employment index inched up 0.2 points to 48.0. This is hardly uniform weakness and screams out to us that something has run amuck in the data. The chief culprit is the weather, which besides the earlier ice storm included two major snow storms in the Midwest and Northeast.

The impact of the harsh December weather was also evident in the housing construction data. Overall housing starts fell 14.2 percent in December, but starts in the Midwest tumbled 30.0 percent and starts in the Northeast fell nearly 26 percent. Oddly enough, nearly everyone cited the weather as the major contributing factor to these declines. If the weather shut down construction in the Midwest and Northeast in December, doesn’t it make sense that it would also have a meaningful impact on manufacturing activity, and thereby the ISM report?

If we are right and the weather was a major factor in depressing the December economic data, we could be set for a monumental turnaround beginning in the next few days. The consensus forecast for January’s ISM report, which comes out Friday February 1 at 10:00 am, calls for an additional 0.5 percentage point drop. Forecasts for the ISM are based on earlier data from regional Federal Reserve banks, which showed manufacturing activity deteriorating sharply during the month. The combination of colder and wetter weather in December and a fairly mild to typical January could set us up for a surprisingly strong number. If the ISM rises back above 50, any talk of the U.S. economy already being in recession should subside considerably.

We will also get the January 2008 employment report on Friday morning. The consensus is calling for a modest gain of around 65,000 new jobs and no change in the unemployment rate. Our own forecast calls for a gain of 110,000 jobs and there is plenty of potential for an upside surprise. First-time claims for unemployment insurance have fallen in each of the past four weeks and remain unusually low at just 301,000 in the most recent week.

The latest claims data are consistent with strong job growth but have been summarily dismissed because they seem so out of sorts with everything else we heard about the month of January. Models that use the claims data to estimate monthly changes in nonfarm jobs produce estimates of around 200,000 net new jobs for the month of January. If the claims data prove accurate, however, and we get a stronger-than-consensus nonfarm job gain, the recession trade will begin to unwind, sending stock prices and bond yields notably higher.

None of this discussion is meant to downplay the extent of the slowdown we are seeing in the economy. The first half of 2008 will be incredibly challenging and there are significant risks to the downside. We feel that too much weakness has already been built into the financial markets, however, and that we could see a reversal if the economic news turns out to be better than expected.

Our own forecast calls for continued economic growth, with real GDP averaging around a one percent pace in the first half of the year and expanding at a two and half percent pace or better in the second half of the year. Moreover, growth could actually exceed our estimates if exports grow more rapidly and capital spending picks back up. The economic stimulus package agreed to by the House of Representatives and the Bush Administration should also provide a substantial boost 3 to growth in the second half of the year, particularly now that the Federal Reserve has begun to slash interest rates aggressively.

As we look ahead to the rest of 2008 we need to be cognizant of not only the challenges the economy faces, but also the opportunities to be created. The New Year will likely be one of transition, with the current troubles in the housing and mortgage markets finally finding a bottom during the first half of the year and emerging strength in exports and capital spending becoming far more apparent in the second half of the year.

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Published on  Tue, Jan 29 2008, 14:58 GMT