US Week in Review

The economic news looked great last week, and earnings data out of the tech, industrial, and financial sectors continued to impress. Unfortunately, off-again on-again bailouts for Greece, continued negative news flow out of Goldman Sachs, and a "sell stocks on the good news" mentality kept volatility high all week, closing on a very sour note Friday after one of the best gains of the year just the day before.

GDP Growth Looks Good, Though not Quite as Good as My Expectations
GDP growth, the broadest measure of economic activity, managed to match the 3.2% consensus forecast but fell short of my 4% target. The part of the number that really matters, consumption expenditures, did manage to fall within my forecast range. The Chicago ISM Purchasing Managers' report was also impressive, indicating that the manufacturing sector continues its strong bounce off the bottom. Transportation data from both the rail and trucking sectors were also exceptionally robust according to our industrials team. Lower delinquencies and much higher spending rates are beginning to drive earnings for major credit card companies. American Express and Capital One both reported powerful results according to Morningstar's financial team. Initial unemployment claims again moved in the right direction last week. During past recoveries, initial unemployment claims improvement has stalled out at a similar point with no detrimental effect on the economy. Rolling last week's news all together, I am sticking with my overall economic forecast for 4.5% growth in 2010, though the first-quarter report will make that target just a little harder to attain.

Forecasting the Economy Is not the Same as Forecasting the Stock Market
Just as one word of caution, I generally view my role as one of forecasting economic activity and not the stock market. While I remain adamant that economic activity will continue to improve and that the economy will not see a double dip, that doesn't necessarily mean the market will continue to move up in a straight line, especially in the short run. Currently, Morningstar's proprietary metric, price to our analyst calculated fair value, is now at 1.07 meaning the market overall is about 7% overvalued if our models are correct. Historically, the price/fair value metric has ranged from a low of 0.55 to as high as 1.14. That doesn't mean the market should go straight down from here. The price/fair value metric remained above or very close to 1 for the entire period from 2003 to 2007 before the market finally began to collapse in late 2007. The current market seems awfully skittish at any hint of bad news and is not responding very well to good news. In addition, the summer doldrums of stock market trading loom in the months ahead. Morningstar would seldom advocate any type of short-term trading, but it might make sense to check your asset allocations and rebalance where necessary to avoid taking on too much risk.

Consumer Spending Drives Real GDP Growth to 3.2%
On the surface, real GDP growth for the March quarter of 3.2% was a disappointment relative to my above consensus forecast of 4.0%. However, the composition of the GDP report was highly favourable with the consumer spending growth of 3.6%, just about what I had expected. In fact, the consumer accounted for 2.6% of the economy's overall growth of 3.2%. Given that consumer spending eventually drives business investment and most of the rest of the economy; I am pleased with the impressive consumer results. Changes in inventory levels, at 1.6%, were also in my forecast range of 1%-2%. However, I was wide of the mark on net exports (exports minus imports) subtracting 0.6% from GDP, whereas I had hoped that this category would make a small contribution to overall growth. Given all the recent corporate earnings reports highlighting strong overseas sales, I was surprised that export growth was so muted, while US imports increased about in line with expectations. There is a chance that the net export numbers will be revised in next month's release. Both residential and business construction were negatives for growth this quarter, though not far off expectations. Dismal weather in February depressed both the residential and commercial numbers. Due to improved weather and the expiring homeowners' tax credit, I believe construction will have a smaller negative effect on the June quarter. Government spending was another small negative surprise this quarter, subtracting 0.4% from GDP versus just 0.3% in the previous quarter. While Federal spending continued to increase modestly, state and local governments continued to cut back in the face of ongoing fiscal problems. While some states, including California, have recently reported better-than-expected tax collections, state and local government increases generally lag improvement in the overall economy by as much as one to two years.

Here is a summary of the contribution made to GDP growth for each category of spending. For example, the consumer contributed 2.6% of the growth, calculated by multiplying consumption growth of 3.6% by the 70% of the economy accounted for by consumption. Some categories, such as Equipment and Software, grew more robustly than consumption, but it is far smaller than the consumption category. Therefore, Equipment and Software's contribution to total GDP growth is smaller than the consumption number. The table also demonstrates that growth was slower in the first quarter of 2010 than in the fourth quarter of 2009. However, the growth this quarter was dominated by consumption and not by a large inventory adjustment as was the case in the fourth quarter. In other words, overall growth was slower, but the quality and sustainability of that growth was far higher this time around.

News out of the regional purchasing managers' reports has been uniformly robust in April, which should bode well for this week's national ISM report. Friday, the Chicago regional ISM report showed surprising strength, jumping to 63.8 from 58.8 in just one month and well off its low in the high 20s. The all-important new order index jumped to 65.2 from 61.8. Since new orders get translated into production and shipments over several months, the outlook for manufacturers is bright. The previously stagnant employment index also jumped, registering its fourth straight month in growth mode, which bodes well for this month's employment report.

Job Growth of 150,000-250,000 Expected in This Week's Employment Report
The key number for the week ahead is Friday's employment report. I expect job growth of 150,000-200,000 for April, with as many as 75,000 coming from temporary census workers. This compares to growth of 162,000 the prior month, with about 40,000 of those being census workers. While there is some concern about the census jobs ending this summer, I think the economy will be growing fast enough on its own by then to absorb many of those census workers. In the interim, much of the money earned by census takers is more likely to be spent than saved (lower wage earners and part-timers have historically spent a higher percentage of their incomes than higher wage earners), further priming the consumer pump. I am relatively optimistic that the economy will generate 150,000-250,000 per month during most of the rest of 2010, based on the employment component of ISM purchasing managers' surveys and anecdotal evidence from many of the companies Morningstar covers.

To put the jobs number in some perspective, at the bottom of the recession we were losing over 700,000 per month, and in a more normal economy 200,000-300,000 new job additions is the norm. Excluding immigration, which may be a big if, the economy needs about 30,000-40,000 new jobs per month for net new job seekers, half the rate it needed just a decade ago. By the middle of this decade, the US-born working age population will begin to decline. All of these analyses are based on the net change in the 22-62 year old age category of those born in the US. In conclusion, while the US still has literally millions of people to put back to work, the pressure from net new workers entering the labor market has diminished and will continue to diminish in the years ahead.

Manufacturing Should Continue to Power Ahead
Also due this week is the ISM purchasing managers' index. Given strong results out of all the regional reports and a surprisingly good number out of Chicago this week, I expect an increase to 60 from 59 when the index is reported on Friday. The manufacturing economy has been key in driving this recovery, and the ISM index has proved to be a great leading indicator. However, the ISM indicator generally ranges from the low 30s in a recession to somewhere between 60 and 70 at its peak, and the index is already in that range. Typically, the economy does well even after the initial spike in the index comes to an end. Remember that even if the index moves down from the previous month, if the index itself is above 50, the manufacturing economy is still expanding.

New Consumer Spending and Savings Data Available This Week
The personal income and expenditure numbers for March that I spoke of in last week's column will be released on Monday of this week and not last Thursday as I had erroneously stated--sorry for the confusion. In any case, I continue to see very healthy growth in consumption approximating 0.6% monthly or 7.2% when annualised based on a plethora of already reported retail data. Unfortunately, a lot of that spending is coming out of savings and stock market gains as I expect that personal income will be up a more modest 0.2%, or 2.4% annualised, which will bring the savings rate down yet again. That's one of the reasons I will be looking intensely at Friday's employment report. I need some combination of job growth, hours worked, and real wages to begin to boost consumer incomes to justify continued increases in spending. So far in this recovery, incomes have been basically flat while spending has increased just over 2%. The good news is that the money is coming out of savings and not debt, since consumer debt was down over that same period of time.

Much more data will be out this week, including auto sales, pending home sales, and productivity. Autos will likely be down a touch after some of the previous month's incentives expired, but still far higher than the previous year and higher that the first month (January) of the previous quarter. Pending home sales for March should tick up given the housing credit deadline of April 30 was looming large in the horizon. Obviously, the April number will look even better when it is reported next month. Productivity growth is likely to be up for the first quarter but slower than the blistering pace of the past several quarters. Such slowing is typical of an economic recovery.