Fed taper not likely in the cards for 2013

As the U.S. economy remains soft and uncertain, tapering by the Federal Reserve is now more likely a 2014 event.

Robert Johnson, CFA 19 October, 2013 | 9:27PM
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After a lot of drama, the budget issues that caused the government shutdown and the debt limit crisis in the United States were pushed off until the New Year this week. Not settled--just saved for a later date. However, the market had assumed that for most of the week.

Instead, the real market movers this week were   Google  GOOG earnings, the Fed's dovish speeches and improved GDP news from China. Overall, the S&P 500 was up 2.4% on the week, making a new recovery high, with the Dow doing somewhat worse because of poor earnings from   IBM  IBM.

Bonds had a really great week with the softer Fed tone, weaker U.S. economic data and the avoidance of the debt ceiling issues. Ten-year U.S. Treasury rates fell to 2.59% after almost hitting 3% a few weeks ago. Better news out of China also helped along the previously faltering commodity markets. However, markets seem to be overlooking a soft economy and lacklustre corporate earnings.

Because of the government shutdown, there wasn't much economic news from the United States. Shopping centrr data was weak again, and initial unemployment claims remained elevated. Next week, the data mills will be flowing again. The September employment report will be issued on Tuesday and the range of estimates remains huge. I continue to expect a below-average growth rate of 160,000 jobs added.

In terms of the government shutdown and debt ceiling issues, the can was just kicked down the road and the uncertainty remains. Both measures were adopted without any concessions to the Republican issues of long-term entitlements and the Affordable Care Act. Some of the language in the extension bill will also make it harder to stop a debt ceiling increase in the next round of fights and put the president in charge of the process. (That is, unless two thirds of Congress objects to the increase.)

Despite the headlines, the Republicans weren't completely skunked. Somehow, the sequester remains the law of the land. As recently as July, the president assumed that the sequester would be overturned by the end of September, in time to spend more money at the end of fiscal-year 2013. Now the sequester is basically extended to early 2014, allowing four months of relatively Draconian cuts in defense and social programs. Despite some comments to the contrary, some of the worst of the sequester impacts will be felt in 2014. The pain from the cuts in spending and increased taxes remains one of the more severe fiscal contractions in decades. By the time the next budget deadline hits, Republicans and Democrats may be looking for ways to take their collective feet off the brake on the short-term economy. Trading some short-term loosening for some long-term entitlement changes may have great appeal for both parties if the economy continues to slip, as I suspect.

The Fed returns to the focus
The Fed governors were on a major speech-giving binge this week, providing plenty of words for economists to parse. On the whole the news pointed to a less bullish Fed that is focused on getting employment growth up no matter what it takes. That's more or less what Minneapolis Fed Reserve president Narayana Kocherlakota said in his speech. He alludes to the Fed's need to stick to its guns to hit its goals no matter what the fallout might be. In this case, the goal is better employment. He likened the Fed's need for resolve in getting employment growing again to the late 1970s, when the Fed dug in its heels on the inflation issue, no matter what happened in the short run to the real economy. A copy of his speech can be found here. (If you want to skip to the really important points, scroll down to the bullet points that are near the end of the speech.)

But Kocherlakota wasn't the only one. Fed governor Charles Evans also sounded a very dovish tone. The speech concludes by noting that Fed policy is likely to remain accommodating for some time given high unemployment levels. He is quite forceful in the final paragraph, stating that now is not the time to change the monetary policy or the bond-buying program.

Between the lack of data, some soft data, Fed speeches, and the timing of a new chairman, it looks to me like tapering is more likely a 2014 event than a 2013 possibility.

Earnings a mixed bag even on reduced expectations
Overall, the third-quarter earnings reports so far have been all over the board. However, as I noted last week, expectations for the quarter were quite muted, ranging from less than 1% to 3% growth, depending on the starting date and how one treats already reported companies. Google's results were a real highlight, beating both top- and bottom-line earnings by a substantial margin. Early reads from manufacturing looked good, too, with   GE  GE and   Danaher  DHR doing better than earnings expectations, although GE's revenue was down as expected.

A large chunk of the companies already reporting earnings are financial stocks, which are poised to be the fastest-growing sector of the S&P 500 for the third quarter. Financials performed well in the third quarter although slowing trading volume hit the investment banks relatively hard, as expected (  Goldman Sachs  GS revenue was off 44%), and conventional banks showed fewer mortgages processed.

However, the news this week was not all good as IBM laid yet another egg with revenue that was actually down year over year. News out of the transportation sector has also been less than stellar. Combining the good with the bad, 79 companies have reported as of Thursday, and 65% are beating earnings estimates, slightly less than the rate in the second quarter. And earnings growth for the companies that have already reported earnings are lower than in the previous quarter.

More worrisome is what will happen with earnings guidance for the fourth quarter. With earnings growth of just 3% in the first quarter and the second quarter and most likely the third quarter, the 10% growth forecasts for the fourth quarter look out of whack with reality. This is especially true considering the impact of the government shutdown, higher interest rates and ongoing fiscal uncertainty that will likely weigh on the fourth quarter. Declining earnings estimates are not great for stocks. Unfortunately, poor earnings and stock performance often cause managers to hit the hiring brakes.

China's GDP growth rate has stopped going down
China watchers this week were pleased that GDP growth (as measured year over year) increased to 7.8% for the third quarter. That rate was higher than the 7.7% rate in the first quarter and the even slower 7.5% rate in the second quarter. Although the 7.8% rate still isn't a great number compared with the rate of the last 20 years, analysts were greatly relieved that at least the growth rate had stopped going down.

While I am no China expert, much of the improvement was due to stimulus programs adopted in June and, to a lesser degree, better European growth. For the first nine months, GDP growth was 7.7%, above the 7.5% official government target. The bad news was that nine-month investment spending was up 20% while retail sales were up just 13%. The government is finding the move to a more consumer-based economy tougher than it bargained for. While commodity markets liked the news and moved up sharply, I am not so sure that much has changed in terms of the Chinese growth rate. It certainly doesn't seem to be enough to move the needle in terms of U.S. and European growth from exports to China.

Initial unemployment claims were too good to be true
Initial unemployment claims made a surprise dip for the week ended Sept. 7, from 323,000 the prior week to 294,000. That rather dramatic fall now appears to be yet another statistical mirage. As it turns out, new computer systems delayed the processing of claims for California, Michigan and at least one other state. (Those states installed new systems that delayed the processing of claims.) In fact, California claims for the wonderful week of Sept. 7 fell from an average of more than 40,000 claims to just 18,000 claims. It appears that California is making up for lost time and processed 71,000 claims the week of Oct. 5.

Smoothing those ups and downs, I think claims have been averaging in the 325,000-340,000 range, little changed compared with recent months. With most of the processing issues behind us (although we won't know for sure until next week) I believe the Oct. 12 number of 352,000 claims is probably close to reality. That number does not include any federal government employees, who are not tracked in this survey. However, this number does look elevated compared with recent trends as businesses serving the government begin to affect the claims report. That phenomenon is likely to continue into next week's report as the settlement occurred midweek, and the reporting period started on Sunday concludes on the upcoming Saturday.

After making some improvement for most of the year, it looks to me like the adjusted claims data hasn't gotten appreciably better or worse when excluding the computer glitches and private sector workers dependent on government activity. For those who believe the claims number is dipping back to 300,000 in the next few weeks, keep dreaming.

Shopping centre sales looking soft
Sorry if I keep harping on this statistic, but without the government's retail sales report or personal income and consumption report, I haven't got a lot to go on in terms of consumer data.

As one might suspect, the news here was not good, given the government furloughs and the related uncertainties. However, the longer-term trend isn't so hot either, with a pattern of lower highs and lower lows dating back to 2012.

This graph is the No. 1 reason that I have been feeling modestly more cautious about the economy since this spring. Manufacturing, employment and GDP cannot improve for very long without consumer spending. Even improved shipments to Europe and China would not be enough to offset poor consumer behaviour. The short-term data didn't look much better.

With the exception of one week in March of this year, one would have to go all the way back to 2010 to find a one-week period of growth this low. That period included government crises, Hurricane Sandy, a tsunami and a massive tax increase.

Data mills go back to work
This week we missed a lot of important economic releases because of the government shutdown. Now many of those missed reports are being rescheduled. They will not come in one big group, as I had feared, but they won't come particularly quickly, either. (It's not like the final economic reports were sitting in a vault, ready to be released at a moment's notice.) For now, many Bureau of Labor statistics reports have been rescheduled, including the employment reports for September and October as well as several price indexes. As of Friday morning, I have seen neither new dates for Census Bureau data, such as housing starts and permits and retail sales, nor have I seen the Bureau of Economic Analysis dates for things such as the consumption or income or GDP reports.

Even without the government data, next week is due to be a busy one for economists. Existing-home sales, home prices, world purchasing manager surveys and consumer sentiment are all due and are quite important. Furthermore, the delayed September employment report will be released on Tuesday.

The September employment report was initially thought to be of huge importance because it was considered pivotal in the Fed's decision to taper bond purchases. Now with the economy slowing naturally and likely to look weaker because of the federal government shutdown, the report has probably lost some of its impact. Still, the report was facing a lot of crosswinds, creating a larger-than-usual range of outcomes. Lower initial claims and purchasing manager data (both of which are now officially suspect) and an improved world economy all suggested employment growth well in excess of the 184,000 per month average.

On the other hand, retail sales have looked awful, and that, along with restaurant employment, had been driving most of the employment growth for several months. I share this view and still believe that job growth will continue to look lethargic at 160,000-170,000 jobs added, modestly below consensus estimates of 185,000 jobs added in October. Nevertheless, the year-over-year growth in private-sector employment is likely to remain in its 2% rut. The privately constructed ADP report for September was unexpectedly soft, with just 166,000 private-sector jobs added, with the thought-to-be strong manufacturing sector adding a miserly 1,000 jobs. However, the quality of those jobs, hours worked and the wage rate may prove even more important than the actual employment number.

The real estate data due next week is also relatively important as that heretofore strong sector was beginning to show some weak spots. Home price growth appears to be decelerating according to some price reports, and next week's report from the Federal Housing Finance Agency should shed some light on that situation. FHFA data grew 8.8% year over year in the report for July, and I suspect August data will be up by just a little more. I think home prices might have gotten a little ahead of themselves and may be more responsible for the recent slowdown in housing activity than the increase in mortgage rates.

Existing-Home Sales Due for a Tumble
I suspect the existing-home sales data may show more chinks in the housing armour. Existing-home sales have gone wild recently as buyers rushed to close deals before interest rates ran even higher. While slow to close, new home sales have fallen apart, and existing sales are at a recovery high. At least part of the recent strengths has been that rush to close and a severe draining of the pending-home-sales pipeline. Pending home sales, which are the fodder for closed existing-home sales reports, has been quite weak for several months, and I think that data will come home to rest in either next week's report on September sales or in the October report, at the latest. Consensus is for a modest decline in existing-home sales from 5.48 million units (a recovery high) to 5.35 million units, which I believe to be too high. Something in the 5.1 million-5.2 million units looks more likely to me. Not a train wreck, but the housing market has clearly stopped accelerating.

Markit manufacturing data could indicate if recent non-U.S. growth is sustainable
Markit's world Purchasing Manager data has proven to be a real market mover, and the flash report is scheduled for next week. Many major economies are more dependent on manufacturing than the United States, so some observers use this data to approximate worldwide growth. The Purchasing Manager Index numbers had been looking much better for several months, but took a bit of a pause in September. With some European and Chinese production and GDP data looking better for the now-completed third quarter, markets will be looking to see if the PMI data and the world manufacturing data are getting better or even accelerating during the start of a new quarter.

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Robert Johnson, CFA

Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis for Morningstar.

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