Economy Surprises On The Downside - What's Next?
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Introduction

Last Friday's report on 4Q Gross Domestic Product was a shocker. Most forecasters had predicted a modest slowdown from the blistering 4.1% annual growth rate in the 3Q. The average pre-report estimate had 4Q GDP coming in at 2.8%. But on Friday, the Commerce Department released its preliminary report showing that GDP rose only 1.1% in the 4Q, the slowest pace in three years.

As I will discuss in more detail below, the latest report showed a significant drop in consumer spending, a similar drop in federal spending and much lower than expected investment by businesses in equipment and software. Making matters worse, the GDP price deflator (the government's indicator of consumer inflation) rose 3.3% in the 4Q, well above expectations, and the "core rate" (minus food and energy) was also well above the Fed's target rate. More details below.

Thus, it remains to be seen if the Fed will stop raising short-term rates in the next couple of months as most analysts expect. A weak 1.1% increase in GDP is certainly enough of an indicator that the economy has cooled, but with core inflation well above the Fed's target, that could mean more rate hikes than currently expected in the future.

While the latest GDP figures will be revised in late February and again in March, last Friday's report was indeed bad news. Despite some encouraging economic reports in November and December, the effects of the hurricanes and soaring energy prices did in fact take a toll on consumers, as I predicted. And as I will discuss below, the holiday shopping season wasn't nearly as strong as early reports suggested.

Fortunately, there are some reasons to believe the economy will rebound in the current quarter and gain momentum as the year proceeds. We will discuss all of this and more in the pages that follow. Let's get started.

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4Q GDP Much Weaker Than Expected

The nation's Gross Domestic Product (total output of goods and services) grew at only a 1.1% annual rate in the 4Q. That is the slowest rate of growth in three years. As noted above, the average pre-report estimate was 2.8%, so economists missed this one badly. The 4Q surprise followed growth of 4.1% in the 3Q. Despite the 4Q sag, the economy grew by 3.5% for all of 2005.

The principal reason for the decline in 4Q growth was a slowdown in consumer spending to a four-year low of only 1.1%. Most notably, American consumers stopped buying automobiles in the 4Q. Purchases of cars, light trucks and parts plunged 44.9% in the 4Q, largely due to the end of summer incentives by the major automakers.

Yet it is important to point out that consumer spending did not go negative in the 4Q. It merely slowed down from earlier levels. For example, just before and just after Christmas, we heard that holiday spending had jumped 5-10% above year-ago levels. That was not true in most cases.

According to the International Council of Shopping Centers, holiday spending rose only 3.2% above 2004 levels. ShopperTrak reported that retail sales during the holidays were up 4.4% from 2004. Walmart/Sam's Club reported holiday sales that were 2.2% above 2004. The point is, consumer spending simply did not rise as much as was widely expected. And it remains to be seen how quickly it will rebound this year.

Residential housing construction rose by only 3.5% in the 4Q, versus 7.3% in the 3Q -- another solid sign that the housing market has topped. In addition, business spending on equipment and software rose only 2.8% in the 4Q, less than a third of the average quarterly rate of growth over the last 2 1/2 years. More details to follow.

Real federal government consumption expenditures and gross investment decreased 7.0% in the 4Q, in contrast to an increase of 7.4% in the 3Q. Defense spending decreased 13.1% in the 4Q in contrast to an increase of 10.0% in the 3Q. More on this later. US imports rose by 9.1% in the 4Q, up from 2.4% in the 3Q. Exports, on the other hand, rose only 2.4% in the 4Q. Higher imports also have a negative effect on GDP. So, a combination of factors converged in the 4Q to produce a much weaker than expected 1.1% rise in GDP. It remains to be seen if this number will be adjusted upward (or downward) in subsequent revisions to the preliminary estimate. Either way, the report was a surprise, at least for mainstream economists.

Not A Surprise For Everyone, Not My Readers

In my August 30 and September 13 E-Letters, I predicted that the national disaster along the Gulf Coast and the effects of soaring oil prices and $3+ gasoline prices would take a significant toll on the national economy. Most of you will recall that I recommended taking profits in real estate and related mutual funds in both of those E-Letters. I hope you took that advice.

The Bank Credit Analyst has also been predicting a " mid-cycle correction" in the economy since last fall. The editors at BCA also correctly called this slowdown and predicted that it will last for 2-3 quarters, followed by a resurgence in growth in the second half of this year. I have not yet received my February issue of BCA, but if there is any significant change in their economic forecast, in the wake of the latest GDP report, I will be sure to let you know.

While predicting the latest economic swoon did not seem like rocket science to me, what with three devastating hurricanes, the Gulf Coast ravaged and oil prices above $70 per barrel, most economists were still predicting 4Q growth of 3-3.5% at the time. Just before the latest GDP report came out last Friday, the average estimate was still 2.8%.

What Happens Next For The Economy?

No doubt, the gloom-and-doom crowd will proclaim that the weaker than expected GDP report assures that we are headed for a recession. But what else is new? For them, we are always headed for a recession and a nasty bear market in stocks.

On the other hand, most economists are still predicting that the economy will snap back to a rate above 3% in GDP in the 1Q, despite last Friday's disappointing 4Q report. The most recent Wall Street Journal survey of leading economists suggested a strong first half of the year, followed by slightly less growth in the second half. As noted above, BCA suggests the opposite -- a slower first half followed by a stronger second half.

Here are my thoughts. I always pay close attention to the Index of Leading Economic Indicators (LEI). The LEI fell in July, August and September. While the LEI is not a perfect forecasting model, three consecutive downward months is historically quite reliable. The decline in the LEI in Jul/Aug/Sep, along with the hurricanes and soaring energy prices, prompted me to make the following forecast in my October 25 E-Letter:

"The bottom line is that the economy is slowing down; it was already slowing down before the hurricanes; and it remains to be seen just how much more it will slow down... I am feeling better about the economy than I did just after the hurricanes, but I still believe that GDP is headed toward 2% or possibly lower for the next several months."

While I was very much convinced that the economy would take a temporary hit from the hurricanes and soaring oil prices, you will recall that I did not predict a recession. I continue to believe that the economy will rebound this year, but the latest GDP report is a troubling development, particularly as discussed in the following section.

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Rising Inflation & Fed Monetary Policy

As noted in the Introduction, the GDP price deflator (the government's indicator of consumer inflation) rose 3.3% in the 4Q, well above expectations, and the "core rate" (minus food and energy) rose 2.9% (annual rate) in the 4Q. This is significantly above the Fed's target rate for core inflation of 1.5-2%.

Virtually everyone expects the Fed to raise short-term rates later on today by another quarter point to 4.5%. Most analysts expect the Fed to raise rates only one more time after today on March 28 when the FOMC next convenes, and then go to a neutral position thereafter.

That remains to be seen, however. As noted above, a weak 1.1% increase in GDP is certainly enough of an indicator that the economy has cooled to the point that the Fed would not raise rates further. Yet with core inflation rising to 2.9% in the 4Q - well above the Fed's target - that could mean more rate hikes than currently expected in the future.

Between now and March 28 (next FOMC meeting), the Fed will no doubt be watching the inflation indicators closely -- as should we. In December, the Consumer Price Index fell by 0.4%. But for the 12 months ended December, the CPI rose 3.4% - consistent with the 4Q GDP price deflator of 3.3%. Just as important, the Producer Price Index (wholesale prices) rose 0.9% in December, and was up 5.4% for the 12 months ended December. No doubt, these numbers are troubling to the Fed.

The Fed will have the benefit of seeing the January and February figures for the CPI and the PPI before making its interest rate decision on March 28. The Fed will also have the benefit of seeing all the other economic reports that are released between now and then. As investors, we need to be paying close attention to all these reports as well.

The Fed has a delicate balancing act. Obviously, the Fed is determined to keep inflation in check, but at the same time, the FOMC does not want to slow the economy to the point that we fall into a recession.

FYI, the Fed Funds futures market is priced for 100% odds that the Fed will hike the key rate by a quarter-point to 4.5% today. The futures are also priced for 80% odds of another quarter-point hike on March 28.

Does The Economy Snap Back Or Limp Back?

We have discussed the facts of the GDP and inflation reports, and the numbers are what they are. The question is whether the GDP will snap back in the 1Q as most economists predict, or climb back very slowly over the next 2-3 quarters. Here is a brief rundown of the relevant factors.

The case for snapping back to 3% quickly:

1. The LEI rebounded strongly in October, rising a full 1.0%; November saw another solid gain of 0.9%; and December was up a modest 0.1%. Overall, it was another strong three months. The LEI data suggest that the economy could well snap back in the 1Q, as most economists suggest.

2. There has been a broad consensus since last fall that growth in consumer spending would slow in 2006. Likewise, there has been a consensus that business investment and capital spending would take up the slack due to slower consumer spending. Because business spending in the 4Q was unexpectedly low, most economists expect a huge jump in the 1Q.

3. The largest component of the decline in consumer spending growth in the 4Q was auto sales. As soon as the summer incentives went away, auto sales fell off a cliff. October sales of cars and light trucks, for example, were the lowest since 1998. But since October, sales have been improving. If that trend continues, it would be good for the economy.

4. Government spending was delayed during the 4Q for a variety of reasons. As noted above, defense spending was down 13% in the 4Q, largely due to contract delays. But does anyone believe government spending will ever decrease? I think it is safe to say that whatever spending got delayed in the 4Q WILL be spent in the 1Q of this year, thus helping to boost the economy.

5. The unemployment rate is close to the level of full employment, so consumers will have money to spend. The savings rate is still negative, so consumers are not shifting from consuming to saving.

The case against snapping back to 3% quickly:

1. Consumer spending does not rebound as much as is currently expected. As discussed above, the boom in home equity refinancings is waning, what with housing prices cooling and interest rates rising. Credit card delinquencies recently hit a new high. For those consumers who have already tapped their home equity, where else can they go for spending money?

2. Increased business spending did not offset the slowdown in consumer spending in the 4Q. It remains to be seen if business spending will take up the slack in the 1Q and thereafter.

3. While auto sales have improved modestly since the plunge in October, US automakers are laying off tens of thousands of workers. GM & Ford are at risk of bankruptcy. This is not good for the economy.

4. With recent results in the long bond market, it appears that some of the foreign entities purchasing our Treasuries are going to other investments, such as gold. This has caused long-term yields to spike up to become more competitive -- more bad news for consumers and the housing and related sectors.

Obviously, there are valid reasons to believe the economy will snap back quickly to the 3% range. But there are also valid reasons to believe it will take a considerably longer period of time. Reality is probably somewhere in between.

Latest Reports Are Encouraging

As noted above, the LEI has been higher for the last three consecutive months. Based on the latest economic reports, there is a very good chance the LEI will be positive again for January. The Conference Board announced this morning that the Consumer Confidence Index rose to its highest level (106.3) in more than three years in January.

Personal spending increased 0.9% in December, the highest level in five months. Personal income in December rose 0.4%. Both of these numbers were better than the pre-report estimates. The Census Bureau also reported that retail sales rose 0.7% in December.

Strong consumer confidence and higher than expected personal spending in December and January raise the odds that the economy will rebound in the 1Q. While this is good news, it also increases the likelihood of more interest rate increases by the Fed.

Market Reactions To The GDP Report

While the GDP report was significantly worse than expected, there was little reaction in the markets. Stocks, which were moving higher last week, have been basically sideways yesterday and today. Bonds, which had been declining (higher rates) last week, continued to fall on Monday. Bonds traders were troubled by the higher than expected inflation numbers in the GDP report, and the increased likelihood of more interest rate hikes by the Fed.

With regard to equities in particular, my first observation is that the markets took the bad economic news in stride. Stocks in general did not fall out of bed over the GDP report, despite the bad news for the economy and inflation. This is a sign of strength. The Dow and the S&P are at three-year highs.

With one exception, all of the equity managers we recommend are long the market and are up nicely so far this year. (Past results are not necessarily indicative of future results.) The one exception is still mostly in cash as his risk indicators continue to be too high to signal a fully invested position.

It is important to keep in mind that there is a lot of risk today in the equity markets and the bond markets, especially if the Fed decides to continue raising rates beyond the next FOMC meeting on March 28.

This is why I continue to recommend that you have a significant part of your portfolio with active managers that can "hedge" or move to cash if market conditions warrant. I also believe that most investors should own mutual funds that have a history of delivering "absolute returns " in up, down or sideways markets. I encourage you to take a look at our "Absolute Return Portfolios" as discussed in detail last week.

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Conclusions

The latest disappointing GDP report was indeed predictable, as BCA and I clearly did last fall. The latest report also demonstrates that we should not automatically assume that the average pre-report estimates by economists and Wall Street analysts will be very close to the actual number.

The figures above suggest that the latest GDP report was NOT an aberration, as many analysts are claiming since last Friday. The hurricanes, the national disaster and soaring energy prices did take their toll on the economy. Consumer spending -- which accounts for over two-thirds of GDP - clearly fell short of expectations in the 4Q.

As discussed above, the economic reports we've seen over the last few days on consumer confidence and spending, along with the three-month increase in the LEI, indicate that the odds favor a bounce in the economy for the 1Q. The question is, how long will this bounce last? That depends, in large part, on the Fed. Will new Fed chairman Ben Bernanke and the other members of the FOMC focus more on the higher than expected inflation in the 4Q, or will they focus more on the much weaker than expected economy? I do believe that if the Fed decides to continue raising rates beyond March 28, we will see another shakeout in the stock and bond markets. Be prepared.

Very best regards,

Gary D. Halbert

Gary Halbert is the president and CEO of the ProFutures companies, a diversified investment advisory firm located in Austin, Texas. ProFutures offers professional financial planning services to a nationwide base of clients. Mr. Halbert's firm specializes in tactical investing, and its recommended investment programs include mutual funds, managed accounts with professional Investment Advisors and alternative investments. For more information about the programs offered, call 800-348-3601 or visit the website at www.profutures.com.

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Forecasts & Trends is published by ProFutures, Inc., and Gary D. Halbert is the editor of this publication. Information contained herein is taken from sources believed to be reliable, but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgment of Gary D. Halbert and may change at any time without written notice, and ProFutures assumes no duty to update you regarding any changes. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Any references to products offered by Halbert Wealth Management are not a solicitation for any investment. Such offer or solicitation can only be made by way of Halbert Wealth Management’s Form ADV Part II, complete disclosures regarding the product and otherwise in accordance with applicable securities laws. Readers are urged to check with their investment counselors and review all disclosures before making a decision to invest. This electronic newsletter does not constitute an offer of sales of any securities. Gary D. Halbert, ProFutures, Inc. and all affiliated companies, InvestorsInsight, their officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Securities trading is speculative and involves the potential loss of investment. Past results are not necessarily indicative of future results.




Posted 01-31-2006 5:49 PM by Gary D. Halbert