A plethora of evidence has emerged of late suggesting that the U.S. economy has entered a soft patch. This notion has gained traction in the financial markets over the past two weeks and is now the dominant theme affecting the markets' behavior. But be clear, there is little basis for believing that the U.S. economy will be in this soft spot for long.
Ostensibly, the source of recent economic weakness appears to be the recent surge in energy costs. The breaking point in oil has been breached, with businesses and consumers beginning to respond with greater acuity once oil rose above $50 per barrel.
Evidence of this is in the recent declines in consumer and business confidence indices, which have fallen despite any meaningful change in underlying fundamentals. Because fundamentals do not change on a dime, the drop in confidence is almost certainly related to the rise in energy costs. Also affecting confidence, and at the root of the soft patch, is the recent tightening of financial conditions, which has begun to impart a modest drag on the economy.
These worries are overdone. Soft patches are actually quite common in economic expansions. Moreover, the current one looks likely to be quite shallow compared with those of past years.
Nothing to See Here
During the 41 quarters of the 1990s expansion, GDP grew at a pace of 3% or under in 15 of them, or 37% of those quarters, and the longest stretch of quarters with growth above 3% was six. In the current expansion, growth has exceeded 3% for seven consecutive quarters, and the figure is likely to rise to eight once all the beans are counted for the first quarter of this year.
Last year's soft patch, which began in the second quarter of last year, was quite tame, with GDP expanding at a 3.3% pace in the second quarter. Still, the slowdown brought down both stock prices and bond yields, underscoring investors' hypersensitivity to short-term growth trends.
Evidence of a soft patch has emerged in the following indicators:
- ABC News Consumer Sentiment Survey: ABC's weekly consumer sentiment index has fallen for five straight weeks, reaching its lowest point since the week ended June 14, 2004, around the start of the last soft patch. The index recently posted a two-week decline seen only 11 times in 20 years.
- Investors Business Daily Consumer Confidence: IBD's consumer confidence index for April fell 10.6% to its lowest level since it began tracking consumer confidence in February 2001.
- University of Michigan Consumer Sentiment: The preliminary results of the UOM's April consumer sentiment index declined to 88.7 from 92.6 in March, the lowest since September 2003.
- Small Business Optimism: The National Federation of Independent Businesses reported that in its March survey, the small-business optimism index fell to its lowest level since September 2003. (Nevertheless, the index remained in rarely trodden territory, though still elevated by historical standards.)
- Money Supply: M3, the broad measure of money supply growth, has increased at a 3.4% pace thus far this year, after increasing at a 7.4% pace in 2004.
- New York Empire Manufacturing Survey: The New York Fed's Empire manufacturing index fell to 3.1 in April from 20.2 in March, the lowest level since April 2003. Weakness in the report was widespread, pointing to low output in the current quarter.
- Industrial Commodities: Industrial commodity prices have moved sharply lower in recent days. Copper, for example, has fallen from the 2005 peak of $1.525 per pound it set just this past Monday to $1.4285 per pound at Thursday's close.
- Market Indicators: The decline in the transportation stocks and in cyclical shares more generally, combined with the decline in Treasury yields, suggests that investors have concluded, on the basis of mountains of evidence available to these millions of people, that the U.S. economy is slowing.
- Retail Sales: Excluding automobile sales, retail sales have increased at a 6.5% pace over the past three months, a slowing from the year-over-year gain of 8.5% seen the previous month. Still, it remains a percentage point above the 15-year average.
Savvy investors should be careful about extrapolating too much from recent events than is justified by underlying fundamentals. Shares in economically sensitive companies might find greater support than recent price action suggests is possible. In addition, any decline in interest rates is not likely to last long.
These "soft patch" indicators are convincing, but so is the case for continued economic expansion. Consider the following deep fundamentals:
- Personal Income: Personal income is currently up about 6% vs. a year ago, or close to a percentage point above its 15-year average. Income gains have broadened to include wages and salaries, dividends, income and proprietorships. As incomes grow, so will spending, as the U.S. savings rate is very low. Increased spending will boost the output of goods and services and hence boost incomes still further. The process of increased production, income and spending is forming the roots of a virtuous cycle of self-reinforcing economic growth that will help the expansion last for many more quarters.
- Business Spending: Corporate profits are currently extraordinarily high relative to capital spending, with both almost equal at around $1.29 trillion. There's typically a gap, known as the corporate financing gap, with capital spending running above profits by an amount equal to roughly 2% of GDP. The lack of a gap means that corporations are flush with cash and thus have the wherewithal to boost their spending. While it isn't a given, history favors the commencement of such activity. The high level of cash on hand should at the very least prevent a significant retrenchment in business spending.
- Strong Banking System: Nearly every metric on bank profitability suggests that the U.S. enjoys a very strong banking system, an essential part of any economic expansion. Bank credit has expanded strongly of late, a good leading indicator of future expansion.
- Pro-Business White House: Previously enacted legislation will provide ongoing stimulus to the U.S. economy, and future legislation is likely to favor U.S. businesses, particularly small businesses.
- Vigilant Federal Reserve: Yes, higher interest rates will hurt various asset classes. But an overriding story is that the Fed's actions will help to control inflation and thus create a stable financial environment that is conducive to sustainable economic growth. The Fed will bring inflation low enough so that it is not a factor in business decision-making, though this is not the case for many businesses at present.
- Productivity: The U.S. is likely in the middle innings of a long-winded surge in productivity growth. This will boost incomes for many more years to come.
Owing to the factors cited above, the U.S. economy looks likely to escape the soft patch and return to solid growth relatively soon. It is therefore advisable to fade any market moves associated with the notion that the soft patch might be long lasting or deep. The wild card of all of this is of course oil, which remains the main dynamic shaping recent events.
Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of
The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. He appreciates your feedback and invites you to send it to
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