Interview With Diane Swonk: 2.5% Q4 Growth With No Broad-Based Recovery And Housing Slowdown

Includes: IYR, SPY, XHB
by: Harlan Levy

Diane Swonk is a senior managing director and chief economist for Chicago-based Mesirow Financial.

Harlan Levy: Looking at August's jobs data, is job creation slowing and the economy weakening?

Diane Swonk: What we saw in combination with the worse than expected report - 169,000 new jobs, although I expected only 165,000 - was that the private sector produced fewer jobs than the overall economy, and that's a reversal from what we had seen. We'd seen the government sector draining jobs for much of the last several years while the private sector generated jobs.

The downward revisions of June and July and two months in a row of downward revisions mean that instead of the second cut of the data capturing more jobs because the economy was gaining momentum, we actually counted less jobs and the economy was losing momentum.

We certainly hit a summer low, and that's important, because it reshapes our view of what the economy was doing. We did see some sequester impact in July. We lost some federal government jobs. We saw some teachers hired back in August, which is good news, but it's not really sustainable over the long haul. It's a one-time event with the start of the school year, but it was good to see some of those teachers coming back, because we had seen those ranked thinned quite dramatically in recent years.

The fall in the jobless rate was for all the wrong reasons. It fell because more than 300,000 people left the labor force, many of them young teens. You do expect them to leave the labor force right now and go back to school, but this is seasonally adjusted data, which means they left in many more ranks than what we normally expect. And what's really amazing is how far the participation rate among young people has fallen. It's fallen from about 45 percent in 2000 to closer to 33 percent today and had another big drop in the last month. That's really important to understand, because it means that young people who want to get skills first of all are giving up entirely, and they're not getting the skills they need to work in the labor force or stay employed later on at some level.

Also we're seeing weaknesses among many college students coming home with a lot of debt who are underemployed and not able to make all the payments on that debt. The default rate on student debt has soared. Or they're not getting any job, and they're staying at home, which is causing more financial hardship for families.

This economy is in recovery. It's better to generate jobs than lose jobs, but it really is a very difficult situation. We're now getting to the point where these persistently high unemployment rates are beginning to accumulate the costs to the broader society.

H.L.: What's the future for private and public sector jobs?

D.S.: Temporary jobs are climbing, but they're not climbing as rapidly. The drivers of growth have been revised down, and that's something we worry about. We used to think of temporary jobs as sort of a toehold to a full-time job with benefits and all that. What we've seen more of late is that these temporary jobs don't always turn into full-time employment. They stay temporary without all of the safety net benefits, and they keep working at the same place. That's a real shift in the way we thought about temporary work, that it was a lead indicator of what would be next in the U.S. economy.

We did see a little bit of improvement in the manufacturing sector, all in autos. Defense and non-durables are getting hit, things like apparel and all sorts of softgoods.

In general we've not seen the broad-based recovery. We'd like to see the spillover from housing, for instance, things like furniture, appliance production, lumber production, all the things that go into a housing recovery. Those things have not come back in a big way, and we're still holding our breath on that and are starting to turn a bit blue on that. Although I do think we'll get a bit of a reacceleration in growth, and we did see things like the ISM manufacturing index tick up, and the construction data was stronger for the most recent month, which may suggest we'll see some upward revisions going forward. That's good news if we can get it, because we need not only a quantity of jobs but improved quality of jobs.

The problem is that we're still looking, at least in the fourth quarter, at an economy that reaccelerates to 2.5 percent. That's not stellar or anything to pop Champagne corks over. The hope is that we get back up to 2 ¾ percent with less fiscal drag next year. We won't have those expiring payroll tax cuts and the additional increases in taxes on the most wealthy households at the start of next year. But of course we've pulled a lot of money from this year into last year in advance of that, so it's a bit of a dicey game. The composition of wage growth just isn't that great, and we have too many low-wage jobs dominating the increase in the jobs numbers.

H.L.: Is the housing recovery weakening?

D.S.: Two things are happening in housing. The uptick in interest rates pulled a lot of fence-sitters and anyone who was waiting on the sidelines to buy, and we did see a big surge in home sales in July. It looks like that might have carried into August as well.

But the housing starts haven't been what we'd like. We have a lot going on in the multi-family market, but the bang for the dollar is in single-family starts. What we've seen there is very uneven growth and, in fact, some setbacks in some months. You really want to see single-family homes grow, because that's where more people per square foot are employed. You get a lot more collateral spending and spillover effects in single-family housing starts than you do in multi-family starts.

We've also seen a shift to people not being able to buy a home. The investors that dominated the housing market are beginning to fall in the share of the market along with first-time buyers. I think this is a residual effect of the overhang of student debt. You don't have that first-time buyer out there. The investors are starting to slow down, because they were flipping these homes to rent, but they were doing it out of the foreclosures, the short sales, and much of that inventory has already been absorbed.

I think we will see some slowdown. The good news is housing prices have come back, and that's very good news for anyone who owns a home. We're restoring some of that housing market equity out there. I just worry about how sustainable that is, because I think a lot of people who've been waiting on the sidelines to list are going to start listing now when market conditions aren't quite robust, particularly from all the investors we had in the market at the beginning of the year. I'm worried about housing. I think it will add a lot to the economy, but the jobs are of a very low base, and that's what's really important to remember. I'm glad we've seen the comeback in prices, but I wish we'd seen more of a comeback in activity faster than we have. It's disappointing to see that the construction activity hasn't really fully come back yet.

Another factor in construction is the lot. Many of the builders I'm talking to face two problems. People don't want to drive as far. You can't just go to a Greenfield site and build a subdivision and have people do a long commute with gas prices as high as they are. That's really shifted demand to closer in locations, where, of course, a lot it is already built, and the lots are much more expensive.

Also, many producers of construction materials, like lumber and drywall, and those kinds of things have gone up quite a bit in price, because many of these producers had to sell below-cost at the height of the crisis and took heavy losses and are not willing to open idle plants. So you've got sort of a stand-off going on that causes a hesitation in the momentum in the U.S. economy, particularly in the housing market.

H.L.: Let's talk about the Federal Reserve. If it doesn't begin scaling back its monthly purchases of $85 billion in bonds and mortgage-backed securities and does nothing, isn't that a sign of weakness?

D.S.: It certainly is. It's a bit of a coin-toss at this stage of the game on whether or not we move forward on scaling back those purchases. Remember: Even if they scale back on the purchases they still will be easing, and I think the chances are now 51-to-49 that they actually go ahead with the tapering, and they do it "tapering-light," so it's $5 billion or $10 billion less instead of the $20 billion we initially thought they would start out. It's like moving from a 1 percent cut in the fed funds rate when the economy is really bad to maybe a half percent cut in the fed funds rate. You're still cutting, but not as aggressively as they were. That's the way to understand that it's still a highly accommodative monetary policy.

They have to use their Sept. 18 press conference to really clarify what "gradual" means, what it means to "taper." It will help them to lay out a roadmap. Clarifying is something the Fed is not very good at, but it really needs to clarify a lot for financial markets to feel comfortable. Also the more that it maps out today, the more that will be institutionalized as monetary policy. Remember, monetary policy doesn't turn on a dime just because someone new comes into the Federal Reserve, and we're going to have a lot of new people sitting at the table come January. I think it's important to understand that monetary police is inertial, and there's a lot of institutional momentum to monetary policy. The more they can set in place today, the less that will be undone quickly, and the more certainty the financial markets will have about continuity in monetary policy. That's another important reason why they'll consider tapering along with the fact that they have to consider whether it's effective to even do what they're doing. That is an ongoing debate within the Fed and outside the Federal Reserve.

H.L.: What do you see the economy doing next year?

D.S.: Next year is set up to be a little bit better year, with less fiscal drag. The sequester is expected to continue keeping the economy from growing above the 3 percent rate, but I think we'll get to 2 ¾ percent next year. That's somewhat good news, because that's better than the economy's economic potential, which means we'll continue to whittle away unemployment for the right reasons rather than the wrong reasons.

Much of that is not strength per se. By this stage of the game we should be seeing between 4 and 5 percent growth given the losses that we endured and how high the unemployment rate still is, especially when you take into account the shadow unemployment rate and how many people are not participating in the labor force. That said, I do think we have some momentum going into next year.

The Fed's not going to go away any time soon. Unconventional monetary policy is going to be around for quite a while. People need to look at the bigger picture on that. The Fed, from the evidence of the Chicago Fed, which has been behind a lot of this, has said that we look for this QE3 to be somewhere around $1.25 trillion by the time we're done. That's more than double the quantitative easing of QE2 of 2010 and 2011. So, it's not an insignificant number. That's a big number. That's where the bigger picture is - that the Fed expects to continue to provide not only that kind of support, but also it doesn't expect to raise interest rates any time soon. I think there's some on the Fed who wouldn't mind not only that the punchbowl stays out there a little bit longer. Maybe some people get a little bit tipsy from this current easing, and you always worry about the hangover.

But to some extent, this unintended consequence, one of the few welcome ones, was what happened since the rates backed up and the fears of tapering spiked, and maybe the message wasn't given very well and then there were the mea culpas they made in June about messaging that. One of the unintended consequences of that is we burst some bubbles that were forming in the U.S. economy, particularly in emerging markets. That's actually welcome news for the Fed, because now some of the weaknesses have been revealed in emerging market economies and different places in the broader economy. Data allows the Fed to move forward without fearing the bubbles that could be residual in this policy later on.

H.L.: What do you think stocks will do the rest of this year and next year?

D.S.: There's a little room for a small rally in stocks if the Fed comes out and messages this right on Sept. 18. But that's a big "if." The Fed messaging and all the contradictory information that we get from the Fed is like going in the kitchen of your favorite restaurant and seeing how the food is actually put together with the rats running around in the corner. You don't want to see it all. It's too much information. You want it all put on a pretty plate delivered to you out front.

If the Fed can really clarify and simplify the message in September and succeed, you could see a small rally, and that would be good news. I think they're really going to target the mortgage market, and we could see a bit of a rally there. I'm a little bit backtracking on rates, but, that said, the underlying trend is for the economy to strengthen, along with the situation abroad stabilizing, particularly in Europe. That should push rates up a little bit. So the great bond market rally that we've known for so long is pretty much coming to an end. It came to an early abrupt end, but nonetheless I think rates are going to be creeping up over the next year.

That said, if the economy really performs the way I think it will next year, and we still have these stagnant wages, you do have an economy that allows for more profits again. This has not been the best year for profits, and I think you'll see profits return much more aggressively next year, not double-digit gains, but some single-digit gains that at least support 4 to 5 percent gains in the broader market. And that's not bad in an economy that's still got very tepid inflation.

It's a trade-off. You can't get the extraordinary rally in stocks when you've got bonds going up on the other side of it. We're talking about profits coming back, but the low-hanging fruit on easy profit has already occurred.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.