Interview With Adolfo Laurenti: 2014 - More Capital Spending, Jobless Rate To 6.5%

 |  Includes: DIA, QQQ, SPY
by: Harlan Levy

Adolfo Laurenti is deputy chief economist at Chicago financial services firm Mesirow Financial. Previously he was an associate economist at LaSalle Bank/ABNAmro.

Harlan Levy: The volatility in the stock market has been extreme these first few weeks of 2014. Is uncertainty over the economy or its possible weakness doing it?

Adolfo Laurenti.: I think it's uncertainty. We got some very confusing readings on the economy probably attributable to unseasonable weather. We had a spell of very cold weather in December. Then we had the polar vortex on the West Coast and East Coast in January. Even if the data has a seasonal adjustment, I don't think the seasonal adjustment captured the extent of what we experienced.

So what we are seeing, quite frankly, is fairly puzzling data on the job report, on housing, and also on industrial production when you look at the utility components.

The bottom line is that we are getting data that do not look good, which we think may be weather-related, but we will not know for sure until the data even out.

The stock market reflects some of these uncertainties. We cannot know for sure what the real trend is for the economy. There is a little bit of a snowball effect, pun intended, because uncertainty in the data translates in uncertainty on the monetary policy path, regarding the tapering of the Federal Reserve's monthly purchases of Treasury bonds and mortgage-backed securities.

Q.: Where do you see the stock market going?

A: I am at the core a fundamentalist in the sense that I believe the stock market goes where the profits go, an the profits go where the economy goes. So, if by the end of the year we are going to be correct, and this will end up being a good year for the economy, I think current prices may actually be right.

But of course, all these uncertainties and the negative experience of the last few years, we may get to the point of a real disconnect between earnings and stock prices.

The bottom line is I do not know.

Q: What are the strongest sectors of the economy?

A: What we are seeing so far is some resilience in durable goods. The latest reports on both industrial production and retail sales seem to show improvement over the consumer reluctance to go out and spend money on big-ticket items. If we can reestablish some strength in the labor market we will see more of that, including more volume in housing, which is a real key.

If we can go back and see more sales transactions in housing, that will have a multiplying effect in many areas like furniture, appliances, and building materials supporting remodeling. This is an area where there is some upside potential.

The other area is capital spending by businesses in machinery, equipment, software, and hardware. We have been lagging on that front, and based on our understanding of the economy there must be some pent-up demand that sooner or later needed to be released.

So, if we can get some momentum in this economy and better confidence, those sectors may be the next positive drivers both for the economy and the stock market.

Q.: What do the latest economic data on jobs indicate about 2014?

A: In October and November we had the sense that there was some momentum building, and we became quite optimistic that 2014 would finally be a good year for job creation. Of course December's employment report was a step back. What December seemed to suggest was more of the same uninspiring performance in the labor market.

We hope that December will be an outlier. As I said there were some weather issues and some unexpected cutbacks in education, so there may have been situations in December that hopefully will be over in January.

Right now we still think 2014 will show improvement, but, quite honestly, the latest economic report has really been a cold shower.

We think the unemployment rate at the end of the year will be close to where it is now. I think it will go down from 6.7 percent now to 6.5 percent. We see some improvement by the end of thee year. The key question is how many people will come back into the workforce because of better conditions in the labor market.

A major driver for reduction in the unemployment rate has been people leaving the workforce, which is not necessarily a good thing. We hope that a better labor market will bring some of these people back into the workforce. That would be good for the economy, but, paradoxically, it might slow down the reduction in the jobless rate.

Q: How can those people get back into the market when the labor participation ratio, the number of employees-to-the-number-of-people-who-can-work, at 62.8 percent is the lowest in 35 years?

A: It's an important question, and there are two sides to it. A better labor market with more labor opportunities will, induce more people to start looking for jobs. What is more difficult to assess is the demographic side of the equation.

A lot of people who left the labor force are in their late 50s and 60s, and it's not clear if they left the workforce for good, or if they may come back. Right now we are not quite sure this demographic is permanently out of the workforce or just temporary and with better conditions will look for something better to do.

Q. What do you think of the housing market?

A.: The housing market has been a little too hot in terms of home prices, because right now they are growing at double-digit gains over a year ago, and that seems to be a little too fast to me, considering what's going on in the labor market and construction. Also, I understand that mortgage rates will move up, and there's some pent-up demand in housing.

My sense is double-digit gains in home prices are not sustainable. I anticipate in 2014 some leveling off in prices.

On the flip side, mortgage rates will remain affordable. The Fed is committed to keep longer-term rates down for a little longer, and even if prices level off, my hope is for increasing sales in new and existing homes.

Q. Is the manufacturing sector strengthening?

A.: Manufacturing should be strengthening. There's pent-up demand in machinery, equipment, and capital goods. The downside risk is the slowdown abroad. Europe is still struggling. Asia is not doing as well,. And emerging country economies are not going to be doing as well as in the past.

So there might be a little bit of a headwind coming for export goods. We hope the strengthening in domestic demand will offset what may not be bought from foreign trade partners.

Q: There are whispers of deflation in Europe these days, while here in the U.S. economists, Federal Reserve members, and pundits say that inflation is minor and no threat. But gasoline prices are up over last year. So are food, insurance, natural gas, electricity, and other daily items. Are the economic data from the government misleading?

A: I do not question the quality of official statistics on prices. I think we have excellent professional, very serious statisticians calculating this data. Sometimes what people miss in making these remarks about rising inflation is that in many items the quality is going up with no change in price or the price is going down. If you think of the variety of services that we get from our technology, form online shopping, buying a GPS for our cars, or various essentials, the improvement in the quality of the goods and services has been astonishing.

Also, think of all the stuff you can get for free these days, from things over the Internet, information you get over the Internet, free books you get over the internet, many of the apps you get for your smartphone that are free. It's very difficult to argue that at an economy-wide level we are missing something on inflation.

Going forward it will be because we have a lot of liquidity in the system and sooner or later inflation may become a problem, but we are not there yet. It is not something that keeps me up at night for 2014. It will come later on. It depends on the exit strategy by the Fed on quantitative easing, but I don't think inflation is an issue for 2014.

About deflation in Europe, I think that might be more of a risk, quite frankly, because the economies over there are still dong very poorly. So there is some risk prices may continue to decelerate in 2014 in Europe, and that may trigger further action by the European Central Bank.

It will affect us by strengthening the dollar and create some additional problems for our exports. But the risk of deflation in Europe is more imminent than the risk of inflation in the U.S.

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