Second Half Economic Outlook: Should I Change My Forecast?

Includes: DIA, IWM, QQQ, SPY
by: John M. Mason


Growth possibilities for the second half of 2014 have not really changed when looking at the fundamental issues.

Labor participation rates are down, bank lending for economic growth is not picking up, and bond markets are pessimistic about future economic growth.

Finally, with a lame-duck president for his last 2 1/2 years, Washington will be doing little or nothing to help things along...leaving the only game in town to the Fed.

Over the past several months, almost everyone else has been changing their forecast for the economic performance of the United States. The US government, the Federal Reserve, the IMF, and so on…have reduced their predictions for economic growth this year.

During this period, I have not been moved to reduce my forecast which has been for the United States to grow at a 3.0 percent year-over-year rate, fourth quarter over fourth quarter.

A 3.0 percent growth rate is not all that good in the first place and certainly, for the fifth year of an economic recovery is not very outstanding. But, to drop my expectations into the 2.0-to-2.5 percent range? I have been reluctant to move.

The year-over-year growth rate in first quarter of 2014 was 1.5 percent as a result of the terrible first quarter performance, which put the first quarter real GDP number 2.9 percent below the figure for the fourth quarter of 2013. Year-over-year, economic growth in the fourth quarter of 2013 was 2.6 percent, the second highest year-end growth rate achieved in the current recovery.

There were several factors, including the weather, that have caused analysts to believe that the first quarter numbers were distorted. Therefore, these analysts have been looking for the economy to "catch-up" over the rest of the year. Thus, the question becomes, how much catch-up will occur?

In terms of my economic forecast for the year, all I am willing to give up is a statement that I believe if there is any error to my 3.0 percent, year-over-year, forecast, it will be to the downside. That is, I am sticking with my 3.0 percent forecast, but admitting that there is a higher probability that this prediction is too high rather than being too low.

Remember, I do not believe that a 3.0 percent growth rate is very robust.

There are three basic reasons I believe that economic growth will remain on the weak-side in the near future. First, I believe that the information from the labor market is not encouraging for higher economic growth over the next couple of years.

I know, the unemployment rate dropped to 6.1 percent and this new low was hailed as a sign that things were getting back toward normal...whatever that is.

I don't believe that the unemployment rate really tells the whole story of the labor market and the state of the economy. I see the labor force participation rate hitting 62.8 percent, the lowest level since well into the 1970s and I worry about, not a cyclical economic recovery, but a shifting employment pattern connected with secular transition in the whole economy.

The labor markets are not the same as they were and this means, for many, family incomes are down and will not recover to where they were a decade ago. This will constrain consumer spending, housing demand, and other spending that we cannot easily describe. And, this will hurt business demand…and so on.

This labor market situation will not be solved quickly and this will lead to continued mediocre growth numbers.

Secondly, I don't see the demand for bank loans picking up in a way that would make me think that the economy is going to pick up steam. As I have recently written, although bank loans have increased, the areas in which they have increased does not give one a lot of confidence when one starts to go behind the numbers.

Furthermore, there is a significant amount of churning in the banking industry as the smaller banks, particularly those below $1.0 billion in asset size, continue to drop out of the industry. In general, there is little indication that these smaller banks are doing much lending at all and they still are having to deal with major regulatory issues, such as implementing new regulations.

Third, it seems as if participants in the bond markets have backed off from their earlier belief that economic growth will be picking up this year. The yield on inflation adjusted Treasury securities (OTC:TIPS), a rate that many consider to be a proxy for the real rate of interest, has surprisingly dropped in the last two months. Economists argue that the real rate of interest is tied to expectations about the future rate of growth of the economy.

For the past year, the yield on the 10-year TIPS has risen to at least 50 basis points, even reaching as high as 90 basis points. This rate rose through 2013 into the first months of 2014 as the market seemed to sense that the economy was going to pick up.

Over the past two months, the yield dropped as the market seemed to be accepting that future economic growth might not be as strong as was thought only a few months earlier. Last Friday the yield on the 10-year TIPS closed as 21 basis points, although it rallied to close at 27 basis points on Tuesday.

Added to these market situations, I believe that the current state of the US presidency is also contributing to the malaise that the economy is experiencing. It has been stated over and over again over the past year or two that businesses were not stepping out aggressively to invest in physical plant and equipment because of the uncertainty connected with the economic policy of the federal government and the state of the congressional gridlock.

This situation, I believe, is even worse now. The polling numbers of President Obama, whether dealing with popularity, how the president is handling the economy, or, how the president is handling foreign affairs are at new lows. Essentially, President Obama appears to have reached the position of being a lame-duck with still about 2 ½ years remaining.

Given this fact, I don't think many people running businesses believe that anything of substance will be done before a new president is sworn in. This means that the only game in Washington, D. C. is the Federal Reserve…and the Federal Reserve will be spending the next 2 ½ years trying to deal with the huge pool of liquidity it has injected into the economy.

You might say that I am a little pessimistic about the performance of the economy over the next couple of years. I would add that, given the information presented above, there are quite a few others that are a little pessimistic about the performance of the economy over the next couple of years.

It's not that the real economy will be going into another recession. It's just that the real economy will be nowhere near its potential.

There will be places to make money as there has been over the past five years…thanks to the liquidity provided by the Federal Reserve…but these will continue to be in asset markets, places that only the wealthier tend to play.

Should I drop my prediction for economic growth? The important thing is for you to understand a little bit more about where I am coming from when I write about the future path of the US economy.

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