Listening to the leaders May 14, 2013

Leading Indicators Continue to Point to Slow Economic Growth, but no Recession

The April Index of Leading Economic Indicators (LEI), due out on Friday, May 17, 2013, caps off a busy week for economic reports in the United States. This week includes reports on:

• The consumer: Retail sales for April 2013 and the University of MichiganIndex of Consumer Sentiment for early May 2013;
• Housing: Housing starts and building permits for April 2013 and the National Association of Homebuilders sentiment index for May 2013;
• Manufacturing: Empire State Manufacturing Index for May, the Philadelphia Fed Manufacturing Index for May 2013, industrial production and capacity utilization for April 2013; and
• Inflation: Consumer Price Index (CPI) and Producer Price Index (PPI) for April 2013.

On balance, these reports are likely to continue to show that the U.S. economy is growing at around 2.0% in the second quarter of 2013, that inflation remains muted, and that the odds of a recession in the next year to 18 months remains low. Policymakers at the Federal Reserve (Fed) will digest all of this data, and likely conclude that its quantitative easing (QE) program — the purchase of $85 billion per month of Treasury securities — should continue over the remainder of 2013.

LEI Updates

If you have not seen the LEI lately, there have been several changes made to its components, although as before, virtually all of the components of the LEI are known before the data are actually released. So in theory, the LEI itself should not be a surprise to market participants, the media, or pundits. Of course, that will not prevent anyone from ascribing movements in financial markets on Friday, May 17 to the LEI data, but we are always quick to point out that the S&P 500 itself is a component in the LEI.

In December 2011, the Conference Board, the private “think tank” that compiles and releases the data each month, made four changes to the LEI:

• The Conference Board’s proprietary “Leading Credit Index” (LCI), an aggregate of several well-known financial market and credit market metrics like swap spreads, investor sentiment, margin account, etc., replaced the inflation adjusted M2 money supply.
• The Institute for Supply Management’s (ISM) New Orders Index replaced the ISM’s Supplier Deliveries Index.
• The U.S. Department of Census’ new orders for non-defense capital goods excluding aircraft replaced new orders for non-defense capital goods.
• A combination of consumer expectations and business and economic conditions replace the University of Michigan’s Consumer Expectations Index.

LEI Places Very Low Odds of Recession in Next 12 Months

According to the consensus estimates compiled by Bloomberg News, the LEI is expected to post a 0.2% month-over-month gain in April 2013. The expected 0.2% month-over-month gain would put the year-over-year gain in the LEI at 2.1%. The LEI is designed to predict the future path of the economy, with a lead time of between six and 12 months. Since 1960 — 640 months or 53 years and four months — the year-over-year increase in the LEI has been at least 2.1% in 397 months. Not surprisingly, the U.S. economy was not in recession in any of those 397 months. Thus, it is highly unlikely that the economy was in recession in April 2013, despite the impact of the sequester, the fiscal cliff (spending cuts, payroll tax increases, income tax rate increases, etc.), the recession in Europe, or the slowdown in China.

But the LEI is designed to tell market participants what is likely to happen to the U.S. economy, not what has already happened. Three months after each of the 397 months that the LEI was up 2.1% or more, the economy was in recession in just two of the 397 months — both in 1973. Six months after the LEI was up by 2.1% or more on a year-over-year basis, the U.S. economy has been in recession in just six of the 397 months or 2% of the time. Looking out 12 months after the LEI was up 2.1% or more, the economy was in recession in just 27 of the 397 months, or 7% of the time. Based on this relationship, the odds of a recession within the next 18 months and two years increase to between 10% and 15%.

On balance, the LEI says the risk of recession in the next 12 months is negligible (7%), but not zero. We would agree. But, the still-fragile state of the economy, and the uncertainty surrounding domestic fiscal policy, the recession in Europe, and the ongoing slowdown in China are telling us that the risk of recession is much higher than 7%. Our view remains that — aided by the Fed’s QE program, the early stages of a housing recovery, and a nascent manufacturing recovery — the U.S. economy is likely to grow at around 2.0% this year. The full impact of the sequester, the looming debate over the federal debt ceiling, weak exports, and ongoing contraction in both federal and state and local government spending are all acting to restrain growth, and these factors are likely to be in place for most of this year. A dramatic deterioration of the fiscal and financial situation in Europe, a fiscal or monetary policy mistake here in the United States or abroad, or an exogenous event (a major terror attack, natural disaster, etc.), among other events, may cause us to change our view.

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IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

* Over the last three quarters (third quarter of 2012, fourth quarter of 2012, and first quarter of 2013) , real GDP growth has averaged 2.0%.

Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Stock investing involves risk including loss of principal.

Quantitative easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

The Federal Open Market Committee (FOMC) , a committee within the Federal Reserve System, is charged under the United States law with overseeing the nation’s open market operations (i.e., the Fed’s buying and selling of U.S. Treasury securities).

The Congressional Budget Office is a non-partisan arm of Congress, established in 1974, to provide Congress with non-partisan scoring of budget proposals.

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INDEX DESCRIPTIONS
The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

The Empire State Manufacturing Index is a seasonally-adjusted index that tracks the results of the Empire State Manufacturing Survey. The survey is distributed to roughly 175 manufacturing executives and asks questions intended to gauge both the current sentiment of the executives and their six-month outlook on the sector.

The Institute for Supply Management (ISM) index is based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders, and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys.

The index of leading economic indicators (LEI) is an economic variable, such as private-sector wages, that tends to show the direction of future economic activity.

The Leading Credit Index constitutes financial market indicators including bond market yield curve data, interest rate swaps, and Fed bank lending survey data.

The NAHB/Wells Fargo Housing Market Index gauges builder perceptions of current single-family home sales and sales expectations for the next six months as “good,” “fair” or “poor.” The survey also asks builders to rate traffic of prospective buyers as “high to very high,” “average,” or “low to very low.” Scores from each component are then used to calculate a seasonally adjusted index where any number over 50 indicates that more builders view conditions as good than poor.

The Philadelphia Fed Manufacturing Index is a survey produced by the Federal Reserve Bank of Philadelphia, which questions manufacturers on general business conditions. The index covers the Philadelphia, New Jersey, and Delaware region. Higher survey figures suggest higher production, which contribute to economic growth. Results are calculated as the difference between percentage scores with zero acting as the centerline point. As such, values greater than zero indicate growth, while values less than zero indicate contraction.

The Producer Price Index (PPI) program measures the average change over time in the selling prices received by domestic producers for their output. The prices included in the PPI are from the first commercial transaction for many products and some services.

Purchasing Managers’ Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries, and the employment environment.

The University of Michigan Consumer Sentiment Index (MCSI) is a survey of consumer confidence conducted by the University of Michigan. The Michigan Consumer Sentiment Index (MCSI) uses telephone surveys to gather information on consumer expectations regarding the overall economy.

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This research material has been prepared by LPL Financial.
To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is
not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Less Defense? Weekly Economic Commentary February 7, 2013

Less Defense?

 On Sunday, February 3, 2013, the Baltimore Ravens defeated the San Francisco Forty Niners 34 – 31 to win Super Bowl XLVII. The talk of the game was certainly not about defense, but defense spending, and its impact on the economy, was a key topic of conversation in financial markets in the week leading up to the Super Bowl.

Economic Data Halftime Show Highlights

The financial markets in the week preceding the Super Bowl (January 28 – February 1) featured four key economic events;

• The Institute for Supply Management’s (ISM) Report on Business for January 2013;
•  The January 2013 employment report;
• The fourth quarter 2012 gross domestic product (GDP) report; and
• The Federal Reserve’s Federal Open Market (FOMC) meeting.

Any one of these events happening in one week would draw a great deal of attention from the media and financial market participants, but all of these top-ranked data points playing out in one week is rare — almost as rare as a power outage at the Super Bowl!

On balance, last week’s economic reports, along with the statement accompanying the FOMC meeting, revealed an economic playbook that included economic growth fast enough to create jobs and move the widely watched ISM index, at 53.1, to a nine-month high, but not fast enough to cause the Federal Reserve (Fed) to think about ending its program of bond purchases (quantitative easing, or QE3) anytime soon.

Last week’s economic data halftime show that drew the most attention was Thursday (January 31, 2013) morning’s release of the surprising -0.1% drop in GDP between the third and fourth quarters of 2012. Economists had been expecting a number around 1%. Within that surprisingly weak report was a stunning 22% drop in defense spending, the largest quarter-over-quarter drop in defense spending since 1972, as the Vietnam War was winding down. This drop alone shaved 1.3 percentage points from GDP. Although there is no precise measurement, the effect of Superstorm Sandy likely shaved another 0.5 percentage points off of GDP. Add in the 1.3 percentage point drag from fewer inventories being built up in the fourth quarter than in the third, and it is likely that real GDP growth would have been closer to 3.0% than to zero.

The drawdown in inventories may have been related to uncertainties among businesses ahead of the fiscal cliff and the impact of Superstorm Sandy. These are likely to be at least partially reversed in the first quarter of 2013 and add to GDP growth. However, the outlook for defense spending is a bit less certain due, in part, to yet another piece of the fiscal cliff: spending cuts known as sequestration.

Defense Spending Running at About 4 – 5% of GDP

At least a portion of the 22% drop in defense spending — from an annualized pace of $698.1 billion in the third quarter of 2012 to an annualized pace of $655.7 billion in the fourth quarter of 2012 — was likely due to the fiscal cliff, as some defense contractors may have curtailed some non-mission critical spending ahead of the pending cuts tied to sequestration. Indeed, the research and development-related portion of defense spending fell at a whopping 58% annualized rate in the fourth quarter, while outlays for troop pay dropped by just 3.0%. Thus, the ongoing drawdown in troop levels in Iraq and Afghanistan also most likely played only a part in the big drop in defense outlays in the fourth quarter. Government spending on big ticket military items like aircraft, missiles, ships, vehicles, and electronics fell by only 2.2% between the third and fourth quarters of 2012.

Between $25 billion and $30 billion of automatic spending cuts will hit defense spending on February 28, 2013, representing roughly a 10% cut to defense outlays, unless Congress acts to modify, suspend, or delay the cuts. Moving past the sequestration, the defense sector remains one of the largest single segments of the federal budget. In fiscal year 2012, defense spending was close to $640 billion and is one of the largest categories of discretionary spending. In recent years, defense spending has accounted for between 50% and 55% of discretionary spending, 4.5% of gross domestic product (GDP), and about 20% of overall federal government outlays. During the Reagan administration at the end of the Cold War, defense spending accounted for 65% of total discretionary spending, 6% of GDP, and nearly 30% of all federal government outlays. After the fall of

the Berlin Wall in 1989, defense spending as a percent of discretionary spending fell swiftly — bottoming out in 2001 at under 48%, 3% of GDP, and 15% of total federal outlays — just as the war on terror and the wars in Afghanistan and Iraq began.

Defense spending is often discussed as an area to cut in order to reduce the long-term deficit because it is such a large part of federal outlays. While there is likely some kernel of truth in oft-cited media reports of $600 hammers and $300 toilet seats being purchased by the Pentagon, eliminating all “waste, fraud, and abuse” from the defense budget, while a worthwhile endeavor, would only make a small dent in overall spending.

 

Potential Slowing in Pace of Defense Spending Ahead

Looking ahead from a budget perspective, perhaps the best that can be hoped for is a slowing in the pace of defense spending, not outright declines similar to those seen in the late 1970s and 1990s Some of the proposals put forth by the deficit commissions and the Congressional Budget Office (CBO) regarding defense spending include: 

• Freezing defense spending at current levels of GDP;
• Cutting the rate of increase in defense spending; and
• Finding savings within the Department of Defense’s procurement system.

 Please see our Weekly Economic Commentary: Budget Defense from November 26, 2012 for more details.

From a GDP perspective, the best case for defense spending in 2013 is that it has a modest positive impact on GDP. More likely, defense spending, after a rebound in the first quarter of 2013 on the heels of the big drop in the fourth quarter of 2012, is likely to be flat. The worst case — again from a GDP perspective — and least likely, would be if Congress can agree to substantial cuts to defense spending as part of an overall budget deal. In this scenario, defense would likely be a modest 0.1 to 0.2% drag on overall GDP growth in 2013 and beyond.

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IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Stock investing involves risk including loss of principal.

International investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors.

The Federal Open Market Committee action known as Operation Twist began in 1961. The intent was to flatten the yield curve in order to promote capital inflows and strengthen the dollar. The Fed utilized open market operations to shorten the maturity of public debt in the open market. The action has subsequently been reexamined in isolation and found to have been more effective than originally thought. As a result of this reappraisal, similar action has been suggested as an alternative to quantitative easing by central banks.

The Federal Open Market Committee (FOMC), a committee within the Federal Reserve System, is charged under the United States law with overseeing the nation’s open market operations (i.e., the Fed’s buying and selling of United States Treasure securities).

International Monetary Fund (IMF) is an international organization created for the purpose of promoting global monetary and exchange stability, facilitating the expansion and balanced growth of international trade, and assisting in the establishment of a multilateral system of payments for current transactions.

Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

INDEX DESCRIPTIONS

The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

The Institute for Supply Management (ISM) index is based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders, and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys.

Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

_______________________________________________________________________________

This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

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