When Goldman says sell, everyone knows they really mean buy. However, when less specialized banks in the art of Kermit rapage, such as Bank of America, come out with a report saying that now is a good time to hunker down, they may just actually mean that.
From BofA's Ethan Harris:
In the spring, the risks to growth seemed to be fading. The economy was weathering the fiscal shock. Politicians decided to delay battles over the budget and the debt ceiling, passing a continuing resolution to fund the budget through September and postponing the debt ceiling drop-dead date to some time in the fall. Meanwhile, financial markets in Europe had settled down, the European economy showed signs of improvement, and commodity prices were stable. In their June directive the FOMC made it official: “The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall.”
Unfortunately, we seem to be entering another of those periods of elevated risk. Three concerns are emerging.
Interest rate shock: The Fed’s tapering talk has caused about a 100 bp rise in longer term interest rates. Clearly this puts economists on high alert for signs of weakness in interest-sensitive sectors such as autos, housing, and capital goods investment. On the one hand, auto loan rates have moved up very little and while auto sales dipped slightly in July, they appear to be on a steady upward track. On the other hand, both housing and capital goods demand are looking a bit shaky. In July new home sales plunged by 13.4% and core capital goods orders dropped 3.3%. These are very volatile series, but they are not the only sign of weakness. Our GDP tracking model now shows a modest decline in equipment investment in 3Q. Meanwhile, the housing data have shifted from steady strength to mixed: the homebuilder survey hit a new cyclical high in July, but the pace of housing starts has flattened out in recent months and mortgage applications for both refinancing and purchasing have been slipping since May.
Fiscal brinkmanship: With Congress on vacation things are quiet in Washington. That ends on September 9th when they are back in session. There will be a partial shutdown of the government if they can’t pass a continuing resolution by the end of the month or can’t raise the debt ceiling some time in October. In our view, investor, consumer and business confidence have become relatively immune to threats of shutdown. However, we think an actual shutdown, lasting more than a couple days, could cause a significant risk-off trade in the markets and could curb some hiring and investment plans.
Geopolitical: The civil war in Syria is now starting to impact the oil and equity markets. During the Arab Spring in 2011, oil prices rose about $20 bbl (Chart 1). This acted like a tax on consumer budgets. One way to gauge this impact is to look at the extra inflation caused by higher energy prices: by the spring of 2011, higher energy prices were adding 1.8 pp to year-over-year CPI inflation. That is a fairly big “tax” considering that wage and salary income was only growing at about 4% at the time (Chart 2). That price pressure presumably contributed to the growth “soft patch” during that spring and summer.
Hoping for the best, preparing for the worst
We hope and expect none of these shocks reaches a crisis level. We are least concerned about the Fed. Some commentators seem to think a steady Fed exit is a done deal. We strongly disagree: the last thing the Fed wants is a big risk-off trade in the markets that aborts the pickup in growth. Tapering in September was already problematic given that both growth and inflation are coming in below the Fed’s forecasts. Rising risks offer yet another reason for waiting. Indeed, we believe the whole exit path is slowly extending.
We expect the budget battles to produce a lot of negative headlines but last-minute deals, with minor fiscal austerity (at most) and no sustained government shutdown. While many fiscal conservatives would welcome a shutdown, we think the leadership of the House is reluctant to go down that route. Public opinion polls suggest that many Americans want smaller government, but do not like shutdowns and will punish the party they deem most responsible. Moreover, incumbents take the blame for any market/economic disruption. President Obama cannot run for re-election, while the whole House must run next fall.
In the Spring, Congress passed both a continuing resolution and a debt ceiling increase without any additional budget cuts. In a recent conference call with House Republicans, Speaker Boehner argued against using the threat of a government shutdown to stop the implementation of the Affordable Care Act and suggested passing a continuing resolution to continue funding into November. While there are many possible scenarios, we now assume a series of short-term extensions as our base case.
Geopolitical risk is a much tougher call, but our forecast assumes only a temporary rise in oil prices. Syria is a relatively small oil producer, with production averaging about 350,000 bbl/d before the civil war. That compares to 1.6 million bbl/d for Libya before its war. Our commodities team has developed a number of scenarios. In their base case, a combination of an air strike on Syria, political tensions, and a variety of other small supply disruptions causes Brent prices to spike to $120-130/bbl.
This would match the run-up in prices during the Arab Spring, but we think the effects would be less pronounced for several reasons. First, the price increase will likely be short lived and hence not fully passed through to consumers. Second, over time US energy prices are getting a bit less sensitive to global developments. The recent $10 increase in oil prices is not enough to change our call. As a rough rule of thumb, a sustained $10 bbl rise in prices that works its way broadly into energy prices slices GDP growth by about 0.3 pp over the following four quarters. If prices rise further on a sustained basis, however, we will be cutting our US and global growth forecasts.
Tapering talk has created two other risks. First, it has put considerable pressure on emerging markets. Since the start of the year we have trimmed our 2013 GDP forecast for EM from 5.3% to 4.7%. So far the blow back to the US economy and markets looks small. Tapering talk has also slowed the healing of household and business balance sheets. Mortgage refinancing has plunged about two-thirds from its peak in early May and this will likely stop the drop in the household debt service ratio. On a similar note, fewer companies are able to term out their debt and refinance at low rates. This balance sheet improvement has been one of the big—often ignored—collateral benefits of QE.
When in doubt, wait
In our view, reduced downside risks have been a key part of the move toward tapering. At the July meeting FOMC members were already talking about increased downside risks. At the September meeting they will face a choice of pushing ahead with tapering or waiting for clarity: is the economy really accelerating and is the recent risk flare is serious or not? While the decision remains a close call, we see and even stronger case for waiting.