The Independent Market Observer

8/21/13 – What If I’m Wrong About the Economy?

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Aug 21, 2013 10:21:33 AM

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Over the past week or so, I’ve had the chance to sit down with several groups to discuss how the economy and the financial markets are evolving. Each time, I’ve laid out many of the arguments, along with supporting data, that I’ve made here on the blog. Briefly, the real economy is improving, and growth can reasonably be expected to accelerate for the rest of the year; interest rates are going to remain volatile and increase over time, although they may drop back a bit in the short term; and stock markets are overvalued and risky.

But what if I’m wrong?

Let’s start with the economy. To determine the consequences if I’m wrong, we first have to determine why that would be. The major assumptions underlying accelerating growth are, first, that consumer spending will continue to increase; second, that the government will cease to be a drag on the economy; and, third, that no external shocks happen.

The consumer spending assumption could be wrong in a couple of ways. Historically, wage growth has accelerated when the average work week was around current levels or when unemployment declined, but certain factors may prevent or delay that this time. The most apparent one would be people currently out of the workforce moving back in, which would push unemployment back up—and help to retard wage increases. The second factor would be additional tax increases, which would directly hit take-home income. The third would be an overall economic decline that leads companies to stop hiring. The fourth would be a decline in consumer wealth or confidence that would dampen spending as people feel poorer.

To take these in order, as people reenter the workforce, they’re typically driven by an improving economy. If the economy were to weaken significantly, this simply wouldn’t happen to any great extent. Therefore, an expanding workforce would be a problem of success, which would slow the improving trend but not reverse it. Next, I don’t think a tax increase is in the cards politically, at least for the majority of the population. The fact that rates went up at the start of the year makes it even less likely. Third, for an overall economic decline to occur, we’d have to see reversals of several trends that seem well established. Again, this is possible—interest rate increases driven by uncertainty around the Fed’s stimulus exit strategy could easily be a factor here—but there are few signs yet of that happening.

The last factor seems the riskiest to me. Rising consumer wealth and confidence (the two are linked) have been based in large part on rising home values and stock markets. Interest rate increases will certainly slow the housing market, so, even if values continue to rise, confidence could be hit. With the stock market at high levels, and likely to show volatility as the Fed starts to exit, a decline there could certainly hit consumers and adversely affect spending.

Given these considerations, I think I see how I could be wrong on the assumption of continued consumer spending growth. If so, we should see signs of it over the next couple of months. If the unemployment rate ticks up again; if wage growth declines rather than increases; if hiring drops or firings increase; if housing values or stock prices drop—any of these could signal I might be wrong. I’m watching for these signs, and you should too.

The second assumption, that the government sector will stop dragging on employment and growth, is largely tied to the first. Much of the decline in state and local spending and employment has been driven by low tax receipts. Unlike the federal government, states and localities (with the exception of Vermont) cannot run deficits; therefore, they must cut spending and employment very quickly after revenues decline. Revenues are now rising, however, and so are spending and employment.

At the federal level, growth has historically been more or less guaranteed, but the sequester spending cuts this year actually resulted in a meaningful reduction. This has pretty much already happened, though, and spending growth is likely to resume. Another round of spending cuts this fall is certainly possible, and, if that’s the case, growth will certainly slow. This is a real risk that warrants watching, but given the current political environment, the damage, if any, should be relatively small. As with consumer spending, if I’m wrong, there is data available that will alert us well before the effects actually show up in the economy, and we should watch for it.

The final assumption, of no external shocks, may be the biggest. The debt ceiling debate in Washington would be the biggest potential shock, but Europe and China are certainly in play as well. Egypt is also relevant, as a large proportion of world trade, including in oil, goes through the Suez Canal. Again, this is worth watching.

There are certainly risks, both domestic and international, that could prove my forecasts wrong. With all of those risks, though, we can monitor what’s happening and revise our forecasts as needed. In the words of Keynes, “When the facts change, I change my mind. What do you do, sir?” One of the keys to success in any field, I believe, is the ability to recognize when the facts have changed and the willingness to revisit your conclusions. That said, I really hope I don’t have to change mine for the real economy.

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