A pothole, not a soft patch

Posted by on June 20, 2011 @ 9:04 am in Economy & markets

Every Wednesday night, my next-door neighbor and I tend to take out our garbage at about the same time. Don’t know how that happens, but we usually get to talking about the usual topics—our kids, sports, the weather. And every week, my neighbor asks me the same question: “How’s the economy doing, Joe?”

My candid response over the past several years has been the same: “It’s been better.”

Over the past several months, however, things have gotten worse. The U.S. economy can’t seem to catch a break. Following a modest acceleration in momentum earlier this year, a host of factors—ranging from $4 gas, surging food prices, unfavorable weather, and the impact of the Japanese catastrophe on U.S. manufacturers, to growing fears of a Greek debt default, the sagging stock market, and the unresolved U.S. debt-ceiling limit—have contributed to a marked deceleration in recent months.

This becomes evident when you look at Vanguard’s proprietary economic momentum index, shown below. Many economists believe this loss of momentum is temporary—a so-called “soft patch” that should dissipate slowly later this year. It feels more like a pothole to me, and our indicators support that view. Given the headwinds (and headlines) facing the U.S. economy at the moment, it is somewhat astonishing that the economy should grow at all this quarter. Good ole American resiliency, I suppose.

Economic momentum and job growth, 1960–2011

Economic momentum and job growth
Source: Vanguard Investment Strategy Group. These figures reflect updated data from Figure 2 in our January 2011 publication, 2011 U.S. economic outlook: Cautious optimism.

Where do we go from here?

As Vanguard’s chief economist, I’m often asked to assess the future—for economic growth, inflation, interest rates, the stock market, and so on. But such predictions are always extremely difficult, a point that is often lost on the investment industry at large, I’m afraid.

At Vanguard, we’re proud of not making short-term prognostications on the markets. No crystal balls. I firmly believe in the old adage that we must “treat the future with the humility it deserves.” As such, we endeavor to provide you with perspective and a holistic view of the risks to the consensus outlook in acknowledgement of the considerable uncertainty that always attends the future.

With this approach in mind, our indicators suggest that the odds of muted, uneven, and ultimately “U-shaped” job market recovery are about the same as where we estimated them at the beginning of the year. Far from 100%, but still the most likely outcome. In short, our outlook is still one of cautious optimism. That said, it’s fair to say that what we economists call “downside risks” are rising, and conditions may get worse before they get better later in the year. That’s why we’re emphasizing the “caution” over the “optimism” in our current outlook.

To me, the recent slowdown is yet another reminder that the most serious challenges to the economy are not cyclical, but rather secular. Among the stiff economic headwinds we’ll face over the next year are continued weakness in the U.S. housing market, restrained consumer spending as Americans work to repair their personal balance sheets, and a sharp transition toward fiscal austerity across much of the developed world. As such, more potholes and more sporadic setbacks should be expected in this post-housing and credit-bubble economy. Yet another argument for broad diversification and balanced investing in the years ahead.

If I can offer any consolation, it’s the fact that all of these secular headwinds were already well known—indeed, they were noted in the Economic and Market Outlook report we published this time last year. Our risk assessment for the capital markets today remains the same as detailed in that report. Should something occur to radically alter Vanguard’s longer-term outlook for the economy and the global capital markets, I’ll be sure to let you know.

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