Business Forecast 2005 | Chicago & New York

 

Joel M. Stern, ’64
Managing Partner and CEO,
Stern Stewart & Co.

 

The Strong But Bumpy Road Ahead

Most people think Spring Training happens in February and March in Florida and Arizona, but for me, Spring Training takes place in September or October when my firm gathers its clients together from all over the world for two days to learn from each other in panel discussions. The price for me attending the EVA Institute is a preliminary economic forecast for both the United States and the European Union. So, my first look ahead took place approximately six weeks ago. It was the last Thursday in October, just before our exciting presidential election. You will recall that the polls showed a dead heat and the Europeans were hoping for a Bush spanking, hoping because according to The Economist magazine, apparently very few Europeans pray any more.

Those of us in great fear that a President Kerry would outlaw layoffs just after forbidding outsourcing and again, just , just after canceling the Bush tax cuts, well, we knew that the economy was not sluggish. How silly of the Kerry-Edwards team to claim a sputtering economy when, in fact, real growth in the year ending September 30 was 4.5%. Job growth, at long last, was running at more than 100,000 a month and this, in turn, of course was net job growth. Occasionally, the economy generates remarkable productivity gains, so high in this instance that although more than eight million jobs were created in 2003, almost eight million jobs were lost in 2003 because of the 6% gain in productivity. In contrast, this year was more normal and so 1.2 to 1.4 million net new jobs will be created for all of 2004.

Kerry-Edwards must have figured they could fool almost all of the people for some of the time and squeak through on the less-than-smooth watch in Iraq, or whatever.

As I mentioned a moment ago, real growth in the year ending September 30 was a truly remarkable 4.5 percent. Remarkable not just because it is in the top nine percentile of all 12 month periods over the past 100 years, but because my forecast for 2004 was 4.9 percent growth and I could not believe my good fortune that the number was so close.

Now it is true that sequential GDP growth in the second quarter was a paltry 3.3 percent, about the average over the past sixty years, followed by 3.7 percent in the third quarter. What happened? What changed? Until the second quarter, I had thought that the theme for this year’s forecast should be: Can very high growth be sustained without an explosion in the inflation rate?

Chicago types usually like this topic because it gives us a wonderful opportunity to yak-yak about how great economies can perform beautifully if given stable monetary policy and limited government intervention, even if the budget deficit is running at close to half a trillion dollars. We just like whacking the Keynesians whenever and wherever possible. Incidentally, if a $500 billion deficit is so alarming, how come interest rates remain so low? Obviously, economic agents like you and me clearly are not bothered by a large budget deficit. That was also true through most of the 1980s so that by now we should have learned the lesson that large budget deficits simply tell us how the government is financing its spending. Deficits mean borrowing or printing money. The alternative is taxes. After a few quarters, borrowing and taxation have about the same net effect on the economy as a whole. The one benefit of borrowing instead of taxation is that the legislator sees less money ahead to fund even more government spending.

Despite the deficit, I believe growth in real GDP for all of 2004 is going to come in moderately under my 4.9 percent original estimate. I forecast the U.S. growth rate will be about 4.4 percent, and this is because the U.S. has taken two body blows. If the growth momentum had not been so strong, I believe that by now the U.S. could well have fallen into recession.

The first blow was a gigantic contraction in the rate of growth in the money supply. Both the narrow M, and the broad M 2, grew at a dangerously high 7.5 percent annual rate for some 18 months, so fast that last year I put the odds at 2-to-1 that inflation would be 3 percent beginning late in 2003 and still higher early in 2004. Panic must have set in in Washington, too, because overnight the money supply growth rate dropped to zero and remained essentially unchanged for almost five very long months.

During this dry spell, my fellow Chicago forecaster, Emeritus Professor Marvin Zonisfor the very first time in close to 10 years on the platform togetherviolated our compact of silence. So concerned was he about the screeching brakes only he and I seemed to hear, that he sent me an urgent message that huge danger could lie just in front of us. He felt that my 4.9 percent growth forecast would be decimated by the pattern of the monetary aggregates. Marvin’s observation was excellent. That is what happens when a superior political scientist sits next to an economist for ten years. Suddenly and unexpectedly Q-2’s growth rate dropped to the aforementioned annual rate of just 3.3 percent.

The good news on the monetary front is that M, and M 2 have been growing since May at about 5 percent and so both the economy and inflation are again doing just fine. As you will hear in a moment, next year is going to be another wonderful year for real GDP growth, but somewhat less than 2004.

The second blow was the unbelievable $25 a barrel increase in crude oil futures, up more than 80 percent over the past year. Although the impact is nowhere near the magnitude in 1973 when the first oil shock facilitated a recession through 1974, there is no escape from the adjustments consumers and businesses must make in order to avoid either a precipitous drop in their standard of living and earning less than the required return on corporate capital, the so-called cost of capital.

Only a small effect has been seen so far in the GDP numbers aside from consumers economizing on gasoline. SUV sales clearly have taken it on the chin and price rebates for large-size vehicles of all kinds are at an all-time high. And this is just the beginning. A reasonable rule for today’s economy is that a $10 increase in the oil price cuts real GDP growth by about four-tenths of one percentage point. If true, over the next 12 months, we will lose about eight-tenths of one percentage point because some of the oil price effect has already taken place over the past four or five months.

In contrast to the current situation, I am forecasting a huge drop in the oil price in 2005 to less than $37 a barrel due to economizing on its use and the tax equivalent effect the oil price increase will have on Asian economies as demand growth falls.

So, to sum up, tighter money for some five months after a prolonged period of explosive monetary expansion combined with the amazing surge in the oil price docked GDP growth in the U.S. by about one-half of one percentage point.

I must stop here before focusing on next year, because I am astounded by continuous reports that Americans believe the economy has been performing poorly. In a Gallup poll in mid-October, nearly two-thirds described the U.S. economy as fair or poor and 48 percent to 43 percent said it was getting much worse. In the presidential debates, John Kerry claimed what he had been saying all through the campaign, the economy is downright sluggish.

What is this baloney? And why has the press failed to challenge it? True, at first the recovery in the U.S. was mild, but for the past two years it has been brisk, deep and widespread.

The U.S. economy had such a mild recession in 2001 that we could only tell a recession had occurred because historical data was revised. The recession began in March 2001, but the National Bureau of Economic Research, a private think tank that dates the turning points in the economy, only announced the economy was in recession in mid-summer about two months before 9-11. And those of us who were worried that 9-11 could prolong and deepen it as consumers and businessmen adjusted to the new world of terrorism were unaware that the recession was over just two months later in December 2001.

As you know, a mild downturn usually means a mild upturnand that is precisely what happened. Although the economy as a whole was out of recession in December ’01, manufacturing (about 15 percent of economy) continued to drop until May 2003. For 2002 the economy was up about 2.5 percent. And since the beginning of 2003, real growth has been a stupendous 4 percent-plus. True it appeared to be a jobless recovery, as the media liked to describe it, but this was due almost exclusively to productivity gains.

Consider this. As I mentioned before, in 2003 almost 8 million new jobs were created, but productivity gains were so huge that almost 8 million jobs were lost. In normal times, productivity gains cause the U.S. economy to lose about 3.7 million jobs every year on average. So, 2003 was very unusual. This year we have returned to more normal times. Net job creation is almost 100,000 a month, which means almost 5 million new jobs in 2004. Perhaps a President Kerry would have outlawed redundancy after he outlawed outsourcing.

John Kerry and his advisors seemed to be rooting for bad news. The fact that they had convinced such a large part of the electorate had me very concerned. Incidentally, the unemployment rate at 5.4 percent is less than the average rate of 5.6 percent since the end of World War II.

Well, what’s next? I believe 2005 will see the U.S. GDP real growth rate at 3.8 percent. On the inflation front, the consumer price index, up 2.8 percent in 2004, will be up a little less in 2005 as oil future prices fall. My forecast is a CPI of 2.5 percent. I, for one, believe conservation by consumers and business will hold down the crude oil price to an average of less than $40 a barrel. Either that or a weakening growth rate in real GDP will do it, but you can be sure it will be done! The broad-based GDP Implicit Price Deflator that cuts across the economy as a whole will be 2.6 percent. Unemployment will average 5 percent of the labor force.

And now for two pieces of bad news. First, in the EU, where real GDP growth has been a disappointing 1.9 percent, and where the official unemployment rate in Germany and France is a remarkable 9.8 percent, growth will continue to be alarmingly low, way below its potential of 3.5 to 4.0 percent. I mentioned last year that a Euro of about $1.20 would significantly retard growth and this has happened. At a $1.30 Euro, real GDP growth in the EU would be less than 1.3 percent, but close to zero in Germany . At $1.10 it would be 2.5 percent. I believe the Euro will average about $1.16 and EU real growth will be a still unfortunate 2.1 percent. The social compact and contrasting national policies will continue to cost jobs and increased growth.

Second, at long last, we must face up to what a Kerry victory could have cost us: at least a half-percent GDP growth in 2005 and much more later. His wing of the democratic party, regulationist, redistributionist, a focus on outsourcing as hemorrhaging, and limits to private decision-making, simply means the U.S. could have had four years to witness another Jimmy Carter episode with likely stagflation, and ultimately a decline in the value of the dollar and the U.S. standard of living. His brand of populism and emphasis on class warfare always suppresses sensible economic policies. He should not have been concerned about the budget deficit, but rather on the size of the full employment deficitthat is what the deficit would be if the U.S. economy was operating at full employment. On this measure, the deficit is made $200 billion less. Adjust the actual deficit for the costs of homeland security, the war and the decline in tax revenues after the stock market bubble burstresulting in less revenue from capital gains taxesand almost 70 percent of the deficit disappears. And then, of course, Kerry told us that wage earners above $200,000 annually should give back their Bush tax cut. The fact is that all of the tax cuts they have received simply moved them back to where they were before Clinton imposed a 10 percent surcharge after their tax rate had already been increased from 33 to 36 percent. This group actually went from 33 to 39.6 percent. Now they are back to 36 percent. What tax cut, Mr. Kerry?

This is my 24 th annual forecast. I witnessed the Carter meltdowninflation and interest rates upstairs in double digits, U.S. prestige downstairs, an embarrassment to our heritage. The only good that could have come from a repeat performance would be welcoming Ronald Reagan’s heir in 2008.

We are going to have a really fine year in 2005. In real terms, profits will be up at least 10 percent. Last year, I forecasted a 19 percent gain for 2004. The actual number is a shade over 20 percent. Tax revenues will be strong too and, thus, the budget deficit will be down sharply to less than $300 billion from well over $400 billion this year.

The really good news I saved for last. After a couple of tough recruiting years, I believe 2005 will be terrific for the MBA graduates in our program. If I am right, Andy Alper should meet his fundraising goal while enhancing his golf handicap, assuming he still has one.

Finally, I am so very pleased that Ted Snyder is our Dean. His accomplishments are so many and so varied that it is difficult to keep count but, most important of all, he remembers every one of us. Isn’t that wonderful? Thank you.