ABL Advisor last spoke with Gus Faucher, senior macroeconomist at The PNC Financial Services Group in the final quarter of 2012. We caught up with Faucher at this year’s midpoint to gain his insight as to where we’ve been and where we're headed economically speaking. In the following, Faucher comments on a number of topics ranging from impact of fiscal tightening, the realities influencing U.S. regional economies to the risks that lurk on the global front.

ABL Advisor: When we last spoke in October of 2012, you noted that the U.S. economic recovery was soft, at best. That assessment was largely due to the state of the job market. Most recently, the Bureau of Labor Statistics reports the unemployment rate at 7.6% as of June 2013. Is your assessment the same or has the situation improved?

Gus Faucher: I think the U.S. economy is on more stable footing and I’ll give you a couple of reasons why. The first reason is the job market has continued to improve. We’ve seen consistent job gains with about 200,000 jobs added per month on average so far this year. That’s well above what we need to keep up with an expanding labor force. Today, consumers are in better shape and they are more confident about the labor market. Layoffs have slowed down and that’s a big positive.

The other positive is the housing market. We continue to see housing starts and home sales improve. According to the latest data we have from the Case-Shiller Price Index, house prices are up about 10% year-over-year. When prices pick up, people are more confident about the economy … they are more willing to spend. In addition, we’re seeing gains in industries associated with the housing market. For example, we’ve noted these gains in residential construction, building materials production and furniture and appliances -- both in retail and manufacturing. These are all positives for the U.S. economy.

ABL Advisor: In your estimation, how severe have the effects of the tax hikes and Sequestration been on U.S. economic expansion? Assuming these events have caused a drag on economic growth, have we experienced the worst of it or could there be more to come?

Faucher: According to the Congressional Budget Office, this tightening that we’re undergoing is going to subtract about 1.5 percentage points from GDP growth in 2013. That’s a pretty significant number and certainly the economy would be doing substantially better if it weren’t for these spending cuts and tax increases. Tax increases have reduced the size of people’s take-home pay, and for high-income households, they are paying dividend and capital gains taxes.

As for the furloughed government employees, they won’t be showing up in the employment statistics, but they will be getting smaller paychecks. That will impact growth as well. And then government contractors are going to see their contracts reduced. They will either cut back on their workers’ hours or hire fewer people. When you put it all together, it’s a pretty substantial hit and I think it’s unfortunate because it might have made more sense to wait until the economy was stronger.

I think we’ve already experienced the worst of it now. The sequestration spending cuts were a one-time thing and taxes won’t go up again, so that’s a one-time drag. The weight from fiscal policy will lift in 2014 and that’s the reason why we expect stronger growth next year as opposed to this year.

ABL Advisor:  Which sectors do you anticipate being the drivers of future growth? Last October, you anticipated a slowdown in manufacturing and a turnaround in the housing market, which you have already addressed. Which sectors will lead and which do you see as lagging behind?

Faucher: Things have played out as we expected them to, and we have manufacturing growth slowing, particularly in export-oriented businesses. That’s largely due to the recession in Europe and slower growth in China. I think manufacturing growth is likely to be soft for the rest of the year. But as I mentioned, the housing market has been a big support to growth and it’s not just homebuilding. It’s also the items people purchase after they buy a new home and to a lesser extent, the mortgage financing industry although financial services are still responding to increased regulation.

Energy-related industries are doing quite well now as well. The strongest economies are in the Dakotas, Alaska, Oklahoma and Texas, all of which are big energy production states. We continue to see gains in energy exploration and production, so that’s going to be a significant factor going forward.

On the other hand, I think financial services are likely to remain soft in the near term as financial institutions adjust to the new regulatory environment. Manufacturing has been leading the recovery and now it is just roughly keeping pace with the overall recovery. For example, we’ve seen auto sales improve from 9 million in 2009 to about 15.5 million, so we’re not likely to see big gains in vehicle sales going forward. We won’t see big job losses, but we won’t see the gains either.

Also, export-oriented businesses are going to remain soft this year until the global economy picks back up.

ABL Advisor: Other than the geographic areas you’ve mentioned, which regions do you anticipate experiencing the most growth for the remainder of this year and into 2014?

Faucher: I think the West and the South are going to lead for a couple of reasons. Both of those regions had the biggest contractions in the housing market and now they are benefitting the most from the rebound. Those regions also have better demographics. Population growth in the South and the West has picked back up again and that’s also a positive.

Also, the South benefits with its trade ties to Latin America and the West benefits with its ties to Asia. In the long run, those trade ties are going to be more important than trade ties to Europe.

ABL Advisor: What are your expectations for the rest of the country?

Faucher: I think the Northeast will lag along with the Midwest, although the Midwest will do so to a lesser extent. The Northeast depends heavily on financial services. It has an older population and slower population growth. The region has also experienced less of a rebound in the housing market and we won’t see much of a recovery in homebuilding because the demand isn’t there. The Northeast is more heavily exposed to Europe than to other regions and that doesn’t help matters.

I think the Midwest is going to be more “in the middle” if you will. I don’t think we’ll see a pickup there since business investment has been a little softer recently, but things could get better since the fiscal situation has become a bit clearer. But that region will still lag behind the South and the West.

ABL Advisor: How do healthcare costs and the implementation of the Affordable Healthcare Act factor into your expectations?

Faucher: We’re still not sure how healthcare with impact things overall. There is some potential for growth in the Northeast. But we aren’t sure how businesses are going to respond to healthcare requirements. There are definitely plusses and minuses here. One minus would be small businesses cutting back on hiring because they are concerned about the 50 employee limit or cutting full-time employees to part time.

On the other hand, there is a potential for reduced job “lock”, which would allow for stronger productivity gains over the longer run. If people feel more confident in the fact that they can retain their health insurance, they may be willing to start a new business or move to another company. That would benefit productivity in the long run as well.

We need to see how this is going to play out, but there is evidence that healthcare costs have slowed over the past two years and that’s not just from the recession. If healthcare cost growth is closer to the overall average, this could prove to be a benefit to the economy.

ABL Advisor: Is there anything to note with regard to the Fed’s monetary policies? In your estimation, is all that can be done to spur growth being done on the Fed’s part?

Faucher: I think so. I will say that I think the markets have overreacted to the Fed’s most recent announcement because I don’t think the Fed said anything new in its statement. We’ve seen yields move up a bit and stock prices move down and I think that’s somewhat overdone. The basic outlook hasn’t changed and if the Fed is cutting back on Quantitative Easing – or providing a little less accommodation – that’s a positive. It means the Fed is seeing that the economy is growing well enough to withstand a little bit less accommodation. The markets have been focusing on the downside rather than on the plus-side and I think that’s a mistake.

ABL Advisor: Are there any other issues on the horizon that could you see could disrupt economic growth?

Faucher: One thing that strikes me is we’ll have to deal with the debt limit again this year. Hopefully, we’ve moved beyond this, but if we get into early fall and it looks like the debt limit can’t be raised or if Washington is up to its old tricks, that has the potential to disrupt things. That was a factor that held back growth in 2011 and it’s a self-inflicted wound. Other than that, I think the big risks for the U.S. are primarily overseas.

ABL Advisor: Let’s look at the issues on the global front. Could you tell us where the risks lie with regard to Europe, Asia and other global regions?

Faucher: Starting with Europe, things are looking better there. They have pulled back on their austerity, which is a plus in my opinion. It looks like the financial system there has stabilized, but that could change quickly depending on what’s going on at any given moment. I think the likelihood of things falling apart has lessened, but Europe is still in recession and I expect it to remain in recession for another three to six months. That’s a drag on U.S. growth and even when Europe comes out of its recession, growth there is likely to be weak because of the bigger structural issues they have. We really can’t count on strong European growth to help bail us out.

In terms of Asia, there’s obviously a lot of volatility in China lately such as concerns over liquidity. It’s important to remember that China is still a developing country and still has some structural issues to deal with. But I think China is likely to work its way through those issues and there is strong underlying potential there. Certainly there is the possibility of upheaval in China that would rebound in the U.S. and we’ve seen some of that lately.

ABL Advisor: In your estimation, are we on track for greater confidence to return to the business sector?

Faucher: I think we’re definitely getting there. It’s been a long process, there’s no question about that. But we’ve seen slow but steady gains in business confidence and the same with regard to consumer confidence. Right now, there’s an element of cautiousness and I think that’s probably a good thing. While the pace of recovery has been disappointing, we are continuing to heal. I think by this time next year, we should be close to a new employment peak and we will have surpassed some pre-recession highs. It’s been a long slog, but we’ve cleared up most of the imbalances that cause the Great Recession. That should set the stage for continued growth for the next few years.