Volume 58, Number 4 | January 28, 2011
It is rare that we find ourselves as far out of the consensus as we feel we are now. After today’s GDP report, the consensus reading appears to be that the US is at the beginning of a consumer led recovery. Calls for 4%, or even faster, real GDP growth for the US in 2011 are common in the economic press. Our own view is that the US economy has seen its strongest real GDP growth for this cycle in the stimulus boosted year just behind us and that there is a growing risk of a return to anemic growth, and potentially recession, before the next presidential election.
The difference in consequences of these viewpoints could not be starker. If the consensus is right, the US has a long, if unexciting expansion, ahead of it that will allow a slow correction of the large imbalances in our budget and trade deficits, with the high unemployment rate descending about 1% a year. Even the consensus has a wide disparity on what this means for interest rates, with some coming down on the side of rising inflation and the Fed tightening by early 2012 and some seeing only modest inflation and a Fed on hold until unemployment has dropped significantly.
Our scenario suggests that the economy will be faltering before the Fed can think about raising rates and that the US may enter the next soft spot with unemployment and budget deficits still excruciatingly high. That would leave us with virtually no policy levers to pull to get out of the downturn, arguing for a much weaker dollar – primarily against rising emerging market currencies — as the most likely solution. Whether an imminent downturn would qualify as a double dip as in 1982 or a second slump as in 1937, the consequences are likely to be profound. We see this risk not as a black swan, but rather a very significant potential outcome.
At the core of our concern is the question of who is leading the global economic cycle. If I was to describe a conventional four year cycle common from the 1950s to the 1970s, when the US was still an industrial rather than financial economy, it would look like this: 1) the economy slid into recession (never mind how, but usually because interest rates were too high); 2) around the second or third quarter of recession, the government caught the scent and stimulus was started – usually lower interest rates first and then tax cuts or spending incentives; 3) the stimulus would lift the economy into recovery after four quarters of decline, with a really big stimulus package potentially lifting the economy right back to where we were before the recession quickly; 4) the economy would expand at an accelerating rate for about two years; 5) strong growth would tighten labor and product markets, leading to rising wages, prices and interest rates – exacerbated by growing fear of inflation; 6) finally, the government would start to tap on the brakes – with increasing severity if growth and inflation persisted — through tighter monetary policy and maybe even fiscal restriction, though more often through regulation than taxes.
This description fits to a tee what has been going on in China over the past three years starting in 2008. China is the global leader now, throwing off more economic growth in dollar terms than the US. Indeed, we believe it was rapidly rising Chinese demand – most strongly reflected in booming oil prices – that put the global economy into the wall in 2008. Bear Stearns, and later Lehman, were more consequences – though in the case of Lehman, a near fatal consequence – rather than initial causes of the recession. Viewed through this lens, it is the growing restriction in Chinese monetary, fiscal, and currency policy that is the critical indicator of future global growth. China has gone from tapping on the brakes to tromping on them with both feet flat to the floor. Reserve requirements have been ratcheted up significantly and could reach 22% by the end of the first quarter. Interest rates are rising as well – but it is access to this still very cheap credit (quite negative interest rates in real terms) that is the key to policy. Restrictions on real estate investment – the heart of the past boom – are ever more onerous. Provincial leaders are being cautioned to rein in growth or face party displeasure. The yuan is once again rising at a 5% annual rate as inflation in China has forced the government to decouple from the dollar peg. The lax US monetary policy that may have suited China a year ago is no longer appropriate – and China is tightening aggressively. Our concern is that it is only when the tide goes out that you learn who is swimming naked.
A Foundation of Sand
A more domestically oriented criticism is that we simply don’t see were the optimism for growth in the US comes from. Fourth quarter real GDP may have come in at 3.2%, just slightly less than expected, but the deflator was only 0.3% — far below the 1.5% consensus. Bottom line, the expectation was for roughly 5.0% nominal GDP growth at an annual rate (after 4.6% in the third quarter), but we got only 3.4%. We have long argued that we prefer to look at nominal GDP rather than real – especially since inflation has been low and stable since 1990 – as that is how most of the raw data is collected from businesses. We look at the value of durable goods shipments, total retail sales, government budget outlays and the value of construction put in place to get nominal GDP. Then, the gnomes in Washington apply deflators to get real GDP by sector and finally sum it up to get reported real GDP. The calculation of deflators can cause big swings in real GDP – especially when the swing is in the import sector due to petroleum and other commodity prices. That is what has happened in recent quarters, with the GDP deflator swinging wildly from 2.0% last quarter to 0.3% this quarter. Bottom line, fourth quarter nominal GDP at 3.4% was the lowest in five quarters. The 4.0% annual rate for the second half of 2010 was only fractionally higher than the 3.9% in the first four quarters of this six quarter expansion. The global economy was booming in late 2010, leading China, India and Brazil to raise rates – and even German-led Europe to consider it – but the US got no more nominal growth than in the first year of recovery.
In the last expansion, the strongest four quarters of growth came in the year ended the second quarter of 2004, at 4.1%, with the second Bush tax cuts lifting third quarter 2003 real GDP to 6.9%. For the rest of the expansion, real GDP growth never exceeded 3.4% in any other four quarter period. The Obama stimulus helped lift fourth quarter 2009 real growth to 5.0%, and the year ended third quarter 2010 to 3.3%. We would not be surprised of that is the fastest growth rate for four quarters in this expansion. Conditions for growth were far better in the last expansion with a shift to low marginal tax rates, the move to a low 1% short term interest rate, and extremely liberal lending regulations. Today, tax rates and interest rates are low – but they have been for years – and it is far more difficult to get credit. It is only the global economy that is more attractive – and exports have been a big part of US real GDP growth. Inflation adjusted exports rose 12.7% in the year ended third quarter 2010 and accounted for 45% of the year’s real GDP growth. If China and the other emerging markets slow, real export growth will dwindle – indeed it has already slowed to an average 7.7% annual rate for the past two quarters.
Corporate America Continues Its Cautious Course
Every quarter when the GDP report first comes out we note that the key lead indicator in a capitalist economy is profits. By our estimate (profits are not reported in the first release of GDP) profits fell at a 3.0% annual rate in the fourth quarter – on modest 2.7% annualized growth in corporate revenues and roughly 4% growth in all of their costs including compensation, indirect taxes, interest and depreciation. A slightly broader measure of return to capital, which includes proprietors’ and rental income was up at a modest 2.9% annual rate. This broader measure has now been equal to 19.0% of GDP for the past two quarters. Over the past forty years of US economic cycles, that 19.0% level has represented the peak of earning power for the capital sector. From here, the combination of profits, proprietors’ income and rental income can be expected to decline as a share of GDP – which means even if nominal GDP grows at the 5% expected by the consensus, these measures will not.
In a similar bent, the major imbalance in the US economy now is the unusually high level of corporate saving. Business saving rose to 4.3% of GDP in the fourth quarter, reversing an encouraging decline over two quarters to 3.4% in the third quarter of 2010. The level of savings remains roughly 25% higher than at the peak of previous cycles. Until corporate America reduces its savings rate via investment or hiring, there is little hope for acceleration in the economic cycle. Unfortunately, the fourth quarter marked the eighth consecutive quarter in which depreciation exceeded fixed investment in equipment, residential and nonresidential construction. Bottom line, businesses (like households) are boosting their financial savings by running down their physical stock of assets. Meanwhile, hiring in the fourth quarter averaged 128,000 new private sector jobs a month, up from 124,000 in the third quarter and 118,000 in the second. Given the stability in hiring, investment and nominal growth, we see this economy as wending a path of same old-same old – but with an every rising burden of federal debt that is sure to draw a restrictive reaction from the newly elected Congress. With everyone else in the world already tightening, the Fed’s QE2 winding down, and Congress likely to join the states in getting budget deficits under control, we remain very concerned about the what legs this already anemic expansion might have – and very, very concerned about the consequences of faltering again before we have addresses the worst imbalances since the Great Depression.