Volume 59 | Number 8
As economic data continues to come in softer – largely as a result of the Japanese supply chain problems – momentum is threatening to slow below stall speed suggesting an imminent boost is needed to save the expansion. A rebound in the second half as supply chain problems clear will certainly help, but the headwinds of state and local governments fiscal tightening and the end of QE2 will be present as well. More headwinds are on the horizon as the payroll tax holiday ends next year and the debt ceiling extension should bring more austerity. Interest rates have fallen, but so far they have not sparked much of a refinancing response, primarily because thirty year mortgage rates remain forty basis points above their low last October when refinancing last kicked up. With no help expected from monetary or fiscal policy in the short run, we would normally expect a weaker dollar, but Europe’s even greater problems with Greek default and shaky Spanish financing may nullify that option. The most likely path to stimulus now is through falling energy prices and low enough interest rates to restart a refinancing cycle, both of which would add to the current meager growth in real spending power. Without a significant boost from either, the risk of a year-long slide toward recession — like 2007, heading into 2008, has become a probability not a possibility.
As the most recent data rolled in showing higher than expected initial claims for unemployment and weaker than expected orders for non defense capital goods excluding aircraft, optimism about second quarter growth has faded. Both Morgan Stanley and Macroeconomic Advisers now estimate that real GDP growth will be only 2.8% at an annual rate – coming after the unrevised 1.8% growth in the first quarter. The average 2.3% growth now projected for the first half would be 0.8% below the bottom limit of the Fed’s annual growth target, requiring 3.9% growth in the second half – not likely! The consensus had expected a 0.4% upward revision in first quarter real GDP growth –especially after robust revisions on retail sales – but lower estimates of consumer spending on energy due to soaring prices offset expected boosts from inventories and trade. Bottom line, consumers have been forced to respond quickly to higher energy prices because they have less access to credit to soften the blow. Unfortunately, many of their employers also have less access to credit, and they have responded to the slowdown in growth with aggressive cuts in hiring and capital spending.
The Cross of Death
The revised first quarter GDP data also revealed an ongoing slowdown in corporate revenue growth – and a decline in domestic corporate profits that threatens the expansion. Total corporate profits were stronger, but only due to a surge in foreign profits which was partially due to the slide in the dollar. Corporate gross value added (or domestically generated revenues) rose at an anemic 2.3% annual rate in the first quarter. Revenues have slowed in each of the past five quarters after a stimulus ignited 9.1% growth rate back in the fourth quarter of 2009. The slowing in corporate revenues and declining corporate profits are classic late cycle signals. Moreover, non-corporate revenues have soared in the past three quarters, averaging a 7.7% annual growth rate. Late in the cycle it is typical for corporate revenue growth to slow while non-corporate business revenues surge. This pattern was seen in 1989, late 2000 and 2007, signaling that the expansion was on its last legs. We are unsure of whether it is caused by statistical mis-measurement or real economic factors. The corporate sector represents 75% of total business revenues, so when measured corporate income slows relative to measured total business GDP (farm plus nonfarm) the unreported residual (we mine this data ourselves at McVean Trading) or non-corporate sector, soars signaling trouble ahead.
Profits are also a residual, as they are what is left over after revenues have been used to pay for taxes, compensation, interest and depreciation on existing equipment. Typically over the course of the cycle, corporate revenues slow as government stimulus dries up and compensation and interest rise squeezing profits growth. Typically, once revenue growth slips below the 4% annual rate, the cycle falters. This is because less than 4% growth will not allow for absorption of labor force growth, pay raises large enough to cover inflation and enough productivity to generate decent profit growth. Either the investor or the consumer losses confidence in the cycle and spending starts to fade.
Longer cycles are driven by successful reinvestment of profits which expand the pie leaving plenty of room for more jobs and more productivity. The long cycles of the 1960s, 1980s, 1990s and the past decade all had high rates of investment. The sixties from the space race, the eighties from deregulation and the Reagan defense build-up, the nineties from technology (especially late in the cycle) and the past decade from housing. Earlier cycles failed to reach critical mass in investment before they faltered. Generally, because the core investment was from inventory rebuilding, rather than capital spending that grew the pie. This cycle has been very weak on new investment, representing just 19% of GDP relative to a 25% norm. However, inventory rebuilding after the Lehman break was a major feature early in the upturn. That process is over now, but despite large cash hoards businesses remain tight with their investment dollars. As domestic profits slowed to a 2% annualized growth rate in the first quarter, new orders for non defense capital goods have slowed to a 2% growth rate in the past three months compared with the previous three as well.
China Still On the Brake
The center of the investment boom that has led this recovery has been in the emerging markets as commodities producers and suppliers of intermediate goods fed off the massive Chinese stimulus in 2009. China’s ongoing growth and their narrowing trade deficit provided the demand that helped drag the rest of the world out of recession. Now, the Chinese are focused on reining in inflation in their housing and agricultural sectors that threatens social stability. While tighter lending requirements are slowing growth, it is not clear that it is moderating inflation. Most official bank lending in China goes to state owned enterprises and some has ended up in less efficient capital investment – particularly in high end real estate. Throttling off this production has lowered demand for construction oriented supplies, but it has also tightened supply of available units with no corresponding reduction in demand. High interest rates have little effect on Chinese high end housing demand as it is generally a cash business, meant primarily as a store of wealth. Only by slowing income growth to the top tiers of the economy will this high end housing price appreciation moderate. Price controls in the energy sector may bring this about as power shortages threaten to truncate the normal summer seasonal upswing in economic activity.
Unfortunately, slower economic growth will likely hit the consumer in his pocketbook faster than food inflation slows – particularly if the government keeps tightening against rising consumer prices as expected. China needs reformed agricultural policies to increase capital investment and productivity, not simply tighter monetary policy. Similarly, it will take stronger incentives to generate supply of low end housing, and likely disincentives to stop the building of more profitable high end product which competes for land and resources. As the demand for high end housing is investment driven, shifting that investment into more profitable agricultural and rental housing opportunities would kill two birds with one stone. However, so dramatic a shift toward using prices, profits and policies, rather than mandates, to direct investment may still be a bridge too far China.
Just as the US appears to need a crisis to bring about serious budget negotiations, and the Euro zone needs a crisis to address structural imbalances between the North and South, China may need a crisis to take the next step toward freer markets. With global growth slowing, the possibilities of all these crisis are rising. The question now is who goes first and does their slower growth cool commodity inflation enough to help out the others — or do all fall down. The Japanese earthquake was initially ignored as a source of global instability, but it may simply be the first domino in a sequence of economic temblors that rewrite policies for the coming decade.