Volume 60 | Number 4
As we write, it seems that a budget compromise is being hashed out and that a government shutdown and default will be avoided. While this is good news and may spark a relief rally in the financial markets, it is also clear from the recent GDP data that the US economy has fundamental weaknesses that have hampered growth in the first half of 2011 which go largely unaddressed in the current debate. Though the package includes no tax hikes, it is still unclear whether it extends the 2% social security tax holiday which looms as a hefty hurdle for growth in early 2012. The package largely reduces deficits in the out years of the 10 year period, but doesn’t resolve the expiration of the Bush tax cuts or the adoption of Obama care in 2013. These issues are left for the 2012 election and will sustain uncertainty as that debate takes place next summer. While the goal is to provide a more responsible path for government borrowing in order to promote business confidence and growth, it also leaves up to the invisible hand the role of correctly pricing US housing and US labor — which both remain overpriced and in surplus supply. We still do not see an outlook which will produce sustained above trend growth, but we may have kicked the can down the road for a couple of quarters and allowed us to continue muddling along. That is damning with faint praise.
A Slippery Slope
The weak 1.3% growth rate for real GDP in the second quarter was slightly less than expected, but the sharp downward revision for first quarter real GDP growth from 1.9% to just 0.4% sent shock waves through the markets and the economic forecasting industry. Indeed, the annual revisions clarified several trends that suggest the US economy is slipping below stall speed and that the risk of a recession is higher than earlier projections. Even with a budget package, the Federal Reserve and the budget forecasters at OMB and CBO will have to revise down their optimistic 3.5%+ growth forecasts for the next three years (yes Virginia, that is what they had forecast) in view of the fact that even after the big stimulus in 2009 the economy averaged only 3.8% real GDP growth for just three quarters before cooling. The new stimulus at the start of 2011 appears to have had virtually no effect, as inflation adjusted consumption growth slowed to just 1.1% at an annual rate in the first half of 2011 despite the social security tax holiday. Similarly, equipment spending slowed despite the adoption of 100% expensing. With austerity replacing stimulus, it is likely lower prices will be the primary driver to absorb the still excess supply of housing, labor and industrial capacity.
Every quarter when we get the first estimate for GDP we remind our readers that the key lead indicator in a capitalist economy is profits. We had estimated a decline in profits when the original data for the first quarter of 2011 was reported, only to be blown out of the water by revisions – which tempered our pessimism. Now the annual revisions redraw a weak profits picture, with domestically produced corporate profits falling -5.7% in the first quarter and (we estimate) rebounding a tepid 10% in the second quarter. The slowdown in profits during the first half of the year to just 2.5% annualized growth is consistent with the sideways movement in the S&P500 index. It is not hard to understand why employment growth and capital spending are waning. Now, with less optimistic forecasts for 2011 likely (after all models largely extrapolate the past into the future and the past has become worse and there is no stimulus on the table to alter the future) businesses are likely to become even more reticent to let go of their hoard of cash.
Indeed, the greatest outlier in this recovery is not the huge budget deficit, but rather the huge corporate surplus that reflects extreme business caution after Lehman. Corporate profits as a percent of GDP were revised significantly higher in the annual revisions despite a now weaker recovery. Profits have now spent three quarters at peak levels – and historically they spend only four quarters at the peak before fading. Meanwhile, corporate savings as a percent of GDP remains at levels higher than at the peak of any previous cycle – a stunning 4.5% of GDP. True, they have retreated from the staggering 7.1% of GDP at the peak of the initial TARP stimulus, but as the corporate surplus must be offset by a deficit elsewhere in the economy, business savings is now the largest funding source for the government deficit.
Underinvestment remains the primary cause of the surplus as fixed investment remains less than depreciation. Businesses (and households) are running down their physical investments to increase their financial holdings. Though residential investment and structures are clearly in the deepest slump, equipment investment remains below its post-war average – never mind its cyclical peaks – as businesses prefer to expand overseas. The strong desire among savers to hold gold or cash rather than lend to investors in domestic industry suggests that the value of existing productive assets must go lower to generate higher risk adjusted returns for investors. Bottom line, expansions falter when weak hands cannot handle their debt and they shift the burden reactively to stronger hands by reducing spending. Expansions begin when strong hands begin to acquire depreciated assets proactively to put them to profitable use. Hands in the US are getting weaker, and those with strong hands are still sitting on theirs. Prices are likely to fall.
Out of Service
One of the clearest messages in the revisions was that the service sector of the US economy is losing ground. This is an integral part of the process of narrowing the spread between labor costs in the emerging markets and the developing world. As rising commodities prices due to EM growth collide with slowing income growth in the developed world, consumers and businesses favor cheap EM labor embedded in imported goods over expensive local services. Note that almost 50% of the capital goods that US companies buy to replace expensive domestic labor are imported – and equipment spending is far outstripping growth in compensation. In the post-war period, consumer services, which account for roughly one-third of US real GDP, have almost always grown faster than aggregate GDP – until Lehman. As we shift from a world of increasing leverage to one dominated by deleveraging, consumers are restricting purchases of domestic services to repay debtors – many of whom are foreign. The rebuilding of savings has hit interest sensitive goods hard, but consumer services have still underperformed. Over the past four quarters, consumer services have experienced both less volume growth and less inflation than aggregate GDP. In the service heavy government sector, inflation has been higher (implicit taxation) – but volume has collapsed. Real state and local government spending was a 0.6% drag on real GDP each of the past three quarters. With services representing 55% of total GDP, the rebalancing of US and EM labor costs will be a long term drag on US nominal GDP growth and hence are ability to deleverage via income growth.
Back to Basics
At the core of the US economic weakness remains a banking system whose lending is largely backed by real estate collateral that is still depreciating. Thus, bankers remain very risk adverse hampering new lending, especially to small businesses. Without a clearing out of the housing mess, the US appears doomed to stagnation – whether inflationary or deflationary. Therefore, it is an optimistic note that the Case-Shiller price index continued to drop in May, falling at an -0.6% annualized rate. Yes, it is good news that prices are dropping, because the oversupply suggests that prices are still too high. However, the pace of decline has moderated, with the 20 city three month average down at only an -0.9% annual rate, compared with a -4.0% pace three months ago and -9.0% six months ago. A significant reason we are finding a price floor is the accelerated clearing of foreclosure and short sale homes in the hardest hit areas of the country. In addition to prices, Case-Shiller reports the volume of matched sales (same house transactions) it uses to determine prices – and over the past three months the only six cities with sales growth higher than the national average are Los Angeles, San Diego, San Francisco, Miami, Las Vegas and Phoenix. The last three – all poster boys for the housing collapse over the past three years (indeed the only cities with price declines of at least 30% in that period) — are the only three cities to post more matched sales during the past three months than a year ago. Case-Shiller’s 20 city average decline in sales was -12.7% from a year ago, which is roughly in line with the -11.9% drop in existing home sales over the same period. Recall that at this time last year, the federal government was handing out $8,000 rebates in a failed attempt to spur the markets – which led to the sharp decline in seasonally adjusted prices over the winter. Since the start of the year, it has been investors paying cash that has dominated the transaction market, accounting for a quarter to a third of all deals every month compared with only 5% normally. Though there is still significant pain ahead in this process, it is one of the few areas we see stronger hands taking on risk. The decline in long term rates will accelerate this process if they survive the budget agreement. We expect there may be a short term pop in rates on euphoria that a deal is done, but major structural imbalances remain — suggesting growth in coming quarters will remain short of that needed for an economic liftoff keeping rates low. Still, a grinding sideways economy a la Japan is preferable to the far scarier alternative of sliding back into recession in our current condition.