Surprisingly strong retail sales in February confirm that the fiscal cliff was more of a speed bump for the increasingly resilient US economy. February retail sales jumped 1.1%, though excluding gasoline station sales they were up a more moderate 0.4%. January retail sales were revised higher as well. Despite the hike in payroll taxes and the reversion to pre-Bush taxes for high income individuals, it looks like real GDP will rise roughly 3% in the first quarter after less than 1% growth in the fourth quarter. Hurricane Sandy hurt the fourth quarter and added to the first, leaving the US growth path at roughly 2%. We expect retail sales to moderate as the gas price shock will not be repeated. Still, the ability of consumers to absorb both higher taxes and higher gasoline prices bodes extremely well for the economy as it faces the smaller speed bumps created by the sequester, the upcoming continuing resolution, and the 2014 budget which takes effect October 1st. We expect growth to improve modestly to 2.5% in 2014 when all the budget drama is ended.
For the US economy to break out of this lethargic recovery path will require a shift in business attitudes toward investment in the US. At McVean Trading we are students of sector balances and their importance to future growth. It is a lesson we learned from Brian Reading of Lombard Street Research, who used it to correctly call the Japanese lost decade and the Asian crisis. It helped us identify the US housing debacle early on, and it is now central to our concern about the ongoing US muddle through. Bottom line, the biggest imbalance in the US today is not government deficits – they are merely the byproduct. The greatest imbalance is corporate America’s cash hoard and their willingness to accept near zero returns rather than invest in new plant and equipment. Without investment an economy cannot expand. It is limited to the status quo of labor force growth and very modest productivity growth from incremental efficiency in the use of existing technologies. That was the cause of Japan’s lost decade as its mercantilist exporters shifted their investment offshore – first to developing Asia and then to China. Today, US corporations are expanding their horizons in Asia as well, but invest very little at home.
A review of the balances – income minus spending – for the four sectors of the economy (corporate, household, government and foreign) reveals the deviation in investment. Compared with a long history from 1983 to 2007, balances in both the household sector and the foreign sector are near normal levels. The consumer is still basically spending everything they earn – better than when they were heavily overspending in 2007, but consistent with long term trends. The foreign sector has a 2.8% surplus, again much smaller than when consumers were buying cars and electronics from abroad, but in line with trend. Meanwhile, the government deficit at 7.8% of GDP (federal and state and local) is about five percent higher than normal. Normally, the government would be borrowing back just the surplus that built up in the foreign sector via the US trade deficit.
Today, the corporate sector is holding a five percent surplus, well above their normal zero balance. The 5% surplus is partially because corporate revenues are about 1.5% higher as a share of GDP than historically. Half of this is from stronger domestic retained earnings and half from better foreign income. On the domestic side, this reflects the shift between wages and profits that is also seen in the household sector where asset based income from entrepreneurship (proprietors’ income), dividends and interest make up a larger share than historically. The stronger foreign profits reflect increased commitment to foreign operations. However, the bigger deviation is that there is no domestic reinvestment of profits. Business investment in plant and equipment is actually less than depreciation. Businesses are holding their domestic and foreign earnings in cash and effectively lending it back to the federal government at exceptionally low rates. We are hampered by the aggregate nature of the data as clearly some firms are investing more than their profits domestically and others are investing at non-zero rates. Yet, the pattern of the corporate sector is mirrored in the caution of the household sector where residential investment and purchases of durables have also shrunk as a share of GDP. Bottom line, five percent of US GDP that would historically be invested in plant and equipment is currently being passively lent to the government which is using it to sustain income via much higher than normal transfer payments.
It does not take a genius to figure out that an economy that borrows – even at a zero interest rate – to sustain current consumption rather than investment is going nowhere. Unfortunately businesses know that too, and so they have little interest in investing in a slow growth environment – especially when there are better opportunities overseas. Japan has remained stuck in this box for twenty years with strong investment overseas, but weak investment at home – exacerbated by a declining population and resulting in a deflationary environment. That successful investment generates growth is obvious in areas like North Dakota where the shale boom has fattened both corporate and government coffers nicely while paying premium wages to consumers. California’s better than expected recovery can be traced directly to ongoing technology investment from Silicon Valley as well. As for Detroit and many other areas, a lack of investment is at the core of their malaise. Though the stock market is doing well, the improvement appears to be primarily in areas with the greatest foreign exposure. Domestic investment as measured by durable goods shipments and construction put in place – or their leading indicators like new orders and architectural billings — suggest no imminent upturn. Indeed, it is still unclear whether recent declines in initial claims for unemployment signal new activity ahead – or just a spreading of existing work among more bodies as the manufacturing workweek is at record levels. Bottom line, for us to forecast a sustained breakout above the 2%-2.5% muddle through pace of the past three years will require stronger evidence that businesses are committed to spending their cash on domestic investment.
Reading the Tea Leaves in China
With the close of the 12th National People’s Congress, China has completed the transition from its fourth generation of leaders – the Hu and Wen years – to its fifth generation now led by President Xi Jinping and Premier Li Keqiang. Most of the pomp and circumstance and new leadership rhetoric went as expected. China promises a transition to a consumer led economy, a further opening up of financial markets and a crackdown on corruption. As the saying goes, the proof is in the pudding, and here there were some interesting changes in the ingredients that may provide insights to China future.
Most interesting to us were the assignments of Vice-President and the four Vice Premiers. Recall that in setting the new Politburo Standing Committee – the real center of power in China — back in November, the committee was shrunk from nine to seven. There had only been ten members of the old 25 member politburo who were eligible for elevation to the standing committee after retirement. The three who were apparently snubbed were Li Yuanchao and Wang Gang – the youngest of the ten eligible members and considered the most reform minded – and Liu Yandong, the only woman. As the new positions were announced, Li Yuanchao was named vice-President – a largely ceremonial role but usually reserved for the standing committee. Liu Yandong and Wang Gang were named two of the four vice-premiers. Ma Kai, the former leader of the NDRC and State Councilor was also named a vice premier. The First Vice Premier will be former Taijin Mayor, Zhang Gaoli who is also on the Standing Committee.
These assignments result in a splitting of power between Party leadership (the Standing Committee) and the new Cabinet, or State government positions – and a much younger staff. All but President Xi and Premier Li are expected to retire from the Standing Committee in five years at which time the changing of the guard between Party leadership and State positions may also be of interest. The only two members of the current 25 member Politburo old enough to serve as President and Premier in ten years are Hu Chunhua (Little Hu), recently placed as Party Chief in Guangdong Province, and Sun Zhengcai, new party Chief in Chongqing. Meanwhile, former head of the CIC sovereign wealth fund, Lou Jiwei, was named new Finance Minister and Zhou Xiaochuan remained in charge at the PBOC. Bottom line, we see these assignments as incorporating more of the expertise of younger Party members to advance China’s integration into the global economy – while the old guard still in charge of the Standing Committee bring discipline to the Party.