Third quarter real GDP growth was estimated at a stronger than expected 2.9% — but it is the word estimated that deserves the most attention. Most of the strength in the report came from inventories and trade where there is incomplete data on the quarter. Real final sales to domestic purchasers (GDP less inventories and trade) grew at an anemic 1.4% annual rate as consumption, residential investment, capital spending and government all underperformed. Meanwhile, real exports exploded at a 10% annual rate primarily due to strong soybean exports after a poor Latin American crop.
Because this is not part of the nonfarm economy, it will not generate better productivity, investment or have much influence on Federal Reserve and other models which generally ignore fluctuations in agriculture.
As always, the key information in the GDP report is profits – the economic driver of the US economy, which in turn is the current locomotive for world growth. Both corporate and non-corporate margins have stabilized in recent quarters at levels that are high by historical standards. Though both may now past their peak for the current cycle, there is little reason to believe they will drop sharply as in earlier cycles. The non-corporate sector has outperformed – as in 2000 – because few financial services are non-corporate, but much of housing is — and they are impacted differently by low interest rates.
While, many analysts will be writing this week about some element or other of the GDP report that suggests an imminent change in the economic environment, our view is that this report confirms we are in an unusually stable equilibrium — with no significant policy changes in the pipeline that are likely to disturb it any time soon. One important measure of economic stability is sectoral savings rates. These are determined as the arithmetic remnant after accounting for all sources and uses of income in the four sectors of the economy – households, corporate, government and the foreign sector.
Together they sum to zero, as one sectors borrowing must be offset by another sectors lending. Because savings are derived, rather than measured directly, one anticipates a high degree of volatility. However, over the last fifteen quarters – the entire second term of the Obama Administration – the savings rates of all four sectors have been effectively unchanged. We believe this equilibrium reflects the result of both slow growth and the lack of changes in monetary or fiscal policy. Given we expect little significant change on the policy front we see no reason for this stability to change either.
We can see that historically, sector balances fall into three eras:
- The Keynesian era from 1961 to 1982 – during which the foreign balance was near zero and very stable (The US was virtually a closed economy). Changes in sector balances primarily reflected the movement in the government deficit as it sought to bail out the economy. Both the household balance and corporate balances were typically positive and highly negatively correlated with the government balance.
- The free trade era from 1982 to 2008, during which the foreign balance skyrocketed and provided the funding for a deeply negative household sector balance. Post the 1997 Asian crisis, a US government surplus provided the funding for a once in a lifetime capital spending boom and negative corporate balance, as firms feared they would die on Y2K if they did not invest. Meanwhile, the household sector moved into deficit and after 2001 movement in its balance completely decoupled from the government and corporate sectors.
- Finally, Post-Lehman, we have reached a slow growth stability caused by caution and policy inactivity. Since 2009, the foreign balance has again been effectively flat — but at 3%. The household sector was at 2% in the first term of the Obama administration and dropped to 0% at the start of the second when the 2% FICA holiday ended. Note the offsetting decline in the government deficit at the start of 2013. Meanwhile, the strong correlation between government deficits and corporate balance remains, but with both relatively fixed over the past four years, with the deficit around 5% — and the corporate balance over 2%, a historically high level suggesting caution in capital spending.
We believe one feature of this low growth equilibrium is an increase in partisanship – and a growing importance of jawboning and posturing, rather than actual policy. In our view the byproduct of quantitative easing has been a massive surplus of excess liquidity which now has funds racing around the world in search of any advantage on yield. As countries argue over low growth and how to return to “normal” – so far with little success according to public opinion – ideas about what to do have flowed toward the extremes.
Around the world we see fringe parties rising and a growing gulf between the even the centrists in two party systems. This has largely left governments in gridlock, with each election awaited with bated breath to see if it will turn the tide one way or the other. We see this as reminiscent of post-WW2 when the US House was hit with a series of wave elections as no government provided sufficient growth during their two year term. Today, the movement is less between parties as within the parties themselves as Democrats, Republicans, Conservatives, Labor, even UKIP etc., tear themselves apart. French and German elections are up next in 2017.
Even at central banks we have an increasingly vocal debate. The last FOMC meeting produced a rare three dissents. The FOMC’s dots reflect a wide disparity of viewpoints on when and by how much to raise rates in the near term. Meanwhile, foreign central banks are in far different positions on quantitative easing and (often negative) interest rates. All central bankers tend to agree they are overburdened and that more fiscal stimulus and structural change is needed from other policy makers.
The result is that while one man, one vote is not providing an answer, increasingly mobile funds – even from China – are moving from currency to currency seeking a comparative advantage on yield. With governments gridlocked, FX movement has tended to be in reaction to promises of higher (or lower) rates from central banks, as opposed to promises of tax cuts or regulatory reform.
In a low growth environment, stronger currencies import deflation and quickly hit exports. As both real growth and inflation slow, so do the promises of higher rates. Bottom line, FX dominates monetary policy because it moves faster. Meanwhile, fiscal policy gridlock due to fear of debt even at very low (often negative) interest rates leaves investors seeking short term gains from buying existing assets rather than making long term investments in new physical capital.
President Bullard of the St. Louis Federal Reserve has suggested that rates should stay low until the US economy enters a new paradigm. We suggest that that paradigm shift may be a break from stable sector balances – that is, when households, businesses, governments or foreigners feel confident or rewarded enough to invest in each other. We believe that a core reason investment remains low is not that central banks want zero interest rates, but that aging developed world investors are saving too much. The item they want to consume with their next dollar is not more housing or automobiles, but heath care in 15 to 20 years. Since they cannot buy this in the current mart of competitive commerce they save – and in low risk ways since they must have the money ready when the time comes.
Note that not all elderly or near elderly save for health care, only the well-heeled. More moderate income households bought into promises of social security and Medicare and consumed their income rather than saving for retirement. Most continue to consume even though there is a threat that these programs will be underfunded. Meanwhile, many millennials and wealthy baby boomers have raised savings as the value of these promises and the rate of return on current investments fade.
For millennials, savings is largely from a smaller investment in housing – which helped bring the household balance rate back into positive territory. For baby boomers, it is a shift away from risky equities, which are increasingly narrowly held, into very low yield fixed income instruments.
We see the most likely shift to a new paradigm as slowly developing over the next decade when the aging baby boom begins to consume more health care. A stronger health care safety net now may encourage some current savers to shift their dependence to the government, but we don’t see much trust there. A more likely option is that better application of current medicine may reduce the cost or expected cost of future medical needs.
In any case, high uncertainty about the timing of need, cost of service, and potential for future developments in health care suggest that those who can will continue to save in anticipation of future outlays. Moreover, as health care spending increases with income, higher income and wealth inequality exacerbates the excess savings to satisfy this expected need.
Bottom line, we are not expecting a significant shift in the current slow growth paradigm any time soon. We note that despite a significantly stronger dollar since 2014, the foreign balance has not changed. Neither housing, which has the biggest impact on the household balance, nor capital spending, which has the biggest impact in the corporate balance, are shifting (note this week’s weak durable goods report).
Fiscal spending? Maybe we will know in ten days – but we don’t expect much change from the gridlock between — or within – parties as a result of this election. Four more years?