Economic Rundown: Volume 80, Number 5

The next President of the United States will inherit an economy that is in good – but not excellent — shape and can expect at least two years of ongoing expansion – unless they screw it up.

All of this week’s data point to a US economy that is reaccelerating from a mid-cycle pause-that-refreshes as the oil patch recession fades in the rear view mirror. China – which was the epicenter of global economic weakness — is improving enough in response to heavy stimulus that authorities can rein in the debt driven real estate sector.

China’s rebounding demand for commodities is underpinning stronger growth in many of the emerging markets.  Europe is seeing better capital goods orders from Asia and is less worried about the Brexit shock at home. US growth appears to be running at a strong 3% annual rate in the second half of the year, after a soft first half.

Bottom line, nominal GDP is running at about 4.5%, while compensation is running at 4.25%. That suggests profit growth in the high single digits, which is more than enough to sustain US hiring and perhaps the start of some capital spending in the year ahead. Globally, the interest sensitive sectors like housing and autos are at their peaks, but not yet fading because capital spending is not crowding them out via higher interest rates. Even when that process starts, a shift to a capital spending driven economy should carry the US and global expansion well into 2018 – if the politicians don’t mess it up by altering the expected policy settings.

With 161,000 new payroll jobs in November, plus 44,000 in upward revisions to the previous two months, the three month average of 176,000 almost exactly matches the 175,000 average new jobs since March. Yet, though employment growth has cooled from last year’s 229,000 a month pace, wages growth has accelerated from a 2.4% gain in 2015 to a 2.9% average gain over the past six months. This is precisely what models project at full employment.

Meanwhile, the higher wages are attracting discouraged workers back into the labor force, keeping the unemployment rate steady despite still solid job growth – just as Federal Reserve Chair Yellen predicted. It is highly unlikely that her success as a labor market forecaster is going to lead her to change her mind that a slow rise in interest rates — dependent on the developing data — is the best path for monetary policy.

The details of the household employment report suggest that the job market is improving despite steady 4.9% unemployment. The broader U-6 unemployment rate fell to 9.5% in November — a cycle low. Meanwhile, job leavers now account for 12.1% of unemployment, a cycle high, indicating departing worker’s confidence a new job can be found soon. Indeed, the share of job leavers still looking for a job after 14 weeks is also at a cycle low.

The three month average for the long term unemployed as a share of joblessness is also at a cycle low – but at a still staggeringly high 25.3%. In most previous cycles this was down to 10-15% at the cycle low. Bottom line, if this number is to be believed, the unemployment rate for those unemployed less than 27 weeks is quite low by historical standards – well under 4.5% — another sign of strength in the labor market.

Yet, despite the strengthening labor market unit labor costs rose an anemic 0.3% in the third quarter – even with compensation per hour running at a 3.4% annual rate. Unit labor costs have been volatile quarter to quarter, but the four quarter average slowed from 2.7% in the last quarter of 2015 to 2.3% in the third quarter this year. Meanwhile, businesses were able to raise prices at a slightly faster pace, increasing inflation from 0.9% at the end of 2015 to 1.2% in the year ended Q3 2016.

Just as labor costs are slowing, so are depreciation charges (due to low capital investment) and transfers – which were mostly from financial firms settling to court cases. The result of these shifts is a reduced (but not eliminated) squeeze on profit margins — and with 3.0% real growth in the second half of 2016 firms have been able to make it up on volume.

The bottom line is that businesses reacted to the slower than expected growth in the first half of the year with a more cautious approach to hiring in the second half. We have often argued that focusing on the employment report (rather than profit implications) is following a lagging indicator. We expect the next shoe to drop will be faster wage growth as both a tighter labor market and firm’s ability to raise prices generates competition for the best and brightest. This should sustain consumption and underpin solid (but not spectacular) growth into 2017.

The key reason we expect a long flat economic cycle is that credit demand from the consumer, business and government sectors is not competing with each other. While the government was running a very large deficit early in the economic cycle, it has been steadily narrowing that gap. Even state and local governments, which are now mostly in surplus, have not ramped up their spending significantly. Indeed, their outlay growth is still well shy of overall GDP, as the government’s share of the economy continues to shrink.

As the government reined in deficits, consumers have ramped up spending on durables – but much slower than normal in this cycle. Auto sales have peaked out over the last several months just shy of an 18 million unit annual rate. Much of this reflects replacement demand as car sales 15 years ago ran in excess of 16 million units and there is still pent up demand for replacement from running vehicles longer than usual post-Lehman.

Though ongoing replacement of the mid-1990s vehicles should keep auto sales solid for several years, we see little pressure for higher sales due to expansion of the fleet. The population under 25 is now shrinking again, reducing first time drivers. A similar dynamic is holding down housing demand, despite low interest rates and strong appreciation (with respect to both rates and inflation). Single family housing starts appear to have peaked for this cycle, with residential investment a poor contributor to second half growth.

Meanwhile, capital spending still shows no signs of a renaissance. Interest rates are low and nominal GDP growth has sustained profits at a high share of GDP. Yet, firms prefer to buy back stock and pay dividends with funds earned in the US – leading to financial reinvestment and a shift to fixed income which holds down rates. Firms are making physical capital investments abroad as devaluation has lowered foreign labor costs for both skilled and unskilled labor. The potential for currency appreciation due to stronger exports and capital investment also favors expanding physical capital in rebounding economies. It is only R&D which is enjoying an investment expansion in the US, as our comparative advantage in education concentrates this activity at home.

Bottom line, we still see inflation as a monetary phenomenon and a lack of credit growth signals weak inflationary pressure. Until two major sectors begin competing with each other for funds, we see little reason to worry about a resurgence in inflation. As noted in last week’s observations on sector balances, this does not appear likely any time soon. Excess liquidity from around the world still quickly flows in to satisfy any burgeoning need, and the stronger dollar then mitigates future growth.

Many believe that the coming spike in headline inflation to over 3% early next year — when year on year comparisons of oil prices are at their worst – will generate a rise in core inflation that spurs tighter than expected policy.  We doubt the FOMC would be that short sighted, preferring to look through to where energy and food costs might be at the end of 2017.  Regardless, core inflation never moves as much as the headline reading, and even a 3% PCE deflator corresponds historically to just 2.2% core inflation.

Most readers will be shocked to learn that the core PCE deflator has not exceeded 2.4% for a year since December 1993! (Right scale on chart below). A generation of Americans – including all millennials — have grown up with no serious inflation episodes during their adult lives.

The real tug of war on inflation is between the two behemoths of the services sector – housing and medical care.  Each accounts for about 1/6 of the headline PCE deflator and 20% of the core. Before Lehman they tended to move in the same direction, but since the collapse of inflation they have been in opposition.

This primarily reflects the fact that both sectors are so large they compete for the consumers’ dollar – but from different consumers! Housing demand and rent inflation is driven by low interest rates – to the detriment of investors who are mostly elderly. They adapt to limited income growth by adjusting one of their largest expenses, medical care.

We suspect that if rates start to rise because of headline inflation, housing will be crowded out – but medical care inflation will rise more quickly. The net result will be core inflation staying close to the 2% target, while headline temporarily overshoots – just as it did to the low side.

The three FOMC hikes proposed before the end of 2017 should be sufficient to moderate inflation and keep the economy in a 2% muddle through for another year and beyond. Unless politicians meddle, which they are likely to at least try!


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