This week’s wave of data defining the US economy just before President Trump’s election shows we are in pretty good shape. The Atlanta Federal Reserve GDPNow forecast is for 3.6% growth in the fourth quarter. The NY Federal Reserve’s Nowcast for Q4 is 2.4%. Their 3.0% average nearly matches the 2.9% Q3 preliminary estimate – which should be revised higher based on the recent data. The strong second half to 2016 will lift annual growth to 2.1% — in line with the 2.2% average over the 7.5 year long expansion.
Since the election, both the expected incoming policy mix and the recent data suggest that 2017 will be stronger than the FOMC’s 1.9% projection. Though higher long term interest rates and a stronger dollar will erode some strength in housing, autos and consumer durables, rising business confidence due to a rollback in regulatory restraint and tax cuts will convert some stock buybacks and dividends into investments in capital goods. This long awaited shift from consumer led to capital spending led growth should accelerate the US — and global — expansion in 2017.
We don’t expect a sharp denouement to the expansion, with rapidly escalating inflation and interest rates. A still weak global economy will both limit US growth abroad and provide a significant competitor for the stronger sales to US buyers.
The rise of protectionism globally reflects the reality that both Monetarist and Keynesian stimulus focus on generating more demand, but the supply of those goods and services does not have to come from within the stimulator’s own borders.
While we fully expect the Trump Administration will raise some trade barriers, we doubt they will be high enough to offset the effect of the stronger dollar since 2014. The US was losing market share even then (though more slowly) with 25% lower relative costs on all domestic production.
Bottom line, we expect a better US economy in 2017 will still throw off growth to the rest of the world – creating faster growth for the factory floor in Asia.
Given extensive global supply chains, we can’t conjure up a scenario in which the US flourishes more than our currently weaker trade partners. Indeed, we suspect that a shift to capital spending led growth in the US will reduce the focus on trade barriers, as growth even modestly above our anemic 1.75% potential will lift wages in an already fully employed job market. For 2017, a capital spending led cycle could be the rising tide that lifts all boats.
The often unspoken reality is that the capital goods sector lies at the heart of modern global trade in labor. Once upon a time, proximity to natural resources was the backbone of trade and immigration was a major source of cheaper labor. However, a rising economic tide around the world has reduced the need to emigrate and increased the importance of capital goods flows to global supply chains.
Capital goods represent the embodied labor of the workers who created them. Sophisticated machines are produced by highly skilled – and paid – employees mostly in developed nations, while simpler machines are fabricated with cheaper labor in the emerging markets.
Roughly two-thirds of the money spent in the US on equipment is for imported goods. This allows firms to augment more expensive US labor – due to superior education and training – with cheaper imbedded labor from abroad. Meanwhile, roughly two thirds of the capital goods that US firms produce are exported – often by US firms establishing new factories in foreign lands.
Increasingly this is not to re-import to the US, but to provide goods and services for that local economy. Thus, the export of sophisticated US capital goods represents a growing market share for US labor in satisfying that nation’s demand.
Bottom line, in the current global economic environment it is unlikely that any degree of trade negotiations – for more restrictive or even freer trade – could produce the improvement in growth that could be achieved by promoting US capital investment.
Over the past two years, the US consumer and housing, which account for 68% and 3% of the economy respectively, have provided 85% and 8% of the growth! This was accomplished while household debt was declining relative to income. Government (19% of GDP) provided only 7% of growth as austerity limited spending.
There is unlikely to be further progress on reducing government’s share even under a fully Republican government. Foreign trade, usually a 3% bite on GDP, was 9% over the past eight quarters due to dollar strength after 2014. However, the greatest underperformance was from nonresidential investment, which provided only 8% of growth despite accounting for 13% of GDP – and just 3% in 2016.
In the first five years of the recovery when labor was plentiful – but tax loss carry forwards and expensing of investment were available – nonresidential investment provided 32% of growth. Note that private sector GDP has sustained an extremely stable 2.4% growth rate throughout the expansion. Any improvement in capital spending is likely to be a win-win situation at least in 2017.
One key to our optimism about the US in 2017 can be traced to a similar call on China in 2016. Where most thought China was on the edge of a debt induced recession, we believed that the simplicity of higher nominal GDP due to government stimulus would provide enough opportunity that economic actors would all improve their positions. Indeed, China is now growing faster than almost anyone expected – including the Chinese authorities.
We have written elsewhere about our concern that they are sandbagging recent strong growth to report later in 2017 when perhaps less robust results occur. Households have used the growth to tap credit markets and satisfy their demand for real estate. Zombie companies have fed off the housing demand while also consolidating and reducing (marginally) excess capacity.
Businesses have reduced their borrowing, relying instead on increased government cash flow. And the government has used the growth as a measuring stick for who will be promoted in 2017. With more market signals uncertainty was reduced and economic activity flourished. We expect the same in the US in 2017 – but with less interference for the invisible hand.
Let’s do a quick recap of what the economic data told us about the outlook for 2017 before Trump initiates any new policies.
Industrial production was up 0.2% for the second month in a row. The Philadelphia Fed was stronger than expected as well. These are more signs that the oil bust is in the rear view mirror and the strength in other goods producing sectors is starting to shine through.
On the labor front, initial claims for unemployment were at a 43 year low of 235,000. This is the lowest ever adjusted for population. We noted just last week that long term unemployed are still 25% of the total. We estimate their average duration currently at over 70 weeks – so they are well beyond unemployment insurance coverage and effectively out of the workforce.
All this suggests to us that the real unemployment rate is quite low, and that wage gains are being held back primarily by weak productivity. In a stronger capital spending environment, who will get the lion share of the upside – capital or labor? If labor, a virtuous cycle should result.
Inflation is much better behaved than the 0.4% hike in the headline CPI for October suggests. Higher gas & oil prices have spiked the headline CPI over the last two months, now up 1.6% year on year. However, core CPI rose just 0.1% for a second month and the 12 month change has cooled from 2.2% to 2.1%. We see clear evidence that energy inflation is crowding out consumers’ ability to cover price hikes in other areas – just as earlier falling oil prices made room for inflation elsewhere.
We expect the headline CPI to converge on 2% — but with the core coming down to that level as well. We feel inflation fears remain overblown in a world where new debt has few takers. Still, there is not much doubt that the FOMC will raise rates in December – and again by mid-2017.
Retail sales jumped a strong 0.8% in October as auto sales posted a second big month. Spending on building materials was up – and restaurants down – as hurricane weather disrupted the east coast. Inventories rose less than expected, probably because the goods were sold! The upward revisions to retail sales exceed the undershoot on inventories, so third quarter GDP should be revised higher. The strength in consumption recently has been from services, which might fade if rents and medical spending lose momentum as the policy environment shifts. Stronger demand for retail goods as wages rise still suggests a strong underpinning for overall consumer spending.
Housing starts were incredibly strong in October as mild weather allowed a 25% bounce primarily in the Midwest and West. Strong permits reinforced the surge in starts, but mortgage applications faded 9% on the spike in long term interest rates. Housing is past its peak – but the late cycle of the expansion always comes despite a deepening recession in housing. That is still some way off.
On the political front, Donald Trump announced his Attorney General and head of the CIA. He is well ahead of the appointment schedules met by the last three Presidents – and we expect a full Cabinet to be named by Christmas. Ahead of schedule and under budget is a key to Trump’s success.
Tell him he can’t do something and he will try his hardest to prove you wrong. So far his picks are as expected. However, the settling of the Trump University case and speaking with Mitt Romney over the weekend projects the tone the markets want to see.