It feels very much like a big waiting game at the moment. Economically the consensus became very excited about synchronised global growth as 2017 ended, and of course the US tax cuts were supposed to propel growth higher. So far Q1 looks a bit pedestrian, and we can quite easily see this continuing into the second half of the year. In financial markets, now that markets have settled down after the volatility washout in February, price action is “coiling” in a number of markets, indicating indecision. At some point, we will get resolution as markets breakout of recent ranges.
The data on the US economy leaves the impression that the economy is unbalanced in some way. The debate on whether GDP is measured correctly seems to be warming up, and indeed whether GDP is the best overall measurement for the health of an economy, but let’s leave that to one side.
On the plus side of the ledger, employment data is strong, business and consumer confidence is very high and the economy is operating above potential and has pretty much eliminated the slack created during the last crisis. Along with the recent tax cuts and increased Government spending, surely the economy is about to accelerate?
On the negative side of the ledger, we have record debt, a near record low household savings rate and now retail sales flat over the last few months. The consumer is supposed to be the juggernaut of the US economy, and without much larger wage growth, it will not be possible for growth to accelerate unless consumers continue to pile on debt, which seems unlikely.
And if the consumer is the juggernaut of the economy, corporate profits are the engine. Historically, changes in profits leads the capex cycle which leads the economy. However, the argument is growing that financial engineering (share buybacks, sometimes with borrowed money, along with M&A) is distorting the picture and hurting the economy. A little bit like throwing some sand in the engine to extend the metaphor.
Before we get onto looking at some charts, the reason for trying to understand the moving parts of the economy as well as the whole is very important. Whether or not you believe that GDP is both the best measure for the overall health of the economy and that it is being measured correctly, this is the data that we as investors and the Fed as policymakers have to hand in making decisions. Furthermore, if the data is in anyway questionable, surely it only increases the chances of policymakers making policy errors.
So what of GDP itself? Last Summer, the US was hit by two destructive storms, and the rebuilding along with replacing damaged vehicles should have actually boosted GDP in the second half of last year. Chart 1 below shows both quarter on quarter (in green) and year on year (in red) growth in US GDP. The pick-up in quarterly growth rates in Q3 and Q4 are extremely modest given the weather/rebuilding argument.
Chart 1 – US GDP (quarterly in green and year on year in red)
Our main concern is that the consumer is tapped out. Chart 2 shows outstanding consumer credit per cent of GDP, and it just keeps rising. As interest rates keep rising, those with debt are going to have to allocate more to debt service payments, perhaps at the expense of current consumption. This is a more complex situation than simply looking at debt. Personal income excluding transfer payments from Government (social security and medical) is struggling, and a recent report shows that 42% of Americans can expect to retire on $10,000 or less. The inequality in the US is hurting the economy, and we see no policies that are likely to improve this; in fact, they may make matters worse.
Chart 2 – Outstanding consumer credit as a % of GDP
Given the recent tax cut and the extremely positive sentiment surveys and bullish start to the year for the equity market, it must surely come as a surprise that retail sales are not doing better. Chart 3 shows retail sales excluding volatile items like auto and gasoline sales which remains below the high seen in November. The year on year rate, having accelerated in the second half of last year, is softening now.
Chart 3 – US Retail sales “Control Group”
One last chart which we came across last week is also quite concerning, and speaks to our concerns that the consumer is tapped out. Historically, delinquencies on mortgages turn before the unemployment rate (and the economy), and as can be seen in chart 4, the delinquency rate has recently popped higher. The question here is whether this is just a blip or a portent of something worse later this year and into 2019?
Chart 4 – US unemployment and delinquency rate on residential mortgages
Predicting GDP is as difficult as ever, it seems. The Atlanta Fed a few years ago developed a real time forecasting tool, and although this is extremely erratic during the quarter, the model seems to be as good as any as the quarter draws to a close. Currently, this model predicts that the US economy grew by 1.8% annualised in Q1 which would result in year on year growth of about 2.7% (the base effect was quite low in Q1 last year). Overall, this would seem to be ok. Not robust but also not recession like.
However, add on tax cuts and the boost to the economy that this is supposed to generate, and the resulting jump in the Government deficit, surely growth should be stronger? Furthermore, a 10% or so drop in the US Dollar in the last year should also have helped. Overall, we do not think that the US economy is performing that well given the boost that should have come from a combination of weather related rebuilding, tax cuts and Government spending, the weak Dollar and the increase seen in consumer debt and record low savings rate.
Of course, we could be just being too bearish, and the US economy may just be about to accelerate. Perhaps the tax cuts are about to kick in with a lag of a quarter or two? Perhaps corporate profits, which are indeed rising quite strongly, are about to lead to a wave of capex and either job creation or wage growth which will alleviate the stretched condition of the average household and lead to a surge in spending? This may all happen, but we are somewhat sceptical.
The early evidence is that companies are using the majority of their tax savings to give to shareholders rather than workers. Yes, some workers have received pay rises or bonuses, but the numbers really are modest when compared to the sums being spent on shareholders. Furthermore, the lower half of the income and assets cohorts pay virtually no tax and hold very few assets. Arguably, they will benefit much less from the tax cuts compared to the wealthy, who may choose to simply save their windfalls.
If we are correct that when one scratches below the surface the US economy is not performing as well as it should be given all the positives, and the Fed continue to raise rates perhaps four times this year, then we think that concerns over a policy error and economic slowdown will gather later in the year.
The next couple of quarters are important for the economy. If growth accelerates, then that may well just galvanise the animal spirits and create a self-sustaining cycle. However, if growth remains sluggish despite fiscal stimulus, then our concerns for a future slowdown will actually increase a notch. Unfortunately, watching the economy is a bit of a waiting game compared to watching price changes in the financial markets. But that does not detract from the importance of how the economy performs in the period ahead.
Stewart Richardson
RMG Wealth Management
