by Eric Bush, CFA, Gavekal Capital
Listen, before we go through a litany of economic charts that pour some cold water on the recent bout of optimism regarding US economic growth prospects we want to stress that we don’t believe economic growth is about to fall off of a cliff. Quite the contrary, we feel that we are on the same “muddle-through” growth trajectory we have been on for the entirety of this recovery. We do, however, question the sustainability of the move back in bond yields because of better “economic data” and are surprised by the number of recent articles highlighting increased inflation fears since the presidential election. Much of the recent optimism seems to stem from a the belief that the new administration will be able to dramatically (and immediately) increase economic growth. The problem is that the US and global economy continue to face major structural issues that seem to be beyond the control of any politician. Increasingly, it is feeling like we are in a “buy the rumor, sell the news” kind of market.
Let’s start with the punchline: US 4Q2016 GDP is forecasted to be a whopping 4 bps higher than 3Q2016 GDP on a QoQ% basis and 1Q2017 GDP is forecasted to be 5 bps lower than 3Q2016 GDP on a QoQ% basis according to now-casting.com. Simply put, we continue to be stuck in the 2%-2.5% growth trajectory of the last 7 years. Currently the data feels stronger because of the the cyclical slowdown in 2015 (which by the way also happened in 2011 and 2013) so the period over period comparisons are easier to beat.
Since 1946, US real GDP has grown at an approximate 3.2% annual growth rate. In order for the recovery that has occurred since 2009 to accelerate to just a 3% annual growth rate real, GDP would have to grow by 5% annually for the next 14 quarters! We have had only one 5% annualized quarter in this recovery (3Q2014…rounding up to 5% from 4.96%) and the last time real GDP grew by 5% on a year-over-year basis was 2Q2000. And for the last depressing statistic on the history of real GDP growth, the last time we had four consecutive quarters of 5% year-over-year real GDP growth was from 1Q1984-1Q1985. Slower growth is a structural phenomenon that will be hard for any one person or one administration to meaningfully change.
The real growth pickup going on in the world is actually occurring in Europe as 4Q2016 and 1Q2017 GDP is projected to grow at the second and third strongest QoQ rates since 2011. Europe is projected to grow at roughly 2% annualized growth but this is good step up from the roughly 1% growth rates of the last several years. Surprisingly, German 2-year bond yields just broke to an all-time low as growth prospects seem to be improving at the moment.
Shifting back to the US, higher interest rates are just not sustainable since debt to GDP has increased significantly over the past decade. As we laid out in an interim quarterly strategy update last week, the US government has paid slightly less interest expense over the past 12 months than it did in 2007 even though total debt outstanding as a percentage of GDP has increased from approximately 65% to 105% (debt held by the public increased from 40% to 75% of GDP). A sustained period of higher interest rates will dramatically eat into the government budget at the expense of many other spending programs.
Infrastructure spending seems to be one of the primary drivers for the recent bout of enthusiasm. The proposed $1 trillion increase in US infrastructure spending by the government over the next decade is really just a drop in the bucket compared to what is already going on in the private sector and in China. Over the past five years, China has spent over $20 trillion in fixed investment while the US public sector has spent just $1.3 trillion. Fortunately, the US private sector has picked up the slack and has invested over $13 trillion over the past five years.
There is also a lot of hope that lower tax rates could spur consumer spending propelling the economy out of the “muddle-through” growth rates experienced in this recovery. Without even discussing who will be the primary beneficiaries of lower taxes, a major issue with this argument is that the behavior of the consumer has changed since the financial crisis. Consumers are simply saving more of their disposable income. In the chart below we show a predicted savings rate based on the amount of consumer credit as a percentage of disposable income. The current savings rates is 5.7% while the predicted savings rate is 2.8%. Since the financial crisis, and especially since 2012, consumers are not leveraging up their personal balance sheets as their disposable income increases. The scars of the financial crisis may have permanently changed the behavior of the US consumer. Consumers are entrenching similarly to how they did in the 1970’s. The problem today is that the savings rate is at 5.7% while the savings rate in the 1970s was closer to 12-14%. This limits the upside of an acceleration in economic growth even if all of the sudden the consumer decided to begin spending more and saving less like they from 1980-2007.
Finally, let’s touch on inflation. An immediate major inflationary scare doesn’t seem to be in the cards. Core inflation during the recovery is running well under 2%. If you strip out shelter as well, inflation has really tailed over over the past three years. Additionally, there is still a measurable output gap in the US. This suggests that inflation is not a here and now problem as there still seems to be slack in the economy. Our CPI diffusion index is also near recessionary lows and our measure of structural inflation is still clearly in a downtrend. The long-term decline in structural inflation seems to stem from demographic problems and those problems don’t seem to be going away anytime soon. All in all, their seems to be an anchor holding down inflation due to excess capacity and changing demographics in the economy.
The US economy is coming out of a cyclical downturn and recent economic data is feeling better because of it. While the effect of the policies put in place by the new administration (and what the actual policy will ultimately be) is still unknown, there are major structural issues facing the economy that may limit the effectiveness of any policy changes. The US economy continues to grow at same pace that it has over this entire recovery. However, neither a major increase in economic activity nor a significant deceleration in the economy seem very likely over the coming quarters.
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