Long-Term Economic Growth Prospects Remain Subpar

Last week I wrote that recent economic data, including the Conference Board’s Leading Economic Index (LEI), lead me to conclude that the US recession is over.

The bad news is that the coming cyclical recovery will be unlike recent recoveries; a more sluggish US consumer and a deteriorating fiscal position for the US government remain key risks.

My conclusion: The US economy will see a few quarters of strong growth as we snap back from depressed conditions, but longer-term growth prospects remain subpar.

The following chart is worth well more than a thousand words:

Source: Bloomberg

This chart shows US household debt as a percentage of GDP going back to 1960. As you can see, US household debt stood around 40 percent of GDP back in late 1959 and rose only slightly, to about 45 percent, in the 1970s.

The big growth in consumer leverage occurred during the post-1982 bull market. This is one of the primary reasons the US consumer became an engine of world growth from 1982 through 2007.

The American consumer bought the US (and in many ways global) economy out of every downturn over this time frame. This is also a major reason that the recessions in the early ’90s and in 2001 were so mild and short-lived.

Although that was truly an amazing run, I see the 2001-to-2007 period as the American consumer’s last run as the primary engine of global growth for the foreseeable future. As I noted last week, the US savings rate has begun to rise sharply off recent lows.

And, as the chart above illustrates, US consumers are beginning to pay down debt; the US household debt-to-GDP ratio is just beginning to fall from a recent high near 98 percent.

If the world’s afterburner of growth is now flaming out, the obvious question is what factors will contribute to a cyclical recovery in the US economy over the next few quarters. And, even more importantly, the world now needs a new growth engine that can replace the US consumer in coming years.

The most obvious near-term boost for the US economy is normalization in inventories. Check out the chart below of US non-farm inventories over the past decade.

Source: Bloomberg

This chart shows the quarterly change in business inventories. As you can see, this number fell below zero in both the early-’90s and 2001 recessions as businesses cut back on production and sold down their stocks of goods.

But the cutbacks during those mild recessions simply don’t register in comparison to what’s happened since late 2007. Inventories have plummeted at an accelerating pace.

But the inventory cycle is now turning in favor of growth. Business inventories are ultra-lean right now, even as there are signs of demand picking up, albeit from low levels.

If history is any guide, companies have probably gone overboard in cutting their inventories and will now be looking to do some restocking.

Given the rapid drawdown in inventories, the snap-back should be equally dramatic. This inventory restocking is one of the first impulses of growth the economy typically sees in a recovery, and I expect this cycle to be no different.

Another factor to watch for is that some of the trends that have been major headwinds for the US in recent years are now either moderating or reversing. Chief among those is the US residential housing market.

Source: Bloomberg

This chart shows the month-over-month percent change in US existing home sales. A declining pace of sales has actually been a drag on US economic growth since late 2006 but has now turned positive once again.

Granted, a record number of these sales are foreclosures. But foreclosures aren’t all bad; when sold foreclosed houses pass from weak holders (banks and delinquent borrowers) into stronger hands at prices that more closely reflect economic reality. Foreclosures may not be a pleasant prospect, but they have been a necessary catharsis from a nasty residential housing bubble.

And I just picked existing home sales for illustrative purposes. Charts of recent Case-Schiller home price data or housing starts would paint a similar picture: The US residential housing market has bottomed, and inventories of unsold homes should drop sharply in coming months.

Housing has been consistently shaving points off economic growth statistics for the past few years but could soon become a minor tailwind.

Even more interesting from a longer-term perspective is the following chart:

Source: Bloomberg

Anyone who’s sat through Economics 101 will remember that imports subtract from GDP and exports add to GDP. This chart shows the net exports figure, total US exports minus total US exports.

As you can see, this number is negative and has been consistently so for decades. That means that the US runs a trade deficit, spending more on imports than it makes on exports.

This chart is in many ways related to the first chart in today’s issue: Americans’ willingness to borrow and spend has been a big driver in the growth of imports. That’s because many of the goods Americans have been consuming are of non-US origin. While consumption adds to GDP, these big negative and declining net exports have acted as a drag.

But note the recent trend. Since late 2006 net exports have soared. Although still negative, this chart shows net exports back at the same level as the mid-’90s. And the data is skewed somewhat by the fact that oil and energy-related products account for a significant portion of US imports.

This makes some sense. After all, in recession, with consumers spending less and importing less oil overall, imports have declined significantly, improving the net export picture.

What’s more interesting from a longer-term perspective is that declining imports are only one facet of this improvement; check out my chart below for a closer look.

Source: Bloomberg

This chart shows the quarterly change in US exports and imports going back to the late ’90s. What you can see is that in recent years export growth has actually picked up steam. And, as the recession started in late 2007, exports actually held up even as imports began slipping.

Also interesting is the fact that US export declines have begun to moderate more quickly than the declines in imports. This suggests that recovery in overseas demand, particularly in developing countries, has helped to power a Renaissance in American exports, even as import demand remains relatively weak. The data also suggests a good deal of this export recovery is actually manufactured goods.

The weak dollar also plays a role in encouraging exports and discouraging imports. I also suspect that relatively low US natural gas prices are helping manufacturers; energy prices add to manufacturing costs.

But this does suggests that rising foreign consumption could help offset a weaker US consumer in coming years. This plays into my long-held thesis that the emerging markets are taking over as the main engine of global growth.

My long-term roadmap for the US equity markets is the 1968-to-1982 period. Over this time, the S&P 500 essentially marched in place; in fact, if we include inflation, the purchasing power of a dollar invested in the S&P 500 in 1968 fell more than 50 percent by 1982.

There were several impressive cyclical moves for the broader market in the context of that long-term trading range, and certain sectors and foreign markets performed well.

While no two time periods are the same, there are similarities. I recommend investors focus longer-term on investing in emerging markets and in sectors, such as energy, that have growth tied to emerging market demand.

Comments

[Roger Knights:]

"inventories of unsold homes should drop sharply in coming months."

Doubtful especially the "sharply" part. As sales of the inventory increase, banks will release an equal (or greater) number of houses of the shadow inventory into the official inventory.

Aug 30 10:41 AM

[Prudent Man...:]

The "shadow inventory" is being ignored by the banks and regulators. It could be as high as double the number homes and businesses in foreclosure. Delinquent debt payments and long-term unemployment continue to increase. Any further increases in unemployment will be in core, the most productive, workers.

With the FDIC leveraged 50:1 and trillions in toxic assets and worthless derivatives unable to be liquidated but held as assets on the banks and Fed's balance sheet at cost, will result, at best, to overhanging supply and write-offs. What if the taxpayers didn't bailout the elitist financial institutions that should have been left to fail and that are insolvent now without bailouts? That debt for the taxpayers continues to rise.

The current equity markets are results of "Black Box" trading; 1987 redux.

Hope is always fine but realism is necessary to adapt to the fact that the world economy was over-leveraged to the point of breaking. How the "entitlement" generation accepts this reality will only result in greater market volatility bot socially and economically.

Aug 30 11:43 AM

[steve graves:]

"Given the rapid drawdown in inventories, the snap-back should be equally dramatic."

You just made the point that this recovery is different, that for the first time (ever, essentially) U.S. consumers will not be in the position to help it along much, and then you predict that the snap-back in inventories will be as equally dramatic as the draw-down. But if we've created an unsustainable amount of retail business during the recent era of debt-financed mass consumption isn't it possible that the snap-back you're refering to will be more of a whimper than a bang?

Aug 30 12:04 PM

[Roger Knights:]

Also, inventory will grow from resetting of Alt-A mortgages, etc. It may even grow "sharply."

Aug 30 12:48 PM

[CautiousInv...:]

As you correctly suggest, consumer spending will be contained by the combined influences of underemployment and the need to save and liquidate debt. While this will vary by income class, in the aggregate, it will hold true and be prolonged by structural unemplyoment. The big question is how high savings might go; presently at 4.5%, some think it may go to 10%.

On housing, let's see what happens when the $8000 tax credit expires at the end of the current year; at current levels, we are down 50% from long term averages. The latest monthly report on consumer spending was essentiall unchanged MOM.

There should be a period of inventory restocking, given the drawdowns and the consumption owing to the cash for clunkers program. In the last reporting period, member companies within the S&P500 reported YOY sales declines of 17%; in the absence of increases in final demand, the inventory rebound will be brief. And with capacity utilization at 69% and the terrifying policies being pursued by the administration, don't look for private investment to support long term economic growth.

Our exports, which should be receiving the same attention and favorable treatment that income transfer schemes are receiving, are contracting though at a slower rate than of imports. In my mind this reflects more about US consumption patterns than it does about the vitality of our foreign trading partners.

Lastly, we have government and its massive influence is being felt everywhere and will make a positive contribution to GDP. But government does not produce wealth and its present scale threatens the fabric of the international monetary system. Recently released forecasts by the CBO for cumulative deficits over the next ten years suggest we will be in the hole to the tune of $9 trillion. The Concord Coalition, who enjoys a better track record, thinks it will be close to $14 trillion.

Given the bent of this administration, they will follow the path of least resisitance, continuing with income transfer programs, raising taxes where politically feasible and counting on the market to feed our prodigiod appetites. At some point this policy direction will collapse at which time we will have another crisis, possibly one more threatening than the one we are dealing with presently. But this approach is not new, as we tend to react than anaticipate.

A more profound question is whether the stock market has sufficiently grasped the nature of the post-crisis model of capitalism the world is moving towards. Governments will be exercising greater control over the management and levels of profit in banking, the motor industry and elsewhere. Regulation will increase, as will taxes. And the populist backlash against bank bonuses threatens to spill over into a wider resentment of profits and wealth creation.

All of this will innovation as an investment environment depends on a strong and stable currency, restrained federal spending, less harmful legislation, dependable contract law, limits on taxation and countercyclical capital regulation.

Aug 30 01:18 PM

[User 479442:]

you have a typo on the fourth chart(exports - imports).
"This chart shows the net exports figure, total US exports minus total US exports." would be "0" all the time

Aug 30 04:39 PM

[Jan Paul:]

I keep hearing the weak dollar helps exporters but, does it really?

For each 1% drop in the dollar, oil goes up $2-4 and usually $4 is more common when demand isn't dropping. If the dollar were to fall to the last low (around 71-72) we would have over $100 oil even if the demand isn't there.

That means all the costs go up for the production of what is exported, plus, what is sold here drops in demand because discretionary spending is going for energy.

Raw materials are priced globally and if the dollar falls, those prices go up.

Transportation to get the exports to port goes up. The cost of fuel for the ships to move the goods goes up. The equipment used to make the goods goes up. The electricity goes up.

Most of any advantage to dollar weakness is gone once current inventory built at lower prices is sold off and new inventory has to be created at higher prices. At current low inventory levels, that won't take long.

I agree that the emerging markets are going to determine when and how much recovery is generated but, the more they generate, the less they need us or our dollar. They are already making non-dollar trade agreements and that trend would grow rapidly if they find they are trading more and more between themselves while our consumer languishes in debt.

They have already realized they have to grow without us. If we recover, they will be that much better off but, they aren't counting on it. That is making their "recovery" more difficult but, they are proceeding without us. Whether they have a fall before moving up again, or not, they don't have much choice but to proceed without us.

We have been using flawed economic and monetary policies for over 70 years and it has caught up with us.

Aug 30 05:50 PM