- US households and businesses have accumulated enormous hoards of liquidity. The gradual normalization of risk aversion and liquidity preferences will drive a significant acceleration of spending growth.
- On aggregate, the balance sheets of consumers and businesses - and their liquidity position in particular - are the most favorable they have been in the past three decades.
- The average age of household consumer durables and US business capital stock is at a record high, suggesting that there is significant pent-up demand.
- A self-sustaining cycle of improved sentiment, accelerated spending and higher income seems to have already kicked off.
- In this report, I will briefly outline the impact of accelerated US growth on key investable asset classes, such as the S&P 500, 10Y US Treasury yields and gold.
In the wake of the financial crisis of 2007-2009, the recovery has been the weakest of any sustained economic expansion in US history. However, the US economy seems poised for a significant acceleration for the remainder of 2014.
The present article is a summary of my detailed 15-page 2014 US Economic Outlook that can be obtained via my newsletter, in which I will outline the reasoning behind my forecast of accelerated US growth, as well as discuss its probable impacts on major US asset classes represented by securities such as SPDR S&P 500 (NYSEARCA:SPY), SPDR Dow Jones Industrial Average (NYSEARCA:DIA) iShares 20+ Year Treasury Bond (NYSEARCA:TLT), iShares MSCI Emerging Markets (NYSEARCA:EEM) and SPDR Gold Shares (NYSEARCA:GLD).
Consumer Spending To Accelerate
Many analysts are still talking about "balance sheet recessions" and "household deleveraging." The problem is that was yesterday's news. After several years of restructuring, reduced spending growth, increased savings rates and debt-reduction, US household balance sheets are in better shape than they have been since the early to mid-1980s, based on a wide variety of metrics. Whether you look at debt service-to-income, debt-to-income, consumer loan delinquency rates, cash balances as a percent of income, or household net worth, the US consumer balance sheets are, on aggregate, in the best shape they have been in several decades.
While the above-cited household data do not provide any guarantees, there are strong reasons to believe that a greatly improved consumer balance sheet, combined with other factors will lead to accelerated consumer spending.
One important factor to consider is that the average age of household consumer durables in the US is the highest since 1962. This suggests that there is considerable pent-up demand.
A second factor to consider is the long-term improvement in Consumer Sentiment, which is generally a coincident indicator of lowered risk aversion and liquidity preference. The University of Michigan Survey of Consumer Sentiment is currently registering a level of 82, which indicates that we are only mid-cycle in the recovery.
A third interrelated factor is the marked improvement in employment and income trends. Virtually all measures of underemployment, unemployment and average hourly earnings are improving rapidly, and this bodes well for self-sustaining consumption growth.
Some analysts remain skeptical regarding the recovery in consumer spending for a variety of reasons. I will address one of the reasons here: Baby boomers will consume less as they retire and/or prepare for retirement. This may be true, to some extent, over time. However, the impact of this secular demographic effect on consumer growth is extremely minor in any given year (even if it is significant over a period of a decade or more), and in no way can drown out the type of cyclical recovery in spending outlined above based on improving consumer sentiment and the satisfaction of pent-up demand.
There are several reasons to believe that the business expenditure cycle will accelerate appreciably in 2014.
First, the age of US capital stock is at an all-time high, meaning that there is considerable pent-up demand to replace equipment, software and the like.
Second, capital expenditures have started to rebound, but is still only at levels associated with previous economic cycle troughs. This suggests that capex must accelerate significantly in order to be able to cope with a normalization of consumer demand.
Is there any evidence that this pent-up demand will translate into accelerated business expenditure? Yes. First, capital expenditures already started to accelerate in the second half of 2013. Second, various independent surveys have concluded that US capital expenditures will accelerate significantly in 2014. For example, an extensive survey by Citibank recently concluded that 750 top US corporations are planning to increase their capital expenditure growth from 2.4% in 2013 to 6.8% in 2014. For example, capital expenditures are forecast to rise by 9.4% in the healthcare sector, 9.5% in the consumer durable sector and 12.4% in the information technology sector.
In sum, business expenditures picked up significantly in the second half of 2013, and are poised to take off significantly in the final three quarters of 2014.
To the extent that consumers and businesses are disposed to accelerate their level of expenditures, financial institutions appear to be well-primed to facilitate this growth. With capital ratios at multi-decade highs and loan delinquency rates at multi-year lows, banks are poised to meet increased demand from consumers and businesses for credit. Indeed, US banks have been loosening lending standards in virtually all credit categories, including consumer loans, credit cards and small business loans.
Total US bank credit is already growing at high single-digit rates, and appears poised to grow significantly further if consumer and business demand accelerate, as expected.
In terms of non-bank credit, strong bond origination growth in 2013 and narrowing spreads across credit instruments are symptomatic of the large pool of excess liquidity in the US financial system that is eager to find non-zero yields. With low and declining default levels and accelerating economic growth, it will be relatively easy for US companies to obtain funding to finance their growth initiatives.
Government Expenditure and Taxation
In the past few years, and particularly in 2013, the rate of government expenditure has slowed and taxation has increased. Many analysts believe that this has represented a significant "fiscal drag" on the US economy. In a separate special report on this subject, I concluded that many analysts have probably been overestimating the impact of fiscal drag on the US economy.
Having said that, government expenditure, particularly at the state level, will cease to contract and may expand somewhat in 2014. At the same time, no major tax shocks are expected in 2014. Thus, the overall fiscal backdrop for the US economy is more benign in 2014 than it was in 2013.
The US economy is remarkably autarkic - more so than any other developed nation in the world, by far. Still, under the right circumstances, international events can have a significant impact on the US economy - mostly through financial channels; less so through trade channels.
The main risks to global economic growth today come from emerging economies, such as Brazil, Indonesia, India and Turkey that suffer from chronic trade imbalances and a dangerous dependence on "hot money" inflows. These nations have been negatively impacted, and will continue to be negatively impacted by stronger growth in the US, higher US dollar interest rates and tightening global liquidity conditions.
Perhaps just as ominously, prospects for growth in East Asia have deteriorated significantly due to the increasing likelihood that the Chinese economy will experience a substantial deceleration of growth. The Chinese construction and real estate industries directly account for about 10% of Chinese GDP, while indirectly, it likely accounts for more than 30% of total economic activity. Massive oversupply, credit excesses and property price bubbles have reached critical levels on a number of key metrics, and there are increasing signs that a near-term contraction of economic activity in this all-important sector has become inevitable.
Direct impacts (via lowered exports) to the US of a slowdown in global growth led by developing nations would be relatively minor, and would be largely compensated by the benefit of lower commodity import prices, in any event. Having said that, the US economy could be affected more significantly through several indirect channels, such as global financial markets instability.
In sum, I do not expect external factors to derail my forecast of significantly accelerated economic growth in the US. However, external factors represent a net negative to my overall US economic outlook, and developments in these areas should be monitored.
I forecast US economic growth of 3.3% in the second quarter and growth of 3.7% in the second half of 2014. This is significantly above current consensus forecasts of around 3.0% for this same period.
As a result of the significant acceleration of GDP growth outlined above, I forecast a significant surge in long-term interest rates in the second and third quarters, with the 10-Year US Treasury yield peaking at around 3.5% in the third quarter. Fourth-quarter growth may be somewhat affected as a result of related financial market volatility and because of adjustments made by households and businesses in the face of a sudden spike in interest rates.
As with any forecast, there are risks. I briefly outline some of the major risks below:
- Surging interest rates. My forecast of accelerated economic growth and concomitantly higher bond yields will bring about major risks of a disorderly adjustment by financial markets that could cause a subsequent slowdown in economic growth.
- Instability in oil-producing countries. Surging oil prices have historically acted as recovery-killers. Therefore, instability in major oil-producing nations is always a looming threat.
- China hard landing. The Chinese government has considerable monetary and fiscal leeway to attempt to engineer a soft landing. Having said that, given the enormous magnitude of economic imbalances in China, such an outcome is far from certain.
- Europe relapse. The massive structural problems that beset the EU have not been adequately addressed, and the economic and political situation in many key countries remains fragile. Therefore, although my base case is for continued cyclical recovery, a relapse cannot be ruled out.
- First-quarter weakness. Skeptics can point to the deceleration of economic activity in the first quarter as a negative indicator of growth going forward. However, a number of detailed analyses of regional weather trends and industry data have shown that the bulk of this deceleration has been weather-related. Underlying economic activity has remained solid and point to increasing strength.
Major Investment Implications
In my upcoming 2014 Investment Outlook, I will provide a much fuller overview of the impacts of my macroeconomic forecasts on various asset classes. For now, I will only briefly summarize a few of the implications that flow directly from the economic outlook that has been outlined in this report.
1. The bear market in bonds will intensify. Prices of long-term bonds, including long-term US Treasury Bonds, will probably perform poorly.
2. US equities will become more volatile, but significant new highs likely. Bond market instability could trigger stock market pullbacks and/or corrections. However, the combination of excess liquidity and the normalization of risk aversion and liquidity preferences suggests that equities should remain well-bid. S&P 500 and the Dow Jones Industrial Average should make significant new highs.
3. Continued emerging markets volatility. Accelerating US growth and rising bond yields are bad news for many emerging markets that are dependent on capital inflows. Emerging markets equities and funds, such as iShares MSCI Emerging Markets (EEM) are likely to continue to underperform.
4. Strong US dollar. Accelerated US economic growth and higher bond yields suggest a strong US dollar (NYSEARCA:UUP).
5. Gold and commodities. The prior four points are all negative for gold and commodities for the remainder of 2014.