While the recovery is tepid at best and unemployment remains stubbornly high, if the US can get past the fiscal cliff (a rather big 'if'), there are numerous developments that paint a much better picture for the future. Together, these could underpin a new secular bull market.
No ordinary economic crisis
First, a short overview of the present economic predicament. As we have explained in numerous articles here, it isn't terribly difficult to explain the present economic situation. Households over-borrowed (part of it due to stagnating wages in relation to productivity) on the back of rising asset prices. Here is Joe Stiglitz:
according to research done by my Columbia University colleague Bruce Greenwald, the bottom 80 percent of the American population had been spending around 110 percent of its income.
Asset prices collapsed, the debt remained, and households are deleveraging, borrowing and spending less, paying off debts.
Leading up to the crisis, households increased their cash holdings available for consumption by extracting equity from their homes, using home equity lines of credit and cash-out refinances, and by increasing their nonmortgage balances, such as credit card and auto loan balances. When the Great Recession struck, consumers reversed this behavior and began reducing rather than increasing these obligations. [Libertystreeteconomics]
The private sector spending less means the economy is not producing to full capacity. The slack caused by the fall in private spending has been partly compensated by large public sector deficits (as it should, to avoid a downward spiral), but decreasingly so.
Such private sector deleveraging is quite normal in the aftermath of a financial crisis. It is quite different from the garden variety business cycle in which the Fed turns on the brakes to keep the economy from overheating, producing a deliberate recession. As we have learned from Japan, such deleveraging can go on for a long time, although one has to understand that the Japanese financial bubble and subsequent crash were three times the relative size of what happened in the US in 2008.
The end of deleveraging?
Here you see the evolution of total US debt/GDP (that is, private and public debt together):
Well, the good news is, American deleveraging is quite far advanced. Here is Rex Nutting:
In the U.S., household debt has now fallen to 84% of GDP from a peak of 98%. Nonfinancial corporate debt has fallen to 77% from a peak of 83%. Financial sector debt has plunged from 123% of GDP to 89%. Public debt has risen to 89% from 56%.
Which has led to:
As of June 30, 2012, total outstanding household debt was down nearly $1.3 trillion since its peak in the third quarter of 2008. [Libertystreeteconomics]
Most of that was through consumers paying off debt, only some through default. This isn't terribly surprising either. Here is Martin Feldstein writing a year ago:
Since the housing bubble burst in 2006, the wealth of American homeowners has fallen by some $9 trillion, or nearly 40 percent.
Of the outstanding $12 trillion of consumer debt (end of 2011, according to John Krainer of the Federal Reserve Bank of San Francisco), 70% is mortgage debt. So while households paid down nearly $1.3 trillion in debt, the value of their houses dropped by $9 trillion, leaving balance sheets quite damaged.
However, households only keep some 27% of their wealth in real estate, compared to a whopping 57% in France [Motley Fool]. Other assets have fared a lot better; stocks and bonds are both near record highs.
Bank balance sheets were also a victim of the financial crisis. Here, the US took the lead early on in ordering realistic stress tests and bank recapitalization, as well as a plethora of other support measures.
Yet house prices have adjusted much more in the US compared to elsewhere:
What's more, the construction of new homes has been unusually small since the financial crisis:
And the following:
According to David Wessel, "The fraction of homes that are vacant is at its lowest level since 2006." [Yahoo]
Combine that with the favorable demographics, which should underpin demand for housing better in the US compared to most other advanced economies, and we might have found a bottom in house prices. Rents are also rising rather fast, an indication that there is real demand out there.
Recovering house prices would be a boon to the US, via the wealth effect and triggering an uptick in construction and durable goods. It could signal the end of the deleveraging process, enabling the economy to return to a more normal growth path. We're not there yet, but we think we're pretty close to the bottom of the housing market, if it hasn't already passed.
By now, most will be aware of the energy revolution that has taken hold of the US. New technologies like fracking and horizontal drilling have reduced the cost of winning gas, liquids, and oil from shale formations. As a result, there has been a boom in natural gas production and a fall in natural gas prices.
This has several ripple effects. For starters, the drilling itself causes significant economic activity. But where gas prices in the US are at $3/mcf, they are at multiples in Europe and even higher ($15/mcf+) in Asia, where they're usually tied to the price of oil and come in long-term contracts.
The effect in the US is quite significant:
Five years ago, coal provided about half the nation's electricity. Today, it's about one-third. Natural gas' share during that time rose from 21% to 30%, according to the Energy Information Agency. [Motley Fool]
It also means electricity costs are much lower in the US compared to most of its competitors, enabling the 'on-shoring' of energy intensive industries and other industries based on carbohydrates, like chemical industry. Here is the Boston Consulting Group:
BCG forecast that a glut of natural gas production in the United States would keep the nation's prices of the fuel 50 percent to 70 percent below those in Europe and Japan, as well as hold down electricity costs.... The biggest gains could come in the industrial machinery, transportation and chemicals sectors -- slices of manufacturing that are both highly energy-intensive and automated, requiring fewer workers, BCG said. [Yahoo]
There are significant developments going on that could give the US a renewed advantage in a broader swathe of manufacturing and services. Programmable, that is. Flexible robots are being developed by the likes of ReThink Robotics in Boston. Here is Thomas Friedman:
it will bring robots to the small business and even home and enable people to write apps for them the way they do with PCs and iPhones
And ReThink Robotics isn't the only game in town, there is iRobot's CEO Brooks:
Traditional industrial robots are fixed and not flexible, and they take a long time - and a skilled engineer - to program them to do one repeatable task. "Our robot is low-cost, easily programmable, not fixed and not dangerous," says Brooks
The same principle is working in "3-D printing," which many argue could develop into a whole new manufacturing paradigm where flexibility and customization reign and economies of scale almost disappear. Here is The Economist:
Everything in the factories of the future will be run by smarter software. Digitization in manufacturing will have a disruptive effect every bit as big as in other industries that have gone digital, such as office equipment, telecoms, photography, music, publishing and films. And the effects will not be confined to large manufacturers; indeed, they will need to watch out because much of what is coming will empower small and medium-sized firms and individual entrepreneurs. Launching novel products will become easier and cheaper.
Whole swaths of services like medical diagnostics and accounting, previously impervious to automation, are being automated by the ever cheaper and faster computing cost and bandwidth, combined with expert systems and other software.
Labor, productivity and relocation of production
Here is a little statistic:
The United States produced about as much output in the third quarter of 2011 as it did in the third quarter of 2007, albeit with about 6 million fewer workers on the payroll [Daniel Gross]
This, of course, is a direct consequence of the technologies described above. As manufacturing employs ever fewer people, labor cost become less and less relevant:
This will encourage makers to move some of the work back to rich countries, not least because new manufacturing techniques make it cheaper and faster to respond to changing local tastes. [The Economist]
The combination of new technology boosting productivity, low wage growth, and a flexible labor market has made it possible for considerable swaths of economic activity to be relocated to the US. What also helps is:
Boston Consulting Group has been banging on this homecoming drum for some time, arguing that wage inflation of 16pc annually for a decade has eroded China's lead. [The Telegraph]
According to a Price Waterhouse Coopers report:
the US has clawed back a cost advantage of 2pc in steel output against China, at least for the North American market. Its "heat map" gives the US the edge in chemicals, primary metals, electrical products, machinery, paper, transport equipment, and wood, in that order. [The Telegraph]
There is a similar report by the Boston Consulting Group, claiming:
High worker productivity and low energy prices driven by a surge in shale gas production will give the United States a cost advantage in exports against Western European rivals and Japan in the coming years... By 2015, those factors will make average manufacturing costs in the United States lower by 15 percent than in Germany and France, 8 percent than in the United Kingdom and 21 percent than in Japan, the study projects. Factories' costs in China will remain 7 percent cheaper than those in the United States, however. [Yahoo]
There is a school of thought that argues that manufacturing is 'special,' in the sense that it attracts a host of complementary activities and services. Manufacturing wages are also generally higher, and
Manufacturing firms are also more likely than other companies to introduce new and innovative products. Manufacturing makes up only about 11% of America's GDP, but it is responsible for 68% of domestic spending on research and development [The Economist]
And the homecoming is already well underway:
Google is building its Nexus Q Music and video player in the US. General Electric and Ford are switching to plants at home. So is Caterpillar [The Telegraph]
We'll just give you a couple of statistics that need little additional explanation:
China's labor force grew by 145 million from 1990 to 2008. The entire U.S. labor force today is 156 million. [Motley Fool]
That sounds terrible, until one realizes that the worst is already behind us:
China's working-age population is expected to shrink by more than 200 million between now and 2050. The U.S.' is expected to rise by 47 million. [Motley Fool]
Quite. US is the only major advanced economic block which has a rising population, which ameliorates a host of problems that rapidly graying countries like Japan, much of Europe, and China face.
There are plenty of hurdles. The fiscal cliff is the most obvious and immediate one. We also think that the anti-government ideology has gone through extremes in parts of the US, overlooking the useful role that government can play in education, fundamental research and science, and infrastructure. But we'll keep that for another time.
In the meantime, if some of these hurdles can be overcome, we see an emerging foundation for the next cyclical bull-market.