By Eric Bush, CFA, Gavekal Capital Blog
We were fortunate enough to have Nancy Lazar, from Cornerstone Macro, in our office today and she emphasized a very important point: nominal GDP is ultimately what really matters. Nominal growth is what drives corporate revenue, and in turn, drives business spending. Because businesses are the backbone of any economy, trends in nominal GDP greatly impact inflation, wage growth, consumer spending, capex and interest rates to name just a few macroeconomic variables. When the first release of 2Q GDP came out in late July, we noted how the 10-year annualized change in GDP had fallen to just 2.94%, which is the lowest growth rate on record going back to 1957. In the subsequent charts below, we see how this structural decline in nominal GDP is reverberating through other parts of the economy.
Let's start by setting the stage a bit. 10-year annualized nominal GDP growth was consistently in a range of about 5%-11% from 1957-2007. As we stated earlier, the current level is just 2.94%. So the first question to ask is how fast and for how long would the US economy have to grow to just get back to that 5% minimum level? To answer this, we extrapolate current nominal GDP by 5%, 6%, and 7% per year starting in 3Q16. If all of a sudden nominal GDP started growing by 7% a year (a growth rate that hasn't been reached, let alone sustained for multiple years, since 2Q04), the 10-year annualized change in nominal GDP would reach 5% in four years (3Q 2020). If nominal GDP started to grow by 6% a year (a growth rate that hasn't been reached since 2Q06), the 10-year annualized change in nominal GDP would reach 5% in six years (3Q 2022). Lastly, if nominal GDP started to grow by 5% a year (a growth rate we haven't seen in this recovery), the 10-year annualized change in nominal GDP would finally reach 5% in ten years (2Q 2026). The point here is that it will be quite a long time, if ever, before we see structural growth rates that were at the lowest end of the range during the 1957-2007 period. A reasonable base case scenario is that US nominal GDP grows around 4% a year as it roughly has since 2010. Given that it seems that US growth is in an extended period of low nominal growth, how will that affect other parts the economy?
The first implication of this low nominal GDP world is that capex will most likely remain subdued. In a high nominal GDP environment, companies are experiencing a lot of top line growth. Because revenues are increasing, this sparks an increase in capex. Capex tends to grow faster than nominal GDP for a period of time, usually as nominal GDP is increasing, and then flips to growing slower than nominal GDP, usually as GDP is slowing. We can see this in the chart below which shows how the capex growth rate has been structurally declining along with nominal GDP since the 1980s.
The next effect on the economy is that wage growth is probably structurally capped around 2.5%-3%. This next chart illustrates how nominal GDP and average hourly wage growth have moved in relation to each other since the 1970s. The 10-year annualized change in AHE is currently the lowest data point on record. If wage growth remains anchored, then inflation and inflation expectations probably remain anchored as well. In addition, given this backdrop, we wouldn't expect to see a return of the pre-crisis consumer anytime soon either.
Finally, this low growth, low inflation world should keep a lid on interest rates as well.
All in all, the US economy will, of course, have many cyclical swings in the years to come. However, the structural growth rate seems to have taken a leg down following the financial crisis, and this has important implications for the economy including less capex, lower wage growth and lower inflation to name just a few.