It has been my view for some time that interest rates would stay low longer than conventional wisdom owing to the unique and enduring deflationary headwinds caused by financial crises (see here and here). Persistent low rates against an historically risky investment landscape (see here, here and here) introduced a conundrum for investors and asset allocators. If risk asset classes present 40-50% downside “at some point”, credit markets are in bubble territory but economic growth and inflation – interest rate predicates – remain depressed, how should one invest in this conflicting factor set? It has been hard to argue for a downside catalyst in the last three years, if one held the outlook for rates, short of an inherently unpredictable exogenous geopolitical shock. But playing portfolio defense for a ten-year time horizon made and makes sense.
Substantive changes to economic growth drivers in the US observed in the last 18 months against the backdrop of an underperforming, underutilized and capital-starved economy may warrant at least a tweak to the near-term outlook for the stock market and other risk asset classes. This report drills down on the reasons to believe the US economy may, in fact, be on a steeper and sustainable upward growth trajectory. Significantly higher US GDP growth for the next two to three years (above 3.0% real) probably warrants heavier exposure to economically-sensitive sectors and names – Consumer Discretionary (XLY), Industrial Sector (XLI), Materials Sector (XLB) and even Tech Sector (XLK) for more risk-tolerant momentum players (despite some of the most worrisome valuations across the S&P 500). Conversely, the defensive sectors are likely to continue to underperform (e.g., Consumer Staples (XLP) and Utilities Sector (XLU). These are trades with an 18-24 month horizon, to be unwound sooner if appreciation reaches 20% or more. The ten-year recommendation to get defensive is unchanged.
Putting politics and personalities aside, does Trump deserve credit for the surge in economic growth? There is no doubt about it. But questions remain about sustainability. There is still no meaningful real wage growth and both labor force participation rates and money velocity – latter a key measure of economic vitality and dynamism – have remained at historic lows. But the table is set for a sustained “second surge” for the economic recovery – better than the sluggish initial recovery – if new-found optimism among private sector capital spenders persists.
As a general rule, there are few levers available to quickly alter the trajectory of the largest, most diverse and complex economy in the world. That was certainly true for president Obama during his first couple of years in office after inheriting an economy in free fall. But president Trump recognized a unique opportunity to jumpstart the economy – a potential exception to the general rule. The economy on inauguration day was growing but underperforming, production capacity was still underutilized despite years of private sector under-investment and historic levels of cash sat on corporate balance sheets. A shift to a more optimistic outlook among private sector capital allocators complimented by shifting more capital from Washington to private hands, had the potential to instantly spark a dramatic increase in capital spending across the economy and accelerating real GDP growth. That is exactly what is happening.
To understand how Trump did in 18 months what Obama, fiscally, and the Fed, monetarily, were unable to do in eight years, one must first understand that production/capital formation drives the economy – not consumption, not government spending and not monetary policy. To be sure, all of these factors play a meaningful role. But failure to understand what actually drives the economy, on a basic level, can lead to obliviousness and perhaps erroneous conclusions as to how policy is impacting production capacity, productivity, jobs and wages.
Dispelling the Consumption Fallacy
The fiction that consumption “drives” the US economy is nearly dogmatic among the financial markets chattering classes. It is maddening to hear lazy repetition of the phrase “consumption drives 70% of the US economy.” No, it does not.
Consumption is the last in a series of effects of capital formation – the construction of plants, equipment, office space and other precedents to production, and the attendant hiring of personnel to build and then operate new production capacity. The wages paid to those employees and the availability of new goods or services support increased consumption – the demand begotten by the new production. The chart below shows real gross output by sector in the US economy – $29.7 trillion in 2017 contrasting with real GDP of $18.1 trillion. The former overstates real GDP by over-counting of dollars changing hands in the economy, to be sure, but it provides a critical window into the actual contributors to the economy – the real drivers. Here’s the problem: treating consumption as a discreet economic factor suffers the same over-counting-of-dollars problem associated with looking at any of the other components making up the $29.7 trillion.
US Real Gross Output by Sector - $29.7 trillion (2017)
Personal Consumption Expenditures (PCE) in 2017 totaled $12.6 trillion. But dividing that figure by GDP and concluding the 70% result demonstrates the primacy of consumption in the US economy is like dividing the $5.4 trillion of gross output from the manufacturing sector into GDP and erroneously concluding manufacturing represents 30% of the economy. Consumption, represented by the PCE figure, is buried in the $29.7 trillion of gross output. It represents 42% of the economy – not 70%. Private industries represent 47% of total gross output and over the long-term, that figure is net of most salaries and benefits bankrolling consumption.
Bottom line, consumption is an important factor in the economy, but plays its biggest role as a floor on GDP during recessions, when consumers may have to draw on savings, borrow and sell assets in order to meet their non-discretionary consumption needs. But long-term, the earnings supporting consumption are derived from and dependent upon production.
Acceleration in Private Sector Capital Spending Responsible for Higher Economic Growth
Private sector capital investment is the engine that drives the US economy, productivity, jobs and real wage growth. The charts below show the relationships are not perfect, but unmistakable.
Private Capital Spending and Jobs
Private Capital Spending and Household Income
In contrast, there is no relationship at all between federal outlays and real household income and a very modest relationship between federal outlays and jobs. As such, big federal stimulus packages since the financial crisis did not yield even normal levels of historical GDP growth, never mind the higher growth typical of economic recoveries.
Similarly, failure of unprecedented easing by the Fed to alter historically sluggish production suggests the problem is not monetary. A spike in the monetary base was offset by a collapse in money velocity, spike in bank reserve ratios and maintenance of near-negative real interest rates did nothing to boost growth.
Interest Rates Moved Opposite Fed Action During QEs, Banks Sat on Reserves as Monetary Base Rose and Money Velocity Remains at Historic Lows …
Trump Took a Market Approach
Trump immediately relieved companies of the most egregiously burdensome, anti-growth regulations and then reformed the least competitive corporate tax regime of any developed economy. Finally, on a more qualitative note, Trump struck a much friendlier tone toward business than that of the prior eight years. Almost immediately capital allocators opened the spending spigots.
Non-residential fixed investment (NRFI) is a broader measure of capital expenditures across the economy and it spiked after the presidential election. Trump has been in office for six quarters. Four of those six cracked the top-ten fastest-growth quarters for NRFI in the last 7 years. Real GDP growth in those six quarters averaged 2.7%, nearly double the last six quarters of the Obama administration and over 40% higher than the median quarterly growth during the two Obama terms – the entire recovery period.
It should be noted that the early economic success under Trump is not entirely new ground since the financial crisis. From 2013 to 2015, the apex of the underwhelming current recovery, the six-quarter moving average of real GDP growth bounced between 2.9% and a peak of 3.3%. That window was bolstered by strength in PCE and NRFI (latter including several very strong quarters of significant but inherently unsustainable inventory building). Six great quarters is a stunning start, but sustainability remains the key uncertainty.
Is Higher Growth Sustainable?
Three factors are the keys to the sustainability of 3% real GDP growth or higher: economic capacity, labor availability and productivity.
Existing Idle Plus New Capacity The weakness of the current economic recovery has been well documented – ranked 11th out of 11 recoveries in annual growth since World War II. The 2.3% growth of the current recovery, and 2.8% of the prior, are even below the average long-term growth rate of 3.2% observed until 2000. On the other hand, the duration of the current recovery is now the second longest since WWII, just ten months shy of the longest ever (119 months).
Overbuilding during recoveries is typically an important catalyst for the next recession as higher spending rolls over and excess capacity in some industries sparks price deflation. At GDP growth of just 2.3% per annum since the last bottom, is it possible the economy remains underutilized and capital deprived? The answer appears to be yes.
The US Economy Still Has Room for Growth
Despite the US economy already producing above the CBO’s moving-target-estimate of potential GDP, industrial capacity utilization stands at 77.6%, below the long-term median of 80.3%. Historical median peak capacity utilization preceding recessions has been 83% and between a low of 81% and high of 89%. The low was prior to the 2008 recession, an historically rare financial crisis for which industry capacity utilization is an unlikely culprit.
As noted, fixed investment is accelerating. According to the Federal Reserve’s August news release:
Capacity for total industry is estimated to have expanded less than 1 percent in 2015, 2016, and 2017, but it is expected to increase about 2 percent in 2018.
A more than doubling of growth in industrial capacity, roughly 20% of the entire US economy, is a spike and one that could persist given the under-spending of the last near-decade.
Office space vacancy levels, as a loose proxy for broader service sector capacity, continues to show ample availability. Vacancy was 16.8% in Q2 2018 according to commercial real estate analytics firm Reis. That figure is down from the post-recession peak of 17.6% in 2011 but up from 15.8% since the end of 2016.
Untapped Labor What about unemployment? For all the talk of record-low unemployment rates for almost every demographic group, the real rate of unemployment is closer to 5.5%, and probably higher - not the 3.9% officially reported. A new “normal” labor force participation (LFP) of around 64% is based on bottom up analysis of the demographic composition of the civilian population, down from pre-financial crisis levels over 66%. But a roaring economy tends to push LFP rates above normal. Could the economy fill another 4 to 5 million jobs from the existing population? Absolutely. In fact, 7 to 8 million is possible before considering any changes to immigration policy.
Labor Force Adjusted for Participation Rate Distortions
If the LFP for the age 16-24-year age cohort returns to median levels observed between 2002 and 2007, the official labor force would instantly increase by 2.2 million. If the median observed during roaring-1990s came to pass, the labor force would rise by 4.1 million. Another 1 to 2 million would be counted if the 25-54-year age cohort returned to the LFP rates of the same periods, respectively.
Productivity As observed in table below, the jump in NRFI has also triggered productivity growth, without which real economic growth would purely depend on added capacity and more employees. Productivity growth has been largely absent during the current recovery, notwithstanding the ephemeral boost from headcount reductions and other cost cutting in the immediate aftermath of the financial crisis. Productivity and hiring are another pair of symbiotic factors for which cause and effect can be hard to discern. What should not be in dispute is the fact that capital spending – new, modernized plants, machines and equipment – concurrently increases both productivity and hiring.
Labor Productivity Finally on the Rise with Nonresidential Fixed Investment
Based on the combination of spiking private sector investment – the metric to keep monitoring – current capacity utilization levels not normally associated with recession and a near-tripling of productivity growth, the faster GDP growth recently observed is sustainable and may even have upside. Labor force participation, real wages and money velocity are lagging derivatives of fixed investment levels – effects of a vibrant, robust economy rather than causes.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.