Presenting The Key H2 Milestones To Observe As The Economy Begins Its Next Pre-Stimulus Contraction Cycle
Goldman's Andrew Tilton has laid out a useful framework of the most relevant factors to keep an eye on as the double dip unfolds in its entirety. While Goldman's bias is traditionally bullish, we are confident that as more and more economic indicators surprise to the downside (and June so far has been an unmitigated disaster - we will post Goldman's macroeconomic "surprise" tracker as soon as the latest version is released - it will be a bloodbath), which will eventually pull H2 GDP far below the administration's expectations for a number well north of 2%, and even Goldman's more tame forecast of 1.5%. Our thesis from the beginning of the bear market rally has consistently been that both the economic "rebound" and the market surge have all been a dollar for dollar translation of fiscal and monetary largesse, which in turn is just borrowing from future growth, via assorted credit mechanisms and an adherence to a Keynesian philosophy that eventually growth pick up will be large enough to overtake the incremental debt funding costs. We know from Reinhart and Rogoff's studies that this is no longer the case when you get into stratospheric sovereign debt levels. And as this is a closed loop, there is no way to get out of this Keynesian toxic spiral without inflicting terminal damage on the economy - perhaps in September 2008 there may have been a different outcome, but now it is too late. Which is why anyone looking for any modest economic bounce will be satisfied for only a quarter or two, as yet another greater stimulus flows through the economy. However, with the marginal utility of any new debt at or below zero, even the government's fiscal stimulus is now becoming useless (even when assuming a perfectly efficient distribution system, which in this corrupt political environment is a stretch). Which only leaves monetary stimulus as the last bastion of the reflation attempt, and we are certain it will be abused over and over by Bernanke, as America slowly careens to the unwinding of the current iteration. Which is why fiat paper will become increasingly worthless, and tangible, undilutable assets: vice versa.
Macro convictions aside, below we present Tilton's checklist for the key items that none other than Ben Bernanke is looking at most intently. We suggest readers use this list not so much as a guideline of when the economy will rebound (never in its current form), but when Bernanke will finally decide to pull the trigger on another $2+ trillion QE episode. Once the negative surprises become sufficiently dramatic, he will have no other choice. And since Obama will be forced to blame the inability of this most recent reflation attempt to heal the economy precisely on the Fed head, the one good outcome from this event, would be the Chairman's (and soon thereafter, the Fed's) exit, stage left, from the US policymaking arena. Alas, it will be too late.
- As the recovery approaches its second year, the jury is still out on its sustainability and strength. Our long-held view is that US economic growth should decelerate to about 1.5% in the second half of the year as short-term supports fade out.
- Consumer spending will be even more important to economic growth in the second half than its 70% share of GDP suggests. The twin boosts of government stimulus spending and early-cycle inventory accumulation are fading. Residential investment appears likely to retrench temporarily over the next few months as the hangover from the homebuyer tax credit sets in. Business investment and net exports are likely to be only small positives.
- Spending growth should slow in coming months if our gauge of ?household discretionary cash flow? (see chart below) is on the mark. Our forecasted deceleration of cash flow and consumer spending could be avoided if bank credit? which is still contracting at a gradual pace? begins to ease in the second half, and/or if employment growth in the private sector accelerates beyond the 100,000-150,000 per month that we expect. Of course, deterioration in either of these areas would likely portend a sharper slowdown.
- Revisions to first-quarter GDP growth revealed a slower pace of consumer spending and more inventory accumulation, with final demand rising at less than a 1% rate. Housing activity slumped following the end-April expiration of the homebuyer tax credit, with new home sales at an alltime low in May. Unsurprisingly, the latest FOMC statement took a more cautious line on growth and reiterated that rates would stay ?exceptionally low? for an ?extended period.?
As the recovery approaches its second year, the jury is still out on its sustainability and strength. Our long-held view is that US economic growth should decelerate to about 1.5% in the second half of the year as the tailwinds from government stimulus and the early-cycle swing to inventory accumulation peter out. We recently laid out a “road map” for major economic indicators in the second half that will help our clients assess whether this forecast remains on track. But which factors are most likely to determine the verdict?
Consumers Remain the Key
Anyone who attended an economics class will remember the standard GDP accounting identity Y = C + I + G + NX. Since consumer spending, C, is 70% of overall GDP, it’s obviously an important part of the outlook at all times. But this is particularly true if we take a quick spin through the other components (splitting I—investment—into its residential, business fixed, and inventory components):
Residential investment has slumped after the expiry of the homebuyer tax credit at the end of April. New home sales fell by roughly one-third in May, more than reversing the entire acceleration in prior months; permits for new construction are down 15% over the past two months. Some of this is a short-term hangover, but we think it illustrates that the housing sector has a long and probably slow path back to normalcy. At only 2½% of GDP, it would need to show very strong growth indeed to move the needle on the overall economy.
Business fixed investment is on a modest growth track, averaging a bit over a 4% annualized pace in the past two quarters, with a modest contribution of 30 basis points to Q1 GDP growth. This masks a sharp divergence between rapidly growing outlays for equipment and rapidly declining structures activity.
Inventory investment added an average of two points to GDP growth in recent quarters, as companies ramped up production sharply after a period of inventory liquidation. But with inventories clearly growing now, this phase is nearly over.
Government spending on stimulus outlays is likely to peak soon as elements of the stimulus package term out. Alongside a likely increase in taxes in 2011, fiscal stimulus is turning from a strong positive to a clear negative going forward (see Exhibit 1, which also shows the contribution of inventories).
Net exports are likely to be an eventual boost as the BRICs and other key fast-growing markets increase their share of the global economy. But this is a gradual process and in the near term, a strengthening dollar and hints of decelerating global activity suggest only a limited contribution to US growth.
In short, although business investment and net exports may provide some help, the 2% growth in real consumer spending that we forecast for the second half will account for nearly all of the growth in the overall economy. Thus, gauging any shift in its pace will be critical.
As Goes Cash Flow, So Goes Spending?
One altimeter for the direction of spending is our proprietary measure of the cash flow available to the household sector. We calculate “discretionary cash flow” as follows: beginning with after-tax household income, we adjust for noncash items, add net growth in consumer credit (including home equity), and subtract spending on essentials like food and gasoline. We then project this series forward based on known policy changes as well as forecasts for specific components. A nontrivial portion of households appear to spend essentially all of their cash flow, so this simple approach has proved a useful guide to broad shifts in spending in the past.
Our estimate for cash flow, including projections through next year, is graphed on the top chart on the previous page (along with the actual and forecasted path of real spending growth). Cash flow growth should decelerate modestly in the second half of the year because of a) the fading boost from tax refunds associated with the Making Work Pay credit, b) a softer tailwind from credit normalization, c) a bit more drag from nondiscretionary spending, including expected increases in oil prices, and d) temporarily slower income growth as short-term Census jobs end.
The most likely candidates for a “surprise” to this path—in either direction—are credit and the labor market. Every 1% increase in consumer credit boosts discretionary cash flow by about 1/3 percentage point. Every 1% increase in employment growth (a little more than 100,000 jobs per month) adds about ¾ percentage point to household cash flow. Of course, other factors such as oil prices could materially affect cash flow as well, but it would be difficult for real spending growth (and overall GDP growth) to deviate sharply from our forecast without a significant change to credit conditions and/or employment growth.
Still Waiting for a Revival of Bank Lending
The availability of credit to households and businesses is critical for the second-half economic outlook. Beyond its impact on consumer spending, a return to more normal bank lending conditions would also enable investment and hiring by businesses too small to access the credit markets; survey evidence continues to suggest that this is a meaningful constraint on growth for at least some firms. Conversely, a renewed tightening would put the brakes on growth at a critical time.
Probably the best measure of bank lending standards over time is the Fed’s Senior Loan Officer Survey. Unfortunately, it is updated only four times per year, so in the interim we must rely on indirect evidence such as lending volumes (which mix drawdowns on old commitments with new lending), bank funding costs, and anecdotal commentary from bank managements. Exhibit 2 illustrates that the modest rise in bank funding costs over the past couple of months pales in comparison with the financial crisis, and still looks consistent with stable (if not improving) willingness to lend.
Private-Sector Payroll Expansion to Continue
Easier credit could boost both hiring and spending, thereby revving up the so-called economic “multiplier,” the virtuous recycling of business revenues into increased employment and wages, and ultimately more spending. With temporary supports for income fading, private-sector employment growth is now as important as spending itself.
The news here has been mixed. Employment is clearly growing again, with private-sector employment up about 100,000 per month on average so far in 2010 (and the admittedly volatile household survey showing a far stronger 374,000). However, new jobless claims remain relatively high, and the total number of people reliant on benefits seems to be trending down only gradually (see chart). Growth in job advertising has slowed after a sharp acceleration in late 2009.
We are cautiously optimistic that June’s payroll report will show a pickup in private-sector payroll growth to around 150,000. In part, this is because there seems to be some “crowding out” of private sector payroll growth by short-term Census hiring—indeed, this may explain a good part of the payroll disappointment last month. Total payrolls should be down about 100,000 in June as a large portion of Census employment rolls off. Softer employment should be reflected in the household survey as well, pushing the unemployment rate back up to 9.8%.