|Summary: The release of weaker-than-expected GDP data from the US this week reinforces the fragile state of the world’s largest economy, and predictions that annual growth forecasts for the nation won’t be met.|
|Key take-out: Even the smallest disappointment will likely lead to a US market correction at some stage over the next quarter or two. With the data the way it is, and price action being what it is, a market correction is the path of least resistance.|
|Key beneficiaries: General investors. Category: Economic and investment strategy.|
I wrote last week in Can the Fed stop printing? that it was unlikely the Federal Reserve’s US growth forecasts would be met.
It didn’t take long for that to be locked in stone (less than a week), with the final estimate of March quarter GDP coming in much weaker-than-expected. As a recap, first-quarter GDP was revised down this week, from an earlier estimate of (-1%) to (-2.9%), which is the weakest growth in five years. That means that for the Fed’s forecast of 2.3% to be met this year, we’re going to need to see growth of around 4% annualised, in each quarter for the rest of the year. That’s not something we’ve seen in this recovery to date, and not something we are likely to see now. More likely, we’ll see something in the order of 1% to 1.5% year-on-year growth to the December quarter 2014.
At the time, markets themselves gave a mixed reaction to the data. Equities didn’t seem too fussed, and were bid initially, despite the result. But bonds rallied (yields fell) and have rallied further since. The move has been decent, the US 10-year yield falling about 10 basis points to 2.52%. That’s not a good sign: the bond market, at least, is concerned about US growth prospects. So too are many analysts and some at the US Federal Reserve itself.
The issue is how much of the slump in first-quarter growth can be put down to weather. There’s a good chorus of opinion, of which I’m apart, that suggests the slump is entirely due to the weather. Others don’t, and they point to the recent slowing in US consumer spending as an ill omen.
It’s a fair point. At 1% in the March quarter, consumer spending was already at the weakest growth rate in years. Now look at chart 1. In the last two months, real consumer spending (adjusted for inflation) is looking even weaker. At this rate consumer spending will be negative, and that’s a big problem for the US as consumers accounts for around three-quarters of the economy.
Now, at this point I have to reiterate that I remain bullish on the US economy. The expansion is strong, and comparatively one of the strongest on record. This is not the consensus view I might add. The consensus is that it’s a weak recovery, but those claims are not making the correct comparisons. In any case, I remain bullish.
The fact is though, it’s looking like growth outcomes will disappoint on the downside and the Fed’s forecasts have very little chance of being met at this point. There are two implications of this:
- As I’ve already discussed – I think the Federal Reserve will use ‘weaker-than-expected’ growth to either prolong the taper or extend guidance on ultra-low interest rates. That is, push out the timing of its first hike – notwithstanding recent hawkish rhetoric from the St Louis Fed President James Bullard, who said the market is too dovish on the Fed and doesn’t understand how close it is to achieving its goals. He reiterated his view that he expects the first rate hike in 2015. The big caveat, though, is that he only expects this if the economy unfolds as he expects – and at this stage this is looking very unlikely.
- Secondly, I think perceptions on the US economy are going to change. The debate is going to change. Recall at this point the ‘secular stagnation’ hypothesis that policy heavyweights like Larry Summers and the IMF are going on about. They’re not trying to resurrect an already debunked theory for no reason. This week’s downward revision will no doubt provide a platform for further discussion later this year as growth outcomes disappoint and jobs growth slows.
I don’t think we’ll got back to the “good ol’ days” of talking about a double-dip recession or anything, but chatter will grow as to whether the US economy has “lost its vigour” and is too weak to sustain a rate hike – or be taken off life support, or some such. We are actually already seeing that – it’s more that this talk will intensify.
Think about what will happen if I’m right. So much bullishness is priced in, that even the smallest disappointment will likely lead to a market correction at some stage over the next quarter or two. With the data the way it is, and price action being what it is, I think that is certainly the path of least resistance.
If this all unfolds as I think it will, noting, as policymakers always point out, the high degree of uncertainty, then it will be natural for even optimists to question the growth outlook. I appreciate I’m only one voice among many thousands, and once a PR campaign gets cranked up it can be difficult for retail investors to ascertain what is true. Thankfully, we’re not flying blind though, and there are several key indicators that we can look at to give us guidance through the noise.
- Jobs growth: Jobs growth has averaged well over 200,000 for the last three months, which is a blistering pace of growth. I expect this pace will slow to a more sustainable pace. When it does it will probably feed fears of a slowdown. As always though, it’s the magnitude of any slowing that will give a guide as to the economy’s true performance. In past years solid outcomes of around 140,000 or thereabouts have been described as weak. This isn’t the case, but I would fully anticipate the same rhetoric if jobs growth slows again. I would only start to worry if employment growth slows to 100,000 or so on a sustained basis though.
- The unemployment rate: At 6.3%, the drop in the unemployment rate has taken policymakers by surprise. Much of it, however, is due to declining participation. I’m not worried by that by the way, it’s merely baby boomers retiring. However, most analysts have quite optimistic forecasts on the unemployment rate. I don’t think those forecasts are going to be met as the participation rate stabilises. At the very least, the slowdown will moderate, again feeding fears the economy has lost some vigour. As I discussed last week though, a stabilisation in the unemployment rate above 6% is exactly what we should expect in this recovery. Noting this, I would only be concerned about a genuine loss in momentum if the unemployment rate rises to above 6.5% on a sustained basis.
- US housing starts: Closely related to that is what US housing starts do. After a surge last year, housing starts appear to have stabilised. A failure to pick up from this point could be a problem, and certainly if they ease from here that would indicate a problem.
- ISM index: Of all the manufacturing indexes, this is the one to watch. Currently it sits at a very healthy 55.5 in May, an acceleration from April. I would only become concerned if this index falls below 50 on a sustained basis. A figure below 50 is consistent with a slowing, but only if it is sustained.
To sum up. I’m optimistic on the US economy, but growth is likely to slow from here and disappoint overly bullish forecasts. While I think growth will slow, and I think that will have real consequences – perhaps even sparking a market correction – I don’t think underlying growth will actually be weak.
Momentum will pick up again. To see if I’m right or not, keep an eye on those indicators above and on the thresholds. For me, these will give a more accurate read than the GDP figures. Who knows, the “slowdown” may even provide the springboard for that explosive growth from stocks I talked about on Wednesday (see Why investors should discount the policymakers).