Is the US really recovering?

The Great Recession, the worst since the Great Depression, was a turning point for the US economy. After a decade of sending manufacturing jobs overseas and replacing them with growing household debt – a process known as financialisation – the US headed into a debt crisis.

For a recovery to take place many, including the Federal Reserve, believed a reversal of these factors was necessary. The Fed pushed interest rates to zero, bailed out the banks and weakened the currency; the Government launched stimulus and manufacturing recovery plans; and an unexpected and fortuitous gas boom added impetus to both.

Naysayers argued that these policies would lead to rampant inflation and a sovereign debt crisis. They may yet be proved right; but right now the evidence is mounting up on the side of the Fed. The United States is enjoying a manufacturing renaissance.

With China stumbling and Europe unable to get up after a huge fall, investors’ hopes for the next few years rest on the US. But does the data support the notion that these policies have driven the US economy to the threshold of a period of sustainable growth?

The answer is a qualified ‘yes’. Take a look at Chart 1, showing US GDP broken into its component parts over the past two and half years of a halting recovery.

Notice two things. First, the government has been detracting from growth since the Great Recession. Although Federal spending rose strongly in its wake, state and local spending has collapsed. As the economy slowly grows, these two elements are slowly reversing; local spending is bottoming out and Federal spending is now falling. US politics being what it is, there’s little chance of public investment contributing to growth in the medium or long term.

Second, see how exports and imports are largely cancelling each other out? Little growth is coming from this area of the economy. That leaves the two mainstays of the US recovery; the dark and light grey blocks of private investment and personal consumption.

Private investment

What’s driving the bounce in US private investment? Until recently, it certainly wasn’t dwelling construction, which so famously overshot during the sub-prime crisis and left the US building very few houses at all for four years.

Growth has come from real and productive enterprise, in manufacturing and the same extractive sectors that have delivered Australia its post-GFC good fortune. According to FRED statistics, whilst government employment has declined and other sectors (such as finance) haven’t yet recovered, there’s been a huge boom in mining and energy employment.

This is the US gas revolution in action. Through the innovation of fracking, shale gas and oil has dramatically reduced the US’s oil imports and forced natural gas prices down from a pre-recession peak of $15.00 per million british thermal units (mmbtu) to $3.50 per mmbtu today.

The International Energy Agency predicts that the US may become an oil exporter in the next decade. And, as any Australian LNG investor will know, US gas is now so abundant it’s in the process of being exported to North Asian markets where Australia has until now held sway.

More importantly, the cheap gas price has helped fire-up US manufacturing, driving a rebound in US employment. US industry consumes more than a third of the country’s energy output and gas is a significant input cost into the manufacture of food, paper, plastics, chemicals, glass, metals, and so on and so forth. That’s a massive boon for a major part of the economy.

Personal consumption

The benefits of the gas boom have also reached into personal consumption. The US is contributing to global efforts to reduce greenhouse gas emissions, largely through conversion to natural gas generation. This and private gas heating has significantly reduced US household energy bills, freeing up extra disposable income, something we in Australia can only dream of. Retail has also been a strong area of jobs growth as a result.

This is part of a matrix of efforts that have worked surprisingly well to restore US personal consumption growth. Its trend is averaging 4% growth per annum, well ahead of Australian retail sales. That’s a lower trend than the 6% average prior to the Great Recession but remains impressive.

Low interest rates have certainly helped. Although US mortgages are mostly fixed over the life of the loan, benchmarked to the 30-year bond rate, lower interest rate periods enable home buyers to refinance en masse.

Over the past two years in particular, the Federal Reserve’s quantitative easing – that is, printing money and buying government bonds with it - has succeeded in driving the 30-year bond rate down to record lows. That’s reduced borrowing costs for consumers, as Chart 2 shows:

The other effect of monetary easing is that the moribund US housing market has also come alive in the past year or more with renewed price rises and a return to dwelling construction, as Chart 3 shows.

For a long time after the Great Recession, US home building was deeply depressed. An oversupply of houses and depressed household formation on a weak labour market meant that there was no demand. Over time, however, this built up a shortage and 18 months ago the market began to turn as household formation jumped back towards long-run averages.

This came at a propitious time. Growth in the US energy and manufacturing recoveries began to slow at the same time as the European recession developed and Asian growth slowed. For the time being, however, US growth has successfully been handed off to construction, where jobs growth is now strong and is forecast to accelerate.

Can it continue?

The US recovery has passed through several phases already. It is now starting to resemble a more traditional recovery with housing and consumers taking the lead as the unemployment rate dips to 7.5%.

The likelihood is that the recovery will continue at current levels of GDP growth of around 2%. But can it accelerate?

It’s doubtful. The plain truth is that the US has managed to force this recovery by driving down interest rates and printing money to such an extreme extent that it is questionable whether the withdrawal of that stimulus will not severely damage the recovery.

Chart 2 shows how recent rumblings by the Federal Reserve that it will begin to ‘taper’ its bond purchases has been enough to cause 30-year mortgage rates to jump, undoing the last two years of cuts, the equivalent of five Australian rate hikes in just two months.

This has already begun to slow the housing recovery at the margin, with refinancing collapsing and new mortgages also falling sharply. That is not to say that the Federal Reserve will not proceed with its ‘tapering’, but in doing so it clearly risks slowing the housing market recovery and the economy.

Portfolio implications

What does that mean for your portfolio?

There are a few points to make: if tapering proceeds in September as planned, a serious correction in the US stock market is possible. The NYSE 100 hasn’t yet reached its pre-crash peak but it isn’t far from it. The Dow Jones Industrial Average surpassed its 2007 high earlier this year. There isn’t much room for even higher valuations without good economic growth to support them.

A substantial component to this recovery is down to government stimulus. Its removal may apprehend it, in which case we could quickly see a return to the policies of the past five years. Whilst the US is recovering, we are yet to discover to what extent this recovery can build on itself without government assistance. In September we may get to find out.

If you're investing internationally you need to consider this alongside local conditions. Continued local interest rate falls will keep pressure on the local dollar, which makes the argument for international diversification compelling, despite the questions over the sustainability of the US recovery.

David Llewellyn-Smith is the founding publisher and former global economy editor of The Diplomat magazine, Asia Pacific’s leading geo-politics and economics website. He is also the co-author of The Great Crash of 2008 with Ross Garnaut and a regular economics and markets contributor for Fairfax and the ABC. David is the editor-in-chief and publisher of MacroBusiness.