Sustainability concerns for America
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Economic numbers for America look encouraging and markets are pointing towards a rate hike by the Federal Reserve, but a closer look suggests the recovery may not be sustainable yet.
Ana Cukic Armstrong is a managing partner at Armstrong Investment Managers
Headline economic numbers coming out of America have looked very good over the past nine months. Based largely on these numbers, markets seem to be pricing in a continuation of a strong V-shaped recovery. But investors should look beyond the headline numbers, and investigate what drove the stated economic growth of 3.5% and 5.9%, in the third and fourth quarters of 2009 respectively.
”A casual glance at the current make-up of GDP should make even the most optimistic bull shudder with self doubt”
A casual glance at the current make-up of GDP should make even the most optimistic bull shudder with self doubt. Increased government spending and a less-negative trade balance were the drivers of third-quarter growth. The reduction of the trade deficit is simply a function of a fall-off in the American consumer, resulting in fewer imports.
Government spending cannot continue at its current rate, as it is approaching a 10% annual deficit. In the fourth quarter, 3.8 percentage points of the 5.9% growth came from an inventory adjustment - growth from businesses restocking shelves and warehouses, not from selling merchandise. This type of growth will not lead to a sustainable recovery and the reasonable conclusion drawn from recent economic data should be one of concern about the viability of the “recovery”. (article continues below)
Optimists will say the consumer is showing some signs of strength. February consumption data does look more encouraging than it did in the middle of last year, but 2010 consumption has not come from higher incomes - it has been driven by lower savings rates.
Consumption cannot drive economic growth much further as it already represents an unprecedented level as a proportion of the American economy.
This leaves investment as the area where sustainable growth can be generated. Investment is an important part of the engine which can drive a viable recovery, but unfortunately it is not taking place.
Investment as a percentage of GDP is at a 60-year low and represents only 11% of the American economy. This compares with a mean of 16% since 1950, and prior to 2009 it never fell below 13%. In absolute terms it has fallen from almost $2.4 trillion (£1.6 trillion) in the second quarter of 2006, to $1.5 trillion. This takes us back to the level of investment in the economy in the fourth quarter of 1998. There has been much talk about the lost decade for stockmarkets, but there have been two decades without nominal growth in investment, and a quarter of a century without any real growth in investment.
Markets seems to be focusing on the positive, and cyclical equities have doubled in value during the past year. Consensus numbers and the futures markets are pointing towards a series of rate hikes by America’s Federal Reserve starting in August, based on expected economic strength.
The Fed will not be able to raise rates as quickly as the market anticipates. High unemployment, and the potential for a double-dip is suppressing immediate inflationary concerns. Unemployment is a lagging indicator, but generally the economy starts to produce new jobs within three months of a recovery. The American economy has finally shown a monthly increase in jobs created, but the unemployment rate is not improving, as there are new participants in the job market.
The Taylor Rule is a monetary policy rule that indicates how the central bank should set the nominal interest rate, as a response to divergences of actual inflation rates from its target inflation rate, and of actual GDP from potential GDP.
The chart below shows how the Taylor Rule has historically been a useful estimate of the Fed’s actual interest rate policy. Using estimates of targeted real rate and target inflation rate, the Taylor Rule is currently recommending negative interest rates to the Fed. Based on this, the market is wrong on the anticipated rate hikes. Using the rule, unemployment would need to fall towards 7.5% before the Fed should raise interest rates. Even with what we consider to be overly-optimistic forecasts on employment, the Taylor Rule will not recommend rate hikes in 2010.
The implication of this is a steeper yield curve than the market expects. Despite the weak economic conditions in the medium term, the massive increase in American government borrowing seen in recent years will inevitably lead to a surge in Treasury yields in the long term.
It is also not just the bond market that is unjustifiably bullish on the sustained recovery expectation. Corporate profits look set to continue to improve as labour cost remains subdued. However, S&P 500 bottom-up earnings estimates for 2010 for over 35% growth will not come close to being achieved.
