Art Micheletti, CFA, Economic Consultant and former Bailard Chief Economist
December 31, 2019
The U.S. economy continued to grow at a 2.1% annualized growth rate based on the most recent reading for the third quarter. While this was slightly higher than the 2.0% trend observed from the turn of the century, it was well below the 3.8% average growth rate from 1950 to 2000. Since the 2016 presidential election, the economy has grown at a slightly better 2.5% growth rate thanks to tax cuts that provided a one-time boost to gross domestic product (GDP) and supported by an expansion in the Federal government deficit (which has grown back to $1 trillion). Unfortunately, the impact of those recent tax cuts has faded and growth is again back to the post-2000 average. The “new normal” growth rate remains at a historically-low level.
The Atlanta Fed GDP Model has projected an annualized growth rate of 2.4% for the first quarter of 2020, whereas the New York Fed NowCast Model projected 1.5% growth. The Organisation for Economic Co-operation and Development (OECD) Leading Economic Indicator has continued to trend lower, suggesting continued slow and deteriorating growth. Over the last three months, the New York Fed Recession Probability Model decreased from a 38% probability to a 24% probability of recession in the next year. The lower probability is still at a level consistent with recession but the directional change is encouraging.
Looking at GDP composition, the consumer has continued to be the strongest sector: payrolls grew 1.5%, average hourly earnings increased 3.1% year-over-year, and the change in weekly hours held steady (all periods ending November 30, 2019). These data points are consistent with 4.5% nominal income growth and— adjusted for inflation of 2%—real income growth is running at a 2.5% rate.
Retail sales growth has slowed to a 3.3% year-over-year growth rate as of November and, after removing the impact of inflation, real growth has slowed to 1.3%. Brick-and-mortar retailers remain under downward pressure but online sales have continued to garner market share. The U.S. Department of Commerce reported that e-commerce sales accounted for 11.2% of total sales as of Q3, 2019, up from just over 4% at the beginning of 2010. Auto sales continued to trend lower overall, decreasing 1.3% in 2019, and inventories have remained higher than average. Consumer spending should remain the foundation of the economy but at a relatively slow pace.
Real Economic Growth (RGDP, %), 1950 - Q3 2019
The manufacturing sector has continued to slow. The Institute for Supply Management’s (ISM) manufacturing index came in at 47.2 for December, 2019, below the neutral threshold of 50.0 that signals a contraction. The service sector index (ISM Non- Manufacturing Index) increased 1.1 percentage points in December to 55.0. Together, the composite index of manufacturing and services remained slightly above 50.0, again reflecting a level consistent with slow growth.
The slow growth trend is evidenced by weakness in new and durable goods orders, led by civilian aircraft (Boeing). Decreases in orders tend to lead to softness in industrial production, which is down 0.75% year- over-year, as of November, 2019. Lower production has reduced inventory accumulation but inventories remained relatively high compared to sales. As of November 2019, the U.S. Census Bureau’s Inventories to Sales Ratio showed a cyclical high of 1.4 month’s supply compared to sales, a figure that suggests continued pressure on production.
Finally, corporate capital spending has continued to deteriorate even as cash flows have increased and debt accumulation continued to rise. Corporate debt remains at a historic high: corporations have continued to use their balance sheets and cash flows to buy back stock and increase dividends. While this provides liquidity in the short term, it reflects that companies are choosing not to invest in future growth.
The housing sector has improved as mortgage rates continued to decline, with the 30-year fixed rate mortgage averaging 3.99% in December. Housing starts increased 3.2% month-over-month to an annualized 1.365 million units in November of 2019, which should contribute to GDP.
Impacts of Trade Tensions
The economy continues to be hurt by weakness in world trade, which has been relatively flat since the middle of 2018 when the trade war with China escalated. Despite the removal of some tariffs as part of the recently-negotiated phase-one trade deal, tariffs remain on $300 billion of Chinese goods. Moving forward, the next round of talks is expected to tackle the large, more difficult issues of protecting intellectual property rights and removing restrictions on capital flows. Even with overall weakness, the U.S. trade deficit has been marginally improving and should contribute to GDP growth. The improvement is unfortunately due to the balance of trade as imports are declining faster than exports. The decline in exports and imports suggests both weak domestic demand (imports) and weak international demand (exports).
We believe debt accumulation continues to be the biggest problem lurking in the economic background.
We believe debt accumulation continues to be the biggest problem lurking in the economic background; without it, there would have been little real economic growth. Debt accumulation effectively pulls demand forward and borrows from future demand and leads to slower structural growth. Typically, higher debt accumulation should lead to higher interest rates, but central banks have suppressed interest rates by buying up debt, expanding their balance sheets, and printing money out of thin air. Excess liquidity has been great for financial assets and helped push interest rates to historic lows... but has done little to build a stronger foundation for long-term growth. The Congressional Budget Office has projected that the U.S. federal deficit will grow to $1.4 trillion by 2029. Relative to the size of the economy, this would average 4.3% of GDP over the next ten years, as compared to an average of 2.9% over the past 50 years.
It would appear that the setup for a near-term correction is in place given investors’ apparent complacency: market bears are few and far between, speculators are net long, short selling has plunged, stocks are over- bought, and volatility remains unusually low. These metrics are completely opposite of one year ago at the end of 2018, which then fueled 2019’s powerful rally. A setback in financial markets would likely be greeted with more monetary accommodation and, as long as investors believe, a correction could be a buying opportunity.
China’s GDP slowed to 6% growth year-over-year in 2019. This continued the steady slowdown since 2010 when growth exceeded 10% on the back of infrastructure spending; China’s fixed investment exceeded 30% growth in 2010 but has since declined to 5%. Similarly, retail sales growth has decelerated to 8% year-over-year from its high of 17.5% growth in December 2009. Industrial production over the same time period fell from 12.5% to 6.2%.
The Official NBS Manufacturing PMI in China was unchanged at 50.2 in December 2019. The Services PMI (the Official NBS Non-Manufacturing PMI) fell back to 53.5 in December, after rebounding from October lows. The move from bad to less bad, if sustained, should be positive for financial markets.
The Chinese economy continues to be weighed down by the trade war with the U.S. Both exports and imports were largely unchanged year-over-year and the trade surplus narrowed modestly, which would be expected to further pull down economic growth. Monetary policy has become more accommodative with China’s Credit Impulse gauge (i.e., the change in the growth rate of aggregate credit to GDP) increasing to 2% year-over-year in November, after being negative for the entirety of 2019.
Japan’s GDP growth expanded 1.7% year-over-year in the third quarter of 2019. However, consumer real income and spending growth have again slipped below zero and suggest little or no growth ahead. Industrial production also indicates weakness and was down 8.1% year-over-year as of November 2019. Despite weaker production, inventories have continued to rise as sales have fallen.
The consensus outlook for little to no growth is reinforced by Japan’s Manufacturing PMI, which fell again in December ending the year at 48.4, well below a neutral reading of 50.0. The same message is being sent by the Tankan survey of manufacturing that fell to zero in December. Japan’s trade balance is off its previous lows, but still in deficit territory. Like the U.S., the improvement is because imports fell faster than exports (-15.7% compared to -7.9%, respectively). The negative export growth reflects weak international growth and the negative import growth reflects domestic weakness. Both trends would likely be aided by a favorable resolution to the trade war.
Quarterly GDP growth in the Euro Area slowed to a 0.8% annualized pace in the third quarter of 2019, yielding 1.2% year-over-year. According to Citigroup, economic data is weak but above consensus expectations, and growth could modestly accelerate in the near term.
Eurozone retail sales increased modestly to 2.2% year-over-year in November, compared to the 1.4% low in October. Real industrial production decreased in October, falling to 2.2% year-over-year. The IHS Markit Eurozone Manufacturing PMI reading of 46.3 in December 2019 posted its eleventh straight month of contraction. With the Services PMI above the 50.0 threshold (at 52.8 in December), the combined reading reflects little strength in the economy.
Although new orders remained in a downtrend, they are off the lows and may provide some hope for growth if the turn can be sustained. The Eurozone trade balance with non-Euro countries remained in surplus and is trending higher. The improvement was due to a surge in exports as imports declined and will be additive to growth.
On balance, we continue to see slow growth but could get a growth surprise with a resolution of the trade war. Monetary conditions also remained positive. M2 is a measure of the money supply that includes cash, checking deposits, and easily-convertible near money. The M2 growth rate has been accelerating after having fallen considerably from late 2016 to late 2018. Negative interest rates have also been keeping the cost of capital down. The International Monetary Fund has called for more fiscal stimulus and more monetary accommodation, which hasn’t previously helped to promote long-term growth. Additionally, debt accumulation has had a temporary impact on growth but it undermines long-term growth and creates the potential for another financial crisis. For now, investors are focused on liquidity and it continues to be readily available.