Friday, May 25, 2012

The U.S. Growth Conundrum

Recently I attended an event in Boulder, Colorado where a renowned business journalist shared his views on the major economic themes of the day, including the onward march of globalization, challenges facing major developed markets and possible future sources of growth.  This gentleman is New York based and thus has his ear tuned to the city’s investment community. One of his contacts, a hedge fund manager, lamented to him that he sees GDP growth in the U.S. hovering around 2% over the next few years. Since fund managers, unlike pundits, put their money where their mouth is, that chilling scenario carried weight.

During the Q&A session, enquiries focused on the Eurozone crisis and a slowdown in China, but I wanted to return to the tepid U.S. growth outlook. Hoping that my logic had missed something, I asked for the journalist’s thoughts on potential sources of growth, which could help us escape the purgatory of 2% gains in output. My question centered on three premises: after a recession or a crisis, exports often lead countries into the promised land of recovery. Alas, compared to other industrialized powers, the U.S. is an island when it comes to foreign trade. Similarly, manufacturing, often of goods meant for export, is another source of early stage growth. But again, manufacturing has become a smaller slice of the U.S. economic pie, and alone is no longer sufficient to dramatically move the dial. Lastly, with these two realities having been abundantly clear to policy makers over the past two decades, the entire country relied upon a housing boom for recent incremental growth. We know how that ended. With foreclosure rates high, consumers deleveraging and excess housing inventory lurking in the shadows of bank balance sheets, we won’t be riding that pony again anytime soon.

As I laid out my rationale, fellow guest snarled in my direction. How dare I, especially in Boulder, voice the apostasy of not acknowledging the infallibility of the message carried in the torrent of political ads of the incipient election season? We are on the cusp of a brave new world after all. One where all Americans happily construct windmill turbines or develop algorithms….since we are so good in math… to manage the nation’s new smart grid. And there shall be a Prius…or better yet, a Chevy Volt….in every garage and an organic chicken in every pot. Fortunately the speaker was a bit more understanding, although not heartening, in his response. He simply said that the United States, throughout its history has had the ability to reinvigorate, if not reinvent, its economy much more effectively than other countries.  Nice words, but I was hoping for something a bit more tangible. It also did little to stop the hisses aimed towards me.
To buttress my defense, albeit ex post facto, this posting will dig slightly deeper into the three growth sources around which I framed my question.  The issue is of import given the backdrop in diminishing U.S. economic growth trends registered over the past few decades. As seen below, from the post WWII era through 1980 (and this includes the lean 1970’s) U.S. GDP growth averaged over 3.5%. By 1980 through the beginning of the housing crisis, average growth had dipped to nearly 3%. Even when excluding the nadir of the crisis, growth has only averaged 1.5% during this so-called recovery. Usually, this is the period when GDP exceeds the trend as consumers and businesses release pent up demand caused by delaying purchases during the downturn. Since the consumer powers 70% of the economy, and he is either deleveraging, marginally attached to the workforce or cannot get credit, we cannot expect John Q. Public to rescue us this time.

But what of manufacturing? No secret here, but services dominate the U.S. economy, comprising 80% of GDP. Over the past 30 years, manufacturing as a share of GDP has dipped from 21% to under 15%. Consequently, manufacturing jobs have atrophied. In 1971 manufacturing jobs comprised 24% of non-farm payrolls. Today it is 9%. In absolute numbers, that is over 5.3 million jobs lost (a 30% decline). Between 2007 and 2009 the market shed 2.5 million manufacturing jobs alone.  One may expect many of those losses to be cyclical rather than solely attributable to the structural decline, but since the beginning of 2010, less than 500 thousand of those positions have returned.
Even when comprising a smaller slice of GDP, manufacturing jobs are important contributors to economic growth, as many of the positions are reserved for high wage, skilled workers, who then spend their earnings on meals out, trips to Vegas and titanium-level cable TV packages. Furthermore, service companies piggy-back on manufacturing growth by providing them insurance, payroll services, software and airline tickets. So yes, there is a magnifier effect, but with only 9% of workers involved in the sector, the virtuous circle of a factory rebound felt throughout the economy is not as large as it once was. This is especially true as U.S. manufacturing is becoming more productive, which is a euphemism for automation. This means opportunities for highly-trained workers….but we’ll just need fewer of them.

With exports, as with manufacturing, there is good and bad. The good is that the U.S. still ranks as the world’s number three exporter. And like number two, Germany, we sell the high value-added capital goods that are in demand by both emerging and developed countries to drive productivity higher. Furthermore, we remain the world leader in business services exports. But like with manufacturing, the slice of the U.S. GDP pie is not large, especially when compared to other industrialized nations (see chart below).  This is important in this economic environment as the policy makers’ playbook often leans of promoting exports to pull oneself out of recession, especially when targeting regions of the world that did not endure a downturn. Indeed, during the past few years, manufacturing exports to emerging markets have been a bright spot, but as subpar GDP growth and lackluster job gains have illustrated, these segments are not sufficient to have substantial spillover effects into the broader economy and overcome countervailing forces.

Chief among these headwinds is the hangover of the housing crisis, which ironically, was the growth elixir of the preceding decade. But as a wise investor once stated, a strong housing market should be a consequence of a robust economy, not a source of it. We’ll save the nuts and bolts of the housing market for another posting. For today, it is only necessary to recognize that turbocharged and distorted housing demand, thanks to cheap credit and low standards, caused residential construction’s share of economic output to rise dramatically. From 1980 to 2000 residential construction averaged 4.2% of GDP. That climbed to 6.3% by 2005. More tellingly, from 2003 to 2005, home building on average accounted for 13% of the nation’s growth in each period. Throw in the knock off effects of outfitting the homes with carpet, furniture and flat screen TVs, not to mention houses being turned into ATM machines to purchase cars and vacations, one can see the tremendous impact the housing boom had on the broader economy. But what comes up, must come down. Mean reversion is such a callous principle. In 13 of the most recent 25 quarters, home construction has been a net negative to overall GDP growth.  With nearly 30% of mortgaged homes underwater and credit standards tight, we cannot look to housing to again rescue us as it did after the 2001 recession.

So where does this leave the United States in its efforts to not only reach the elusive escape velocity from the downturn so treasured by officials, but also in the country’s quest to maintain historical growth rates? The journalist’s comments about reinvention reflected the can-do attitude and ingenuity that signify the American experience. But past periods of strong growth were in a different world, one not of emerging global powers and heated competition for resources. Also, America of the 20th century was a leader in secondary education. Currently we rank 17th in science and 25th in math out of the 34 industrialized countries in the OECD. This must improve if the country is to produce the next batch of knowledge workers and entrepreneurs who will drive global productivity higher.  Years ago, this concept was similarly framed by local high level executive who has conducted business throughout the world. She said that the U.S. separates itself from the rest of the world by its freedom, flexibility and innovation. To that, being the investment guy, I added financing.  Our risk-taking culture provides a necessary fuel…capital….for nascent firms to implement their ideas. But as a foundering educational system undermines some of these differentiators…especially innovation….the national fiscal situation and a new wave of government regulation may stymie others of these historical competitive advantages

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