After writing (ad nauseum) last week about developments in the Eurozone, we return to the status of the U.S. economic recovery, which, it can be argued, is a liberal use of the term recovery. Where are we? Is the economy expanding, stalling or (heavens!) settling into a malaise-inducing new normal? These are questions on the forefront of the minds of investors, consumers, business leaders and policy makers. Usually, 11 quarters after the minds at the NBER call an end to a recession, the economy is racking up impressive data flow. Although there have been a few strong numbers registered in certain pockets (e.g. exports), momentum has repeatedly tapered off. Further clouding the picture is the origin of the recession (a housing bust), which usually takes longer to find a floor than a run-of-the-mill excess-inventory and rate-hike driven recession. Distortions rattling around financial markets and the real economy due to unprecedented policy responses meant to combat such a deep and long-lasting slowdown only add to the uncertainty. Results of initiatives such as cash for clunkers, first-time home-buyer tax exemptions and others, have pulled forward certain activities like home and auto purchases, robbing growth from future quarters. At the same time the Fed’s rock-bottom interest rates have pushed investors into higher yielding corners of financial markets, potentially creating asset bubbles disconnected from valuation fundamentals.
The uncertainty about our location in the business cycle complicates the planning of corporations considering ramping up capital expenditure and hiring, investors when determining which asset classes and sectors in which to rotate, and consumers as they consider their future earning power before opening up the purse strings. Competing interpretations the economy’s position and future prospects will likely monopolize the airwaves over the coming months in advance of November’s pivotal election.It’s physics….well not really.
Basic physics teaches us that every action has an equal but opposite reaction. While hardly applicable to a behavioral science such as economics, when it comes to recessions and ensuing recoveries, the principal roughly applies. Deep recessions are usually marked by equally robust periods of expansion. The rationale is fairly simple. As economies slow and credit contracts, companies and consumers, in face of the unknown, put off purchases. Eventually…usually after interest rates fall in order to spur investment…this pent up demand is unleashed. Overused factory equipment is replaced and consumers, sick of donning threadbare socks and driving cars held together by duct tape, hit the malls. Over the past two decades…roughly the period described by Alan Greenspan as the great moderation…recessions have been shallow and recoveries equally temperate, but predictable. Not so this time around. As seen in the chart below, in the 11 quarters since the recession was nominally called over, growth has averaged 2.4 %. After the ’91 recession, quarterly GDP growth (annualized) averaged 3.1% over the next 11 quarters. Post 2001 recession, it registered 2.9%. The mirror-image trajectory premise has not panned out this time around. Theories as to why abound. Two obvious culprits are the continued deleveraging of the consumer, which is further magnified by the tighter credit conditions extended to them as well as to the small-business growth engine of the economy. Regulatory uncertainty, potential repercussions of the Fed’s easy monetary policy, and the much harped about 2013 fiscal cliff, have also likely played roles.
The ability of an economy to make up for lost ground post-recession has resulted in the establishment of a fairly consistent pattern of GDP growth. This is illustrated by the trend-line in the chart below. When a deviation from the trend occurs (i.e. a recession), it can be followed by one of three possible outcomes. As explained in the section above, the economy can play catch-up by experiencing a period of above average growth. The result is the trend being maintained. A second scenario is the eventual return to long-term growth rates, but without the initial period of excessive growth driven by pent-up demand. Although long-term rates are maintained, the economy tracks below the established trend-line, resulting in a steady gap between current growth and the lost potential of the earlier trajectory. We’ll call this the what might have been scenario. The final possibility is no period of initial excessive growth coupled with the establishment of a new, lower growth rate. Here the divergence between the original trend and new trajectory continues to widen. Although maybe not as cataclysmic as the Decline and Fall of the Roman Empire, this scenario could be used to describe the slowing of western Europe’s economy after its post-World War II multi-decade economic miracle.
During America’s recent great moderation, deviations from the trend were minor. It does not take a Nobel Prize winner in economics to notice something is awry with the current gap (see chart). If either of the two latter scenarios plays out, the result could be trillions of dollars of lost production over the next few decades. Possible consequences of this include even weaker wage growth than present, a lower standard of living, lower corporate earnings and thus weaker performance by financial markets.
Another concept along similar lines is that of an economy’s output gap. This is the difference between the pace at which the economy is running and its optimal output. Divining what actually is the optimal output is complicated and there are various competing models. The chart below is based on IMF assumptions, but likely other models, such as that of the Congressional Budget Office, show similar results. When the economy is running close to maximum output, resources are being used efficiently and there is little spare capacity. Should the economy overheat and growth exceed the optimal level, demand for finite resources (labor and materials) will increase price pressures and excess production may eventually result in a glut of goods, thus spurring an inventory-driven slowdown.
That is not the case presently. Slow GDP growth means that the U.S. has plenty of room to expand before its economy is anywhere close to overheating. This is relevant today for two major reasons. Limited pricing pressure from inputs (now that the 2011 energy spike due to the Arab Spring has subsided) and substantial idle capacity means that the Fed believes it has maneuvering room to launch another round of quantitative easing to spur growth….since the first two rounds worked so well….without unleashing inflationary pressure. The other reason why the large output gap matters is that much of that idle capacity is in the form of displaced workers.The Jobs Picture (Another Maalox Moment)
As alarming as the previous charts are, the one below is really the gut-wrencher as it concerns the livelihoods of American workers….millions of them. When the term jobless recovery entered the vernacular a few decades back, it was referred to as an annoyance, such as the common cold: uncomfortable for a while, then gradually going away. Now it is more akin to a debilitating illness, defying all known treatment. At its nadir, the U.S. economy had shed over 8.4 million jobs. Since the beginning of 2010, it has clawed back only 3.7 million of them. The rule-of-thumb is that the economy must add 125,000 to 150,000 jobs per month just to keep up with population growth. Using the north end of that range, it would take 33 months for the U.S. to winnow away the remaining five million jobs that were lost during the recession. Using the average payroll gain recorded since the beginning of 2010 (115k/month), it would take 44 months.
Other employment data are equally nauseating. The unemployment rate stands at 8.2%, but that is partly a consequence of the labor force having dwindled to levels not seen since 1983. The labor force participation rate currently stands at 63.8%, down from a pre-crisis level of 66.8%. Should so many workers not have left the labor market, the unemployment rate would be well north of 10%. Another measure of the underutilized workforce is the U-6 rate, which combines the unemployed along with those marginally attached to the workforce (e.g. part-timers who’d prefer a steadier gig). That number has dipped from a crisis high of 17.2% to 14.8%, but still well above the 18-year average of 10.3%. And maybe most troubling is the duration of unemployment. Of those unemployed, nearly 43% have been out of a job for 27 weeks or longer, twice the long-term average. Again referring to Mr. Greenspan, the former Fed Chairman postulates that overall economic potential is diminished as idled workers’ skills atrophy, motivation is lost, earning power is weakened and many drop out of the workforce permanently, often choosing to apply for long-term disability benefits or live off savings…which have been battered (refer to last week’s Fed report that shows the net worth of the American household has taken a 39% hit over the past few years).
Given that consumer spending accounts for 70% of the U.S. economy, the fact that so many Americans are either officially unemployed (thus counted as such), marginally employed or have left the labor market entirely, any chance of a robust consumer-driven rebound is diminished. Such a predicament is manifested in various consumer surveys. Although one may dismiss such reports as soft data and instead cast his attention to durable goods orders or the sports page, sentiment actually matters. A glum population, unsure of their future employment status, with dramatically lower net worth and lack of access to credit, is not likely to ramp up purchases anytime soon. Other headline risk such as fights over budget ceilings, government debt and regulatory uncertainty only add to the apprehension. The Consumer Sentiment Survey below shows that although attitudes have recently risen from their crisis lows, at 79.3, the May reading is still well below the long term average.