The Growing Deficit

September 19, 2018

The U.S. federal government reported last week that it ran a deficit of $214 billion in August, the fifth largest deficit for any single month in US history.

The Congressional Budget Office thinks these numbers are consistent with a budget deficit of about $800 billion for Fiscal Year 2018, which ends September 30. If so, that would be the largest annual deficit in raw dollar terms since FY 2012. This deficit is roughly 4.0% of GDP, which would be the highest since FY 2013.

For many, this growing deficit is a dagger to the heart of the tax cut enacted in late 2017. They say the tax cut was irresponsible. However, economic growth has picked up because of the tax cut, and growth is the key to higher fiscal receipts down the road – in fact tax receipts are still hitting record highs.

Between 2010 and 2017, the U.S. passed two large tax hikes, yet the deficit was still $665 billion in FY 2017, which was not exactly a model of fiscal purity. As a result, we call “politics” on all those now fretting about deficit spending only when a tax cut is involved.

It’s important to recognize that the tax cut has, so far, reduced revenue compared to how much the federal government would have collected in the absence of the tax cut. But, total federal receipts are likely to end the current Fiscal Year up slightly from last year and at a record high. Next year, according to the CBO, revenue should be up 4.6% and at another record high.

In other words, the tax cut didn’t lead to an outright reduction in revenue, it just slowed the growth of revenue.

Spending is the problem. Total federal spending will rise about 4% this year and is scheduled to rise about 8% next year. In spite of an acceleration in economic growth, government spending is rising faster than GDP.

While this is a long-term problem, it will not turn the U.S. into Greece overnight. No fiscal crisis for the nation is at hand. Last year, net interest on the federal debt amounted to 1.4% of GDP. The Congressional Budget Office projects that net interest will hit 2.9% of GDP before some of the tax cuts theoretically expire in the middle of the next decade.

That is a large increase, but net interest relative to GDP hovered between 2.5% and 3.2% from 1982 through 1998. The U.S. paid this price and the economy still grew more rapidly than it has in the past decade. The U.S. didn’t become Greece.

Compare two economies of equal size. One spends $500 billion, but with zero taxes, the other spends $2 trillion, but taxes $1.5 trillion. Both have $500 billion deficits, but the first economy would be more vibrant and could finance the debt more easily. It’s not that deficits don’t matter, but deficits alone are not a reason for investors to run for the hills.

And when deficits are partly caused by more federal spending on interest payments you know who will hate it the most? The politicians.

Here’s why. Politicians like to deliver things their constituents are grateful for, things that make voters more likely to vote for them rather than someone else. Tax cuts help politicians get more votes, at least from those who actually pay taxes. Government programs can also help incumbents corral votes. Pass out government checks and you can get more votes, too. But bondholders have no gratitude for politicians when they receive the interest they’re owed on Treasury securities.

Higher net interest payments will eventually “crowd out” future tax cuts and government programs, making it tougher for incumbents to get re-elected. As net interest payments rise, more politicians will start obsessing about the deficit again, just like in the 1980s and 1990s.

The true threat to long-term fiscal health is spending. If left unreformed, entitlement programs like Social Security, Medicare, and Medicaid will take a ceaselessly higher share of GDP, leading to a larger and larger share of American production being allocated according to political gamesmanship rather than individual initiative, in turn eroding the character of the American people.

Unless we change the path of spending, last year’s tax cuts – and the boost to economic growth they’ve already provided – risk getting overwhelmed in the long run. But, for investors, this isn’t an immediate problem. After all, deficit fears have been around for decades and equities still rose. Stay bullish, for now.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Wage Growth Steps Up

September 12, 2018

Friday’s jobs report finally included what appears to be evidence of the long-awaited acceleration in wage growth.

Average hourly earnings grew 0.4% in August, which meant they were up 2.9% from a year ago, the largest 12-month increase since the economic recovery started in mid-2009. By contrast, these wages were up 2.6% in the 12-months ending in August 2017. Moreover, this measure of wages doesn’t include extra earnings from irregular bonuses and commissions, like those paid out since the tax cut was passed late last year.

Total wages, which factors in both average hourly earnings as well as the total number of hours worked, are up 5.1% in the past year, meaning consumers have plenty of earnings to keep increasing spending.

Nonetheless, many still argue that the 2018 corporate tax cut didn’t help workers. Nothing could be further from the truth. In December 2017, figures on average weekly earnings as well as private payrolls suggested private-sector workers were earning wages at a $6.0 trillion annual rate. In August, those total wages had increased to a $6.2 trillion annual rate – a boost of $200 billion per year. By contrast, corporate profits – which have also grown rapidly – were up by just $100 billion annualized from the end of 2017 through the second quarter. Workers have taken home two times more than companies!

When hit with this data, the anti-tax cutters argue that this increase in wages has been concentrated at the top of the pay-scale. The rich are getting richer and the tax cuts haven’t helped lower to middle income workers. Guess what? This isn’t true, either.

Usual earnings for the median full-time wage & salary worker grew 2.0% in the year ending in the second quarter this year. But these earnings grew 3.9% for workers at the bottom 10th percentile, while workers at the top 10th percentile had their usual earnings grow only 1.2%. Usual earnings for people who never finished high school are up 7.6% in the past year, faster growth than for any other educational category.

Put it all together and we have a labor market that is already tight and set to get tighter. Back in June, the Federal Reserve projected an average unemployment rate of 3.6% in the fourth quarter of this year and 3.5% in the fourth quarter of 2019 and 2020. The projection for this year sounds about right, but we’re forecasting a jobless rate of 3.2% by the end of 2019 and 3.0% in 2020. Either way, wages are likely to keep growing at an accelerating pace in the next few years.

That means the Fed will likely remain more aggressive with their rate hikes than the market is now projecting, but don’t fret. Even with our more aggressive forecasted path of two more 25 bps rate hikes this year and four next year, the Fed will still not be “tight.”

Tax cuts and deregulation have turned the Plow Horse Economy into a Kevlar Economy for the foreseeable future. And if we get trade deals that reduce tariffs along with some real focus on limiting government spending, the strength of this economy could make Superman jealous.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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The Week Ahead

September 6, 2018

In spite of woeful prognostications to the contrary, the US economy seems to be wearing Kevlar. Rate hikes, tariffs, Turkey, you name the fear, the economy remains unscathed. Case in point, through all the supposed turmoil, the U.S. grew at a 4.2% annual rate in the second quarter and looks set for a similar pace in Q3.

We get a boatload of economic data this week, including the ISM indexes for both manufacturing and services, as well as data on construction, auto sales, and, of course, Friday’s employment report. While we expect the data to continue painting a picture of robust economic growth, data are, as we all know, volatile.

While today’s ISM Manufacturing report was white-hot – the highest so far this expansion – we also expect gains in the Services index later this week, and car and light truck sales to be so-so, clocking in at a 16.8 million annual pace in August versus a 17.3 million pace in the past year.

The one piece of data we think could disappoint is the headline employment number out Friday. In recent years, August employment data have been prone to disappointment, with the initial report leading to unnecessary fears of an economic slowdown.

Back in September 2011, for example, we got a payroll report that showed zero nonfarm payroll growth for August. That’s right: a big fat goose-egg. The S&P 500 fell 2.5%. Some even talked openly of entering the long-awaited “double-dip” recession. But just two months later, the report was upgraded to 104,000. Now, after multiple annual revisions, the government says 112,000 jobs.

And 2011 wasn’t an anomaly. August payroll growth has fallen short of consensus expectations for seven years in a row. And just about every time, the pouting pundits have taken it as a bearish economic signal.

The jobless rate shows some seasonal distortions, as well. The unemployment rate finished 2009 at 9.9%. Since then it’s dropped to 3.9%, down 6.0 points, or an average of 0.06 points per month. So take any calendar month over the past 8½ years and the unemployment fell on average 0.5 points. But for August, the unemployment rate has dropped a grand total of only 0.1 point – we’re not sure why, but that’s the data.

As a result, our forecast is that payroll growth for August will be a little softer than the consensus expects (and will be revised higher in the months ahead) and the jobless rate is going to stay unchanged at 3.9%, versus consensus expectations of a drop to 3.8%.

The key thing to remember is that if we’re right – and, obviously, we hope the report is better than we expect! – you shouldn’t get caught up in any pessimistic story you hear from the doomsayers. For the time being, the US has strengthened from a Plow Horse Economy to the Kevlar Economy, and none of these reports are likely to change that one iota.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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US Stops Subsidizing Global Growth

August 29, 2018

For decades the United States has, directly and indirectly, subsidized global growth. For example, after World War II, the U.S. provided direct economic aid to Western Europe with the Marshall Plan, while also helping to rebuild Japan. And since then, we have provided never-ending direct aid to foreign countries, which has been a constant political football.

But in the economic scheme of things, the biggest subsidies of all have been indirect. For decades the U.S. has held trade tariffs below those of most foreign countries. And until recently, the U.S. has maintained a corporate tax rate significantly above the world average. At the same time, the U.S. hindered, through regulation, its production of energy.

According to the World Trade Organization, before the Trump tariffs were put in place, the U.S. had an average tariff of 3.4%. Canada had an average tariff of 4.0%, the EU 5.1%, Mexico 6.9%, China 9.8%, and South Korea 13.7% – all higher than the U.S., which means the playing field was tilted in favor of foreign countries. The U.S. was subsidizing them.

In 1993, America lifted its federal corporate tax rate to 35%, from 34%. When combined with state and local corporate taxes, the average rate was 38.9% and held there until the Trump tax cut in 2017. In 1993, the average worldwide corporate tax rate was roughly 33% (about 6 percentage points below the U.S.) and by 2017, the average had fallen to 23% (about 16 points below the U.S.). In other words, at the margin, businesses looking to invest globally had an incentive to invest outside of America.

The slowing of energy production in America became a direct subsidy to those who produce energy. Russia, Saudi Arabia and the Middle East, Venezuela and Mexico all benefited as the U.S. bought most of its crude oil from overseas.

But things have changed – in a huge way. The geopolitical implications of this are coursing through the world right now. In some places, like Venezuela, it’s an economic crisis. In others, like China, it’s reflected in slowing economic growth. And if anyone doesn’t understand the relationship between fracking and the fact that women in Saudi Arabia will be allowed to drive, they aren’t thinking hard enough.

But, more to the point, cutting the U.S. corporate tax rate to 21% and boosting tariffs on select countries and products is removing a huge subsidy to growth for the rest of the world. The U.S. is the dominant economy in the world and when it stops subsidizing foreign countries, who have not followed free market principles, economic pain spreads.

The U.S. has become not only the largest producer of petroleum products in the world, but a net exporter to some regions. And output keeps going up. This is altering the balance of world power in a huge way.

The impact of all this is to put pressure on other countries to come back to the table and talk about more equal trade. It also forces countries that previously were able to have high income tax rates, huge government budgets, and lots of red tape to rethink their fiscal policies. The global establishment have never been under attack like they are today. The world order is changing for the better.

This means the U.S. economy and its stock markets are in better shape relative to others. However, if these pressures really do lead to more freedom and less political interference in economic activity, the world could end up seeing a boom like it did in the 1980s, when Reagan’s tax cuts led other countries to follow suit.

While news shifts rapidly, the pressures we outlined above already seems to have pushed Europe, Mexico, Canada, and China to negotiate on trade. We think this will eventually lead to lower tariffs, not a full-blown trade war. After all, because the U.S. is removing a subsidy to these countries, their growth will suffer relatively more. They have an incentive to follow better policies.

No one knows exactly how this will turn out, or whether the establishment will fight back and find a way to resist change. But, for now, the U.S. is benefiting from an increase in investment and growth due to better policies.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Capitalism Works, Don’t Change It

August 22, 2018

“Wealth creation” versus “the redistribution of wealth” is an age-old political/economic battle. And once again, Senator Elizabeth Warren – among others – has capitalism in the crosshairs.

Adam Smith defended capitalism in 1776. Karl Marx attacked it in the 1800s. William Jennings Bryant attacked it; Grover Cleveland defended it. FDR attacked it; Ronald Reagan defended it. And, today, the battle goes on, with many Democrats openly promoting socialism.

Elizabeth Warren wants her own “new deal”, employee-elected board members and companies responsible to communities over shareholders. She complains about “short-termism” – quarterly reporting that makes companies only worry about the bottom line in three-month periods. Even President Trump has weighed in; after talking with the CEO of Pepsi, he has suggested six-month reporting cycles.

We don’t disagree that some companies make decisions to “hit” quarterly earnings targets. Many believe privately-held companies often make better long-term decisions because they aren’t kowtowing to analysts. But, Warren Buffet downplays his quarterly reports and the stock market hasn’t punished Berkshire Hathaway. And don’t think private companies ignore their monthly, or even weekly, results. They don’t.

We’re not arguing that freedom shouldn’t be applied. If companies want to report every six months, let them. But, our bet is that the market wouldn’t like that. Investors deserve timely information. Even today, companies are free to say “we aren’t managing to quarterly data.” Let the market decide what matters. Let companies experiment. But more information, not less, is almost always better.

Over the years, political attacks on companies for short-termism have come and gone. We find this disingenuous. Washington DC, and many state capitals, make a complete mockery of fiduciary responsibility. Budgets haven’t been balanced in decades, and after eight years of economic recovery (and even before the recent tax cut) the budget deficit in 2017 was still over $650 billion. Not even Keynes would stand for that.

And Congress isn’t on a quarterly reporting cycle. Politicians report to the people in 2-, 4- and 6-year cycles. Yet, Congress can’t balance its budget, or in many recent years, even produce a budget. We find it fascinating (to put it nicely) that politicians who have shown such incredible fiduciary irresponsibility would even attempt to reform a system – The Capitalist System – that has produced unfathomable wealth and higher standards of living for so many. Before the nation debates a takeover of corporations by political fiat, maybe Congress should get its own house in order.

Senator Warren has proposed The Accountable Capitalism Act. Her Act would allow “stakeholders,” which include employees, and unstated others, to sue companies if they think they are not sharing profits equally with other stakeholders.

This is a terrible idea. Corporations provide products to consumers, and profits are simply a sign they are doing it effectively. As long as there is freedom for capital to move, for people to change jobs, and for investors to choose what to invest in, then the system holds no one hostage. As long as contracts are fairly enforced, the system remains equitable.

Profit signals opportunity. Profit signals growth. Some are complaining that corporations are returning too much of their profits to shareholders, but without these investors there would be no company in the first place – and far fewer jobs. In fact, today there are more unfilled jobs in America than there are unemployed Americans. In other words, workers have choices and companies must work hard to attract labor.

Senator Warren, and others, complain that profits are up while wages are stagnant. In her Wall Street Journal Op-Ed, she said “In the early 1980s, large American companies sent less than half their earnings to shareholders, spending the rest on their employees and other priorities. But, between 2007 and 2016, [they] dedicated 93% of their earnings to shareholders.”

The data doesn’t support this. Real average hourly earnings fell 7.3% from January 1980 to January 1995, while they rose 7.3% from December 2006 to December 2017.

Profits are the lifeblood of capitalism. Reporting them, earning them, and returning those profits to shareholders creates more investment, more wage growth, and more wealth creation. Politicians can’t balance a budget. Why would a sane electorate give them even more control of private wealth?

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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The Kevlar Economy

August 14, 2018

Since March of 2009, the predictions of economic, and stock market collapse have been non-stop.  Doom-and-gloomers have been unrelenting.  And it’s doubly frustrating since you can’t disprove a negative until it doesn’t happen.

We have written hundreds of pieces since the recovery – and bull market – began, arguing that the pessimism was unjustified.  We’ve argued that Brexit, Grexit, resetting ARMs, student loans, government debt, Obamacare, no QE4, tapering,…etc., would not stop growth.  The doomsayers have been wrong. Constantly.  For our troubles we get labeled “perma-bulls”, despite our arguments proving true.  Meanwhile, the “perma-bears” have never had to answer for their fallacious forecasts.

Now they’re talking Turkey, tariffs, a strengthening dollar, China selling US debt, Fed rate hikes.  They never give up.  But, we still aren’t worried. 

The United States, for the time being, is a Kevlar economy.  It’s practically bulletproof.  By allowing other counties to maintain higher tariffs, America, the world’s biggest consumer, has helped those countries grow.  By holding corporate tax rates higher than most other countries, the US has subsidized non-US growth.

But under new management, the self-sabotage is being eliminated.  Cutting corporate tax rates and reducing regulation have made the US more competitive.  No, we are not ignoring the negative impact of tariffs on some US producers and consumers, but tariffs hurt foreign countries more than they hurt America.

Countries without the Constitutional rule of law, property rights and true free markets need foreign help to grow.  The US is removing some of that help in making itself more competitive.  As a result, the US will continue to grow, while other countries suffer a loss of investment and sales.  Once again doomsayers will be proven wrong.

Yes, it’s true that a slowdown in the growth of other countries can impact corporate earnings, or even have some impact on US growth, but the damage will not be nearly as great as the pouting pundits proclaim.  We still forecast 3%+ real GDP growth over the next few years, along with continued jobs growth and the lowest unemployment rate in decades. 

Doomsayers, take note.  There are five real threats to prosperity: 1) Excessively tight Fed policy.  2) Excessive government spending.  3) Excessive regulation.  4) Tax Hikes and 5) Trade protectionism.

Right now, the Fed is not tight, far from it.  Government spending is too high, that’s why growth isn’t even higher.  The Regulatory environment is improving.  Tax rates have been cut and are not likely to be hiked anytime soon.  Finally, tariffs are going up, but by a much smaller amount than taxes were cut.  We also do not expect a protracted trade war because that would harm other countries much more than the US.  Ultimately, we expect deals to bring tariffs down.

In other words, of the five threats, two are negatives (with trade likely to turn) and three are positives – and don’t forget new and unbelievably positive technologies!  Someday, a recession will happen again, but for now the Kevlar economy will only get stronger.   

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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No Recipe for Weak Housing

August 7, 2018

Something strange happened after last Friday’s jobs report – the yield on the 10-year Treasury Note fell, finishing Friday at 2.95%, down four basis points from Thursday’s close.  To us, this makes no sense. If anything, it serves to reinforce our view that the bond market is making a big mistake. 

Yes, we realize that July nonfarm payrolls (at +157,000) were lighter than the consensus expected 193,000.  But, as we wrote in our Data Watch, May and June were revised upward by a total of 59,000.  In other words, July payrolls were 216,000 higher than the Labor Department estimated in June.  If we assume these new workers make the average weekly wage, that equals $10.5 billion more in annualized earnings for American workers (216,000 x $933.23 x 52) – in just one month!

Meanwhile, civilian employment (an alternative measure of jobs that includes small-business start-ups) rose 389,000 in July, helping push the jobless rate down to 3.9%.  Even more impressive, the U-6 unemployment rate – what some people refer to as the “true” rate, which includes discouraged and marginally-attached workers as well as and those with part-time jobs who say they want full-time work – fell to 7.5%, the lowest reading since 2001. 

The Hispanic unemployment rate dropped to 4.5% in July, the lowest on record dating back to the early 1970s.  At 6.6%, the black jobless rate was not at a record low, however, these figures are volatile from month to month and have averaged 6.9% in the past year, the lowest 12-month average on record.  Notably, the unemployment rate among those age 25+ who never finished high school is 5.1%, also the lowest on record dating back to the early 1990s.  You sensing a trend?   

Put it all together and we see plenty of reasons to be optimistic about economic growth in the third quarter.  It’s early, but right now we’re tracking 4.5% real GDP growth in Q3, which would boost the year-over-year increase to 3.3%.  Some analysts tried to discount the growth in the second quarter because of a surge in exports, but we think the more important quirk in Q2 was that companies reduced inventories at the fastest pace since 2009.  A return to a more normal pace of inventory accumulation means a large boost to growth in Q3, more than offsetting any impact from trade.               

The conventional wisdom just can’t wrap their collective heads around the idea that tax cuts and deregulation are truly boosting underlying growth.  And, like much of the previous nine years, keep looking for a reason to be bearish about the economy.  This time they think housing will collapse.  After all, housing starts fell in June, so did new home sales, and existing home sales have fallen for three straight months.

That said, it’s too early to rule out that this is simply statistical noise.  These figures will go through some quite substantial revisions in the months and even years ahead.  The softness could be completely revised away.      

And remember, home building is still below fundamental levels, based on population growth and scrappage.  The US has about 138 million housing units, so annual population growth of 0.7% per year suggests we need to build about 950,000 new housing units per year (0.7% of 138 million).  Add to that homes replaced due to scrappage (voluntary knock-downs, fires, floods, hurricanes, tornadoes) and the 1.25 million housing starts of the past year simply isn’t enough.             

Finally, while higher mortgage rates would pose a problem for homebuyers if everything else were unchanged, that’s not the case.  Mortgage rates have moved higher because of faster anticipated economic growth.  In that environment, mortgage rates should be higher, and home-buying should move higher as well.  An economy with 3% real GDP growth and a jobless rate below 4% is going to create more buyers than the Plow Horse economy that prevailed from mid-2009 through the start of 2017.

In spite of our optimism, one of the things we know for sure about the next couple of years is that, from time to time, one part of the economy (or more) will lag others.  We expect the pouting pundits to use that weakness to predict doom and gloom.  We can’t prove they will be wrong, just like we can’t “prove” the sun will come up tomorrow.  But, for the past nine years we’ve disagreed with the pessimism, and we still do.  The economy – and housing – will continue to grow.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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The Economic Surge

August 2, 2018

Paul Krugman, Larry Summers and Bob Gordon have some ‘splainin to do.  Where’s that “secular stagnation?” 

Since 2009, they, along with many others, have said the US economy is stuck at 2% real growth.  Their theory got traction after 2009, as the U.S. saw what we called a Plow Horse Economy.

But, we never believed slow growth was permanent.  The real problem was the size of government – too much spending, too much regulation and excessively high tax rates were holding the economy back.  We believed the idea of “secular stagnation” was another Keynesian red herring, designed to hide the damage government was doing and fool people into accepting slow growth as something that couldn’t be fixed. 

But after cutting tax rates and regulation, Friday’s GDP report demolished their theory.  Real GDP grew at a 4.1% annual rate in the second quarter, and is up 2.8% in the past year.   And although some analysts pointed out that net exports were an unusually large boost in Q2, they ignored that inventories were an unusually large drag (the largest drop since late 2009).  As a result, our initial forecast for real GDP growth in Q3 is 4.5%, even faster than was just reported for Q2. 

So now some of the same people who said the economy couldn’t grow any faster are saying that the acceleration in growth is just temporary, due to tax cuts.  While we certainly agree that tax cuts boost growth, we think the change is more than temporary, particularly due to the cut in the corporate tax rate and the move to full expensing of plant and equipment.  Not only has real GDP growth picked up, “potential” GDP growth has accelerated, as well.

Potential growth is a term economists use to mean how fast the economy would grow if the unemployment rate remains steady.  We calculate it by using “Okun’s Law,” named after economist Arthur Okun, President Lyndon Johnson’s chief economist.  Okun’s Law says that for every 1% per year the economy grows faster than its potential rate, the jobless rate will drop by 0.5 points.      

Working backward from the unemployment rate declines of recent years shows that potential GDP growth has picked up.  From mid-2010 thru mid-2017, Okun’s Law said potential real GDP grew at just a 0.6% annual rate.  But in the past year, potential GDP has risen to 2.0%, and signs suggest it’s moving higher.      

Maybe this is a statistical fluke that will fade away over the coming years, but it sure looks like something changed a year ago. Deregulation and tax cuts are boosting growth, and the Keynesians are back to the drawing board.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Economy Surges in Q2

July 25, 2018

Economic growth surged in the second quarter this year.  The only question is, by how much?

Predicting this Friday’s GDP report is trickier than usual.  First, it’s the initial report for the quarter.  Second, we have to wait until Thursday for key data on exports and imports, which is particularly important because the trade sector looks to have had an unusually large influence on second quarter growth.  And third, this is the release each year where the government goes back several years and makes revisions to its methods and calculations.

Over recent years, GDP releases have suffered from problems with “seasonality.”  For example, over the past eight years, real GDP has grown at a 2.2% annual rate.  But the average annualized growth rate in the first quarter each year has been 1.3%, while the second quarter has averaged 2.8%.  The government is supposed to apply seasonal adjustments to make sure normal winter weather doesn’t artificially drive down GDP growth, but apparently those adjustments haven’t been working.

So what happens if the government fixes this problem, resulting in upward revisions to Q1 growth rates and slower growth rates in Q2?  We have no way of knowing if the government plans to tweak their methodology and, if so, by how much.  As a result, our forecast faces atypical risks.

All that said – and keeping in mind that we might make adjustments when we get Thursday’s data on durable goods, inventories, and trade – our forecast for real GDP growth in Q2 stands at 4.8%.  If so, and assuming no net revisions to recent quarters, real GDP growth would be at a 3.4% annual rate so far this year and 3.2% in the past year. 

Here’s how we get to 4.8%: 

Consumption:  Automakers reported car and light truck sales declined at a 1.4% annual rate in Q2.  Meanwhile, “real” (inflation-adjusted) retail sales outside the auto sector grew at a 6.0% annual rate.  However most consumer spending is on services, and growth in services was moderate.  Our models suggest real personal consumption (goods and services combined), grew at a 3.2% annual rate, contributing 2.2 points to the real GDP growth rate (3.2 times the consumption share of GDP, which is 69%, equals 2.2).

Business Investment:  It looks like another quarter of solid growth, with commercial construction growing at a 10% annual rate, equipment investment growing at about a 2% rate, and intellectual property growing at a trend rate of 5%.  Together, that means business investment grew at a 4.5% rate, which should add 0.6 points to real GDP growth.  (4.5 times the 13% business investment share of GDP equals 0.6). 

Home Building:  Residential construction paused in Q2, although we think the recovery in this sector will pick right back up in Q3.  For the time being, though, the sector will have no impact on the real GDP growth rate.

Government:  Both public construction projects and military spending were up in Q2.  As a result, it looks like real government purchases rose at a 1.8% annual rate, which would add 0.3 points to the real GDP growth rate.  (1.8 times the government purchase share of GDP, which is 17%, equals 0.3).

Trade:  At this point, we only have trade data through May.  Based on what we’ve seen so far, net exports should add 1.2 points to the real GDP growth rate.  However, an advance glimpse at June trade figures arrives Thursday, which could shift this key estimate up or down. 

Inventories:  We’re also working with incomplete figures on inventories.  But what we do have suggests companies were accumulating inventories more rapidly in Q2 than in Q1.  This should add 0.5 point to the real GDP growth rate.

Add it all up, and we get 4.8% annualized growth.  The Plow Horse economy is dead.  That doesn’t mean we’re in a boom like the mid-1980s or late 1990s, but tax cuts and deregulation have finally killed off the plodding roughly 2% growth rate of 2010-2016.           

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Yield Curve Inversion

July 18, 2018

The yield spread between the 2-year and 10-year Treasury Note has narrowed to 25 basis points, its smallest spread since 2007.  This has many investors worried the narrowing spread will lead to an inversion of the yield curve (when short-term rates exceed long-term rates) – which throughout history has often occurred prior to a recession.

In reality, an inverted yield curve simply means long-term investors expect short-term rates to fall in the future.  A 2-year bond is just two 1-year bonds, one after another.  So if the 2-year yield is below the 1-year yield, then investors are saying the yield on the 1-year bond, one year from now, is expected to be lower.

For the record, an inverted yield curve does not cause a recession.  Typically, the yield curve inverts because the Fed drives short-term interest rates too high and over-tightens monetary policy.  It’s this tight monetary policy that causes the recession, the inversion is a symptom of the bigger issue.  Investors, realizing the Fed is too tight, push long-term rates down because they expect the Fed to reduce short-term rates in the future.  It’s the overly-tight Fed that causes both the recession and the inverted yield curve.

This is why we do not believe the current narrowing yield spread signals looming recession.  The Fed is far from being tight.  Short-term rates remain well below the pace of nominal GDP growth, and even below many measures of inflation.  As a result, rates are likely to rise in the future, not fall.  If anything, the 10-year Treasury note appears overvalued – possibly in a bubble (meaning yields on the 10-year Treasury are far too low).

But just like most overvalued markets, investors seek ways to justify it.  In 1999, despite weak – or no – earnings growth, the US stock market became massively overvalued.  By our measures, over 60% above fair value.

This has now apparently happened to the Treasury market. Justification for low yields include low foreign yields, an imminent recession, and a belief the Fed is (or will soon become) too tight.

Nominal GDP (real growth plus inflation) grew 4.7% in the four quarters ending in March, and looks to have grown even faster in the four quarters ending in June.  At 2.83%, the 10-year Treasury note yield is 187 basis points below nominal GDP growth.  For comparison, over the past 20 years (1997-2017) – the 10-year Note yield averaged just 43 basis points less than nominal GDP growth.  In other words, today’s spread is substantially – and we think unsustainably – larger than its 20-year average. 

Nominal GDP growth is a good proxy for a “natural or neutral” rate of interest because it’s the average rate of growth in the economy – a reasonable proxy for investment returns.  Some companies grow much faster than GDP, some grow much slower.

If interest rates are well below nominal GDP, then companies growing less than average are encouraged to borrow.  But this makes no economic sense.  It’s “malinvestment”…investment that hurts growth and slows the creation of wealth.  In other words, interest rates today are well below levels justified by fundamentals.

More importantly, the economy is accelerating, and the Fed is chasing both rising real growth and rising inflation.  Even if the Fed lifts rates to 3.5% by the end of 2019 (which would require six more rate hikes at the current pace), the Fed will still not be tight relative to nominal GDP growth.  So, the odds of a recession in the next few years remain very low even if we get a technical inversion.

That said, we don’t expect the yield curve to invert in the near future.  It may.  But if it does, it just means that the bubble in long-term rates still exists.  At some point that will cease.  It won’t be pretty for long-term bond holders, but at least it should end the inversion-recession fears.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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