What Recession? GDP Set to Grow 3%
The gloomy stock market notwithstanding, economic growth in the U.S. could be the best in years.
By Gene Epstein
The answer to that question highlights two quite divergent outcomes for 2016—one good, one terrible.
We subscribe to the former view. But before we make our case, let’s consider the bear argument.
If recession is imminent, then economic output will contract for an extended period, the stock market will continue to head south, and credit spreads will rapidly rise. The near-full-employment economy, signaled by January’s jobless rate of 4.9%, will quickly unravel and vault toward 6% within months.
But what if, as often happens, the indicators signaling recession are false alarms? Then, the generally quite favorable fundamentals at this stage in the expansion should dominate. Indeed, we expect economic growth to run at an annual rate of 2.8% through the first half of this year, then accelerate to 3.2% by the second half.
Growth of real economic output in 2016 would therefore come in at 3%, by the conventional fourth-quarter-over-fourth-quarter measure. This would make 2016 the best-performing calendar year since the expansion began in mid-2009. Under this scenario, the job market will continue to tighten, as the unemployment rate falls toward 4%. Credit spreads will narrow, and the stock market could rebound, probably touching new highs by the end of this year. The wild card: the presidential election.
Our 3% outlook, while upbeat, isn’t off the charts. According to the Feb. 10 release from the monthly Blue Chip Economic Indicators, the consensus of 50 forecasters projects growth in 2016 at 2.4%. Blue Chip’s “optimistic” consensus of top 10 forecasts puts growth at 3% to 3.1%.
Skeptics might wonder if these two divergent routes to famine or feast are too extreme. Might there be a more plausible in-between scenario that splits the difference between recession and accelerating growth?
To begin with, while a 3% increase in gross domestic product might sound unduly ambitious, this reflects only the lowered ambitions of the current era. Every expansion since World War II has gone through intervals of slow growth. However, all have had years in which economic growth ran at 4% or better, including the 2002-07 expansion. If the economy rises by 3% this year, the current expansion will still retain the dubious honor of being the weakest on record (see chart above).
Growth of 4% seems unattainable due to the drag on exports from weak economies abroad, combined with a strong dollar that makes those exports more costly, plus below-par performance of the small-business sector and slowed expansion of the labor force, owing mainly to the retirement of baby boomers. But if the vicious cycle of recession is avoided, a virtuous cycle should ensue, as positive factors reinforce one another.
Employment gains and the tight labor market are already driving up wages and salaries. That is boosting consumer spending, which is encouraging capital investment, which is causing businesses to hire, which, in turn, is driving employment gains. The virtuous cycle has also begun to include the housing sector.
Employment gains make it possible for more people to form households, which spurs demand for apartment buildings and detached homes, which, in turn, leads to greater gains in employment.
With faster top-line growth, corporate profits can also rise. Profit increases typically slow long before an economic expansion runs out of steam. The pace of the bull market of the past few years has probably slowed, but stock prices can still reach new highs.
IF RECESSION IS AROUND the corner, it will turn history on its head. Take the impact of oil since the mid-1970s. As the chart below shows, each of the past six recessions has been preceded by a spike in crude prices, often called an “oil shock.” The logic is straightforward: Businesses and consumers suffer financial shock when this essential commodity suddenly becomes more costly.
Of course, cheaper crude does hurt energy producers. But since most publicly traded companies are consumers of energy, it makes no sense for the broad stock indexes to track oil.
The recent pattern in which the Standard & Poor’s 500 index moves up and down in concert
with crude seems to reflect equity traders’ belief that a low price for crude signals an economic slowdown.
Hopefully, the market will soon break out of this circular-reasoning trap. If Barron’s is right that oil will rise to $55 a barrel by December, this pattern will be broken by events. Our Feb. 6 cover story, “Here Comes $20 Oil,” referred to the likely final leg of the energy bear market, which should end by April, before a rebound to $55 by December.
Defaults by the energy sector on loans are hurting U.S. banks. But according to estimates by economist Carsten Valgreen of Applied Global Macro Research, such loans account for no more than 4% of the banks’ total loan book. So even if losses on these loans run as high as one-half, this should hardly trigger a banking crisis.
As Valgreen also points out, in all three categories of bank lending—commercial and industrial, consumer, and residential real estate—conventionally calculated loss ratios are near historic lows.
“Bank lending has been gathering steam,” observes Rennaissance Macro Research economics head Neil Dutta, noting that over the 13 weeks through Feb. 3, commercial bank lending accelerated across all categories. Valgreen, who helps run a hedge fund that trades on such insights, believes that the recent selloff in U.S. banking stocks offers a unique buying opportunity.
Another channel through which low energy prices supposedly threaten recession: weakness in developing lands that export oil. Making matters worse is slower economic expansion in China, Japan, and the euro zone.
But while U.S. growth will certainly take a hit from lower exports to the global market, Michael Lewis, economics chief at Free Market, observes, “In the modern era, there is not a single recession that can be traced to foreign economic woes.”
For example, the 1998 meltdown in the Asian economies that caused a brief selloff in the U.S. stock market didn’t trigger the recession that many expected at the time. Adds Lewis: “While a U.S. sneeze can give the rest of the world the proverbial flu, the reverse still does not happen.”
To be sure, the ultralow interest rates maintained by the Federal Reserve have created a breeding ground for financial excesses that, when painfully corrected, often bring recession.
But so far, it appears that the Fed and the economy have been lucky. Major excesses are hard to find.
Even if stocks make new highs by the end of the year, standard price/earnings ratios will be noticeably below their peak of 2000, especially if earnings make modest gains. And the home-price bubble that started to burst in 2007 is a long way from forming again. The classic excess cited in the textbooks—the excessive buildup of inventories—is hardly present today, especially in light of the cuts to inventory investment in the second half of last year.
ONE INDICATION that the economy has found renewed strength: the labor force turnaround of prime-age workers 25 to 54. Much of the reason for slowed growth in the labor force has been demographic. The baby boomers are reaching retirement age, and they are merely following a predictable life cycle by leaving the workplace. But as Barron’s has pointed out (“Work’s for Squares,” Aug. 30, 2014), another, far more disconcerting trend was also evident: lower participation by prime-age workers.
This unanticipated trend is a key reason that forecasters have been surprised by how far the unemployment rate has fallen, despite modest growth. Skeptics have therefore dismissed the decline as bogus. Why place any value on a statistic that becomes more favorable as job seekers stop seeking jobs? But that is no longer true of prime-age workers, and the turnaround is due to the full-employment economy signaled by the jobless rate’s decline to 4.9%.
The prime-age labor force fell to a low of 100.6 million in second-quarter 2014 from its fourth-quarter 2007 peak of 104.4 million. Over the past six calendar quarters, however, it has rebounded by 1.3 million, to 101.9 million in January. The unemployment rate’s decline over this period, to 4.9% from 6.2%, has therefore been accompanied by more prime-age job-seekers rejoining the workforce.
THE RECENT TREND in the unemployment rate also tells us something about the diminished chances of recession. Evidence shows that increases in joblessness consistently lead economic turndowns. In the 12 months before all 11 recessions since World War II, the jobless rate rose on a three-month basis at least once, and usually several times, no doubt because it started to feel the tremors from reduced economic activity before the recession hit.
In the 12 months prior to the 2008-09 recession, the unemployment rate rose on a three-month basis no fewer than seven times. Before the previous recession, of 2001, it climbed five times, and before the 1990-91 recession, six times.
But over the past 12 months—in fact, over the past three years—the three-month change in the unemployment rate has generally been negative and occasionally flat; it hasn’t risen even once.
The last three-month increase in joblessness occurred as of January 2013, when it hit 8%.
Further confirming the positive trend in the labor markets: the persistent decline in new claims for unemployment insurance. As Free Market’s Lewis points out, initial claims are “one of the most reliable leading indicators, typically giving ample warning of recessions.” But, he adds, there is “not even an inkling [of a rise] yet.” In the four weeks through Feb. 13, weekly claims averaged 273,000, one of the lowest figures in decades.
For real GDP to grow by 3% this year, real consumer spending must do its part, rising at an annualized 3% or more in each calendar quarter. So far, at least, consumption seems to be off to a good start. Based on the solid retail sales report for January, economist Neil Dutta is tracking 3.2% growth in the current quarter. If that persists, it will be noticeably higher than the lackluster performance of 2015, when real consumption for the full year rose by just 2.6%.
Last year, the money generated by the boost to disposable personal income was mainly saved, rather than spent.
Applied Global Macro Research economist Jason Benderly predicts that consumption will rise by 3.4% this year. His forecast seems plausible if, as he expects, three factors that figured in 2015’s weak performance recede this year.
The first factor, which weighed on consumer spending, was a fall in confidence. Benderly has found the best indicator of consumer confidence isn’t the standard surveys of confidence, but rather credit spreads. The spread between yields on Baa corporate bonds and 10-year Treasuries widened steadily over the course of last year and is now even wider. But as recession fears recede, this spread should start narrowing. That should signal a rise in confidence, he argues, accompanied by a rise in spending.
The second factor is, ironically, faster growth of wages and salaries. Benderly has found that consumer spending responds with a lag when wage-and-salary growth accelerates. That happened last year, with the extra income going into extra saving. This year, however, consumer spending should start to catch up with the increase in income.
THE FINAL FACTOR is also a lagged response, in this case, to lower energy prices. Benderly has found that when prices of necessities decline, consumers initially save much of the windfall, only to spend it later.
So last year’s plunging energy costs went into savings, but much of it will be spent on consumption this year.
Another key component of economic output—investment in plant and equipment— was hurt by the severe cutbacks by the energy sector. But if the oil price rebounds to $55, as Barron’s expects, then key parts of energy investment will make a comeback before the year is out, says Citigroup senior energy analyst Anthony Yuen. And in general, Benderly anticipates a gradual rebound in U.S. manufacturing, as it responds with a normal lag to the pickup in retail sales.
The government portion of output, which began to make small contributions to growth in 2015, should pick up a bit this year, too, given the turnaround in state and local employment. Residential investment, which has been making steady contributions to GDP growth, should also climb a bit faster, as rising incomes spur greater household formation, in turn causing greater production and spurring greater employment and formation of households.
In short, the virtuous cycle should dominate.
The current collapse in petroleum prices has also been called an oil shock, even though plunging tabs for such items as gasoline, heating oil, diesel fuel, and jet fuel have enriched those same businesses and consumers.