Wall Street's Best Minds
FRIDAY, DECEMBER 20, 2013
U.S. Economy May Be "Only Game in Town"
By DIANA CHOYLEVA
An economist with a global perspective argues that the U.S. will stand tall in 2014 on a relative basis.
Editor's Note: Diana Choyleva is head of macroeconomic research at Lombard Street Research, a London-based macroeconomic forecasting firm.
Renewed U.S. competitiveness in an improved economy is likely to spur a business investment-led economic recovery in 2014.
More of what America consumes will be produced at home. The U.S. is best placed to outperform, with GDP growth accelerating to 3%-4%.
But it won't be the global locomotive of the past. With poor growth prospects elsewhere, global capital will flow into the U.S., pushing up the dollar and lifting U.S. asset prices.
Good news is still at a premium in the global economy. But America's outlook for 2014 is decidedly positive. The U.S. economy has made tremendous progress correcting its underlying imbalances, well beyond the claims of some commentators that it has merely been 'printing money'. The U.S. recovery is set to take output growth well above trend to average 3%-4% over the next few years. It will be a production-led recovery, not a consumer-led recovery i.e. America will import less of what it consumes.
Growth should also prove durable, as inflation will not be a concern for some time. The economy continues to have significant spare capacity, while faster GDP growth could also pull up the economy's potential growth rate.
Energy prices and the U.S. dollar will exert downward pressure on inflation, thanks to shale fracking and America's relative-growth outperformance. Subdued inflation is likely to keep policy rates ultra low for some time. Importantly, even when the Fed decides to raise interest rates in response to a sustained revival in growth, this will not derail the economy because it is no longer plagued by excessive levels of debt.
The dramatic fiscal squeeze, which the OECD estimates at 2.7% of GDP, was the main drag on growth in 2013. This was the biggest annual budget tightening since WWII and comes on the back of four years of continuous fiscal retrenchment.
The fact that private demand expanded strongly enough to outweigh tight fiscal policy in 2013 by itself bodes well for 2014, when the fiscal tightening is set to be much less. The budget deal reached in Washington would mean not only even less fiscal tightening in 2014 than assumed before but importantly also reduced concern about U.S. political dysfunction. It removes one of the main risks to our growth forecast for 2014. The other risks are a premature rise in bond yields and weak global growth undermining business confidence.
Reshored to the U.S.
The U.S. dollar is now competitive, crucially against the Chinese yuan and the other Asian currencies. Relatively cheaper labour and energy place the U.S. – the second-largest manufacturer in the world – in a great position in a world of deficient consumer demand. The U.S. is likely to see a much lesser rate of off-shoring production and a rising wave of reshoring. This trend has only just begun.
The fortuitous development of cheaper shale energy in the U.S. is not to be underestimated either. Natural gas from shale is much cheaper in terms of oil equivalent and the incentives to develop it are huge. This major U.S. energy transformation should ensure not only cheaper energy but also a strong flow of capital spending into improving the distribution infrastructure.
America has expertise in many manufacturing industries, which means investment-led growth shouldn't take long to take hold. U.S. firms will not only have the incentives to invest, but they are flush with cash and are able to invest. The main threat is the tax incentives that encourage firms to keep their cash abroad. But the structural forces described above should provide a substantial impetus to investment irrespective of whether firms bring their cash back or decide to finance their expansion plans with low-cost debt. Most of the other potential uses of the large corporate financial surplus, such as dividends, share buybacks, M&A activity, will also be positive for U.S. domestic demand.
A durable economic revival
But investment-driven recoveries can fizzle out if they substitute capital for labor and firms hog the resulting productivity gains. However, both reshoring and shale energy argue for investment in new production capacity, not substitution of capital for labor.
So this investment-led boom should translate into higher employment and wages, spilling over into higher-consumer spending. A production-led recovery is also much less susceptible to weakness in the rest of the world.
Broad-based growth, above the economy's noninflationary-growth rate, has a much better chance of lasting if it starts when the economy is operating with slack. There is considerable uncertainty about the level of existing slack in the economy and the extent to which the global financial crisis damaged the economy's underlying supply potential. But our assessment is that plenty of slack remains, which must be used up before demand-pull inflationary pressures build. We also share the Fed's optimism that stronger growth could pull potential growth higher, meaning it takes even longer to eliminate slack in the economy.
Given continued weakness in the rest of the world, the U.S. dollar should also strengthen, which will further dampen inflationary pressures. Meanwhile, shale fracking will keep energy prices down. But while inflation isn't an immediate concern for policymakers, the Fed might eventually worry about asset-price bubbles. U.S. real assets look the most attractive investment in 2014, with further potential upside from Chinese capital inflows. This will present the Fed with a difficult dilemma, but not until 2015. In 2014, it will stick with its labor-market centric 'forward guidance'.
Wage inflation to coexist with subdued CPI inflation
Untangling the labor market story is crucial. The U.S. participation rate has plunged, to reach its lowest level since 1978. Productivity growth has slowed but remains robust. Our estimates, given official population forecasts, suggest the participation rate will not rise dramatically in coming years.
This is a worrying development as it would leave a large part of the U.S. population out of the labor force. Even more worrying, the share of long-term unemployed workers has been extraordinarily high in this cycle. If we count those people as unemployable, the participation rate would plunge to an alarmingly low level and the unemployment rate would fall to a level not far off the economy's underlying noninflationary rate of unemployment.
If the current situation is one of potential workers not being willing to work at the currently offered wages rather than being unemployable because they've been out of the labor force for too long, wage inflation has to rise to induce them back into the labor force. A production-led recovery in the context of weak global-consumer demand and a historically high U.S. profit share suggests wage inflation could coexist with subdued CPI inflation as firms take the hit in profit margins. In fact, this will ensure the growth revival will be sustainable even if the U.S. dollar rises to erode U.S. competitiveness.
Monetary tightening will to take time, but won't tank growth when it comes
On-balance, the considerations above suggest that while the Fed will wind down its asset-purchase program fully in 2014, it is unlikely to hike the policy rate. The Fed will want to be sure the recovery is entrenched. And when the Fed does raise interest rates it shouldn't cause growth to collapse because the U.S. economy has eliminated the excesses of the previous boom.
The U.S. housing market was where the crisis began, but the adjustment there is now complete. House prices are rising and the backlog of unsold homes is falling. Substantial downpayments required for a mortgage are an inhibition for buyers, but the demographics relative to current housing supply are positive, affordability is high and easy money has made rentals very profitable. U.S. housing should be a buoyant area over the next couple of years, both in terms of rising investment and the wealth effect on households.
The U.S. household-debt crisis is now also over. Households have lowered their debt to a sustainable level relative to their income even if interest rates return to 'normal'. They may still need to raise their savings rate but cheaper shale energy should provide a big boost to real incomes over time and the investment recovery should fuel employment and wage growth. U.S. banks have also returned to health, increasing their capital buffers, boosting profits and improving their net-charge-off rates. They are now willing to lend, which together with QE has pushed real broad money growth to rates consistent with above-trend growth.
The last remaining adjustment is to stop public debt from rising further. But the public sector deleveraging has been under way for some time now. Moreover, on current fiscal plans the primary budget deficit will be brought back to a level consistent with stable public debt by end of 2014. Strong growth will help to lower the public debt-to-output ratio over the next few years.
U.S. asset prices and the dollar set to gain
The global recovery from the financial crisis has been uneven. The U.S. is the only major economy that has adjusted fully and looks like the only 'game in town'. The export-led growth model has always relied on the U.S. as the "consumer of first resort." But this no longer works because the U.S. real exchange rate is at its lowest since WWII. As a result, the export-led emerging markets' will not be buoyed by strong U.S. growth, while all emerging markets will be vulnerable to higher-U.S. bond yields.
Lacking domestic sources of strength, the euro area will continue to stagnate, with the risk that deflationary pressures in the periphery spread to the core. Meanwhile, Japan will continue to scoop demand out of the rest of the world, with its Abenomics-led competitive devaluation also stealing growth from the future.
This suggests global capital will flow to the U.S., pushing up the dollar. It is more likely to flow into real assets, with the U.S. housing market doing particularly well. But at the same time the continued global-savings glut and Japan's drive-through Abenomics to push Japanese investors to seek interest-bearing returns abroad suggest the natural cyclical upswing of Treasury yields could be later and slower than has happened in the past.
While Treasury yields are likely to flat-line for now, they should be more volatile. Ultimately, Chinese financial sector reforms, now underway, could be a decisive factor pushing Treasury yields up. These reforms include proposals to remove controls on private-sector capital outflows from the country.
The outflows have been large even with the controls. Take them away and a tidal wave is likely – unless the authorities partly reimpose them. But Chinese investors will be seeking real assets – houses in San Francisco, farm land in Tennessee, stocks and shares – not interest-bearing assets. Chinese financial reforms have the potential to rewrite the story for U.S. and global financial markets.
On-balance, the considerations above suggest that while the Fed will wind down its asset-purchase program fully in 2014, it is unlikely to hike the policy rate. The Fed will want to be sure the recovery is entrenched. And when the Fed does raise interest rates it shouldn't cause growth to collapse because the U.S. economy has eliminated the excesses of the previous boom.
The U.S. housing market was where the crisis began, but the adjustment there is now complete. House prices are rising and the backlog of unsold homes is falling. Substantial downpayments required for a mortgage are an inhibition for buyers, but the demographics relative to current housing supply are positive, affordability is high and easy money has made rentals very profitable. U.S. housing should be a buoyant area over the next couple of years, both in terms of rising investment and the wealth effect on households.
The U.S. household-debt crisis is now also over. Households have lowered their debt to a sustainable level relative to their income even if interest rates return to 'normal'. They may still need to raise their savings rate but cheaper shale energy should provide a big boost to real incomes over time and the investment recovery should fuel employment and wage growth. U.S. banks have also returned to health, increasing their capital buffers, boosting profits and improving their net-charge-off rates. They are now willing to lend, which together with QE has pushed real broad money growth to rates consistent with above-trend growth.
The last remaining adjustment is to stop public debt from rising further. But the public sector deleveraging has been under way for some time now. Moreover, on current fiscal plans the primary budget deficit will be brought back to a level consistent with stable public debt by end of 2014. Strong growth will help to lower the public debt-to-output ratio over the next few years.
U.S. asset prices and the dollar set to gain
The global recovery from the financial crisis has been uneven. The U.S. is the only major economy that has adjusted fully and looks like the only 'game in town'. The export-led growth model has always relied on the U.S. as the "consumer of first resort." But this no longer works because the U.S. real exchange rate is at its lowest since WWII. As a result, the export-led emerging markets' will not be buoyed by strong U.S. growth, while all emerging markets will be vulnerable to higher-U.S. bond yields.
Lacking domestic sources of strength, the euro area will continue to stagnate, with the risk that deflationary pressures in the periphery spread to the core. Meanwhile, Japan will continue to scoop demand out of the rest of the world, with its Abenomics-led competitive devaluation also stealing growth from the future.
This suggests global capital will flow to the U.S., pushing up the dollar. It is more likely to flow into real assets, with the U.S. housing market doing particularly well. But at the same time the continued global-savings glut and Japan's drive-through Abenomics to push Japanese investors to seek interest-bearing returns abroad suggest the natural cyclical upswing of Treasury yields could be later and slower than has happened in the past.
While Treasury yields are likely to flat-line for now, they should be more volatile. Ultimately, Chinese financial sector reforms, now underway, could be a decisive factor pushing Treasury yields up. These reforms include proposals to remove controls on private-sector capital outflows from the country.
The outflows have been large even with the controls. Take them away and a tidal wave is likely – unless the authorities partly reimpose them. But Chinese investors will be seeking real assets – houses in San Francisco, farm land in Tennessee, stocks and shares – not interest-bearing assets. Chinese financial reforms have the potential to rewrite the story for U.S. and global financial markets.
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