For the first time since the industrial revolution, the U.S. faces two significant growth issues: 1) a declining labor force; and 2) a job skills mismatch. The declining labor force is demographic in nature and is occurring in every industrial economy; likely a function of the long-term success of capitalism. The skills mismatch is a function of technological change that is so rapid that the skills of the existing labor force can’t keep up. The result of the two is a declining rate of raw economic growth.
Because GDP, itself, is such a large number, small changes in its components (as better data become available) can have large impacts on the real GDP growth rate. Given the low level of real growth in today’s economy, we might already be in a recession and not yet know it because the data are still in flux. Still, the equity markets are humming along as if real economic growth is about to accelerate, a view corroborated by Janet Yellen and her Fed colleagues but, unfortunately, not confirmed by any hard data.
The Importance of Growth
“Growth” itself is a fundamental consideration in equity valuations; without it, today’s PE ratios are way too high, at least by historical standards. A significant portion of the population has assets in the equity markets, so a slowdown in raw growth will ultimately have an impact on equity prices, and thus, on the balance sheets of most Americans including the middle and working classes. Today’s equity market has yet to recognize the impact this slowing growth will have on corporate top and bottom lines. On the other hand, today’s bond traders appear to grasp the fact that slow growth means interest rates will remain lower for longer.
Sentiment may be Misleading
In the post-election period, the significant rise in business and consumer sentiment has not translated into economic reality, and those sentiments are now receding. For example, the University of Michigan’s Consumer Sentiment Index fell to 94.5 in June, well below the expectation of 97.1 which also was May’s actual level. The high for this index was 98.5 (January) and, just for comparison, September’s and October’s readings were 91.2 and 87.2 respectively. I suspect we will see the index return to these levels in the months ahead.
Fed Tightening: A Policy Mistake?
Enter the Fed. They announced the third 25 basis point rate hike (one quarter of one percentage point) in the Fed Funds rate (the rate banks pay for their reserves) in the last six months beginning in December. Today’s hard data indicate that the Fed is tightening into a weakening economy. If weakness continues, continued tightening would be a policy mistake.
Currently, the Fed’s forecast is for real GDP to grow 2.2% this year (2017). With Q1 already in the books at 1.2%, the final three quarters have to average 2.5% for the Fed’s forecast to be accurate. Considering that in this entire expansion, three consecutive quarters of 2.5% real GDP growth only occurred in 2010, at the beginning of the recovery when there was pent-up demand, this appears to be on the extreme high side of consensus estimates.
Some Hard Data
It is clear that we have seen the peak in auto sales for this cycle, and now, during the seasonal peak in driving, oil and gasoline inventories are rising, indicating less demand than the energy industry thought. Because of disappointing tax revenues, the aggregate of state budgets is only up 1% for the coming year. The May measurement of retail saw an unexpected 0.3% fall in sales. Restaurant sales, a reliable indicator of consumer health, have now fallen four months in a row. May’s employment data were also a disaster (138,000 with significant downward revisions to March and April); had it not been for a decline in the labor force participation rate, a sign that job seekers had simply stopped looking, the U3 unemployment rate would have risen from 4.4% to 4.6% instead of declining to 4.3%. The hard data shows real softness in the economy.
Does the Fed have Secret Data?
Despite May’s data, the Fed’s formal statement indicated that “the labor market has continued to strengthen.” Additionally, they continue to believe that the lull in inflation is just temporary. What secret data are they looking at? In this economic cycle, the Fed’s 2% inflation target has been achieved in only 4 of 103 months according to Wall Street economist David Rosenberg. He says that was “in the face of the greatest monetary easing of all time.” Yet today, when the Fed is tightening, “somehow they want us to believe that inflation will rise to 2% as soon as next year.”
To compound this, in September Chair Yellen said they are going to begin a negative Quantitative Easing (QE) cycle. Shouldn’t we expect that a negative QE policy will have the exact opposite impact that positive QE had (i.e., the main impact was on asset prices!)?
Due to the continuation of a tighter monetary policy, including the initiation of the negative QE program, investors and economists should be on a recession watch. Ten of the last 13 tightening cycles have resulted in recession; so, what’s new?
Robert Barone, Ph.D.