US GDP at highest level since Q3 of 2014, buoyed by falling unemployment and higher wages.
Despite this, several indicators point to continued stresses in the economy.
Flattening yield curve could signal the coming end of a historic bull run in equities.
Fallout from trade-war likely to put a lid on economic momentum going forward.
US second quarter GDP growth was the highest in many years
The recent US Bureau of Economic Analysis announcement of 4.1% second quarter GDP growth–up from 2.2% on the first quarter and the highest quarter-on-quarter growth since the 4.9% under Barack Obama in 2014–came as a surprise to economists and commentators from across the political spectrum, and internationally. This is because the strong economic performance contrasted strongly with the negative perception of the Trump administration's handling of the economy, particularly with respect to his willingness to start a trade war with allies and adversaries alike.
The decision to scrap the nuclear deal with Iran has also put the US at odds with several EU countries, many of whom had already laid the ground work for considerable investment in Iran. But regardless, the numbers have been strong and the US economy appears to be in better shape than many expected so far in 2018.
When looking beyond the headline data, however, there are several factors which suggest the current growth and optimism may be short-lived.
Looking beneath the headline numbers
The fall in unemployment was a boon for the economy and a significant factor behind the strong GDP numbers, with the headline unemployment figure of 3.9% at the lowest level since the turn of the century. Although it is too early to attribute the latest fall in unemployment to President Trump's corporate tax rate cut (lowest historic unemployment figures have counter-intuitively coincided with periods of comparatively high corporate taxation), there are indications that some businesses are relocating to the US to take advantage of the favourable conditions.
Additionally, different interpretations of labour data reveal that the unemployment picture may not be as robust as the figures suggest. For example, part-time workers who would rather be working full-time, as well as those of legal age that have given up looking for work –so-called 'discouraged workers'– still make up a significant number of the workforce, yet are not included in the headline statistics. As can be seen from the chart below, when these subsets are included it yields a figure of over 8% – a radically different picture, and one that suggests the 3.9% figure may be flattering to deceive.
Source: US Bureau of Labor Statistics, McKay Research
What is good news for Americans, however, is the continued rise of the prime-age (25-54 years) labor force participation indicator from multi-decade lows, and the next few months will crucial in determining whether these positive developments are merely a rebound from a cyclical low or an actual reversal of the long-term labour market rut. Solidly low unemployment numbers for additional successive quarters would reconfirm this trend and vindicate the current administration's macroeconomic polices.
Source: US Bureau of Labor Statistics, McKay Research
Personal consumption still lacking in momentum
As the workhorse that drives approximately 70% of US GDP, consumer spending is a key economic sentiment indicator. Rather than look at consumer confidence which lags changes in spending momentum, we can look at the year-over-year changes in personal consumption expenditures (PCE) to gauge momentum of US household spending on good and services. As can be seen in the chart below, PCE has been in an uptrend for the first two quarters of 2018, helping to boost economic growth and inflation.
Source: US Bureau of Economic Analysis, McKay Research
But the outlook is less optimistic when looking at historic PCE cycles. We can see that growth in spending on goods and services has yet to surpass the 4.7% level from the fourth quarter in 2014. Further, going all the bay back to 1950, momentum in cyclical consumer spending between recessions (grey areas) typically always exceeds 5% growth (red line) at a given point in time. However, the period following the financial 2007-8 financial crisis represents a clear break from this pattern and points to a broader long-term trend of decelerating consumer spending.
Source: US Bureau of Economic Analysis, McKay Research
Accompanying the narrowing PCE growth bandwidth has been an increase in consumer household debt. Total US consumer debt has now increased for 16 consecutive quarters and stands at around $13.3 trillion. This is $618 billion higher than the previous high of $12.68 trillion in the third quarter of 2008, once again underlining the risk posed by further Fed rate hikes to millions of over-extended households.
Yield Curve approaching inversion
The difference in interest rates between long- and short-term treasuries–known as the yield curve–is an excellent proxy for market sentiment and the medium to long-term direction of the economy. A sharp difference between interest rates generally reflects an economy's ability to grow; if the number is low, it typically signals poor inflation and growth prospects.
Though more an indicator of correlation than of causation, the yield curve has turned negative all but three times over the past 30 years (black line over blue line), and each of these three occasions preceded an economic recession. In the chart below, we can see that the yield curve are is once again approaching the inversion point, currently standing at 22-basis points. And with the Federal Reserve eyeing up two further rate hikes in 2018 after already having raised rates for the second time in June, the yield curve is likely to flatten further.
Source: Federal Reserve Bank of St Louis, Wilshire Associates, McKay Research
Meanwhile record stock market performance has continued to paint the picture of an economy firing on all cylinders, though much of this performance is being fuelled by record stock buy-backs boosting earnings per share despite falling revenues. Here again, the yield curve appears to be signalling an equities bull cycle on borrowed time, and investors will be watching it very carefully along with announcements of further Fed tightening to appropriately de-risk their portfolios.
Trade war to dim economic growth prospects
Although the US economy is sitting pretty for the moment, the indicators outlined are but a few of many that show that any talk of economic 'miracles' is premature, whether by previous or current administrations. Crucially, there are real signs that in unleashing tit-for-tat tariffs with the European Union, Canada and Mexico, Trump's "America First" policies may stop economic momentum in its tracks as consumers bear the brunt of the protectionist policies through higher prices – something that has prompted several major retailers to write a letter to Trump to express their concerns.
The bottom line: yes, the corporate tax cut may have a short-term positive effect on jobs and wages by boosting capital investment, but the unintended consequences of the escalating trade war also means higher prices for US businesses on goods and materials sourced from overseas, thus neutralising any benefit. It is a case of cutting off one's nose to spite one's face, economically speaking. And with higher prices sure to dampen consumer spending, prospects for another headline-grabbing GDP performance over the second half of 2018 look increasingly remote.
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