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The Coming US Cyclical Revival
Dr Cees Bruggemans
22 May 2007
Despite the ongoing US housing correction, the US economy is clearly not imploding.
Florida real estate may be devastated, with large price declines already a reality, and many subprime borrowers nationwide casualties of deadly mortgage terms and growing lender reticence to continue lending. Yet according to Fed chairman Bernanke the broader US property market is bearing up well, including a large part of the subprime mortgage market.
There is no banking distress of note, not least because much subprime risk was sold off as a matter of course, spreading such risk among a vast universe of risk takers, in a manner of speaking 'losing' such risk among a large institutional multitude, domestic and globally.
Also, US household consumption has continued mostly unchecked, as if there are few constraints on its ability to do so. This is actually quite true, for the good reason that US employment and income growth have remained strong, indeed much better than expected.
GDP growth was disappointing in 1Q2007 below 1% (and 2% over the past four quarters). But whereas housing detracted 1% from GDP growth, net exports turned neutral after years of detracting. Consumer spending remained strong at 3.4%. The other major negatives were disappointing business investment and deeper destocking than expected.
For some commentators this lineup suggests more weakness to come as the US housing correction bites ever deeper, employment growth erodes more decidedly, and US consumers finally capitulate by pulling back.
But that is hardly a universal expectation. The more optimistically inclined see US housing ceasing to be a GDP drag quite quickly. Others are more inclined to see the deep inventory decline clearing the manufacturing deck for an early industrial rebound. And then there is foreign trade, imports now only increasing by 2% and exports doing +10%. Trade is going to be a net contributor to US growth for the first time in years.
As regards US business investment, it has been rather disappointing over the past year, but supposedly coming back in the year ahead.
The main growth expectation is a positive one. Provided the US consumer doesn't belatedly give the ghost, but keeps up the good spirits, buoyed by ongoing employment and income gains, the turning of the trade and inventory conditions and the stabilization of the housing condition should ensure a cyclical US revival into 2008, in turn reinvigorating US business investment.
The housing cleanup may take longer than imagined, by most accounts, and may therefore remain a depressant. The trade and inventory reversals are probably going to take hold as punted. But business investment may disappoint for longer, too.
The funny thing is that US companies haven't apparently cut back on their fixed investment that much, going my company reports. The shock realization, little commented upon, is that the larger US companies are simply doing more of their investing overseas rather than at home. In China, for instance, where the consumer markets of the future are taking shape.
US business investment may be disappointingly down, but global business investment continues to expand briskly, led by US companies.
The betting is that even though US core inflation may now be coming down glacially, the Fed won't cut rates until unemployment is clearly rising unacceptably. With US productivity growth disappointing of late, the slower US GDP growth continues to support fairly good employment gains, even if these have been eroding somewhat recently.
Adding up all these various sentiments, US financial markets continue to look for some Fed rate easing into 2H2007 as the labour market finally weakens. Also helpful may be housing market weakness which may erode rental growth sufficiently to finally impact on a very large component of CPI inflation (owner equivalent rental).
It is on the expectation of interest rate downside and a slowing economy that the Dollar has weakened in recent months, mainly against the Euro (1.34-1.36) and Sterling (2.00) as these economies actually gained strength and raised their interest rates.
But although the US cyclical easing is still very much playing out at present, and the Fed may even be enticed to grant minimal interest rates easing over the next six to twelve months, this will probably not be much of a cyclical GDP underperformance and possible interest rate dip, before the next US revival comes into view, importantly assisted by consumer resilience, and trade and inventory revival.
Though such a cyclical turn cannot remain without effect on US fixed investment, the latter could nonetheless remain weaker than expected, as US companies are strongly into global expansion, for very good reasons.
This could mean that although the current US cyclical easing is remaining very mild, more in the nature of a mid-cycle breather and not even coming close to being a growth recession (never mind risking a real recession) because most of the weakness is concentrated so far in housing, the subsequent US growth revival may get back to potential (+3%), but not necessarily much beyond it.
Such an outlook suggests remarkable stable US interest rates, possibly for a considerable time to come, with the Dollar also less volatile than perhaps currently assumed.
While the Dollar could still weaken against the Euro and Sterling in the short-term, and the Chinese may feel compelled to appreciate their Renminbi some more to appease American trade sensibilities, the tepid US recovery prospects looming in the 2008 foothills and the changing interest rate expectations this will probably support may actually minimize such Dollar weakness.
What does this imply?
In the short-term, the easing US growth doesn't seem to undermine the global growth condition much, in part because it is mostly housing weakness (a non-tradable sector), with consumer vigour (very much a tradable sector in the US) still an important booster for the global economy. Equally important is that other parts (Europe, Japan) are still mildly accelerating or are maintaining strong growth themselves (China).
Once the US starts to revive cyclically (implying an end to housing, inventory and trade negatives), the growth recovery may remain sufficiently modest, given dragging business investment, for it not to threaten global overheating or major interest rate or currency disturbances.
A still weaker Dollar in the short term should underwrite commodity prices, while ongoing growth and limited interest rate risks should support equity markets, in the US but also globally.
This benign condition favours ongoing global growth, with available saving surpluses (in Germany, Japan, OPEC, Russia and China) available for global investment, but also allowing for more foreign reserve diversification as well as increased risk-taking (as shown by increasing number of sovereign funds favouring limited private equity placings). Preferred investment outlets will be high-returns in Asian industrial fixed investment, emerging equities as well as rich country equities.
This worldview is not devoid of risk. War, oil disruption and pandemics remain favoured event surprises, with financial crises focused on too much risk-taking and credit leveraging also a major uncertainty.
Yet so far these risks have refused to be activated to any degree and may well continue to do so for some time. It is not as if such risks can be ignored. Still, they remain for now AWOL and the global outlook as a consequence looks a lot more benign than what it would be in their active presence.
The world looks good for ongoing 5% growth, inflation falling back towards 2% (and even below) in the richer countries, the resource-rich countries and emerging markets remaining favoured by strong terms-of-trade and/or strong capital inflows, further transforming their external finances favourably, keeping their currencies firmly supported and their inflation suppressed, and their domestic demand strongly expansionist, also in many instances supported by major infrastructure expansions.
It continues to look like an environment favouring high global growth and strong equity advances. As to risk, it has to show itself more clearly to get due recognition.
Original article published at www.fnb.co.za.
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