What is one to make of the state of US GDP growth after the stumble to 0.2% annualized of the advance estimate for 1Q? The immediate causes for the slump are known and have been tracked here repeatedly for the past few months, including: the unexpected rise in the personal savings rate, the opening up of a supply/demand disequilibrium in the industrial sector, the deterioration in inventory ratios both for manufacturers and wholesalers and the stalling of capital goods spending.
Some of those are clearly transitory disruptions generated by a completely unexpected shift in relative prices, notably the fall in energy prices. And in at least two cases, the most recent monthly data suggests that there is some reversion to previously-experienced ‘normality’ is already underway. For example, it is likely that the fall in petroleum prices gave households an unexpected windfall which they initially banked rather than spent. This ratcheted the personal savings rate from 3.9% in November to a peak of 5% by February, but this retreated to 4.6% in March. The dynamic may now be changing but even so, personal savings jumped 16.2% yoy in 1Q, whilst personal spending growth slowed to 3.5% in 1Q from 4.1% in 4Q14. Secondly, by February, the unexpected climb in manufacturers’ inventory/shipment ratio which had taken it from 1.3 in September to 1.36 in January seems already to have peaked, falling to 1.35 in February.
Whilst we can watch some of these transitory dynamics develop and begin to resolve themselves, the1Q stumble reveals deeper weaknesses which cannot be resolved so quickly.
Those weaknesses show up when we subject the US economy in 1Q to a Dupont-style breakdown in an attempt to identify factors affecting growth, return on capital and cashflow.
The core problem is that there is more to worry about than merely 1Q’s stagnant topline growth (nominal GDP was stagnant). In addition, the first quarter saw stagnation in the previously-improving terms of trade, and an unexpected and unwelcome return to deleveraging strategies.
The result is that even though household savings rates and tallies rose, the private sector savings surplus for the economy as a whole almost certainly sank into deficit in 1Q. This is an unexpected result which strongly indicates that corporate profits must have been hit hard during 1Q, with asset turns, margins and leverage all contributing to a fall in return on capital. And whilst one should certainly expect some topline relief in 2Q, there seems no good reason to expect either a further boost to terms of trade, or an early willingness to change leveraging/deleveraging behaviour. The logical conclusion from that is that the current weakness in the capital goods cycle is unlikely to reverse sharply in the near future, and consequently that the business cycle is similarly unlikely to bounce in the near future. At present, consensus expects a rebound to 3.1% annualized growth in 2Q: the risk to that consensus, I’m afraid, is probably on the downside.
Let us look at these components one by one.
ROC and Capital Stock. The 1Q stumble has, of course, hurt the ROC directional indicator (generated by expressing GDP as a flow of income generated by a stock of fixed capital, with that stock estimated by depreciating gross fixed capital formation over a 10yr period). That downturn has now lasted two quarters, which is the longest fall since the financial crisis. Despite this, the indicator remains at historically very high levels (better than anything achieved in the 1990s) and capital stock growth is still extremely muted at just 2.6% yoy. The current deterioration is only a modest decline from a propitious starting point, so unlikely by itself to be sufficient to be itself the cause of further deterioration.
This does not necessarily point to a new slowdown in the capex cycle since a) there is usually a lag between the downturn in the return on capital indicator and a clear downturn in investment spending and b) the ROC indicator remains at historically very high levels. However, this two-quarter fall in the ROC indicator is consistent with the uninterrupted decline decline in capital goods orders seen since August.
For labour, the data makes easier reading: in yoy terms, the number of employees rose 2.3% yoy and real GDP rose 3% yoy, so output per worker rose 0.7% yoy in real terms. Perhaps surprisingly, this is the highest yoy rise since 4Q13. With capital per worker rising 0.4% yoy, output per worker adjusted for changes in capital per worker still showed a rise of 0.3% yoy. This is hardly inspiring, but is probably sufficiently positive to maintain positive momentum in labour markets.
The rise in output per worker has been running ahead of capital per worker now almost uninterruptedly since 2010. However, it is worth noting that even now capital per worker also rose 0.2% qoq and 0.4% yoy, which is the highest it has been since the Great Recession. In the immediate future, this combination of rising output per worker (deflated by capital per worker) and (probably) still rising capital per worker is likely to sustain both labour markets.
Terms of Trade. Difficult this: the improvement in terms of trade which accompanied the fall in petroleum prices was sustained between July 2014 and January 2015, and lifted them by 5.5%. Such an improvement should have resulted in improved trading and profit margins for companies, and for households, reduced energy bill. Both should have improved cashflows into the financial system. If it did, what happened to that money? Also note that in 1Q15, that that improvement stalled, which will have removed that stimulus (if any).
Leverage and Money. When we look at banks’ loan/deposit ratio we can see precisely what happened: the extra cashflow was banked. A relatively modest rise in bank loan/deposit ratios which emerged in 2Q14, fractionally reversing a decline in the ratio virtually uninterrupted since the financial crisis. The LDR rose from a low of 74.8% in April 2014 to a peak of 76.2% in October 2014. But there it peaked, and retreated very modestly to 75.6% in March. In short, the trading gains from the rise in terms of trade were banked (as the rise in the personal savings rate suggested) and the timid releveraging of early 2014 was snuffed out.
The same story materializes when we look at the relationship between money and the economy. Two things are evident. First, in 1Q the recovery in liquidity preference (M1/M2) which had been quite dramatic since 2008 flattened out in 1Q15, suggesting a reduced transaction and speculative demand for money - consistent with a reduced eagerness to spend money. Second, the decline in monetary velocity (GDP/M2) which had been arrested during 2014’s brief flirtation with re-leveraging, bit back again with a vengeance in 1Q. In plain terms, when falling energy prices delivered a windfall from trading margins (companies) or budgets (households), those gains were banked in deposits not spent (hence souring trends in liquidity preference and monetary velocity), which in turn reduced 1Q GDP.
Private Sector Savings Surplus
But now we come to a conundrum: all this suggests cashflows should have been very positive, and that the private sector would have generated a rising savings surplus in 1Q. But unless there is a sharply more positive current account position reported than seems likely from Jan-Feb data, this simply didn’t happen. Rather, the currently available data for federal debt and likely current account balance point to a small deficit (US$20.6bn) in 1Q, sharply reversing the $186.8bn surplus achieved in 1Q14, and cutting the surplus to a meagre 0.3% of GDP for the 12m to 1Q15.
How could this possibly be consistent with the rest of what we think we know about the economy? There are two potential sources of savings surpluses: household savings and corporate profits. Since we know from the personal income and spending data that household savings rose sharply during 1Q, assuming the 1Q estimate of the PSSS is not badly awry, the numbers must point to a far sharper downturn in corporate profitability than the ROC directional indicator suggests. This is, of course, consistent with the sharp downturn in orders of capital goods, and the way export growth has stalled in recent months.
There is a further implication: movements from private sector savings surpluses to deficits generally tend to put pressure on bond yields and fx rates.
Likely Near-Term Trajectory of the Cycle
Two of the three factors affecting return on capital seem unlikely to be helpful in the near term. First, last year’s jump in the terms of trade is unlikely to be extended or repeated, and this is likely to compromise margins and cashflows. Second, it is difficult to find a good reason to expect the current deleveraging will be once again be reversed in the near term. There is, however, a third factor which should improve: the energy price windfall isn’t getting any bigger for households, but conversely, spending/savings patterns are likely to revert to normal (which means more spending). The net impact is probably neutral to positive for on household spending.
But if corporate profitability has already been hit more than is immediately obvious (which seems to be the lesson from the private sector savings deficit), then the removal of terms of trade gains and sustained deleveraging will put more pressure on the capital goods cycle. And that, of course, puts pressure on the dynamic of the business cycle, and consequently on the prospects for a 2Q rebound.