US Savers Turned the Screw in 1Q

• US Cyclical Factors including ROC and Real Labour Productivity Remain Sharply Positive
• But Deleveraging Accelerated Again in 1Q, Pushing Up Private Sector Savings Surplus , and and Pushing Down Loan / Deposit Ratios
• Renewed deleveraging is anomalous, and is not reflected in asset prices or straightforward risk measurements
• Renewed deleveraging is anomalous at a time of exceptionally bad bond-market value
• So the Growth Risk for the Rest of the Year Remains on the Upside

We now have quarterly GDP numbers for the world's major economies, so it's time to start tracking movements in the fundamental ratios which structure the world's business cycles, starting with the US.

Our view based on these ratios for 4Q11 were (in this piece)as follows: “. . . by our estimate returns on capital are around their highest since 2000 and are still rising, which will continue to foster investment spending; labour productivity continues to grow (adjusted for changes in capital stock), which will underpin the slowly- accelerating addition of jobs; and, most importantly, we believe that the net develeraging of the economy which started in 2008 is now complete. We do not expect significant re-leveraging to take place this year, but the mere fact that deleveraging is no longer the key dynamic will shift the economy out of its modest 2.4% annualized growth trend which it has sustained since the end of the recession in 2009 and towards a 3%+ rate.”

How much of that is still right? The good news is that returns on both capital and labour continue to rise, at an accelerating pace – the best underlying news for a sustained business cycle upswing.

ROC is still climbing, and this continues to fire major capital investment spending: in nominal terms, total fixed capital investment jumped at an annualized pace of 20.8% during 1Q. In real terms, private capital spending rose only a miserable 1.4% annualized - but there seems to be an unaccounted seasonal factor at work depressing the 1Q investment numbers, since this was the best 1Q reading since 2006. Overall, nominal capital stock is probably growing around 1.2% a year – still less than half the c4% yoy nominal GDP growth, so we should expect ROCs to continue to rise along with asset turns.

Real output per worker, adjusted for capital stock per worker, also accelerated mildly to 3% during 1Q, an inflection from from 2.8% in 4Q10 which should be enough to sustain improvements in the labour market. 

As far as margins are concerned, the US international terms of trade have held steady since they bottomed out in December 2011: since then export prices have risen 2%, whilst import prices have risen just 1%.

All of this suggests the US cycle should be in buoyant good health. But it doesn't seem to be: the 2.2% annualized GDP growth recorded in 1Q was lower than I expected, and a retreat from the 3% of 4Q11. And there's probably more on the way, since the GDP data disappointed even before the 'soft patch' began to show up in the data for April and May's economy.

I have previously explained the origins of that 'soft patch' in the industrial sector, using changes in momentum of output, domestic demand, inventory and export demand. I think that analysis is both correct and useful . . . . but also incomplete.

For the big disappointment of 1Q is that deleveraging had not stopped, as I expected. Rather, it re-started and re-intensified – and it is that which so far is the decisive factor in the US recovery. One can capture this by two counts. First, the private sector savings surplus jumped to 8% of GDP in 1Q from 5.2% in 4Q11. There are strong seasonal factors at work, but nevertheless, that jump was sufficient to push up the 12m ratio to 4.7% of GDP, from 3.8% during calendar 2011. This is the only quarter since 2009 that the PSSS has risen significantly. 

Second, the same story is written in the banking system's balance sheet: during 4Q11 banks' loan to deposit ratio stood at 81.8%, and was rising gently, having seemingly bottomed out in 3Q11. But by early May 2011, the ratio had fallen again, to 80.8%, with deposits rising US$153bn since the beginning of the year, compared to a rise of only US$70bn for loans. 

Awaiting Eurogeddon, it may seem obvious that caution must reassert itself. But, of course, the timing doesn't fit. More, reawakened caution was not obviously reflected – and frankly, still is not obviously reflected – in US financial asset prices. During 1Q, most measurements of risk were in retreat: 5y bank CDS rates declined to average 201bps in 1Q12 from 252bps in 4Q11, whilst the capital risk premium on 10yr Treasuries (spread between 10yrs and 10yr TIPs) widened modestly in a way which usually signals improving risk tolerance.

More, US Treasuries became ever more expensive relative to the fair value you would expect in an economy growing 2.2%, CPI inflation of 2.82% and a Fed Funds target of 25bps. Historically, as the chart below shows, when Treasuries represent such astoundingly bad value, one expects Private Sector Savings Surpluses to start to dwindle. But rather, the opposite happened.

In conclusion, we really do not know what has provoked re-invigorated deleveraging in the US during 1Q12 - for the time being it remains anomalous. Unless or until a workable explanation is found, we should expect precisely that it will be an anomaly, which is likely to be corrected in the coming quarters. If so, the upside risks to US growth during the rest of 2012 continue to look greater than the downside risks.  

How to Account for the US 'Soft Patch'

The shocks to consensus on US industry keep coming: this week we've already had disappointments from April's Empire State Manufacturing survey (just 6.6 vs a consensus of 18), and a second consecutive month where industrial production flatlined (and manufacturing fell 0.2%). The previous couple of weeks saw shocks from regional manufacturing surveys in Milwaukee, Kansas, Richmond and Dallas. It's time to start asking what ails US industry right now: why is another 'soft patch' materialising in the data?

We do not have the dramatic excuses of last year: we've had no environmental catastrophe punching holes in global supply chains; and though WTI oil prices have risen, the movement from around US$100 a barrel in 2H11 to a rapidly fading peak of US$110 is no repeat of the 2010-2011 jump from around US$85 to US$112+. What's more, banks are once again lending modestly (up 5.1% YoY in March and early April) and commercial paper markets are open to non-financial domestic companies (up 17.8% YoY). Finally, throughout 1Q we've got used to housing markets and labour markets, perennial bear-factors, are regularly delivering more positive surprises than negative shocks.

With none of the usual suspects fitting the frame, it's time to try to account for the soft patch from the bottom up – ie, by looking carefully at where US industrial output ends up. And it turns out that this step-by-step accounting approach does yield some answers.

Industrial output must either be bought by someone directly, be added to inventory, or written off. When we look at monthly data for manufacturing and trade sales, we find they remain relatively robust (latest data February), rising 7.6% YoY, and with a positive underlying sequential momentum which remains unchallenged (the 6m trendline for sequential movements is 0.21 standard deviations above the 10yr average). So sluggish domestic sales by themselves don't look to be the problem.

Output which isn't immediately sold to the end user can end up as inventory temporarily: there's a measurable lag of about four months. Total business inventories are matching sales, rising 7.6% YoY in February: there's no story here, since inventory/sales ratios have been essentially unchanged now for a full two years. No pressing inventory adjustment is likely to be generating a 'soft patch'.

But now let's consider the difference in momentum between what's being produced (industrial output) and where it ends up in the domestic economy (sales and inventory). In the chart below the blue line tracks momentum of sales, and the pink line tracks momentum of output minus inventories. In a closed economy which typically operates somewhere near equilibrium, the two lines would track each other closely – as indeed they do usually.

What if they don't match, however? Let's look at the difference in momentum between the two. In the chart below, the thing to remember is that if the line is in positive territory it tells us that the momentum of output is greater than the momentum of end sales plus inventories – in other words, one can and should expect a correcting retreat. Conversely, if the line is below zero, sales and inventories additions have greater momentum than domestic production, and one should expect a positive correction from industrial output.

More, the direction of travel helps us understand the mini-cycles which bubble up in the data. Thus by late 2010 the US had reached a point where for the first time since the financial crisis hit, momentum of sales and inventories was stronger than momentum of industrial output, heralding the unexpectedly strong growth in output during 1Q11. So it's really not surprising that the 'soft patch' of 2011 caught everyone by surprise, nor is it surprising that commodity markets reacted so strongly to the upturn. The shock of supply-side disruptions distorted the picture even more, and it was not until well into 2H11 that output momentum began to catch up once more with sales and inventories.

Notice what's happening now, however, is that that catch-up period has ended – all other things being equal we would expect a modest step-down in pace, unless the pace of sales and inventory momentum lifts.

So far, we have considered US industry operating in effectively a closed economy. But that's wrong. International trade can be seen as a balancing item: when output is rising faster than (sales + inventories), then one possibility is that the surplus output can be exported. Similarly, when output is lagging (sales +inventory) the shortfall in supply to the domestic economy will be made good by imports. As our final chart shows, it doesn't always work out like that – there's more flex in these arrangements than our accounting methods acknowledge.

However, what is clear is that the signals for trouble come when momentum of output minus (sales + inventories) is positive and rising, whilst momentum of exports is negative and fading. That's the point at which you must expect cuts in output – an industrial recession in other words. This was the situation in 2001-2002, and much more intensely in 2008-2009.

Obviously, US industry is not in a similar position now – but it could be getting there. If the trends seen in the last nine months were simply to be extended for a further nine months, the position would become similar: output momentum would be rising significantly faster than (sales + inventories), whilst the ability to export the surplus dwindles as export momentum turns negative. It is precisely to avoid this dynamic that the 'soft patch' is emerging.

What conclusions can we draw from this?

First, the industrial 'soft patch' is no simple mistake or data-blip: rather it is a slowdown necessary to secure something like industrial equilibrium. It can be expected to maintain downward pressure on bond yields, downward pressure on commodity prices (both of which are already manifest) but also, if it lasts, downward pressure on the dollar.

Second, the US industrial cycle is not self-contained, and is not insulated from trends in world trade. In fact, fluctuations in world trade play a crucial role in finding, keeping and maintaining the balance between domestic supply and demand. Right now, that means the US industrial cycle is exposed particularly to potential downturn in Europe, as well as to potential reflation in China.

Third, the imbalances are only just emerging, and industry is acting to ensure they don't curdle into a recession: the modest shocks now ought to prevent worse shocks later. But the exit from the soft patch is likely to need positive momentum surprises in sales, or inventories, or exports – and preferably a combination of the three.

Bond Yields and Saving Behaviour in the US

What relationship, if any, consistently holds between interest rates and private savings behaviour? Do savings really go up when interest rates go up? And can excessively high savings ratios be brought down by keeping interest rates low? If so, what rates, and how low? And if savings rates stay high regardless does that mean we're in some sort of liquidity trap?

I should probably have had this down decades ago when I first encountered an ISLM graph, but the truth is that I've never met anyone in the market who actually uses ISLM analysis. Or mentions it.

Instead I have focussed on private cashflows and savings behaviour, usually looking at private sector savings surpluses and tracking their impact on bond yields. For emerging markets, this is often crucial: the most powerful financial dynamic bar none in emerging markets is what happens to government bond yields when a private sector savings deficit flips over into a surplus, or vice versa. In these cases, the cashflows are easy to trace: if an economy develops a savings surplus, then on a net basis, the private sector is dumping cash into a financial sector which, by definition, can use it to buy only government bonds or foreign assets. Hence bond prices rise and yields fall. Easy money.

Even in the massively-open and highly disintermediated financial system of the US, traces of the relationship remain.

Interesting though this is, it's hardly a complete theory linking bond yields with savings behaviour. Nor would one expect it to be: if private sector savings surpluses and deficits were the only determinant of bond yields, the world wouldn't have so many fixed income economists (and professional Fed watchers). And the financial world would never had heard of 'fair value models' for bond yields.

So let's look at those models. In my experience these fair value models regress and regularly recalibrate from three factors:

• policy rates
• inflation rates
• growth rates

A movement, or an expected/forecast movement in any one of these will change what the model signals to be the 'fair value' of a bond.

Anything that regresses and recalibrates enough will end up looking like it has useful explanatory power. Here's how my simple fair-value model of US bond yields compares with what actually happened over the last 21 years. It's not a superb fit, and even if it was, that would be testament simply to the power of serial recalibration rather than the theory it allegedly sets out to test.

Nonetheless, the conclusions which we can draw from this model are remarkably similar to those wrested from doubtless far more sophisticated models produced by our august Wall Street friends. And so are the conclusions are drawn by comparing actual bond yields with 'fair value' yields. What screams out in retrospect is that during 2004-2008 bond yields were far lower than 'fair value'. And from there it is but a step to conclude that the chief reason for that was that policy rates were set too low for too long, and, moreover, were expected to be kept too low for longer still. The graph serves as the charge-sheet against Alan Greenspan. And as it looks as if the same thing is happening again now (bond yields far lower than 'justified' by likely economic growth and inflation), we might eventually find it thrown into evidence against Ben Bernanke at some later date.

What the chart is saying right now is simple: bond yields are simply too low, making bonds an unattractive investment. Let's put it even more bluntly: who in their right minds would save to invest in bonds right now? At which point, we get to ask (and answer) an important question – regardless of the absolute nominal bond yield, does sufficiently 'bad value' in bond yields usually dissuade saving, and do sufficiently 'generous' bond yields usually encourage saving?

And I think we can answer than question empirically with a simple 'Yes'.

Consider the relationship between the deviation of bond yields from fair-value, and movements in the private sector savings surplus. The chart below illustrates it well, and that's not just because I've fiddled the axes. More importantly, the correlation between sequential movements in these two during the last 87 observations passes the 1% significance level quite easily.

For those of us interested in recent US economic history, and in global savings/investment imbalances, this chart is pretty irresistible, as it links the descent into major private sector savings deficit during 1997-2000 and again in 2005-2007 with bond yields being somehow maintained at levels which actively discouraged saving. When yields rose (relative to 'fair value') savings deficits were trimmed and reversed.

And now? Bonds represent absolutely rotten value, and as long as this is the case, the US private sector savings surplus will continue to decline, boosting US consumer demand at a pace slightly exceeding those of private sector income growth (widely defined).

One more thing: there is absolutely no sign of a Keynesian 'liquidity trap' anywhere on this chart.

Thinking About Fear . . . . And Measuring Its Impact

‘Nothing to fear but fear itself’. Actually, that can be re-written for today’s media-wrapped world: ‘Yes, we have stuff to fear, but My God, brace yourself for the wave of confirmation bias CEO quotes coming our way.’

That’s perhaps a bit unfair.  But we should recognize that, among other things, we’re now in a period where there’s a ready market for business journalism based on the whining of CEOs ready to tell us how demand for their services/products is disappearing, and the government must do something.

Actually, if you’re prepared to ignore the ticking of the EuroDoomsday Machine, the impact of fear becomes more . . . measurable. Fear postpones purchases, postpones investments, postpones expansion. And it does it for one big reason: households and companies meet fear rationally – by working hard to limit their financial exposure.

Consider first the behaviour of the US corporate sector: in a way, the whining CEOs aren’t kidding – in real life they remain immensely cautious for years after the end of the last recession. We can track this behaviour through the US flow of fund accounts. When recession hits, the corporate sector finds ways to stop the growth of their net exposure to credit markets. That much is obvious: rather less obvious is the amount of time it takes them to get over this fear. Take a look at the chart:

• The 1990/91 mini-recession ended in 1Q91, but it wasn’t until 1Q95 that corporate’s net credit exposure dipped back to pre-recession levels, and started growing once again.
• The 2000-2001 semi-recession was ended in 3Q2001, but it wasn’t until 4Q2004 that companies were prepared to take on more net credit.
• The 2008-2009 recession  officially petered out in 2Q2009, and so far net credit exposures have not returned to pre-recession levels.

Nor, it currently seems safe to say, should we expect a corporate appetite for credit to revive any time soon – previously experience suggests we might wait until 2013 or 2014 for revived credit appetite. It could, of course, be worse this time.  That’s the impact of fear.

Households reacts to economic and financial fear in much the same way – they net-repay debt. I have shown previously (here) how US households have repaid more than half their net debts to banks and credit markets since the cUS$3 trillion nadir of mid-2007. At the current rate of net repayment, the US household sector can expect to be net creditors to credit markets again by around 2015. 

But notice that this net repayment has been made not principally by repaying debts, but rather by shifting the balance of their savings from risky instruments (equities and equity mutual funds) to less risky (deposits).  At the peak of US household financial risk appetite  - during the tech bubble of 2000 – equities etc accounted for 37.2% of all gross household financial assets, whilst deposits etc accounted for just 18.5% at their lowest point.

The subsequent market collapse eroded that share both directly (by prices falling) and indirectly (by people switching out of equities) to reach first 22.8% in 3Q02, and then 20.4% in 1Q09. Notice that the subsequent market recoveries never took that equity proportion back to glory days of the late 1990s. Rather, it seems likely that, post-disillusionment, the proportion meets a ceiling of 28-29%. More likely, the volatilities in these ratios are gradually trending back to pre-1990 norms (ie, deposits representing 30-35% of assets, equities etc representing 15-20% of assets).

We do not yet have the data for 2Q, but there is likely to be little change in equity holdings in 2Q, since the S&P ended June only about 50 points lower than it ended March. To get much of a change in the US$13.84 trillion  holdings of equities and equity mutual funds, you’d need to assume a general exodus of households from equity markets – ie, a change in risk preference. That doesn’t seem particularly likely.

But it does now, doesn’t it? Prior to today’s opening the S&P 500 was loitering around 1,136. Roughly speaking, every 50 points change in the S&P currently represents a change of just under US$500 billion in net household financial assets.  Even with no change in risk appetite, this implies a fall of just under US$2 trillion in the value of households’ equity holdings, and a fall of the same amount in household’s net and gross financial asset – which stood at US$34.97 trillion and US$48.85 trillion respectively at the end of March 11.

This sounds dramatic: but so far, in fact the impact in both dollar and proportionate terms, is rather lower than in previous market collapses – a reflection purely of the more risk-averse construction of household portfolios. Here’s how I think US household net financial assets’ position is likely to have changed since 1Q11: the last two data-points are my estimates – but shouldn’t be far out. 

Unless the S&P has much further to fall, at this point is seems unlikely that the current round of fear will have the impact on household balance sheets that the bear markets of 2000 and 2008 had – the sizes of the financial shock at this point simply are not comparable. Maybe we’ll get there. Or maybe at some point, we’ll remember that the US is still an economy that is creating loads of jobs, and loads of ideas no other society seems capable of producing, and is paying down its debts at a rapid clip. 

A Second Look at Double Dip

The first piece in this series laid out the dumb statistical basis for expecting a renewed recession in the US within a year. Those dumb stats tell us that the low-risk bet must now be for recession – and this means that it’s a brave Street economist who in such uncertain times is prepared to spurn the low-risk bet. Among many other factors,  markets right now are anticipating an avalanche of downgrades of economies and earnings which we can assume will follow.

But the second article didn’t allow the data to be dumb – when we got it to talk, it had a tale to tell. It turned out that the pattern of 1Q and 2Q growth was at worst explicable, and at best compatible with renewed growth. The slowdown was largely due to the impact of the supply-jam in the auto sector, the impact of higher fuel prices on fuel consumption, and the predictable (but larger than previously seen) fiscal drags which appear regularly as an economy exits recession. Absent these effects, personal consumption demand is holding up well, investment spending far better. The private sector, in other words, isn’t rolling over.

Nonetheless, we are moving into a period where the statistics very likely to point to a recession. It’s also very likely that the Street will also change its forecasts, and maybe its view, to get into line with the dumb power of the stats.  Later, we must also factor in the impact of a falling stockmarket on household finances.

So is there a case for ‘no recession’ and if so, what is it?

To get a handle on the likely turning points in a business cycle, I look at what’s happening to the return on factors of production. If return on capital is rising, ceteris paribus, it’s unlikely that investment spending will fall. If return on labour (ie, real labour productivity) is rising, it is unlikely that unemployment will rise. If both investment spending and employment continue to grow, it takes something pretty extraordinary to overturn the business cycle. (Although, again,  a complete and prolonged collapse in financial confidence might just do it).

Working out what’s probably happening to return on invested capital isn’t necessarily easy (and conventional economics has shockingly little useful to say about it). What I do is express the flow of GDP as an income from a stock of fixed capital. The trick then is to work out what’s happening to the stock of capital, and this I do by taking a 10yr straight line depreciation over all fixed investment spending. If GDP is rising faster than the stock of capital, then it’s a fair bet that the return on that capital is rising.  This is an unconventional measure, which, as far as I know, I’m alone in calculating/using. However, it has two far more respectable relations. First, it is an attempt to replicate the ‘asset turns’ ratio (total revenues / total assets) used in the Dupont decomposition of return on equity. Second, it is kissing cousins with the ultra-respectable ICOR (Incremental Capital-Output Ratio) so beloved of the World Bank, IMF, OECD etc. Anyone who’s actually tried to work with ICOR will know its drawbacks: but if it helps, think of this measure as an ACOR (Average Capital Output Ratio). 

Here’s how returns to the US factors of production look right now: 

Even after the GDP revisions, return on capital is clearly rising fast, and is probably at its best since the turn of the century. Real labour productivity growth has come off slightly, but is still extraordinarily positive.

Has there ever been a situation in which these readings were so positive, and yet were interrupted by a recession?

Since 1980, we’ve had four recessions: each of them had been preceded by an inflection in this return on capital indicator. Contrariwise, we’ve not had a recession whilst this indicator was rising. It is extremely unlikely that this indicator is going to turn any time soon, since capital stock is still shrinking by around 0.32% YoY, whilst nominal GDP is growing (in 2Q) by 3.7%.  

What about labour? Here the picture is not quite so clear-cut. The three last recessions happened after a period when real labour productivity inflected had downwards, and was  sharply negative. Right now, labour productivity continues to grow very sharply, but it has inflected downwards. This negative inflection seems to have produced a period of labour market softness. However, this is very easy to exaggerate, and I believe it has been very much exaggerated by the seasonal adjustment process. Before seasonal adjustments, non-farm payrolls were growing by 0.9% YoY in June, down from a high of 1.1% in April. They grew 0.5% in May (in line with historic seasonal expectations) and grew 0.3% MoM in June (vs flat historic seasonal expectations). The rising unemployment ratio, of course, masks the continued growth in jobs.

If employment is still growing quite strongly, growth of wages has nonetheless slipped – and it’s this we see showing up flat personal income data.  

Once again, a little historic perspective might be helpful: compensation of employees as % GDP hit a multi-decadal low, nearly 3SDs from historic average, at the end of 2010, it recovered somewhat in 1Q 2011, but was steady during 2Q 2011. Do we think this is proportion has the potential to go lower? If not, then there remains some potential for a positive surprise from wages (and demand).

Notice, once again, that over the last 30 years, recessions have tended to happen after a period when this indicator was rising, or at a high level relative to recent previous experience. At the moment, we seem a very long way from that.  

My conclusion? The dumb stats point to the likelihood of recession. When you get the underlying data to talk, that doesn’t seem like a foregone conclusion. And when you look at what’s happening to returns to factors of production – even after all the revisions – a recession in the next year would be unprecedented in recent US economic history.

So it’s probably right to be brave at this point.  Unfortunately, that leads us straight into the next collision.  “The only thing we have to fear is fear itself.”  Was FDR right?

Growth Scare - What Killed US GDP?

Fear and greed: today, the sharpest fear - fear that takes down the S&P five percentage points in a single day, fear that recoils from the double-dip recession that today seems certainly upon us.

The markets have already done their own forecast revisions, leaving the economists as usual limping behind, blinking and sniffing as we try to understand the path. But as we tinker with our models, the truth is there is a biggish problem: there’s virtually nothing in the high-frequency monthly or weekly data which should have led anyone to anticipate such a collapse in growth during 1Q. That monthly data is statistical history right now, and ought to be safely dead and buried in the databanks. But now, like some bewhiskered Victorian detectives, we need to exhume it to see if, belatedly, it holds clues as to “What Killed 1Q.”

The odds don’t initially seem good. For years whilst in Asia I kept a small momentum model for US domestic demand, tracking employment, wages, retail sales, auto sales and construction orders. For all of these, I compared monthly movements against seasonalised historic patterns, and normalised the ‘error’. The results showed how many standard deviations this data was above or below what you’d normally expect. It’s a crude model, and not one I’d rely on now, but it has rarely been as abominably out of kilter with US GDP growth as it was over the last 12 months to June 2011:

(PS. There are loads of ways I could present this as a more attractive visual fit, either by a bit of quiet smoothing on both indexes, or just presenting the straightforward YoY GDP, rather than the annualized QoQ. But it would be particularly perverse to fiddle the visuals in a piece about how to read the underlying data. Actually, you’re looking at an R score of 61 over 60 observations.)

But when one looks at the personal consumption expenditure portion of GDP, things turn out not to be out of kilter with the underlying data after all:

This tells us immediately that whatever it is that afflicted the recent revisions, it wasn’t a shock about the underlying strength of demand in the US economy.  It’s something else.

In fact, the fall in consumption expenditure in 2Q is not so difficult to trace:  auto sales were down 22.7%  annualized, and it seems reasonable to accept this as a an enforced constriction of consumption with its origins in the disruption of Japanese supply systems post March 11. Gasoline sales were down 6.7% annualized, presumably as consumers adjusted their schedules to higher gasoline prices. Once again, it needs no great leap of imagination to expect this adjustment to have a lagged effect on the rest of consumption. Exclude those two exogenous impacts, and the rest of consumption expenditure was growing by 1.8% annualized in 1Q11, slowing to 1.4% annualized in 2Q11.

And that is about in line with the monthly surveys of personal income and spending, in which spending was running at an annualized 1.2% in 2Q11. It’s not a great result, but, crucially, it is an explicable result, and one which does not necessarily commit us to the early onset of a new recession.  There’s no surprise that the US economy slowed in 2Q – but equally it probably was a slowdown, not a stall.

What about ‘the rest’– the c29% of the US economy which is not accounted for by personal consumption? Here the news for 2Q is surprisingly good: ‘the rest’ grew by an annualized 4.2%, recouping almost all the ground lost in 4Q10 (when it contracted 0.5%) and 1Q11 (when it contracted an annualized 3.7%). Above all, the fluctuations of the last nine months look ‘normal’ – and particularly normal as the economy exits a recession. Look at the chart below, and in particular compare what happened in ‘the rest’ over the last nine months with what happened to it in 2002-2003.

When we look at the detail, things clarify quite quickly: gross capital formation is doing well, rising 7.1% annualized in 2Q after 3.8% in 1Q , with matters looking pretty similar even once you take out the inventory cycle (1.2% in 1Q followed by 5.8% in 2Q). Net exports were up 10.2% annualized in 1Q and down 16.5% in 2Q, but the net figure is so small (around 3% of GDP) that these fluctuations make little impact on the overall GDP total.

 

Which leaves government consumption, which at 18.9% of GDP, or 64% of ‘the rest’, is inevitably the dominant factor.  And the annualized growth trajectories over the last three quarters stand like this: -2.8% in 4Q10, -5.9% in 1Q11, and -1.1% in 2Q11.   I don’t want to antagonize either side of the US debate about the trajectory of government debt but, folks, this is good old-fashioned fiscal drag. As you come out of a recession, tax receipts begin to rise, social security claims begin to fall and before you know it, the pace of the build-up in the national debt begins to moderate, and net government consumption begins to fall. It happened in 2002-03, and it’s happening again now – albeit on the more exaggerated scale with which we are now in other respects familiar.

Yes, it’s snuffling works for dullards, this poking around in details. If you’re still hanging on in there at the end of it all, you deserve the conclusion. Which is simple enough: the presumption of a double dip is today exaggerated hugely by fear. There are shadows across the US economic x-ray, no doubt. But we know what they are, and, to me at least, they don’t look like The Big One. 

US GDP Revisions - Well Below "Stall Speed"

It hasn't happened quite yet, but whilst I'm away on 'holiday' it's a very safe bet that the US Street will be cutting its GDP forecasts for 2011 quite savagely. Quite possibly, the more venturesome of them will alter not just the numbers in the tables, but their underlying view. The onset of these downgrades will come in response not to the debt deal, but rather to the blunderbuss of GDP revisions with which the Bureau of Economic Analysis blasted the accepted version of recent US economic history.

Before we get into details, one bottom line is this: the US economy is approximately US$140 billion smaller than we though it was.

The details matter, though, particularly since the revisions tell us that in 1Q11 the US economy grew only 0.4% annualized, rather than the 1.8% previously recognized, and grew only 1.3% in 2Q (and that's a preliminary reading,too).  This means that the US economy right now remains smaller in real terms than it was immediately prior to the crisis - 0.4% smaller, in fact. Worse, the series of 0.4% followed by 1.3% is ominous, because it means that the US has been growing much slower than 2% now for two consecutive quarters.

This means the US economy is bumping along well below the 2% 'stall speed' which the US Fed economist Jeremy Nalewaik tentatively identified with developing recessions. In a paper for the Fed this May (available here), he observed that statistically since 1947, when two-quarter annualized real GDP growth fell below 2%, recession followed within a year 48% of the time. We're there already.


The odds get worse, however, when YoY real GDP growth falls below 2% in two successive quarters:  recession then follows within a year 70% of the time. We're not yet there yet, but annualized 3Q GDP growth would have to come in around 4% to avoid that fate. I've just checked the Bloomberg consensus, and only three out of 64 surveyed economists expect that (step forward the brave economists of Pierpoint Securities, MFGlobal and First Trust Advisors).

(One possible reason 2% might be a "stall speed" is that that labour productivity growth in the US tends to  average around 2% a year. So if the economy cannot manage to grow at such a pace, employment markets will certainly be slack. As we observe today.)

So economists, who had a consensus forecast for US GDP growth of 2.9% as late as May, and still apparently expect 2.5% growth this year, followed by 2.9% next, are now very firmly on the on the wrong side of historical probabilities.  Unless they can provide convincing reasons why this time is different, the low-risk, high-probability default position should now be for renewed recession in the US, within a year.

A third detail is also worth noting: the toll the financial crisis has taken on the US's stock of capital is greater than previously expected, and the recovery has not yet begun.

Working on a 10yr straight line depreciation schedule, the previous data suggested that by March this year US capital stock had shrunk 0.9% from its 1Q09 peak, but was expected finally to have started growing in 2Q11.  The revised data tells us that the contraction of capital stock has been 1.3% since the peak, and is still contracting in both YoY and QoQ terms. Capital accumulation is a fundamental engine of economic growth - and in the US, it's still now happening.

US Consumer, and the 2Q Slowdown

Barrels of analytical ink have already been spilled over the disappearance of US growth in 2Q.  The line generally taken is that it is explained mostly by bad luck: first the weather was foul and inventories were building a bit; then oil prices spiked because of the Arab Spring (and then Libya); and then the global auto industry discovered just how utterly dependent it was on a few parts plants in Tohoku, Japan, knocked out by earthquake/tsunami/power-outs.  All true, no doubt, but the best economists on the Street reckon even this combination doesn't account for much over half the slowdown.

Something else was going on as well. Can we understand it, and by tracking it get a heads-up on the likely direction for the rest of the year.

I think we can. In an economist's ideal world, national flow of funds tables would be published on a weekly basis, so we could track just what's happening to balance sheets. In that way, we could hope to get a better fix on cashflows.  But alas, the Fed serves them up on a quarterly basis. Still, they still have a story to tell.

And the most important, epoch-making story they tell is of a great restoration of 'normality' to US household balance sheets. Take a look at the following chart - it shows the net position of the US household sector with credit markets (including banks) between 1970 and 1Q2011.

Actually, this chart is one of the two mainsprings of the world over the last 50 years (the other being China's emergence). And it neatly divides into three parts. The first part is 1970-1991, during which time the US household sector behaved exactly as household sectors are historically expected to do: i.e., they save, bank the savings,  and the banks then allocate those savings to industry. (Well, that used to be the theory.)  By 1991, these net deposits amount to just under US$1.5 trillion - the equivalent then of 25% of GDP.   But that year is the pinnacle: for starting in 1991, we have an absolutely startling change in financial behaviour: the US household sector starts to run down its net bank savings systematically and increasingly rapidly. By  1999, it's spent the lot, but, being 1999 the party continues.  In fact, the recession of the early 2000s merely accelerates the trend, and by 2Q2007, the US household sector owes credit markets a net US$2.97 trillion, equivalent to 21% of GDP.

And that's it - that's the bottom.  Since then, the sector, voluntarily or otherwise, has improved its net balance with credit markets by US$1.5 trillion, and as of March 2011 its net debts had contracted to US$1.42 trillion, or 9.5% of GDP.

The chart tells you that one way or another, this is a fundamental, one-in-a-generation change in financial behaviour.  It is also the central fact that is dominating US economic growth, and, most likely will continue to dominate it for years to come. This household deleveraging - which, incidentally, is as much a function of diminished appetite for financial risk as represented by equity investment as it is of blunt debt-repayment - is the financial driver of the 'new normal'.

When we track its evolution via the flow of funds tables, we can make a very good guess at what the missing element was that sabotaged US growth in  2Q, coming so hard on the heels of comparative over-achievement in 4Q10 and 1Q11.

Take a look at this chart, which tracks changes in this net debt situation on a quarter-by-quarter basis - i.e., it gives the fine grain detail to the broad sweep of the first chart.

It doesn't look much, does it - another damned dull chart, in fact. But stifle your yawns, take a moment, and  you'll see that although this deleveraging seems to have a marked seasonality, with most net changes taking place during 1Q,  this year the deleveraging barely occurred. During 1Q2009, the household sector's balance improved by US$454 billion; during 1Q2010 it improved by US$288 billion; but during 1Q2011, it improved a paltry US$55.6 billion.

When I model US domestic demand momentum against underlying financial conditions (a model that's fraying heavily at the edges, to be honest),  we saw a marked and inexplicable over-performance in 4Q10 and 1Q2011.  My belief is that that over-performance was the result of a lapse in deleveraging behaviour which, by 2Q2011 was being noticed, regretted, and reversed.

Until the 2Q2011 flow of funds tables are issued (Sept 16, mark your diary!) we won't be able to prove it. As I say, ideally flow of funds tables would be published every week. They aren't - but bank balance sheets are, and we can use those to give us a good idea of what has happened since.  I do this by simply looking at how many deposits are coming into US banks, vs how many new loans are being made - in ridiculously simplistic terms, this is a cash in vs cash out measurement.  Here's what it looks like, up to early July:

And the picture does indeed tell the same story as the flow of funds charts: perennial negative cashflow (more loans going out than deposits coming in) is replaced in 2008 by massive and sustained deleveraging. The pace of that deleveraging declines (though remains positive) throughout 2001 and into the first quarter of 2011.  And then. . . . well, the pace is picked up again in 2Q, and appears now to be stabilizing. 

In terms of the domestic demand, that means a strength of demand in 2010 and into 1Q11 which runs slightly ahead of underlying 'organic' growth (which is also why we get a mini inventory-cycle), followed by a correction in 2Q2011. 

End of the earth? End of the cycle?  By no means - but growth with deleveraging is the new normal in the US, and that's not going to change.  Anytime it looks like it has abated, assume it hasn't. And watch carefully the swings in banks cashflows - at least until they get round to publishing flow of funds tables on a weekly basis. 

US Bond Markets, and the Novelty of Saving

The truth is, the US financial community isn't used to their economy running a private sector savings surplus - which is hardly surprising because until the financial crisis came along, it hadn't run one since the early 1990s. One result is that there are plenty of people in the US financial industry who don't instinctively understand the link between that surplus and cashflow/balance sheet movements in the banking industry.

Two strands of recent popular economic contention illustrate the point. First, when the Fed stops hoovering up government debt (sometime in June), will that result in a major bond correction? Second, now surveys show US loan conditions beginning finally to ease, are we about to see banks forced into selling off their bloated portfolio of government securities in order to fund new private sector credit?

Behind both worries lurks the same (probably unanswerable) question: why is US government debt trading above its fair value, with 10yr bonds changing hands at around 3.2%, rather than nearer the 4% that underlying conditions (policy rates, inflation, growth) would imply?  Will either of these two near-term worries upset the apple-cart.

Once again, I turn to the US private sector savings surplus.

The key point about the private sector running a savings surplus is that it represents the direction of cashflow between the US private economy and the financial system. If there is a surplus, then the financial system, after it's done all the lending and investing it can with the private sector, remains a net receiver of cash, day in, day out. And since by definition it can't deploy that cash in new private sector lending, it must necessarily end up buying either government debt or foreign assets.  When there is a deficit, by contrast, the financial system faces an urgent need to generate the cash it needs to give to a private sector which otherwise would have to make its own adjustments. And what are the two main ways for banks to raise cash? Liquidate its government bond position and/or take on net foreign liabilities. 

So when we look at the emergence of a private sector savings surplus in the US since mid-2008, we can understand why  holdings of securities have jumped by just under half a trillion dollars, and why, at the same time, net foreign liabilities of the banking system have shrunk by just under US$700 billion. What else could possibly have been expected?

Whilst the private sector continues to run a savings surplus, these flows will - must - continue, regardless of the curtailment of the Fed's buying, and/or the improvement of credit conditions.

For those worrying about the fair value of US government bonds, then, the question should be: how long will the US private sector continue to throw off surplus savings.  There are two techniques for determining this. The first is to model the numbers line by line. So far as I can tell, no-one on the Street is doing that (and neither am I, before you ask). The second is to eyeball the trend. This gives you two alternative answers. First, if the steep decline seen in 1Q is maintained (which, I suspect, can be translated as 'if oil prices continue to rise') then the US will get through its surplus by mid-2012.  If, on the other hand, the more modest trajectory of normalization seen over the last two years is extended, the surplus will endure until around mid-2013.  My guess? Even by mid-2013 the US will still be running a savings surplus, and the rest of the economy will adjust around that fundamental choice. Quite simply, it's what defines the 'New Normal'.

Luckily, by that time, less unorthodox economists than myself will be explaining it far better than me, and the Street will understand it instinctively.
   

US 1Q GDP: Returns, Velocity, Oil & Savings

Judging from the 1Q GDP data, the US economy continues to thread its way between the Scilla and Charybdis of Fed-incubated and oil-price fertilized inflation, and economic recovery. Even though the headline GDP growth rate slowed to an annualized 1.7% in 1Q, from 3.1% in 4Q10, don't expect the Street to start revising forecasts down significantly. In fact, it wouldn't surprise me to find some of them revising up.

The main thing to notice is that the fundamentals driving the US business cycle remain unusually strong. Even after the 6% YoY rises in investment spending during 1Q, capital stock is probably still slightly shrinking (assuming a 10yr straight-line depreciation of all investment spending), so there are big operational leverage gains still to be made by any company that can secure some topline growth. And since nominal GDP is still growing by around 3.9% YoY, that means most everybody. So, as a rule of thumb, US asset turns are rising, and so too therefore are returns on assets - which in the absence of monetary policy tightening, suggests the investment spending cycle still has a long way to run.

But its not just the return on capital that's rising - so too is return on labour, or labour productivity. Adjusting for the (shrinking) amount of capital per worker, the 1% YoY rise in employment goes hand in hand with a 3.6% YoY rise in nominal output per worker.  That remains at historically extremely high levels. So we should also expect labour markets to continue strengthening.

So with returns to capital and labour both rising, you'd have to have a powerful opposing factor to expect the cycle to abort any time soon.  Could the price of oil be that factor?

Not yet. The second thing to notice is that consumption demand rode out the rise in oil prices, rising 4.4% in nominal terms (vs 3.8% YoY in 4Q10), and 2.8% in real terms (vs 2.6% in 4Q10). Within this, spending on gasoline rose by US$63.7 billion, or 17.5% YoY,  out of a total rise in consumption spending of US$453 billion. Even though gasoline represents only 3.6% of consumer spending, the worry has been, and to some extent, continues to be that the rise in oil prices represents simply a tax on consumption, and that money shelled out at the pumping station is also money that can't and won't be spent elsewhere on Main Street.

Yet it hasn't worked out that way - or more precisely, this factor evidently did not trump other factors working in the consumer's favour. In fact, on my analysis, what happened was that the rise in oil prices simply quickened the erosion of the extremely high private sector savings surplus which the US economy now runs. By my calculations, that private sector savings surplus came in at around US$142 billion during 1Q11, which was down by US$174.7 billion from 1Q10. On a 12m basis, it sank to a still-robust 5.8% of GDP, down from the 7% averaged during 2010.  The lesson is that the US economy can continue to sustain consumer spending growth at these sorts of levels, despite the rise in oil prices. But only if the private sector remains sufficiently confident about the medium/long term prospects for their financial situation to allow them to scale back excessive saving. Financial confidence, (ie, bull or bear markets), remains an extremely important part of the picture.

My third observation is less cheery: there's still no sign that the relationship between the financial system and the economy is really on the mend. On way of checking this is by looking at monetary velocity. Normally when rates of return on capital are rising, monetary velocity (GDP/M2) tends to rise, as loans deployed end up generating greater cashflow. Now although velocity bounced last year off the previous year's historic lows, the rise was not sustained, and velocity actually fell back slightly during 1Q11. So the banking system remains a serious drag on the economy. On the other hand, if velocity stays down here, then the consensus that the US has little to fear from inflation, despite the Fed's best efforts, is going to be right.