Third quarter GDP growth was revised upwards slightly today, from 3.0% to 3.2%. This is encouraging, of course, but it does little to change the bigger picture, which is one of unusually slow growth. Over the past year, the economy has expanded by a very modest 1.6%, and over the past two years it has risen at a mere 1.9% annualized rate. It's managed annualized growth of only 2.1% since the recovery began in mid-2009. I can think of no better way to emphasize how painful this recovery has been than the following chart, which I have been featuring and updating regularly for many years now:
The chart above uses a semi-log scale on the y-axis to emphasize how, for 40 years, the economy has followed a 3.1% annualized real growth path, bouncing back after every recession except for the last one. Never before has the U.S. economy posted such a weak recovery and such a long period of sub-par growth. Demographics—the retirement of baby boomers—can explain some of the slow growth since late 2008, but not all of it; demographic changes take years to unfold.
What we do know is that business investment has been very weak, especially in recent years, and despite record-setting profits; jobs growth has been modest; and productivity has been miserable. At root, I believe the underlying problem has been a lack of "animal spirits," a shortfall of confidence, and the persistence of risk aversion. People have simply been unwilling to work and invest more. We also know that, beginning in 2009, the economy has been burdened by 1) an unprecedented remaking of the entire healthcare industry (Obamacare) which in turn has impacted the lives and healthcare costs of nearly everyone, 2) sweeping new regulatory burdens on the financial industry (e.g., Dodd-Frank), 3) a massive increase in government spending and transfer payments (the ARRA), 4) higher marginal tax rates on income, dividends, and capital gains, and 5) a huge increase in the federal debt burden. You don't have to have a political bias to believe that these changes could go a long way to explaining why the economy has been so weak during the Obama years.
Let's call this the Obama Gap. It's depressing because it represents a huge amount of lost income and jobs that were never created. But to look on the bright side, it is a measure of the massive amount of untapped potential in the U.S. economy. If my analysis of the economy's current malaise is correct, then if the Trump administration can succeed in rolling back the burdens heaped upon the economy in the past 8 years, the future growth potential of the U.S. economy could be enormous. For example, it would take 5% real growth per year over the next 8 years just to close the Obama Gap.
Here are some recent and encouraging developments that suggest the market is in the very early stages of anticipating the unlocking of the economy's upside potential:
I've been following this chart for a number of years, and the relatively tight relationship between the price of 5-yr TIPS and gold never ceases to amaze me. (I use the inverse of the real yield on 5-yr TIPS as a proxy for their price.) Two completely different asset classes have behaved in a similar fashion for the past 10 years! The one thing that gold and TIPS have in common is that they are both a refuge from uncertainty: gold is the classic "port in a storm," and TIPS are not only government-guaranteed but also promise protection from inflation. Both have declined in price in recent weeks, and I think that is a sign that the market is less desirous of paying for protection, and by inference, somewhat less risk averse.
The Conference Board today released their November estimate for consumer confidence, and it registered a new high for the current business cycle. Confidence is still lower than it has been during previous recoveries, but it is moving a positive direction.
Since November 4th, the Vix index has fallen from 22.5 to 12.7, and the 10-yr Treasury yield has jumped from 1.8% to 2.3%. That adds up to less uncertainty and more confidence in the economy's ability to grow. Not surprisingly, the stock market is up almost 6% over the same period.
The chart above shows that there is a decent correlation between the economy's underlying growth rate and the level of real yields on 5-yr TIPS. Real yields are up some 40 bps since November 4th, which suggests the market is pricing in a modest increase in the economy's underlying growth potential. This might be just the beginning of a significant rise in real yields, however: the chart suggests that if the economy manages to sustain 4-5% annual rates of growth, real yields could rise to 3% or more. That would further imply 5% nominal yields, assuming inflation expectations don't change much from where they are currently. If we manage to close a decent portion of the Obama Gap, then the Fed is still in the very early stages of hiking short-term rates.
Would a huge increase in nominal and real yields kill the economy? No, because yields don't cause growth; yields are driven by inflation, growth, and expectations for the future. Higher yields would be the natural consequence of stronger growth, not the enemy of growth.
Monetary policy only becomes a threat to growth when the real and nominal yield curves become flat or inverted. Flat or inverted yield curves are a sign that the market realizes that the Fed is more likely to cut rates in the future than raise them, and that in turn only happens when high real and nominal rates begin to depress economic activity. The chart above shows the current real short-term rate (red line) and the market's expectation of where real short-term rates will be in five years (blue line); it's positive, and that means the real yield curve is still upward-sloping. I wouldn't start to worry about the Fed unless and until the red line moves above the blue line—which is what happened prior to the last two recessions. We're likely still years away from that point.