Wednesday, March 26, 2014

Growth outlook remains modest, and that's bullish

As we emerge from the bad winter weather in the Eastern part of the country (the West has enjoyed a very mild winter), some areas of the economy—construction, factory orders, employment—are likely to pick up. But the overall outlook for the economy remains modest; growth is likely to continue in the 2 -2.5% range that we have seen in recent years, though it might tick up a bit to 3%. In any event, 2-3% growth is hardly something to cheer about when the economy continues to carry the potential to be some 10% stronger. But that's not necessarily bad news.

Here are some charts with recent updates that continue to suggest we will see 2-3% growth for at least the next year.

New orders for capital goods (above chart) have been relatively flat for the past year. Even though they have managed to eke out a new high in nominal terms, capex orders are still about 20% below their inflation-adjusted high that was reached fully 14 years ago. Business investment has been unimpressive for quite some time, even though corporate profits have reached an all-time, and previously unimaginable high relative to GDP. It is this lack of investment (driven, as I have argued, by a lack of confidence and a general aversion to risk) that has given us lackluster gains in employment and in productivity. Without new investment in productivity-enhancing capital goods, worker productivity is going to continue to be lackluster, and this amounts to a fundamental headwind to stronger growth.

If productivity continues to plod along at the 1% annual pace of recent years (see chart above), and if the labor force manages to grow 1% per year (it has only grown at about half that pace in the past two years, but it averaged about 1% annual growth prior to 2009), then we shouldn't expect to see real growth do much better than 2-2.5%. (Add the growth rate in the labor force to the growth rate in the productivity of that workforce and you get a rough approximation of overall real growth.)  


The first of the above charts shows the Chemical Activity Barometer, which has been calculated and published by the American Chemistry Council since 1919. As Calculated Risk has pointed out, there's a pretty good relationship between this index and industrial production, with the CAB index tending to lead. As the second of the above charts shows, there is also a pretty good fit between growth in the CAB index and real GDP growth. The CAB index has grown about 2.5-3% over the past year, and that points to real GDP growth of about 2-3%. Steady but lackluster growth.

2% or even 3% GDP is nothing to get excited about. But it could be a lot more than what is priced into the market, and if so, then a continuation of modest growth could end up being good news for equities. The chart above compares real yields on 5-yr TIPS to the 2-yr annualized growth rate of GDP. It's reasonable to think that these two variables should follow a similar pattern over time. Strong and sustained GDP growth such as we saw in the late 1990s should result in relatively high risk-free real yields on TIPS (which are guaranteed by the U.S. government), whereas sluggish growth should correspond to low real yields on TIPS. And indeed, real GDP grew at a 4-5% rate in the late 1990s, while real yields on TIPS were just under 4%. As GDP growth has ratcheted down over the years we have seen real yields also fall. But today's level of real yields seems very low compared to the real growth of the economy. Why accept a guaranteed loss of your purchasing power by buying 5-yr TIPS with a real yield of -.5%, when you can expect to earn at least a 2-2.5 real yield by buying anything exposed to real economic growth?

I think the market is still priced to very pessimistic assumptions. If I'm right, then real growth of 2 or 3% should result in equity prices—and interest rates—moving higher.


Benjamin Cole said...

Very solid blogging, and sad but true.

The USA is leaving about 10 percent of output on the table, and neither Obama nor the Fed seem to think this is a problem. Nor the Dems or GOP'ers.

Seems to me market valuations in everything---stocks, property and bonds--- are about where they should be.

Scott says maybe stocks are underpriced. Maybe so. But since reading the book "Panic" recommended By Scott, I am not so sure. Plus, any stock can blow up overnight. Or the market can lose 20 percent in a day (1987). Or get cut in half (2009). Obamacare promises to be a drag on the private sector too. They found a malicious Rube Goldberg to design that program.

The Fed is not going to tolerate inflation above 1.5 percent, so I doubt we will see much robust demand going forward.

Scott is right, we are witnessing all-time and astonishing records in corporate profits, relatively and absolutely. These are the good ol' days when it comes to corporate profits. This speaks to the ever-improving output of the private-sector that always does more for less.

I guess we will see more stock buybacks--maybe that will be good for share owners, if you are in the right place. Follow Icahn.

rkevanm said...

I found your blog thru Wesbury, and continue to enjoy and learn. Regarding US markets, would you view CAPE and VLMAP with little regard now or would you feel that they are valuable, but perhaps too early, as an indicator of near-term market price movement? Similarly, would you feel that 'secular consolidation phase' is more likely over or not yet complete?

Scott Grannis said...

See my post on the subject of CAPE here:

Todd said...

Regarding capital goods orders, labor force participation rate, etc. Do you know how that is related to the impact of public policy on small business specifically. My understanding is that small business is the real engine of jobs growth. In my area small business is hammered by uncertainty. I would appreciate you thoughts about the role of small business on the economy and the effect of economic policy on small business growth. Thanks

Todd said...


Regarding the capital goods orders and your previous plots showing the economic output gap and gap in the labor force participation rate, what is the role of small business? My understanding is the small business is the real engine of jobs growth and economic output, but, at least in my area, small business has been hammered with uncertainty.

I'd appreciate your thoughts on how small businesses impact macroeconomic indicators (particularly jobs) and whether government policy has disproportionately impacted them. If so, would policy changes impacting small business fix a lot of our problems?


Scott Grannis said...

Todd: You are absolutely right. Small business has been hammered with bad policies, huge regulatory burdens, and higher taxes. It's no wonder that jobs growth has been sub-par. It would be relatively easy to fix things with growth-oriented and business-friendly policies.

Hans said...

Why is modest growth bullish?

This author states, that without QE we would be already in a recession.