U.S.

The U.S. Expansion: Does Slower Growth Spell Longer Expansion?

August 14th, 2014 | By Nick Sargen

Highlights

  • The U.S. expansion is now five years old, matching the post WWII average duration while being considerably slower in terms of growth. Skeptics cite this as evidence that the business cycle is living on borrowed time, while optimists believe the subdued recovery will prolong the expansion. A research note by J.P. Morgan sides with the optimists and concludes that the expansion should run for another 2-4 years.
  • Fed Vice Chairman Stanley spelled out the complexity policy makers face in a speech this week. First, they must understand why aggregate demand has been unusually weak, and whether this is temporary or ongoing. Second, they must also assess the extent to which the economy's productive potential has been lowered by declines in labor force participation and factor productivity.
  • The view that the current expansion is likely to be prolonged is an important component of our investment strategy. While the debate about the economy's long term potential will not be resolved for years to come, we still expect economic growth to accelerate in the next 1-2 years, as fiscal drag lessens. If so, this should underpin profit growth and the stock market while bond yields rise.
  • One risk to our outlook is the Fed could tighten monetary policy prematurely. However, the bigger risks are geopolitical developments that could undermine recovery in Europe and/or lead to an oil supply disruption in the Middle East.

The Case for a Prolonged Expansion

This quarter marks the fifth anniversary of the economic expansion that began in mid-2009. Based on post-war experience in which expansions have averaged five years, the current one would appear to be long in the tooth. However, when one considers the amount of slack resources in the economy and the lack of excesses, this is less evident.

The unemployment rate at 6.2%, for example, is comfortably above the rate associated with full employment, which the Fed estimates to be in the vicinity of 5.2%-5.5%. Moreover, the U-6 measure that includes workers that are employed part-time and are actively seeking full-time employment is at 12.2%. At the same time, capacity utilization in manufacturing at 79.1% is well below the 82% threshold that in the past has been associated with price pressures. And while it appears the inflation rate has bottomed and is edging higher, most indicators do not point to a significant acceleration in the next year or two.

Based on these considerations, our assessment is that the current economic expansion could be prolonged, lasting well into this decade for two reasons: (1) the Great Recession left the economy with much greater slack than in previous recessions; and (2) growth in the recovery phase, which has averaged just over 2.0% per annum, has been below the economy's productive potential. Viewed from this perspective, moderate growth has increased the prospect for a longer-than-average economic expansion.

Nonetheless, while this argument has intuitive appeal, one may ask whether there are facts to support it. I have found a recent J.P. Morgan research note by Michael Feroli to be helpful in this regard.1 Feroli examined the ten expansions in the post WWII era, and found that (i) cycles that start with more slack tend to last longer, and (ii) cycles that grow slower also last longer. "Every percentage point larger the output gap is at the beginning of an expansion implies that the expansion should last an extra two quarters. And every percentage point slower that growth is relative to trend should add about eight quarters to the expansion."

Feroli also observes that in the era of modern central banking (i.e. post 1979) expansions have, on average, ended about three years after the unemployment rate fell below its natural rate. His take is that the unemployment rate is not likely to fall to this threshold until mid-2015, which would put the peak risk of a recession about four years from now.


Some Caveats to Keep in Mind

The main rebuttal to the above view is that the analysis hinges critically on the assumption about the trend growth rate of the economy. Historically, it has been 3.5% per annum since the late 1940s and 3.0% per annum since the early 1980s. However, proponents of the "new normal" contend that future growth is likely to be below the long-term average owing both to slower growth of the labor force and productivity. According to this view, the current pace of economic growth is close to the economy's trend rate, which implies there is less slack in the system than commonly believed. If so, inflation pressures could surface earlier than the Fed's forecast implies, in which case policy tightening would also begin earlier.

Fed Vice Chairman Stanley Fischer spelled out the challenges policymakers confront in a speech this week entitled, "The Great Recession – Moving Ahead" (August 11, 2014). He first noted that the global recovery has been disappointing, and that this has caused the FOMC members to lower their projections for long-term economic growth from a range of 2.5-3.0% in January of 2009 to 2.0-2.25% at the meeting in June of this year. The major headwinds that the U.S. economy confronts on the demand side are (i) a subpar recovery in housing; (ii) significant fiscal drag; and (iii) slow global growth. On the supply side, he acknowledged the uncertainty about the economy's potential growth rate.

"At the end of the day, it remains difficult to disentangle the cyclical from structural slowdowns in labor force, investment, and productivity. Adding to the uncertainty, …there are real risks that cyclical slumps can become structural…But three things are for sure: first, the growth rate of productivity is critical to growth of output per capita; second, the rate of growth of productivity at the frontiers of knowledge is especially difficult to predict; and third, it is unwise to underestimate human ingenuity."

My own take is that there are valid reasons for expecting the economy's trend growth rate to be lower in the future. However, I do not fall in the camp that 2.0% growth is the new normal. Mainly because U.S. businesses today are far more competitive than they were in the 1970s and 1980s, when productivity growth slowed significantly in the wake of the first two oils shocks and rampant inflation. Second, demand side considerations also suggest growth is likely to improve in the next year or two, as the effects of fiscal drag, which are estimated to have reduced overall growth by about 1-1.5 percentage points last year, diminish over time.


Risks to the Expansion

The principal risks to the expansion, in my view, include the possibility that the Federal Reserve could make a mistake in exiting its current policy stance and the threats that arise from geopolitical risks. Financial markets understandably have been paying considerable attention to the Fed's exit strategy, and there is a possibility it could tighten policy before mid-2015 if the economy strengthens and inflation accelerates. However, the leadership of the Fed is more likely to err on the side of waiting for wages to rise to provide clear evidence the labor market is firming up. If so, there is greater likelihood the Fed will react belatedly rather than prematurely.

My own take is that the greater threat to the expansion would be from an adverse development abroad. Should events in Ukraine deteriorate and result in further trade sanctions with Russia, one cannot rule out the possibility of Europe experiencing a "triple dip." While this would not likely result in a U.S. recession, it could slow the pace of economic growth. Another risk is the possibility that conditions in the Middle East will continue to deteriorate and at some point lead to a disruption in oil supplies. I consider this to be the primary risk, as five of the ten U.S. recessions in the post-war era were associated with spikes in oil prices.


Investment Strategy

Weighing these considerations, our investment strategy has been predicated on the likelihood that the current expansion will continue for several more years, especially considering the Fed may be a year away from tightening monetary policy and that it will likely proceed very cautiously. If the economy accelerates, as we expect, top line revenue growth should improve and offset any declines in margins, while bond yields are likely to resume their upward trend. Normally, this is the phase in the cycle in which stocks outperform bonds; accordingly, we are maintaining a moderate overweight in favor of stocks over bonds in balanced portfolios. 


[1] "U.S.: happy birthday to the expansion, with more to come," Global Data Watch, August 8, 2014.