Real GDP rose at a 0.7% annual rate in the advance estimate for 4Q15, roughly what was expected before the release, but a lot lower than was anticipated at the start of the quarter. It’s not as bad as it looks. Growth was held back by foreign trade and slower inventory growth. Domestic demand was mixed, but moderate. The fourth quarter numbers don’t tell us much about the important question: what’s growth likely to be over the course of this year. More troublesome, there are more important concerns about the economy’s long-term prospects.
Net exports subtracted 0.47 percentage point from fourth quarter GDP growth, according to the advance estimate. Slower inventory growth subtracted 0.45. Private Domestic Final Purchases (consumer spending, business fixed investment, and residential homebuilding) rose at a 1.8% annual rate, vs. a 3.2% increase over the four previous quarters – so we can’t pin fourth quarter softness on the rest of the world alone. Consumer spending slowed. Business fixed investment turned down, with weakness concentrated in structures (mostly energy exploration) and transportation equipment (no detail available).
While GDP growth slowed in the fourth quarter, monthly figures suggest a sharp loss of momentum in November and December. Durable goods orders fell sharply. Consumer spending was disappointing. One possibility is that consumers and businesses may have been reacting to the news. Fear of a slowdown can become self-fulfilling. This is a greater concern for the rest of the world than it is for the U.S., where business can make adjustments as demand picks back up (if the fear is contained and unwarranted). However, it bears watching closely. One of the key elements in the financial crisis was panic. Panic made the housing correction and deleveraging much more sinister. A panic is difficult to predict. Bad news can feed on itself, but it’s hard to gauge the timing and magnitude.
Many point to the data as evidence that the Fed made a mistake by raising rates in December. Hindsight is a wonderful thing. However, the Fed would likely have faced greater market adjustments if it waited. Postponing a rate hike in September led to further undue risk-taking. The Fed’s focus is on the job market (slack still being reduced) and the inflation outlook (likely to move back toward the 2% goal as oil prices stabilize). The Fed did not cause January’s stock market weakness (which was more sentiment than fundamentally driven). Investors were disappointed with the January 27 policy statement. The Fed simply signaled that it was keeping its options open. Investors were hoping for a strong signal that rate hikes would be on hold for the foreseeable future. By stressing the job market in the policy statement, the Fed implied that a March rate hike was still on the table (although widely seen as not very likely).
While investors have been fearful that the U.S. economy will not escape the pull of slower global growth, there are more important long-term concerns. Slow fourth quarter growth, combined with strong job market improvement, means that productivity (output per work-hour) likely fell in 4Q15. These figures are erratic (large quarterly swings and sizable revisions), but the trend over the last few years has been poor (about a 0.6% annual rate). The weak trend adds support to the view that we’ve entered a period of secular stagnation.
Labor costs are an important part of the inflation outlook, but you need to account for what you’re getting for that added labor expense. That’s were productivity comes in. Unit Labor Costs (labor expense per unit of output) are trending at a higher rate. This could show up as higher inflation if firms can pass the higher costs along, or it could show up as a squeeze on corporate profits if they can’t. Nobody knows if the productivity slowdown will be temporary or longer lasting. However, a more permanent slowdown would have far reaching implications for the longer-term economic outlook.
Global economic conditions do not appear to be severe enough to justify this year’s adverse market action. However, the adverse market action may pose a risk to the global economic outlook. While the global financial system may currently seem a bit unstable, it’s unlikely that fear will become a self-fulfilling prophecy. At least, that’s the hope.
Currency attacks on individual countries are a well-known phenomenon. Something bad happens. Investors start pulling their money out of the country. That puts downward pressure on the currency, creating more incentive for investors to pull their money out. Central banks can try to break the cycle and keep capital from fleeing by raising interest rates, but that slows the economy. This pattern was repeated across several countries during the Asian financial crisis of 1997. China is seeing such a run now. The country still has a large trade surplus, but outflows have exceeded that, putting downward pressure on the yuan. Most of this appears to be due to Chinese investors looking to put more of their money overseas (seemingly justified by expectations that the central bank will allow the currency to depreciate). China has capital controls to limit that, but most of the capital outflow appears to be funneled through Hong Kong and disguised. The central bank has plenty of reserves to defend the currency, but it has been burning through those rapidly. Last month’s decision to begin referencing the yuan against a basket of major currencies, rather than against the U.S. dollar alone, was taken as a signal that the currency will depreciate. Indeed, a lot of China’s financial woes have been self-inflicted. Authorities have been sending mixed messages.
The price of oil, as anyone who passed Econ 1 can tell you, is dependent on supply and demand. The U.S. is producing more (and importing less). The lifting of Iranian sanctions will lead to more supply. Reports have indicated a large number of filled tankers in the Gulf waiting to go somewhere. Concerns about a lack of available storage have become an issue. Where are we going to put all this oil? However, in recent weeks, financial market participants have acted as if the price of oil were more a reflection of global demand. This logic can be circular. Stocks are down because the price of oil is down, but the price of oil is down because stocks are down.
The benefit of lower oil prices to energy consumers usually outweighs the pain for energy producers. However, we have not seen as much of a boost from lower gasoline prices as we would have in the past. Consumers may have been saving a large part of the windfall, doubtful that gasoline prices would stay low. Another possible explanation is that the U.S. is simply less dependent on imported oil and domestic producers will take a hit. Energy exploration is capital-intensive and has been supported by debt in recent years. With the price of oil having fallen further, there are increased concerns in the fixed income market of widespread defaults. Data also suggest that energy-related debt has increased even more as the price of oil has declined. Pain has been felt, and will continue to be felt, by those who own that debt, but this doesn’t appear likely to be a systemic problem for the overall U.S. economy.
Last week, the International Monetary Fund lowered its outlook for global growth by a whopping 0.2 percentage points – not a huge change. However, the IMF noted increased downside risks to the outlook. These included the possibility of a sharper-than-expected slowdown in China (with more international spillover and downward pressure on commodity prices), adverse corporate balance sheet effects and funding challenges related to the tightening of Fed policy (further dollar appreciation and tighter global financial conditions), a sudden rise in risk aversion (sharper depreciations and possible financial strains in emerging economies), and an escalation of ongoing political tensions. Sounds scary, but it’s important to remember that these are risks, not the IMF’s expectations.
The global financial system appears to be much more fragile. Of Friday, the Bank for International Settlements put out a note on fixed income liquidity. To date, “the effects of ongoing regulatory, technology and market structure changes do not appear to have had large, persistent effects on the price of liquidity services for most major asset classes, but rather have been reflected in increasingly fragile liquidity conditions.”
Okay, we have nothing to fear but fear itself. While a more serious global slowdown is not expected, it remains a possibility, perhaps hastened by a fragile global financial system. After the last few weeks, investors may have more moderate expectations for 2016, but it’s the greater risk than matters.
Recent economic data releases have been mixed. However, despite strong job figures, most have been on the soft side of expectations. Lower commodity prices are tough for producers of raw materials, but beneficial to the buyers of those materials. However, the bigger concern is why commodity prices are falling. Many view the drop in oil prices as signaling a more pronounced global slowdown and fear that the U.S. domestic economy may not be robust enough to escape that. The anecdotal data from the manufacturing sector is much worse than is suggested by the hard economic data reports.
Last week, we heard more talk of the possibility of a U.S. recession. Curiously, while the odds have gone up, a recession in 2016 is still viewed as unlikely. We are never “due” for a recession. The probability of recession does not depend on the length of the economic expansion preceding it.
We’ve never had a sustained decline in industrial production without a recession in the overall economy, but that doesn’t mean much – as the manufacturing sector has accounted for an ever smaller share of the U.S. economy.
What do we mean by “recession?” The common definition is “two consecutive quarterly declines in real Gross Domestic Product.” However, for the U.S., that’s only a rule of thumb. The official call is made by the National Bureau of Economic Research’s Business Cycle Dating Committee (which sounds like a lonely hearts club for pedaling nerds). A recession is defined as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” Nonfarm payrolls, a coincident indicator, have continued to improve at a strong pace. Industrial production is now trending a bit lower. Real personal income should be moving higher.
In recent months, the weakness in industrial production has been most pronounced in the output of utilities (unseasonably warm temperatures) and the contraction in energy exploration. Manufacturing output has softened, but not a lot. However, the Fed’s IP data measure real output (which doesn’t appear to be falling much and may be supported by quality adjustments). Nominal factory shipments fell 3.9% in the 12 months ending in November (durables +1.7%, nondurables -9.1%). Export prices are down over 10% since December 2013. Anecdotally, manufacturers generally report that things are tough all over, reflecting soft global demand and the impact of a strong dollar.
Energy has been an important component of the U.S. economic recovery. Up until the bust in oil prices, jobs in energy exploration were rising about five times faster than overall employment. However, the number of jobs is tiny compared to overall nonfarm payrolls (we’ve lost 129,000 mining jobs since the end of 2014, while nonfarm payrolls rose by more than 2.6 million). While this may be devastating for local communities (these tend to be high-paying jobs), it’s not much on a national level. On the other hand, energy exploration, which is capital intensive, has been a much bigger factor in business fixed investment. Much of the correction took place in the first half of 2015. However, the price of oil has now gone from $60 per barrel in late June, to below $30. Simply put, if $40 was “horrible” for most energy producers, $30 will be “impossible.”
The bigger concern is why oil prices have fallen further. Some of that is supply, but we are seeing global investors react to the day to day movements in the price of oils as if it were a gauge of global economic strength – hence, adding to the negative mood.
Can the U.S. economy withstand global weakness? Of course it can. Our economy is largely self-contained, with consumer spending (70% of GDP) being the key factor. However, 2016 GDP growth may be slower than what we had hoped to see.
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