Commentary

2014 as an inflection point

By Edward Harrison

Daily Commentary

When I last wrote you I was talking about 2013 as being akin to the mid-cycle tightening year of 1994. In this view, we are well into a business cycle but it is far from over because of cyclical agents could spur the cycle on. But what about the opposite view, that we are nearer to the end of the cycle? Some very brief thoughts here

The case for a robust outlook

What I was suggesting on Friday is that there is a possibility that a tightening a la 1994 precipitates a capital spending binge as it pulls forward demand in anticipation of further tightening. This works to accelerate the business cycle along with the associated hiring and interest income that also boosts wages. There is some evidence that we are on the cusp of an uptick in capital spending in 2014, something that would re-create that pattern.

For example, the Wall Street Journal is running a story that on why business investment could break out in 2014.

Rising stock prices and real-estate values, sturdier household finances and lower gas prices should help consumers spend more in the months ahead. And the two-year budget deal reached by Congress late last year should reduce the risk of another Washington-made crisis when lawmakers tackle the nation’s borrowing limit again next month. While Friday’s jobs report was a big disappointment, the larger picture in the labor market has been steady albeit unimpressive growth.

It is against this backdrop that more companies appear likely to step up their spending. One gauge of business investment—new orders of nondefense capital goods, excluding aircraft—grew 4.1% in November, the biggest jump in nearly a year, after shrinking for two months. A broader measure of business spending that includes buildings and software grew at an annualized pace of 4.8% in the third quarter of 2013 and 4.7% in the second, after declining 4.6% in the first quarter.

Economists now expect business spending to keep accelerating. Bernard Baumohl, chief global economist with The Economic Outlook Group, expects the broader measure of business investment to expand 7.3% in 2014, versus 2.5% in 2013; IHS Global Insight sees this gauge speeding up to 4.9% this year and then to 6.3% in 2015 and 7.8% in 2016.

“The incentives to invest are there,” said Doug Handler, IHS’s chief U.S. economist.

If one looks at the auto industry, the same dynamic of increased capital spending holds – and much of it is built around frothy credit markets due to toward loosening credit standards. Globally, automakers are ramping up R&D. And we see auto sales picking up in the US, the UK, China and most other important economies – the eurozone being an outlier. GM is thinking of re-introducing a dividend – sales are that good.

If one looks at where the demand is coming from, much of it is cyclical i.e. driven by the credit cycle. I had a twitter rampage on Sunday referring to the new subprime mentality in autos and corporate lending.

My view here is that tightening via tapering as the economy improves will accelerate the move into subprime and junk bonds as issuers of debt will move forward their issuance to lock in lower yields. That can only work to strengthen growth in the US over the near term.

The case for a cautious outlook

But the sticky wicket there is growth. In autos, US car makers had disappointing December sales. I believe this is important as it points to weakness in retail in the auto sector where credit quality has diminished. If we see more of this, we will have an inventory and jobs problem, especially given the auto sector’s 2014 expansion plans.

Though I tend to be relatively upbeat about the retail sales numbers, the holiday season trend is not clear. ICSC, a retail association group, said retail sales were up 3.7% in December. Yet, at the same time, retailers have slashed fourth quarter earnings estimates. I presume the disconnect is because of heavy discounting and competition rather than poor retail sales numbers. But the concern has to be that the lack of wage growth is catching up to US consumers.

The US jobs report for December was decidedly weak with only 74,000 jobs added, 87,000 in the private sector. Although the ADP data showed a much more robust 238,000 add. So it isn’t clear where the trend is on jobs. But the unemployment rate trend is down, with the unemployment rate now dropping to 6.7%.

The Evans rule which has the Fed moving to a tightening bias at 6.5% is officially dead and the forward guidance the Fed has given has no clear numerical focus. What this could mean – if you think the economy is weak due to poor employment and wage growth – is that the Fed is tapering into a weakening economy.

Conclusion

I lean heavily toward the robust outlook narrative but one can make a case for the cautious outlook narrative. I believe we will have more information after the earnings season. If inventories are ok, that will point to consumer demand continuing enough to pass the cyclical baton to business investment and wage growth, making 2014 a good year for growth. Corporate profits would be boosted by this scenario in conjunction with the ongoing debt issuance and share buybacks that is boosting earnings per share. This is a scenario in which elevated stocks do not come crashing down but continue to levitate higher – as they did in the late 1990s, by the way.

And then we could really move into a bubble scenario. 

We are at an inflection point. If growth weakens due to low wage growth sapping consumer demand, the Fed will lengthen its tapering timetable, rates will fall and we will continue a muddle through. If growth continues at a good clip, business investment and increased hiring will carry this business cycle to new heights.

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Edward Harrison 7783 posts 575 comments

Edward Harrison is a senior Editor at Bloomberg. He is also the founder of Credit Writedowns newsletter, a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.

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