Upbeat cyclical trends are juxtaposed to underlying financial fragility
This post is on the same topic of the US economy that I addressed yesterday. But I want to go a bit deeper and add more colour to my comments. Signs that the US economy’s cyclical outlook are improving are getting ever more numerous, especially when we look at the labor market.
In the US, jobless claims came out today, showing that in the week ending July 26, seasonally-adjusted initial claims were 302,000, an increase of 23,000 from the previous week’s revised level. Now, the previous week was a red-hot 284,000, which is really the lowest we can expect the claims series to go. The 4-week moving average is now 297,250, a decrease of 3,500 from the previous week’s already low number. The 4-week moving average is now at the lowest level since April 15, 2006, during the glory days of the housing bubble.
So what can we make of these numbers?
First, the numbers suggest an economy now adding 250,000 to 350,000 jobs per month. That’s a good clip and up from my last statement of 200,000 to 300,000 jobs. We will get the number tomorrow. I understand Morgan Stanley’s Vincent Reinhart expects 230,000 for the non-farm payrolls and an unemployment rate down to 6%, just outside the lower end of the range I am giving.
Second, data out today also show wage growth catching on. The US Labor Department reported that the Employment Cost Index, which is a broad measure of labor costs, rose 0.7% in Q2. That is the largest gain since Q3 2008 and follows a 0.3%gain in Q1. Through June, labor costs are up 2.0% year-on-year. That’s higher than the 1.8% year-on-year uptick we saw after Q1. While labor costs and wages are two separate numbers, I think they are reasonably close so we can use this as a proxy. These numbers support a baseline advance of 2% in economic growth.
Third, when numbers get to these levels, which are cyclical highs, there are two forces working at odds with one another. On the one hand, we should expect slack in the labor market to disappear rapidly. When you have a cyclical low in claims, the uptick in job growth will be apparent and the wage pressure should mount. Those are good things. Moreover, these pressures should add to production in the form of inventory building, such that the baseline for growth moves above the job growth plus wage rate growth level. I would push up the trend growth level to 2.5 to 3% based on the labor cost and jobless claims numbers, meaning while 2014 is a 2% trend due to the hiccup in Q1, we are now in a rolling 2.5 to 3% trend growth phase. On the other hand, we should expect mean reversion at these levels.
The composite picture I draw then is of a US economy that is starting to fire on all cylinders and that has a trend growth level of above 2.5%, with additives coming from capital investment and inventory accumulation in addition to wage and job growth. This means, if business investment kicks in, we could actually surpass the Q3 2013 level that I have long seen as peak growth for this cycle. At the same time, the fact this cycle is five years old and statistical mean reversion suggests that we are in a position more akin to April 2006 as the jobless claims numbers suggest than earlier in the cycle. We should be thinking of 2006 and 2007 as comparisons for the real economy and asset markets of today.
I should say at this point that I agree with commentators that wage growth is a good thing, not something to be feared because of inflationary consequences. An economy that is not seeing job and wage growth is an economy that is either weak or growing on an unsustainable basis. So I welcome these signs that wages are finally rising. The problem is that they are rising in the context of a late-cycle credit environment, with asset markets overheating. Financial fragility is a problem then. I will discuss this in a bit but let’s look at the GDP numbers first.
There were a few components to the GDP numbers yesterday that bear discussing here because it helps inform how to think about how this recovery is progressing.
Neil Irwin at the New York Times has some good graphs in his breakdown of the Q2 GDP numbers. Here are three.
What we see in this second graph is that personal consumption is supporting just under 2% growth, what I would consider the base of economic support, while the rest of growth is coming from cyclical factors of capital investment and inventory builds. The Irwin graphs only show a 0.3% GDP growth support from government spending but there is a lot of cyclical juice there from state and local governments. State and local government spending rose 3.1% quarter-on-quarter because their economic situation has improved due to the improvement in the economy and their tax base. The fiscal drag from federal spending is a secular trend due to the anti-fiscal anti-deficit politics of Washington.
This third graph shows what I have been saying about 2%ish trend growth being the norm for this cycle. And while that has been true, I do think the most recent figures have bumped this up and we should expect the growth trend to start rising toward 3%, with much of this due to cyclical factors of business investment, inventories and state and local government.
All of that cyclical data is good. If anything, the wage data gives the Fed less room to maneuver and we should expect the Fed to increase noises about tightening, especially given the recent FOMC dissent from Plosser.
My concern here is financial fragility. I think a good reference point is 1996 Japan. The US has recognized bad debt a lot more than Japan and so, ostensibly, the financial institutions are in better shape. Nonetheless, it is the consumer side where I am still concerned. I don’t think we have seen anywhere near enough deleveraging in the US to take us down to levels that are sustainable on a secular basis.
And the following excerpt from the Washington Post makes clear that deleveraging will return if the economy turns down in the next two years:
About 77 million Americans have a debt in collections, a new report finds.
That amounts to 35 percent of consumers with credit files or data reported to a major credit bureau, according to the study released Tuesday by the Urban Institute and Encore Capital Group’s Consumer Credit Research Institute. “It’s a stunning number,” said Caroline Ratcliffe, senior fellow at the Urban Institute and author of the report. “And it threads through nearly all communities.”
The report analyzed 2013 credit data from TransUnion to calculate how many Americans were falling behind on their bills. It looked at how many people had non-mortgage bills, such as credit card bills, child support payments and medical bills, that are so past due that the account has since been closed and placed in collections.
Researchers relied on a random sample of 7 million people with data reported to the credit bureaus in 2013 to estimate what share of the 220 million Americans with credit files have debts in collection. About 22 million low-income adults who did not have credit files were not represented in the study.
This is the first time the Urban Institute calculated the collection figure, but Americans may have been struggling with debt for a while: Researchers noted that the 35 percent is basically unchanged from when the Federal Reserve studied the issue in 2004 and found that 36.5 percent of people with credit reports had debt in collections.
That last bit is important to remember when gauging the likely effects here. What the numbers suggest is that large swathes of the US population has been living in a constant state of debt stress. The growth in the last cycle when the Federal Reserve study in 2004 was released and in this cycle when the Urban Institute study was released has occurred under that backdrop. Moreover, given the lack of wage growth to support increased debt, the figures strongly suggest that asset prices, particularly housing as it is middle income American’s major asset, has been a big factor in supporting growth.
What conclusions should we draw on financial fragility then?
- US banks have been recapitalized better than their Japanese counterparts at this point in a secular deleveraging
- However, US consumers are in a constant state of debt stress that can only be alleviated by reduced interest payments, increased wages, increased asset collateral value or decreased debt
- Debt service payments are at three-decade lows. This reduces debt stress. But given rates are low in nominal terms, any increase in rates will have an unusually adverse impact on households. Note that mortgage rates are likely to be decoupled from Fed policy as the cycle turns down, meaning that mortgage rates will rise as the housing market softens irrespective of the Fed Funds rate.
- The economic model of structural reform that makes it easier to fire workers and weakens labor power that the US has followed over the last 30 years implicitly suppresses wages by increasing power of capital over labor. Large corporations have wage bargaining power that individuals do not. The result has been, and I believe, will continue to be weak wage growth regardless of the recent cyclical uptick.
- In the past, the Fed has acted against incipient wage pressure rather quickly. However, the Fed’s reaction function has become less geared to suppressing wage growth. So we may see the Fed intentionally try to get behind the curve, Plosser (and potentially) Fisher’s dissent notwithstanding. We could see more wage growth that counters financial fragility.
- Cyclically, the rise in house prices reduces financial fragility. Las Vegas was number one on the Urban Institute debt in collections number with 47% in collections. This is likely due to the steep fall in house prices. Much of the rise in asset prices in places like Las Vegas have gone to institutional cash buyers. Therefore, it is unclear what the impact on cycle trough deleveraging will be. In any event, the rise in house prices is slowing.
- On the consumer debt front, we are into a releveraging phase now. So debt is increasing relative to wages, and relative to GDP. This is increasing financial fragility.
The composite picture I draw from these points is a US that is still very much susceptible to a large-scale deleveraging at this cycle’s next trough, particularly if housing weakens markedly. House price falls would mean a large-scale deleveraging and potentially another financial crisis.
On a cyclical basis, the US economy is looking good. Growth is headed up, wages are increasing, and jobs are more plentiful. So trend growth is increasing. And financial firms are in much better health. But financial fragility is rife on the borrower side of the ledger. If we have a recession in the next two years, we are likely to see another large wave of deleveraging with the concomitant negative impact on the financial sector.