Author: Simon Baptist

Location: London

Date: 2014-02-06

The economic expansion in the second half of 2013 was the fastest in a decade, supporting our view that the recovery is broadening and that the US is embarking on an extended period of faster growth. Higher employment, less debt (as a share of income) and low bank borrowing costs have boosted consumer spending, which grew in the fourth quarter at the fastest pace since 2010. This is particularly encouraging as consumer spending accounts for almost 70% of the economy and, generally, tends to track headline GDP growth.

After five years, the US is finally turning a corner

Three broad trends have brought consumer spending to this tipping point. Job creation over the past two years has averaged 183,000/month and the unemployment rate fell to 6.7% in December, the lowest level since 2008. Households are nearing the end of a deleveraging cycle: they are beginning to spend more and devoting less income to paying down debt. The ratio of household debt to disposable income fell from 126% before the recession in late 2007 to 100.6% in the third quarter of 2013. Meanwhile, although the US Federal Reserve (Fed, the central bank) has started to wind down its very loose monetary policy, interest rates remain near historical lows. This combination of factors suggests that, more than five years after the start of the Great Recession and several false dawns later, US consumers are ready to power the economy again.

Signs of strength were evident throughout the economy in the fourth quarter. Exports grew by an annualised 11.4%, while imports expanded by just 0.9%. It is likely that these trade numbers will be revised—the US normally cannot have such high consumption growth without drawing in imports from around the world—but trends in the trade data bode well for the economy in 2014. The main factor dragging down import growth was a drop in petroleum purchases, which fell by 11% in the first 11 months of the year, compared with a 2% increase in non-petroleum imports. This is due to the rapid rise in unconventional domestic shale gas and oil extraction: the International Energy Agency now estimates that the US will be the world's largest oil producer by 2015. Meanwhile, after several years of low wage growth and economic restructuring, the US has become more competitive. As a result, auto exports increased by 3.8% in January-November 2013 and consumer goods exports climbed by 5.1%.

The future is brighter

In addition to the upturn in job growth and the pay down of debt, the economy in 2014 will also be supported by a return to fiscal expansion. After more than three years of decline, state and local government finances have rebounded. Tax collection is up, public sector employment is rising, and state and local governments were net contributors to economic growth in the past three quarters. This is a significant turning point. While the federal government attracts more media attention, it accounts for only 40% of overall public outlays, compared with 60% at the local and state level. Thus, despite a continued decline in federal spending, it looks as if overall government spending will increase in 2014 for the first time since 2010.

No return to the boom years

The decision to increase our real GDP growth forecast for 2014 to 3% is backed by an improvement in the economic fundamentals; indeed, the risks to this forecast remain to the upside. That said, the US is not on the verge of a boom. The unemployment rate is still elevated, debt levels need to fall further, and market interest rates will increase gradually in coming years, acting as a headwind. Moreover, while real GDP growth of 3% would be the fastest rate since 2005, and better than any year during the recovery, it is still below the period from 1992-2000, when real GDP growth averaged 3.9%.

In addition, despite the positive data in the second half of 2013, and brighter economic conditions expected this year, there are still significant risks. The housing market slowed towards the end of 2013 as market interest rates rose. Residential investment contracted in the fourth quarter, for the first time since 2010. In December, the volume of home mortgages fell to the lowest level in five years. However, we think this dip will prove temporary. The recent flight to safety from emerging markets has lowered the US 10-year Treasury bond yield from 3% at the start of January to just 2.65%, which will reduce mortgage rates. An expected increase in housing supply, combined with a further improvement in household balance sheets, will also support the sector.

The second risk, weak business investment, is more of a puzzle. Although US corporate profits as a share of GDP have reached their highest level in more than half a century, investment by companies has been lacklustre and growth in non-residential investment slumped from 7.3% in 2012 to 2.6% in 2013. This low level of business investment is due to a combination of factors, including uncertainty over the economic outlook, tighter business regulation, and strong incentives for many corporations to buy back shares rather than reinvest profits. Although a much smaller portion of the economy than consumer spending, business investment has a significant impact on job creation. We would prefer to see investment rebound to 6-7%, which would indicate that companies have greater confidence in the economic recovery and are investing to meet higher future demand.

Although risks remain, the US economy looks poised to enjoy its best year since 2005. A broader US recovery, which has been heralded every year since the financial crisis, is finally set to materialise.

 

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