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Bright Spots in an Otherwise Lackluster Recovery

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1-Auto Industry    2-Capital Investment in France   3-Consumer Spending in Spain

Although there are still legitimate concerns about the future of the euro area, the recession is definitely over. Like all such episodes, this one comes with a number of pleasant surprises. Here are the three main ones:

• The first and most significant surprise from the investor standpoint is a recovery in Europe’s auto industry, along with improved stock performance for the firms involved.

• The second—and much more surprising—surprise is that the indicators we track on the French economy show a brighter outlook for industrial investment in France

• The third, and possibly most important surprise—given the risks that Spain’s sluggish economy pose for Europe as a whole—is that spending by Spanish consumers is clearly trending upward.

While none of these surprises taken alone has enough weight at this point to convince us to make any major changes to our growth forecasts, they each help restore a modicum of confidence—perhaps even with unexpected repercussions.

World Growth Monitor

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Going it alone. The global economic picture is unquestionably looking brighter. Unlike previous recoveries, however, this one is fueled above all by consumer spending. The trend is especially noteworthy in Europe now that austerity policies have been scrapped. But it can also be observed in the United States—since the country has steered clear of the fiscal cliff dangers at the start of the year—and Japan, where the Abe administration’s first moves have lifted the spirits of local consumers. Even in China, sustained consumer spending is what has offset the negative impact of an end to export support. So on the whole, the environment is more encouraging. Yet the missing ingredient here is what proved to be one of the key drivers of global growth in the 1990s—world trade. This has two main implications:

  1. Global growth will be weaker than in the past, and will stay that way for some time.
  2. There will be greater risk for economies that are still too dependent on exports, i.e., the emerging economies in general and more specifically those suffering from structural imbalances—Brazil, India, and South Africa—and increasingly burdened by mounting current account deficits.

The Upcoming Fed Meeting: Playing for Time

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Most pundits agree that the question isn’t if the Fed will taper off its liquidity injections, but by how much. And they hope to find answers in the minutes of the next FOMC meeting a month from now. It’s unlikely the Fed will backtrack from previous guidance; even that was enough to steer markets back in the right direction. Long-term interest rates are returning to more normal levels, and capital is starting to flow back into money-market funds. An about-face by the Fed at this point would be more likely to wreak havoc than anything else. However, a closer look reveals that the economic indicators predicating investors’ newfound optimism don’t actually point to a U.S. recovery (see below). Many of these indicators remain weak, signaling that the world’s largest economy isn’t strong enough yet for a return to regular interest rate levels.

Japan Bull Markets Die of Anemic Demand

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Japan’s reflation campaign looks impressive. Unfortunately, it is unlikely to work.

True, the substantial depreciation of the yen brought about by the BoJ policy of massively injecting liquidity into the system has driven up corporate profits since the start of the year—even way up in some cases. But this competitive surge has had such a depressive effect on other economies in the region that they now offer a shrinking market for Japanese goods. In fact, what Japan is exporting may well be its own deflation, and to a degree at least commensurate with the inflation target set by the government.

So what can be expected of “Abenomics” if it fails to engineer a rebound in exports? Domestic forces certainly won’t generate inflation: population aging has already done serious damage to the country’s growth potential, and encouraging mass immigration—the only policy with a chance of reversing that trend—is simply not on the government agenda today.The other measures announced will therefore be about as effective in boosting potential output as a band-aid on a wooden leg. With its supply-side bias, the Abe administration’s strategy will have no lasting impact on growth unless it succeeds in re-igniting demand.

All this makes it hard to buy into the current stock market enthusiasm. The Nikkei bull run since last December just doesn’t square with the persistently bleak outlook for the Japanese economy. What follows is a new analysis of this issue by Frank Benzimra, one that concludes with the firm recommendation to dump Japanese equities.

The Euro Area on its Own—With Some Heavy Lifting to be Done

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The recession in the euro area is almost officially over, but that doesn’t mean the economy is back to normal—far from it. As long as no structural growth policies are enacted, the outlook for the EMU will remain grim and member states will have as much trouble meeting their fiscal targets as before. This leaves just two options open. Either Europe reverts to austerity—in which case the recovery will collapse and we’ll be in for another slump with highly unpredictable consequences—or the ECB completely overhauls its policy stance. The latest developments in the international arena make this second option increasingly likely.

Bernanke and the Fool’s Gold of Falling Unemployment

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The last time U.S. unemployment fell below the 6.5 percent mark, the country’s GDP was growing at an annual clip of about 3 percent, real household spending was rising at nearly 4 percent a year, monthly job creation was flirting with 300,000, and annual wage growth was just over 2.5 percent. That was back in March 1994, but similar conditions prevailed in March 1987 and in December 1977. Each time around, labor utilization and capacity utilization were close to potential output—making monetary tightening to one degree or another the right choice. And each time around, a cycle of higher interest rates duly ensued. But in 2003 and 2004, the economic climate was entirely different. Not only had the jobless rate been stuck below 6.5 percent for about a decade; there wasn’t a single blip on the radar screen to suggest that the economy might overheat. So it wasn’t until mid-2004, with unemployment hovering at around 5.5 percent, that the Fed initiated a rate-raising campaign. A good many pundits would later criticize this belated adjustment, identifying it as a major inflator of the now-infamous real estate bubble.

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Thus, when it came time a few months ago to provide forward guidance on monetary policy, the Fed understandably selected the 6.5 percent unemployment mark as a key criterion for when and how to taper its quantitative easing program.

Even so, this policy choice raises a whole host of questions. A given jobless rate may in fact reflect a much shakier economy today than it would have during previous, seemingly similar periods. 

How Effective is the Wealth Effect?

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The wealth effect—the increased consumer spending thought to result from rising financial and real estate asset prices—is frequently cited as a key argument for renewed faith in the U.S. economy today. That faith, however, may soon prove to be misguided, as we will attempt to show in this paper.

Economists use the term wealth effect in a very precise way: to explain how household savings patterns shift in response to changes in household net worth. When net worth goes up, due to an increase in the assessed value of homes or to rising stock prices, for example, people tend to set a smaller share of their wealth aside—in other words, their personal savings rate goes down, leaving more money for consumer spending. The term wealth effect basically refers to this higher consumption.

The wealth effect was particularly significant during the 2000s. It isn’t hard to demonstrate, for example, that in every year from 1998 to 2007, rising property values alone shaved as much as one percent off of the U.S. household savings rate. This made it possible for consumer spending to grow faster than disposable income, which had slowed as a result of weak job creation. For one thing, the perception of greater wealth created by rising asset prices tends to reassure households and boost consumer confidence in ways that encourage spending. For another, in countries with highly developed mortgage markets, increased net worth improves household balance sheets and enables homeowners to borrow more extensively. The macroeconomic benefits often produced by these factors would, of course, be particularly welcome in the United States today, since the Federal Reserve’s policies have turned out to be more effective in driving up assets prices than in stimulating the broader economy.

However, a number of problems are likely to prevent the wealth effect from operating as in the past:

  • The first, and by far the biggest one, is the current savings rate in the U.S. Because the processes described above don’t directly generate income, they can’t influence growth unless consumers dip into their savings. This means that the strength of the wealth effect depends to a large extent on how high the personal savings rate initially is. As it turns out, that rate was equal to just 2.5 percent of U.S. disposable income in April, leaving very little room, if any, for a further decrease.
  • The second problem hinges on how much debt American households already carry and on whether paper wealth gains will enable them to borrow more. The answer is: they won’t unless those households can afford a higher debt ratio—a rather improbable scenario at this stage. To understand why, it is important to bear in mind the distinction between the household debt service and household debt ratios. Due to falling interest rates—which have allowed U.S. homeowners to refinance their mortgages—and to extensive debt cancellation brought about by the wave of foreclosures in recent years, debt service payments as a proportion of disposable income have plummeted. This decrease in the debt service ratio has made more money available to households and has therefore been a major contributor to the recovery in consumer spending over the past two years. But this process can’t rightfully be considered a wealth effect, and since it is already behind us, it is unlikely to be much of a stimulus to future consumption. The debt ratio, which measures the stock of household debt as a proportion of income, is the only reliable predictor of household borrowing capacity. Unfortunately, it has remained stubbornly high: barely 20 percent below its pre-crisis peak, and thus well above its long-term average. So there is probably very little scope for a substantial increase in U.S. household debt—which in any case would be a bizarre development right after a debt crisis of the kind we have just been through.

All this, along with low job creation numbers, should make it clear why we have more doubts than most on the prospects for buoyant consumer spending in the U.S.

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The U.S. Economy: Don’t Count Your Chickens Before They Hatch

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Sentiment on the U.S. economic outlook has gone from a flurry of uncertainty at the start of the year to renewed optimism. Admittedly, there are grounds for being bullish. Growth has held up despite tougher fiscal and tax policies; the housing market recovery has continued; and the Fed has stuck to its easy money policy. But let’s not get carried away! The latest numbers are no more encouraging than those available at the end of last year. In particular, decelerating productivity growth, with all that it implies in terms of profit, investment, and job trends in the next few quarters, may well drag the U.S. economy back down in the second half of the year. And with a policy mix that is less accommodative than before, the key ingredients for a genuine recovery are still nowhere to be seen. All this has conditioned our analysis on several points:

  • We wonder whether a change in monetary policy is on the short-term agenda—and worry that the Fed may withdraw its support too soon.
  • While we aren’t overly concerned about trends in the U.S. bond market and the euro’s exchange rate, we do suspect that the stock market will be more vulnerable to disappointing macroeconomic data.
  • We have very little faith in the American economy’s chances of regaining its status as powerhouse of the global economy before the year is out.