There is much debate these days regarding the direction of the US domestic economy, especially in light of the "fiscal cliff" that lies four short months ahead of us. We think it's very safe to say that Europe is now and will continue to be in recession, if not something worse, for some. In like manner, the emerging economies have been weakening on a trend line basis for a good while. One look at their respective equity markets tells the tale. On a relative basis, the US is for now the "cleanest dirty shirt" economy, according to our friend Mr. Gross at PIMCO.
The respected folks at the ECRI (Economic Cycle And Research Institute) tell us that another US recession has already begun, despite the fact that we cannot yet "see" it in headline economic stats. Several very credible pundits have likewise suggested we are in or very near global recession (John Hussman, Gary Shilling, etc.). Rather than debate the merits we wish to analyze the real character of the US domestic economy in the current economic cycle. What has been driving growth stateside? Will those drivers change? What are the key data points we need to watch?
The pallid, uncertain character of the US economy's "recovery" so far in this cycle differs from anything we've seen in at least 50 years.
The US economy, and specifically GDP, are driven by: 1) personal consumption of goods and services; 2) domestic investment; 3) net exports; and 4) government spending. In 2Q, personal consumption of goods and services accounted for 71% of total US GDP growth, by far the key driver of headline GDP numbers. Further, consumption of services specifically accounted for over two thirds of total personal consumption and in isolation is the largest driver of US GDP at 47% of the total. No other individual economic sector contributor to US GDP even comes close. Herein lies what we believe is one of the most important differentiating factors and watch points of the current economic cycle.
Consider US economic cycles since 1970. Again, focusing on the most important driver of US GDP - personal consumption - let's break apart the contributions of goods and services sectors to total GDP. In the chart below we are looking at the percentage contribution of the US goods sector to real GDP by quarter since 1970 (the data is presented on a seasonally adjusted annualized basis).
Back in the 1970's, the US was much more a goods oriented economy than today. Starting in the '80's, services came to dominate the total domestic US economic landscape. Quarterly contribution by the goods sector to GDP tapered off after the 1970's, but you can see that the pattern of the contribution of goods to GDP since 1980 has been very rhythmically consistent in all economic cycles since that time, including the current. We've put the dashed lines into the chart above to demonstrate the consistency of the goods contribution to total US GDP in each economic cycle of the last thirty years - it has been a very well defined range of experience. Can we say that the US goods sector has experienced something close to a normal economic recovery in the current cycle? We think that's a pretty fair statement based on the pure data. But what is different in the current cycle is that the US goods sector has contributed 80% of GDP growth, a level well above anything seen in three decades.
But here comes the curveball. You've probably heard over the past few years that the current headline economic recovery since 2009 has been one of, if not the weakest in the official history of US GDP data. You've heard this because it's true. But wait a minute, the recovery in the goods sector as seen above looks very normal. Again, true. However, the anomaly in the current economic cycle is the character of the recovery seen in the all-important US service sector. Point blank, it's the weakest service sector recovery in a half century, particularly within the context of an increasingly services dominated domestic economy. The chart below proves the point as we are again looking at the quarterly percentage contribution of the US service sector to headline real US GDP numbers. We've again drawn in dashed lines that measure the range of quarterly GDP contribution by the service sector in the current recovery. The subdued growth stands in stark contrast to historical service sector strength.
The muted growth in services in the current cycle is crystal clear relative to historical precedent. Why has this happened? Answers include wage and employment growth that have been extremely constrained, especially important in that households are still in the midst of balance sheet deleveraging. This set of circumstances for consumers is showing up in diminished services consumption. A second answer is lack of consumer credit growth, often the rocket fuel for services consumption in prior cycles. No HELOC deluge this cycle, to say nothing of cash-out refis that have now become cash-in refi activity. Lastly, as we stand here today US consumers must be contemplating perhaps meaningfully higher tax rates as the New Year dawns.
What we hope is that this perspective helps reframe or refine in focus the potential recession conversation as we move ahead. First, we know Europe will show us slowing import demand, a drag on the US export contribution to GDP. Secondly, the as-it-now-stands fiscal cliff issues mean US government spending is set to fall sharply and personal taxes set to rise. Although we expect this cliff event will be pushed off legislatively after the election, consumer and especially business folks alike do not have the luxury of "guessing" how it will all turn out. The default is to plan for the worst. Finally, although domestic investment is important, it accounts for 13% of total US GDP at present. It's just not meaningful enough to move the macro US GDP needle in any substantial magnitude. Although nominal US GDP has gone on to new highs in the current cycle, domestic investment today remains 12% below its prior peak in 2006. That leaves us right back where we started with a sharp focus on US goods and services, and as explained above with a clear analytical emphasis on the lead horse that has brought us in the current cycle - the US goods sector.
I do not expect an out-of-the-blue recovery in US service sector activity that could help blunt the possibility of a weakening US goods sector. It won't come from financial services, a big US service sector component that is driven by the rhythm of credit acceleration we know that's modest in terms of growth trajectory. Neither from health care services, the other big services sector that has seen consistent growth for decades and is already in the numbers.
A number of weeks back the US retail sales report for July hit the tape. Cheers went up on a "better than expected" number, one that was seasonally adjusted upward. On a non-seasonally adjusted basis the measure was actually down. Importantly, demand for goods are not about what happens in one month, but rather what happens in each economic cycle in terms of longer term upward and downward trends. The chart below is a look at non-seasonally adjusted US retail sales. To smooth out the monthly noise, we are looking at the year over year rate of change in the six month moving average of retail sales. There is a clear peaking rhythm to retail sales in each economic cycle.
Have we already hit the peak for the current cycle? Retail sales data of the moment aren't predicting or confirming recession, but for now the momentum or trend of goods demand is softening on a rate of change basis. Watching this trend will be very important ahead.
Lastly, as part of the highlight focus on goods, we know that goods manufacturing has been a bright spot in the current cycle. Relative US manufacturing advantages such as low natural gas prices and subdued domestic manufacturing wages have helped. A lot of non-durable goods demand is caught up in the retail numbers.
Larger, big-ticket durable goods then become the next watch point. Below we see the character of capital goods new orders. These orders, usually for large durable manufactured goods are high-ticket and require meaningful lead times. These orders for large capital goods aren't placed on whims.
As of July data reported in late August, the year over year change in capital goods orders has ventured well into negative territory and the recent contraction has been steep. The important quarter over quarter rate of change number also shows contraction. Remembering that US recessions have been earmarked by meaningful declines in capital goods orders, we're now resting at critical downside levels of activity based on historical precedent. Given recent weakness, capital goods new orders are now a key watch point for the economy as the current recovery has been 80% driven by the US goods sector.
Again, no date specific predictions about official recession or otherwise - that's not the point. The point is we need to focus on the components and rhythm of the US goods sector in the current cycle. Watching the character, components and trend of retail sales and capital goods news orders will be very important in thinking about the direction of the total US domestic economy. We know Europe, and to a lesser extent demand from the emerging markets, will be headwinds. The US fiscal cliff looms as the level of current political brinkmanship has certainly gone to new highs. Can the US goods sector save the day?
The answer lies dead ahead. When it comes to the US economy, we've got the goods on 'em.