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Monday, November 11, 2019

Economy Past Peak, No Recession Yet

In this article I confirm and reinforce my analysis that the economy is past its growth peak and taking a "breather". However, we can still head for a recession if two things go wrong in the fourth quarter of this year.

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A month ago, after examining second-quarter GDP numbers, I concluded that the U.S. economy is going to take a "breather", not go into a real recession. Based on preliminary GDP numbers for  the third quarter, I reinforce my conclusion. 

The key variable is gross fixed capital formation, GFCF, or business investments. Here is what they look like for the last two years:

Table 1
Source: Bureau of Economic Analysis 

2017 2018 2019
Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
GDP 2.80% 2.86% 3.20% 3.13% 2.52% 2.65% 2.28% 2.03%
GFCF 4.76% 5.46% 4.06% 5.55% 5.13% 5.11% 3.89% 0.21%
Nonres. 5.43% 5.98% 6.85% 6.76% 5.87% 4.78% 2.55% 1.25%
Nonres. structures 1.52% 2.65% 4.85% 6.41% 2.60% 0.69% -4.75% -8.15%
Nonres. Equipment 8.54% 8.62% 7.22% 6.37% 5.04% 3.35% 2.70% 0.99%
Nonres. IPP 4.00% 4.83% 7.76% 7.55% 9.31% 9.59% 7.50% 8.15%
Residential 4.18% -0.05% -0.43% -0.96% -4.42% -3.38% -3.18% -0.97%


The GDP number suggests that the peak of this growth cycle is over. The same applies to the growth injected into the economy from the Trump tax cuts. They were good and necessary, but their emphasis on the corporate side simply did not inject enough purchasing power into the economy to sustain this growth cycle any longer than this. 

It is clear now that business investments have completed the growth cycle generated by the tax cuts. The spending on structures - manufacturing plants, storage facilities and office space - expanded the production capacity of the economy. To fill that new capacity, businesses bought new equipment; expectably, equipment purchases have continued to grow a couple of quarters after there was a stagnation and then decline in investments in structures. The new square feet of production capacity has now basically been filled up, as indicated by the 0.99 percent growth in non-residential equipment investments. 

Home construction has declined for seven straight quarters. This is not as much a business cycle indicator as are non-residential investments, but it suggests that the supply of home square footage has reached the height of demand. It is too early to determine whether or not this is due to investments ahead of an otherwise strong market, or a stagnation or even decline in demand for homes. A closer look at consumer spending and personal income will help us determine which of the two we are witnessing.

Speaking of consumer spending. It remains strong, and although its growth rate is below 2.5 percent in Q3, a first for a quarter in two years (Q3 2017), there is an uptick in spending on goods:

Table 2
SourceBureau of Economic Analysis 

2017 2018 2019
Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
C 2.95% 2.77% 3.17% 3.44% 2.64% 2.51% 2.64% 2.49%
    Goods 5.03% 4.53% 4.52% 4.40% 2.93% 3.00% 3.78% 4.26%
        Durable goods 7.74% 7.44% 7.54% 6.44% 3.75% 3.24% 4.40% 5.42%
        Nondurable goods 3.67% 3.07% 3.01% 3.37% 2.52% 2.88% 3.46% 3.67%
    Services 2.01% 1.97% 2.56% 3.02% 2.52% 2.29% 2.13% 1.70%


In fact, spending on goods has accelerated - the growth rate has gone up - for three quarters straight. We saw no such thing in the 2015-2016 "breather"; data from the Millennium Recession in 2000-2002 is not available at that detail of a level; a review of current-price data shows the expectable V-shape in goods spending. In other words, during the Millennium recession consumer spending on goods declined until it reached the bottom in Q3 of 2001, whereafter the growth rate accelerated again.

We are not seeing this pattern yet - on the contrary, goods spending is not just rising (a positive growth number) but actually accelerating (the growth number increases). Add to this that unemployment remains low at 3.6 percent and that labor costs are growing at the same rate on an annual basis. 

Consumers are making good money. There is still steam in this economy. 

If Christmas shopping is strong, it is fair to expect business investments to pick up again in the spring. These advance-estimate GDP numbers point to a resilient Christmas season. Another reason to expect this correlation is that while consumer spending on goods now rises at more than four percent on an annual basis, imports of goods is actually stagnant. Growth in consumer spending on goods has outpaced growth in goods imports for three quarters in a row now, indicating that domestic manufacturers have picked up more of consumer demand for goods. 

It is worth noting that not all goods imports are consumer goods. Nevertheless, keep an eye on manufacturing hirings in the coming months; if the resiliency in consumer goods spending is indeed benefiting domestic manufacturers, we should see some positive numbers there in the fourth quarter of this year.

To sum up: the economic breather will not escalate into a recession if Christmas shopping is strong and if U.S. manufacturers show resiliency in the fourth quarter. If consumer spending loses pace this Christmas, it is unlikely that manufacturers will keep hiring and get back to investing. Therefore, a disappointing holiday shopping season will tell us that it is time to upgrade the "breather" forecast to a recession forecast.

My bet, though, is on a breather, not a recession. 

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