Having escaped the quagmire that is Washington’s bureaucracy, Peter Orszag provided some very interesting commentary during our conference call titled, “Out with the Rhetoric and In With the Facts on the Budget” that took place yesterday. Here I will focus primarily on the insights he provided that pertained most directly to his view of the general outlook for the U.S. economy.
In terms of GDP, the bottom line is that there are many headwinds coming into play. Furthermore, if the Federal Reserve’s $600 billion Quantitative Guess does not work (you know where we stand), the outlook will become even less promising.
First, we need to provide some context around where we have been. Total private sector borrowing amounted to almost 30% of GDP in 2007 and in 2009 it had fallen to less than minus 15% of GDP, so you're talking about a roughly 45% of GDP swing in private sector borrowing over a two-year period. This was a traumatic hit to the nation’s economy, not seen in generations.
The tectonic shifts in the financial sector, housing market, and subsequent (and ongoing) consumer deleveraging pose drastically difficult obstacles for the Federal Reserve to surmount. Unlike slowdowns that are associated with monetary policy being tweaked in order to address inflation concerns, Orszag stated that downturns triggered by the financial sector tend to take result in longer and more sluggish recoveries.
As alluded to by Orszag, a recent study by Reinhart and Reinhart of roughly thirty similar instances of economic downturns triggered by difficulty in the financial sector suggests that the average unemployment rate in the decade following such crises is 5% higher than immediately pre-crisis; housing prices being 15-20% lower over the entire subsequent decade versus pre-crisis levels and government debt as a percentage of GDP being 90% higher that the pre-crisis level. The increase in debt, according to Orszag, reflects the downturn itself and the policy measures that are taken to offset it.
What does the nest 12-to 24 months look like? First the positives:
- Real exports are growing quite rapidly (aided by the debauching of the U.S. Dollar)
- (Notwithstanding the CSCO news today) Investment in equipment and software has been growing nicely. Firms making significant investments in short-lived assets. The problem on the investment side is on the long end; assets with longer depreciation schedules are seeing a historically low share of investment allocation.
- Corporate profits have improved. They were ~12% of GDP in 2006 and 2007, falling to 9% in 2009 and are now back up to ~11% of GDP on 2010. The difference between 9% and 11% represents $300 billion in GDP so it’s significant step up.
One caveat pertaining to point number three is that the surge in corporate profits is not resulting in significant hiring or long-lived investments. Rather the profits are being retained as liquid assets. The psychological impact of the Great Recession is clearly impacting the behavior of the Consumer and Corporate America. The effectiveness, or lack thereof, of the Federal Reserve’s actions is leaving a huge question mark over the economic outlook.
The factors that supported growth in late 2009 and 2010 will become significant headwinds in 2011.
- The inventory cycle is going the wrong way in the first part of 2011; moving to net-neutrality towards impact on GDP growth. (I recently posted that inventory accounted for 2.6%, 0.08% and 1.4% for the first three quarters 2010, respectively) As a side note, Orszag noted that the sequential improvement in GDP in Q3 was unintentional as some firms were caught out by the slump in demand during the summer and unintentionally built up inventories in Q3. That trend, Orszag expects, will reverse itself in Q4 and the early part of 2011.
- The Recovery Act, despite the controversy, added 2%+ to GDP in 1H10. By design the act was to have all the money “out the door” by the end of September and succeeded in doing so. Going forward, the cost of the Recovery Act will be net neutral and eventually as it ramps down and, eventually – in terms of cash flow – will be net negative to GDP growth.
- The final factor is state and local deficits which are projected to be $100 to $150 billion a year for the next two tears. Going forward, a much smaller share of which will be offset by federal subsidies, therefore a much larger share will need to be closed through tax increases and spending cuts at the state and local level.
Taking points two and three, together that added a net 2% to GDP in 1H10 and will be a negative 2% to growth in 1H11. If you then add the positive inventory cycle in 1H10 of 3.4% and you get the total contribution to GDP growth from the three factors of 5.4% in 1H10.
Depending on your view of the inventory cycle, we are looking at a potential year-over-year swing in GDP in 1H11 of around 5.4%, which becomes a headwind in the next 12 to 24 months. At best, we are looking at flat to 1-2% GDP for the next 12-24 months.
What does all this mean for the consumer and the unemployment rate? Under a good scenario, it’s going forward it’s going to be a hard slog of 1-2% GDP growth, which will prove to be inadequate in an effort to reduce the unemployment rate. According to Orszag’s rule of thumb - to get to what the unemployment rate is; take whatever the GDP growth rate is, subtract 2.5%, and divide by two. So, to get a 1% reduction in the unemployment rate you need GDP growth of 4.5% for one year.
Given the GDP headwinds outlined on the call, it seems unlikely that the unemployment rate will improve meaningfully any time soon. This is particularly problematic for U.S. corporations levered to domestic demand.
Howard Penney
Managing Director
