Finally, A Late Cycle Economy: Productivity, Investment, and The Coming US Growth Acceleration

“[T]he isolation of cyclical fluctuations is a highly uncertain operation. Edwin Frickey once diligently assembled 23 trend lines fitted by various investigators to pig iron production in the United States, and found that some of the trend lines yield cycles averaging 3 or 4 years in duration while other yield cycles more than ten times as long. This range of results illustrates vividly the uncertainty that attaches to separations of trends and cycles, though it perhaps exaggerates the difficulties. If an investigator fits a trend line in a mechanical manner, without specifying in advance his conception of the secular trend or of cyclical fluctuations, he may get cycles of almost any duration. But an informed investigator who is seriously studying cycles of a given order of duration will use whatever guidance he can get from history and statistics…

It is fairly common for statisticians to assume that the elimination of the secular trend from a time series indicates what the course of the series would have been in the absence of secular movements, and that the graduation of a time series, whether in original or tend-adjusted form, indicates what the course of a series would have been in the absence of random movements. There is no warrant for such simple interpretations …

There is always danger that the statistical operations performed on the original data may lead an investigator to bury real problems and worry about false ones. When new commodities, new techniques of production, new methods of organizing business, new methods of financing are first introduced on a substantial scale, they affect the general business situation more profoundly than at a later time when they have fully penetrated the economic system and become a part of routine experience.”

Measuring Business Cycles
Chapter 3: Plan of Treating Secular, Seasonal, and Random Movements
By Wesley C. Mitchell and Arthur F. Burns, 1946

 

US economic growth over the past six years depended on a recovery in housing and autos, a significant up cycle in commercial real estate, and a large expansion of the healthcare system. However, with the change in government in Washington, D.C., the movement to faster growth, and the rise in interest rates, their role in leading the race appears over. As they hand off the baton, new areas of the economy are rising to the forefront to drive overall economic growth. These areas include Investment, Infrastructure, and Government Stimulus. These areas will carry economic growth moving forward as the country moves into a true expansion phase of the cycle.

Economic transitions, such as the one the United States is undergoing, occur at points in time when natural economic cycles in select sectors and industries peak out while other sectors and industries see their growth continue and/or accelerate and new areas see their growth bottom and turn up. In this case, the US leaves behind the traditional sectors of Autos and Housing as well as a traditional mid/late cycle sector, Commercial Real Estate, which turned into an early/mid-cycle sector this time. These peaking sectors, the traditional interest rate sensitive, “early cycle” sectors, exhibit a leveling out in their cycles that indicate they will no longer drive economic growth. From 1985 – 1990 and from 1998 – 2006, Auto sales flattened out growing little. As the following chart demonstrates, auto sales stand today at the same level as 2015:

A similar story is unfolding for Housing. Existing Home Sales normalized over the past five years. With the rise in interest rates transactions are leveling out:

This leveling of housing turnover would replicate the path housing took from 1986 – 1995 when housing turnover went sideways. Unlike this earlier period, national new home sales prices today continue upward, according to the government:

However, according to the public homebuilders, prices have decelerated and in some cases are flattening out. This would make sense as prices now exceed their peaks during the housing bubble a decade ago:

S&P/Case-Shiller U.S. National Home Price Index, 1987 – 2017

And for the low to middle end of housing, the marginal buyer of a home, rising interest rates present a real bite. The following chart shows the recent jump in rates, yet how they stand a long distance from where they stood back in 2000:

30 Year Fixed Rate Mortgage Average, US, St. Louis Federal Reserve Economic Database

In fact, the rise in interest rates coupled with the massive rise in prices over the last few years drove Housing Affordability down to its lowest level since 2008.

Chart courtesy of Haver Analytics

 

And while the above chart shows a significant bounce in affordability since June, mortgage rates today stand 0.5% higher than June and home prices continue to outpace income growth, which likely means homes are less affordable today than six months ago. The latest Pending Home Sales show future sales down 3.8% year-over-year. That data more likely reflects reality than the Housing Affordability Index above.  Should Mortgage Rates just return to their 2008 level of 6.0% from their current level of 4.4% over the next few years, the monthly payment would rise an additional 20%, putting further pressure on Housing. Given this reality, Autos and Housing face a period of sideways motion over the next few years.

In their place will stand raw mined stones that will turn into the gemstones of tomorrow as time moves onward and the gem cutters and polishers exhibit their work. These stones begin with Investment. Due to the entry of China into the World Trade Organization (WTO) and the granting of permanent Most Favored Nation (MFN) Status by the Clinton Administration, the US exported a significant portion of its manufacturing to China collapsing domestic Capital Formation (GFCF):

Gross Fixed Capital Formation to GDP, US, 1960 – 2017, St. Louis Federal Reserve

 

And while Capital Formation rose from 2004 – 2007, it came from the Housing Bubble and not proper industrial investment. As a result, this non-productive investment, which did temporarily maintain economic growth, became obsolete in the ensuing recession, bankrupting the banking system. If we remove the impact of the bubble from the chart, instead of a rise in GFCF, there would exist a straight line down to the bottom in 2010 from 2000. As housing recovered from 2011 to today, Capital Formation recovered, but only to levels reminiscent of the post-recession lows in 1993 and 1976.

With Housing set to move sideways for the next few years, the next upward leg will need to originate in true Investment. This will come from both the Manufacturing side of the equation as well as the Infrastructure side of the equation. As the below chart demonstrates, Real Private Fixed Investment in Manufacturing stands no higher than almost 20 years ago:

Real Private Fixed Investment: Manufacturing, 1999 – 2017, St. Louis Federal Reserve

But, with Real GDP up 109% from Q1 1999 to Q4 2017, Real Manufacturing Investment stands 52% below its 1999 levels as the following graph shows.

Real Manufacturing Investment to GDP, 1999 – 2017, St. Louis Federal Reserve

This drop makes intuitive sense given the following factors:

1. The rise of China as a manufacturing powerhouse as US companies exported their manufacturing to government subsidized, Chinese companies to maximize margins over the short term. (If a government pays for 50% or more of the capital to construct a manufacturing plant, then the products can be sold at prices well below the true cost of manufacturing as the companies do not bear the full cost of building the plant.)
2. US Corporations focused on maximizing Free Cash Flow at all costs, regardless of the long term impact on their growth or competitiveness. (This can be seen in the ratio of Capital Investment to Revenue which averaged 5.2% from 2000 – 2017 compared to 7.2% from 1990 – 2000.)

Fortunately for the US, spending on Research & Development (R&D) remains high:

Research & Development Spending to GDP, St. Louis Federal Reserve

Thus, the US can fix its Manufacturing Investment through the reversal of exporting its manufacturing capacity, what is known as Reshoring, given that it still possesses strong Intellectual Property (IP) due to maintaining high levels of R&D. And not only can the US do this, it can benefit from implementing the latest manufacturing technology such as 3D/Additive Manufacturing, Robotics, and Artificial Intelligence. In the process, as a side benefit to the country, these plants should become the most efficient in the globe, obsoleting much of the capacity erected in China and elsewhere over the past 20 years. Thus, not only would they restore US Capital Formation to levels not seen since the 1990s, but they would improve Productivity and accelerate GDP growth. In effect, they would restore the United States to its position as a premier global manufacturer, underpin the country’s global strategic position, restore economic growth, and undercut a global rival’s strategic position, all at the same time.

While such a change in Manufacturing would address a portion of the collapse in Capital Formation, a full redress requires the country to increase its Infrastructure spending. As the below chart makes clear, Public Construction Spending stands almost 10% below its level in 2009:

Total Public Construction Spending, 1993 – 2018, St. Louis Federal Reserve

While on the surface it appears that the US treaded water for the past decade, that is an illusion. When viewed in Real Terms relative to GDP, Total Public Construction Spending collapsed over the past decade. It now stands 35% below its level in 2009 but, more importantly, over 20% below its Normalized Level from 1993 – 2007:

Total Public Construction Spending to GDP, 1993 – 2018, St. Louis Federal Reserve

This collapse did not go unnoticed by the public. Voters approved a record amount of public bonds to fund infrastructure at the state and local level in 2016. And in 2 states with troubled finances, Illinois and New Jersey, voters approved measures creating “Lock Boxes” that prohibit state lawmakers from diverting transportation fees to non-transportation uses. (Voters seemed to have an issue with legislators diverting money to pay for pet projects or budget holes they created in those two states for some reason.)

The one remaining area for increased Public Infrastructure Spending remains the Federal Government. And while President Trump proposed a massive $1.5 trillion Public-Private Partnership to move Infrastructure forward, Congress acted as Congress does under the rubric, “The President Proposes and Congress Disposes.” In other words, the Trump proposal became a non-starter for Congress which possesses its own plans. These plans include a modest amount of incremental spending of around $20 billion in some of the current legislation. But as the chart above makes clear, the US needs to spend an incremental 4% of GDP or almost $800 billion to just reach its 1993 – 2007 average. While it remains unclear the source of this funding, pressure will rise on Congress to act as the 2020 elections approach. As a member of Congress’s #1 priority is re-election and the public patience for Congress stands thin, the probability of action rises as the 2020 elections approach.

While the handoff in the economy from early/ mid-cycle industries to late cycle will be bumpy and likely entail a slowdown in H2 2018 and early 2019, this hand-off, already in process, remains critical for the economy. It stands as the lynchpin of President Trump’s economic program which recognizes the lack of Investment in the US. It focuses on driving faster economic growth by increasing Investment which undergirds productivity growth, the bedrock of long term economic growth:

Copyright 2018 by Green Drake Advisors, LLC. All Rights Reserved.

 

And, as the handoff gains steam in 2019, Real Investment should begin to rise at a rapid pace. Once this train begins to move, it will gather steam as the salutary effects on the economy become apparent and the above virtuous circle moves into ascent. In addition, with pressure on Congress growing to spend money on basic infrastructure sorely in need of a facelift as opposed to new social programs, the following positive dynamic should come into view as well:

Copyright 2018 by Green Drake Advisors, LLC. All Rights Reserved.

And with both these dynamics in play, Productivity Growth should make a long term bottom and head upward once again as Finally, A Late Cycle Economy stands in place. And with Productivity and Investment both charging ahead, The Coming US Growth Acceleration will transform the economy once again, as it has repeatedly over the past 250 years. (Data from St. Louis Federal Reserve, Haver Analytics, Bureau of Economic Analysis, Census Bureau, MKM Partners, tradingeconomics.com, and public company reports coupled with Green Drake Advisors analysis.)