One, Two, Three...Dip!
Tracking the economy in recent times is like learning new dance steps. Forward two steps, backward one step, slide sideways, spin around, and you're back where you started.
Unfortunately, this economic two-step is a source of frustration for many economists — and angst for many Americans. Just when it seems that economic growth is in reach, sobering numbers appear to dampen enthusiasm.
Last week, the GDP report from the Bureau of Economic Analysis (BEA) provided the wet blanket. Expecting 2.5% growth according to Bloomberg median estimates, analysts were disappointed by paltry 1.2% second quarter growth. In addition, the first-quarter GDP was revised down to 0.8%. Should these numbers hold through revisions, the 1% average growth will be the worst first-half economic performance over the past five years.
The headline numbers sound grim, yet there is positive news to be unearthed in the BEA report. Why not start an analysis with some good news?
Consumers Lead the Way
Pat yourself on the back, because you and your fellow consumers are saving the day. Consumer spending rose by a robust 4.2% in June, providing a solid economic boost. The windfall of low oil prices continues to put more money in consumer's pockets while the job market remains steady. Wages are beginning to rise and stay in front of inflation, as second-quarter disposable personal income rose by 3.1%. After years of caution, consumers are feeling confident enough to spend money again.
The Employment Cost Index (ECI) numbers suggest that consumers will continue to have more spending money on hand. ECI is an indicator of what employers are spending to maintain their workforce, and it is up 2.3% over the previous year — but an even better sign is that the wage and salary component is up by 2.5% (the greatest increase since 2008) and gaining momentum. In other words, compensation improvements are coming less through benefits and more through ready-to-spend cash.
The disposable income windfall from low oil prices is likely to continue as well. Production increases around the globe and the inability of OPEC to rein in supply — as they have done in past decades — have sustained the worldwide oil glut and throttled price increases. Both WTI and Brent Crude are trading in the $41-$44 per barrel range as of this writing, unable to even reach the temporary April 2015 peak in the $65 range (much less the $110 per barrel of just over two years ago).
Thus, we can expect consumers to keep pulling their weight. However, considering that the US economy is 70% driven by consumer spending, why are the GDP numbers so sluggish? The answer lies at the other end of the commercial transaction. Put simply, several factors associated with businesses are on a downward swing.
Businesses Are Lagging
Ironically, perceived lack of consumer demand in the past plays a role. Business inventories have declined for three straight quarters. The drop in inventory alone subtracted approximately 1.2% from GDP. (Fortunately, consumer consumption swamped this and other business-related subtractions by adding 2.8% to GDP.)
Business investment has decreased as well, down 2.2% to represent the third consecutive quarter of decline. Lower levels of exports, aggravated by strength in the dollar, have caused businesses to pursue a conservative strategy. However, the fresh data showing a 1.4% increase in exports compared to a 0.4% drop in imports may help to spur businesses into greater action. If the ECI and oil market trends noted earlier hold, robust increases in consumer spending should bring business production and inventories back into a growth phase.
Keep in mind that while wage improvements are necessary, they do raise the cost of doing business and therefore will eventually raise the cost of goods. Businesses attempt to make this up through improvements in productivity — and poor productivity may be a longer-term problem for US firms.
More People Doing Less
Lower productivity is actually helping to prop up the job market. That's because, when productivity falls, more people are needed to produce the same amount of goods and services. When the job market is outpacing economic growth, the implication is that businesses are getting decreasing benefits out of increases in headcount. Labor productivity was down by 0.6% in the first quarter of 2016 (second quarter numbers are not available as of this writing). A downturn in business investments may be aggravating the productivity problem.
If consumer demand stays strong and forces manufacturers to rebuild instead of pulling from inventory — as it must do eventually — productivity factors increase in importance. Less productive businesses are likely to raise prices to compensate, resulting in inflationary pressures. At long last, the Federal Reserve may finally have some inflation to fight.
Fed Food for Thought
While inflation is not on the radar at the moment, reports from the recent Federal Reserve meeting had raised speculation that the Fed could move more quickly on their plan to gradually increase rates. The majority of recent economic data (jobs, housing, etc.) have been showing signs of improvement, leading to talk of a rate hike as early as September. That may still happen, but lower GDP growth is likely to give the Fed pause (another short-term silver lining in lower GDP readings).
For context, the GDP growth throughout the recovery period beginning in 2009 is a meager 2.1%. The final two quarters (and revisions) in 2016 must average just over 3% to maintain that rate — achievable, but rare, during this recovery cycle. Average growth in GDP since the last rate hike is below 1%, inclusive of Q4 2015 that included the implementation of the rate hike.
The gap between GDP growth and the labor market makes the Fed's decision even trickier. If increases in jobs, improved consumer spending, and prolonged low interest rates do not spur economic growth, what will?
At some point the Fed will have to act even if GDP remains low, if for no other reason to avoid creating an unsustainable bubble in stocks (and there is some argument that we are closing in on that point already). For now, a post-election rate hike seems more likely — keeping rates low in the short term and bypassing a potential brake on economic growth.
Slow growth — how many more times will we use that phrase? The recent GDP data suggests that we may be using it throughout the rest of the year, although there are positive signs underlying the data.
Confident consumers with cash to spend can give business activity a jump-start — if rising prices or some fresh economic or social shock does not throw a monkey wrench in the works. If you do have extra money to spend and are managing your debts properly, by all means get out there and do your part to help the economy with economic stimulus. Businesses await your reaction to recent economic data, to be expressed through your pocketbook.