The recent economic and market bearishness is simply not justified by the data. For nearly every negative, pessimistic assertion being made today about economic conditions, there is a factual, data-driven response that clearly shows we’re in the midst of a durable expansion.
Assertion: The April jobs report wasn’t strong. Job gains were almost all due to the government’s model of the birth and death of new firms. According to the Dow Jones newswire, “In April, this amounted to 257K of the 274K jump in payrolls.”
Response: This position mixes different types of data and is wrong. The 257,000 from the birth-death model is a non-seasonally adjusted statistic, so it should be compared to the non-seasonally adjusted job growth for April, which was 1.2 million, not the headline 274,000 net seasonally adjusted growth. The birth-death model caused 21 percent of April job growth, which is normal, and not 94 percent. The Labor Department’s household survey gained a very strong non-seasonally adjusted 1,180,000 last month, or 598,000 when seasonally adjusted. These net figures understate the dynamism of the U.S. economy. On a gross basis, it created 7.9 million jobs in the second quarter of 2004 (latest data, seasonally adjusted, not annualized) while losing 7.3 million jobs for a net quarterly gain of 600,000, part of the 2.2 million net new jobs in 2004.
Assertion: First-quarter growth was weaker than the reported 3.1 percent because inventories built up, adding to GDP, but subtracting from future GDP.
Response: First-quarter GDP will likely be revised up substantially — perhaps to 3.8 percent. Demand growth remained strong in the first quarter, so even after the inventory build, inventories are at low levels relative to sales, arguing that the inventory build is necessary and helpful to future growth. Inventories built in the first and second quarter of 2004 without causing a slowdown.
Assertion: The labor market still has slack. Said St. Louis Fed president William Poole in a May 11 speech, “Although unit labor costs edged modestly higher over the second half of 2004, growing at a 3% rate, their rate of gain in the first quarter of 2005 slowed to about a 2.25% rate … As the modest first-quarter gains in the employment cost index showed, the threat level is not terribly high … “
Response: The labor market is tighter than widely perceived. Unemployment is 5.2 percent. Unit labor costs rose 4 percent in the third quarter of 2004, the most recent quarter with revised data, after being originally reported up 1.6 percent. Unit labor costs rose 1.7 percent in last year’s fourth quarter and 2.2 percent in this year’s first quarter, a brisk pace that is also subject to possible upward revision when actual compensation data surfaces from state unemployment insurance taxes.
Assertion: Real wages are falling.
Response: Pre-tax nominal wages rose 2.6 percent over the last year while the overall consumer price index (including gasoline) rose 3.1 percent. Real wages fell by this measure. But real wages typically decline well into an expansion and have done at least as well in this expansion as in the strong expansions of 1994 and 1986, especially on an after-tax basis. The wage measure being used to show the worst wage performance is for non-supervisory production workers, a group that is under particular pressure in a globalized economy. A broader inflation measure (the overall PCE deflator for all personal consumption) was up 2.4 percent, so real wages were higher than inflation by this measure.
Assertion: Credit-market debt is too high. “Total credit market debt as a percentage of GDP rose from around 120% in 1980 to over 300% at present,” according to Marc Faber’s April 20 Gloom, Boom and Doom Report.
Response: It makes sense for debt (and assets) to grow faster than GDP in a flexible, financially innovative economy. Faber’s 300 percent figure includes corporate debt, much of which is cascading (for example, an auto buyer borrows from a financing company which borrows from the credit markets). Other causes of increasing U.S. debt are low interest rates and the increase in home ownership. The issue is not so much the level of debt but whether sufficient capital formation is taking place in a market-based way to maintain growth. I think it is.
Assertion: Consumption has risen to over 70 percent of GDP, so people are using up their savings.
Response: The rise in consumption per GDP is a long-standing trend for the U.S. economy. There are several reasons for this. 1) Investments are increasingly in the form of education and research, which show up in consumption. 2) For tax and other reasons, people seek capital gains rather than ordinary income. The proceeds show up in savings and consumption but not in GDP, distorting the ratios.
Assertion: The U.S. is a low-saving nation if you don’t count houses.
Response: This is incorrect. Including all the mortgage debt and none of the houses, the U.S. household sector is the world’s biggest net creditor ($37 trillion of financial assets versus $11 trillion of household debt) with one of the world’s fastest growing pools of liquid (non-house) savings (up $1.5 trillion in 2004). The personal-savings-rate statistic does not reflect or attempt to reflect actual changes in savings or the annual additions to savings, both of which have been large.
Assertion: The deficit is going to sink us. “We are approaching a trillion-dollar trade deficit,” said Sen. Harry Reid in the May 10 New York Times. “We can’t survive as a viable, strong country doing that.”
Response: I expect the trade deficit to get bigger and the U.S. economy to remain strong and prosperous. U.S. imports grow with the U.S. economy while exports grow with foreign economies. The U.S. trade deficit is being driven by capital inflows related to the demographic gap between the U.S. and other developed countries. With a growing population, the U.S. needs more capital than other countries do and benefits more from adding it. Conversely, with an older population, foreigners want to buy bonds even at today’s low yields, allowing the U.S. to capture the spread between the cost of foreign capital and the return on investments in the U.S. The U.S. trade deficit will likely grow until Japan and Europe undertake pro-growth structural reforms, developing economies get substantially bigger, or the demographic gap narrows.
Assertion: Higher interest rates will slow the economy.
Response: Real interest rates are very low and haven’t risen much. Interest rates rose in 2004 and didn’t cause a slowdown. I think the Fed’s measured rate hikes have been acting as an accelerant to the economy, maintaining low real interest rates, giving assurance against faster rate hikes, allowing longer-term yields to stay low, and encouraging a “get it while you can” reaction.
Assertion: Money supply growth has slowed, pointing to a slowdown.
Response: I don’t think money growth is well correlated to GDP growth when exchange rates are unstable and money velocity is as variable as it has been since the 1971 departure from the gold standard. Growth of the M2 money supply (currency, checking accounts, and savings accounts) slowed with the pace of mortgage refinancings after the jumps in bond yields in June 2003, April 2004, and March 2005, yet GDP growth didn’t slow. Growth of M0 (basically currency outstanding, since U.S. banks now have very little in assets that are subject to reserve requirements) is slow today because interest rates are rising and the dollar weakened in recent years.
Assertion: The yield curve has flattened, pointing to a slowdown. “Shrinking disparity between long and short (Treasury) notes waves caution flag on economy,” went the Wall Street Journal headline of May 9.
Response: Longer-term bond yields have stayed low in part due to unusually accommodative and restrained monetary policy. Rather than indicating a slowdown, low long-term bond yields have, at least in 2003 and 2004, preceded a surge in economic growth. I don’t think bond yields, inflation-protected TIPS, or the shape of the yield curve are useful economic indicators when exiting a deflationary period by way of an extraordinary monetary policy. I expect bond yields to rise in 2005 in jumps, as in 2004 and 2003, in response to evidence of economic growth, inflation, and continuing Fed rate hikes.
Assertion: Inflation is understated. A May 9 Wall Street Journal headline said, “Critics say U.S. plays down CPI through adjustments for quality, not just price.”
Response: I expect a moderate inflation problem, with core CPI rising above 3 percent year-over-year (it’s now at 2.3 percent). I don’t think the definitional issues (e.g., the difference between the CPI basket and the broader PCE and GDP measures; hedonic quality adjustments) are that important in evaluating monetary policy. The economic and market issue is whether monetary policy weakens or strengthens the value of the dollar. I have been concerned for over a year about the “free lunch” in liquidity and the dollar weakness caused by very low real interest rates, but I think the distortions did not build to a degree where the economy was undermined.
Assertion: Culled from the May 5 Wall Street Journal: “As boomers retire, a debate: will stock prices get crushed?; Prof. Siegel says only Asia can stop a U.S. meltdown; filling a $123 trillion [retirement] gap.”
Response: The value of a stock depends more on company earnings than the number of Americans who own the stock, particularly with international diversification of equity ownership likely to increase. Further, retiring U.S. investors will time their equity sales differently based on their personal financial circumstances. I expect the U.S. retirement age to gradually lengthen, drastically reducing the notional $123 trillion retirement gap.
Assertion: Stock prices haven’t come down enough. “Blue-chip stocks have still posted average annual gains of 13.2% over the last 20 years,” according to the May 8 New York Times. “The 1926-2004 annual average is 10.4%.”
Response: Part of the above-average nominal equity gains in the 1980s and 1990s was an adjustment of equity prices to the weaker dollar that followed the dollar devaluations of the 1970s. Price-earnings multiples are not high now, especially relative to bond yields. I expect solid long-term equity returns as the expansion progresses.
– David Malpass is the chief economist for Bear, Stearns.