US GDP grew at a very disappointing 1.20%pa in the second quarter of 2016. But as always, the headline is misleading
Three key points should be noted from the GDP release:
- Business inventories dragged down GDP by 1.16%. As inventories’ impact on GDP typically averages zero over any period of a year or more, this can be expected to reverse in coming months.
- Consumer spending (“personal consumption expenditures”) is back at long term averages and holding up well. Consumer spending drives 75% of the US economy, and is also important for restoring business confidence.
- Business investment, even with inventories stripped out, is a concern. This has been the stubborn part of the economy in the US and Europe and is still struggling to recover pre GFC levels.
More on inventories
Inventories will fall where either sales are ahead of expectations or businesses are intentionally scaling back. With consumer sales at very strong levels in recent months, the former explanation is much more likely. This means inventories are likely to bounce back to be a more positive contributor in the revisions to the Q2 GDP figures when they come out in August.
Weak Investment post GFC is the number one challenge that QE has failed to impact
It would be easy to blame “the Trump factor” for the lack of business investment in the last quarter, and that remains a possibility, but investment has been weak for a decade.
This is the problem plaguing all major western economies since the GFC: investment simply has not recovered. Non residential investment in the US was strong during the shale oil investment phase, much like the mining investment boom in Australia, and housing construction has picked up to above average rates, but is still much lower than prior to the GFC.
In the US, private sector investment has not grown for ten years, since 2006. It recovered post the dramatic dip in 2009, but only to grow back to the same level of annual investment in 2006. In Europe, the picture is identical: no change since 2006; and Japan’s investment is now 5% lower each year than ten years ago.
This is the major frustration or failing, depending upon your perspective, of the whole QE experiment. QE involves the central bank purchasing assets from banks to provide them with liquidity. In order to stimulate the economy, this liquidity then needs to be lent to the private sector. The problem is two sided: the business sector needs more confidence to borrow more and then invest; and the banking sector needs more confidence to ease lending rates and conditions. Rates for lending to US businesses are still around 30% higher than their long term average levels for example.
US at least has consumer spending
Consumer spending is 12% higher in the US than its 2006 level after adjusted for inflation. In Europe on the other hand, consumer spending has not kept up with inflation. That is the biggest difference between the two economic giants. With the ongoing political, economic and social challenges in Europe, it is hard to see a quick turnaround either.
Consumer spending in a mature economy is the critical first step in a recovery. Once businesses are confident that consumer spending will remain stronger, they will invest in new projects and employment. The US economy, despite the weak headline data released last week, at least has consumer spending on its side.
Conclusion
The weaker than expected US data, regardless of the less relevant inventories data, has three likely effects:
- It will give the US Federal Reserve more pause, and possibly even push the next rate hike out into 2017, although I still believe late 2016 to be more likely
- It will put more pressure on the RBA to cut rates. Before this data release from the US, the odds were pretty evenly split, but this is likely to tip the odds in favour of a cut.
- It is likely to cause short term weakness in the USD. If inventories push GDP back to expected levels in the coming months, this will recover. If not, the USD’s direction will be driven by relative interest rate policy changes. In other words, if the Fed holds rates but other central banks continue to push their rates down, the USD will remain the favoured currency. I maintain my view that the 65 to 70c range is fair value for the AUD, largely based on a slower Fed being more than offset by continuing decline in conditions in Australia pushing our rates down towards 1.00%pa.