The Pelican Report

Strong growth in exports of goods and services was the primary support for the economy in the second quarter, but this is likely to weaken as continued international tensions from Russia’s invasion of Ukraine and China’s slowdown tamper foreign demand of US goods and services. The growing prospects for energy shortages in Europe this winter as Russia retaliates for NATO’s support for Ukraine is particularly worrisome.

The modest 1.5 percent growth in consumer spending, also known as personal consumption, during the second quarter is likely further slow or turn negative in the second half of the year as inflation continues to outpace wage growth.

As the following graph shows, real disposable income has been declining since the middle of last year. As a result, households have been able to support modest growth in consumption only by tapping into their savings. Without a prospect for a turnaround in disposable income growth, households are likely to start pulling back their consumption in the second half of the year.

This is already being seen by the pullback in the housing market. New home construction, also known as residential fixed investment, fell by 16.2 percent in the second quarter. Further increases in home mortgage rates in the second half of the year driven by the Fed’s policy to continue to raise interest rates to bring down the highest inflation in a generation will prevent any recovery in the housing market this year.

Finally, rapidly rising interest rates are also causing businesses to pull back their investment spending. Further interest rate increases by the Fed will lead businesses to reassess their long-term investment plans that were based on the continued availability of low borrowing costs.

Privately-owned housing starts showed continued strength in January, coming in at a seasonally-adjusted annual rate of 1.567 million units, according to the US Census Bureau. This was 10 percent higher than the 1.42 million expected by most economists and 21.4 percent higher than in January 2019. The already strong December number was also revised upward from 1.608 million units to 1.626 million units.

As I mentioned previously, housing construction is now the main driver of private investment spending, compensating for continued weakness in non-residential fixed investment. This strong showing, if continued, should spill over into new durable goods orders in coming months and provide a solid base for GDP growth through at least election day in November.

Construction spending shows a continuing split between residential and non-residential construction, according to the latest data from the US Census Bureau, with non-residential construction continuing to fall. Total construction spending rose by a seasonally-adjusted annual rate of 0.2 percent in December, failing to meet economist expectations of 0.5 percent growth. Total construction spending in December rose by 5.0 percent on a year-on-year basis.

Private residential construction continues to show strong growth, rising by 1.4 percent in December, or by 5.5 percent on a year-on-year basis. Low interest rates and a housing shortage likely will help maintain healthy residential construction during rest of this year.

Private non-residential construction fell by 1.8 percent in December, or by 0.1 percent on a year-on-year basis. All categories of private non-residential construction showed declines, mimicking the fall in non-residential fixed investment in the fourth quarter of 2019 reported last week.

Public construction also fell in December, declining by 0.4 percent at a seasonally-adjusted annual rate. On a year-on-year basis, public construction spending was up by 11.5 percent, reflecting higher growth in public construction in previous months of the year.

The fall in the monthly figure for private non-residential construction is particularly worrisome in that it indicates that there is still no revival showing up in data for non-residential fixed investment.

The preliminary estimate of real gross domestic product (GDP) growth for the fourth quarter of 2019 on the surface shows a continuation of solid continuation of the economic expansion, but the underlying data contains several areas of concern. GDP rose by an annual rate of 2.1 percent in the fourth quarter of 2019, according to “advance” GDP estimate released by the Bureau of Economic Analysis on Thursday, which was in line with expectations. In the third quarter, real GDP increased 2.1 percent.

The good news

On the positive side, residential fixed investment continued its strong rebound from the third quarter, rising by 5.8 percent. The probably was due to a combination of a shortage in housing inventory and support from the Federal Reserve’s interest rate cuts. An 8.7 percent drop in imports, largely due to international trade tensions, helped to boost the net exports (exports minus imports) component of GDP growth.

The bad news

On the negative side, non-residential fixed investment fell for the third straight quarter in row, dropping by 1.5 percent. This category of spending will need to return to positive growth soon for the economy to continue to grow at more than 2 percent.

Mixed indicators

Although personal consumption spending growth remained relatively strong at 1.8 percent, it has weakened in the last two quarters. Results from the next two quarters should show if this the result of consumers taking a breath from the more rapid increases of the second and third quarters or the beginning of a longer trend of consumption growth below 2 percent.

I would also place the 3.6 percent increase in federal consumption and investment spending in the mixed category. Over the short term, this spending rise does give a boost the GDP growth. Over the long term, however, government spending cannot continue to rise faster the supporting economy without squeezing out private-sector investment and consumption.

Looking forward

Residential construction is likely to remain strong until the current shortage in the housing inventory is reduced, which should support economic growth over the next several quarters. The declining non-residential investment remains worrisome and could drag the economy into more sluggish growth if it is not reversed soon. It is unclear which side of the trade ledger, imports or exports, will gain the most from the recent easing of trade tensions with China. The impact of the Wuhan coronavirus on US-Chinese trade and global economy is also a wild card at this point.

The latest budget and economic outlook from the non-partisan Congressional Budget Office (CBO), released on Tuesday, projects the federal budget deficit will rise from 4.6 percent of GDP in 2020 to 5.4 percent in 2030. These large deficits in turn will push the federal debt held by the public from 81 percent of GDP this year to 98 percent in 2030, and to 180 percent of GDP in 2050.

• The CBO warns that a high and rising federal debt would reduce national saving and income, boost the government’s interest payments, limit the ability of policymakers to respond to unforeseen events, and increase the likelihood of a fiscal crisis.

Congress’s failure to rein in spending is the main culprit in the increase in the size of the deficit in the next 10 years. Specifically, the CBO projections point to the ever increasing costs of mandatory spending programs, particularly for Social Security and federal health care programs.

• The CBO projects that by 2030 total outlays for Social Security and federal health care programs will rise to 13.0 percent of GDP from 10.3 percent this year, or 2.7 percentage points higher than this year and 5.4 percentage points higher than in 1995.
• In the CBO outlook, defense and non-defense discretionary spending will fall to 5.6 percent of GDP in 2030 from 6.4 percent this year. Any new federal programs not already established in law would make the deficit even worse.

Whoever wins the presidential election this year will face the daunting task of addressing this mismatch of revenues and spending. President Trump’s preferred path, so far, of attempting to close the deficit by spurring economic growth will not work if the growth of mandatory spending continues to outpace economic growth.

• Even the most optimistic growth projections produced by the Trump administration fall short of the 5 percent annual growth in mandatory spending estimated by the CBO during the next 10 years.
• President Trump has promised new health care reforms to curb the growth in federal health care spending but he has not released any details.

The proposals of the various Democratic presidential candidates to vastly increase taxes to close the fiscal gap are even worse. The CBO outlook estimates that federal revenues will return to 18 percent of GDP by 2027 from 16.4 percent this year. As I mentioned last week, the historical data strongly suggests that there is a practical federal revenue ceiling of about 18 percent of GDP.

• Any attempts to increase the taxes above this level would almost certainly fail as tax payers and corporations move to shelter more of their incomes or pull back from economic activities whose reduced after-tax profits are need seen to be worth the risk.
• The economic consequences would be an economic slowdown, or even a recession, that would simultaneously reduce revenues below planned levels and increase demands for more social spending, thus widening rather than reducing the deficit.

The only long-term solution is to cut the growth in mandatory spending. The only question is whether the leadership in Washington will have the courage to take this action early enough to do it in an orderly manner or if they will wait until a fiscal crisis imposes a solution upon them. History will not look kindly on them if they choose the later path.

New orders for manufactured durable goods in December increased by $5.7 billion or 2.4 percent to $245.5 billion, the US Census Bureau announced today. A shape rise in defense orders, which were up by 102 percent from November, drove the increase. Transportation equipment orders, driven by a 168 percent increase for defense aircraft, were up by 7.6 percent.

• Excluding defense, new orders decreased by 2.5 percent.
• Excluding transportation, new orders decreased by 0.1 percent.
• Non-defense aircraft and parts declined by 69.1 percent as the grounding of Boeing’s 737 MAX airliner continues to hit the aircraft industry.

Although the preliminary results for December were significantly better than the consensus expectation of a fall of 0.3 percent, the heavy concentration of the growth in defense goods underlines potential weakness going forward.

The IMF is forecasting global growth will rise from an estimated 2.9 percent in 2019 to 3.3 percent in 2020 and 3.4 percent in 2021, according to its World Economic Outlook Update released today. Although there are few visible signs of turning points yet in the global macroeconomic data, it supports its forecast with the following points:

• Market sentiment has been boosted by tentatives signs that manufacturing activity and global trade are bottoming out.
• A broad-based shift toward accommodative monetary policy.
• Intermittent favorable news on US-China trade negotiations.
• Diminished fears of a no-deal Brexit.

For the US economy, the Fund is expecting growth to moderate from 2.3 percent in 2019 to 2 percent in 2020 and declining further to 1.7 percent in 2021. It bases its view on the fading fiscal support from the 2017 tax overhaul and waning support of any further loosening of monetary policy.