I wrote yesterday that “bad is good,” in that the poor results for fourth-quarter GDP actually concealed quite a bit of underlying good news. I still feel that way, but after taking a closer look at the numbers, I think it’s worth considering what the report means for the economy in the next couple of years.
There are two major things going on here: the recovery of the real economy, and the slow removal of federal fiscal and monetary stimulus.
First, the real economy. Alan Greenspan said last year that the recovery would not really begin until investment in long-lived assets picked up again. That is just what we’ve seen, especially in the fourth quarter. Housing construction is coming back and can be expected to continue to strengthen; business investment had a surprisingly strong growth rate, despite uncertainty. Investment in long-lived assets is indeed coming back and, in fact, is further along than most people think.
Consumer demand, which is two-thirds of the economy, is also doing well. Consumer spending depends on wages, borrowing power, and accumulated debt. Wages continue to grow (although the personal income report for December was misleadingly strong—don’t get too excited), and there is a good argument to be made that wage growth will accelerate in the next couple of months. The number of jobs continues to increase at a steady rate. Household borrowing is growing slowly but steadily, and savings rates are still at reasonable levels. The ability to spend is there.
The willingness to spend is also there, largely due to pent-up demand. Housing and autos are doing very well and, as long-lived assets dependent on financing, are a great expression of buyers’ expectations for the future. Overall, consumer spending will provide a solid base for the recovery to continue.
But, while consumers are doing well, and business is finally doing its bit, government is pulling back. This is necessary and overdue.
Of the three factors that pulled GDP growth down, one, the decline in inventories, will probably be reversed. The second, a decline in net exports, is actually based on the stronger economic performance of the U.S. versus our trading partners. That may not reverse in the short term. But, as Europe recovers, for example, our exports will increase as well, while imports continue at similar levels. Both of these factors will moderate over time.
The third piece of the fourth-quarter decline in GDP—a drop in government spending—is the one that won’t be going away; in fact, it will get worse. There are two pieces to this. The tax increases that took place at the start of the year have adversely affected consumer confidence and may well reduce consumer spending, but this will be offset by the positive factors mentioned above. This headwind will undoubtedly have a short-term effect, but over time, growth should continue once the impact is absorbed.
Unlike the tax increases, decreases in government spending will be ongoing, acting as a continual headwind. The decrease in defense spending—the largest in 40 years—was the culprit in the fourth quarter, but we know more spending cuts are coming our way. The sequester, even if Congress moderates it, will impose significant cuts in the discretionary budget, and we have to make changes in mandatory spending, including social security and Medicare, which will also result in cuts over time. As I said, this will be an ongoing headwind.
The question we now face, then, is whether the growth created by an organic recovery is great enough to offset the necessary pullback in federal spending. More than that, when the Federal Reserve starts to pull back monetary stimulus by raising interest rates, will the organic growth be able to offset that headwind as well?
We don’t know the answer yet, but we do know that these two headwinds will slow growth down below what it would have been otherwise. We face an adjustment period of years when growth will, at best, fall below what was considered normal in the past. Growth will also be more volatile, as the government’s ability to spend to moderate recessions is about tapped out.
What this means for investments is that we have to be careful which areas of the past we look to for comparison. The bull-market era of declining interest rates and government spending to alleviate recessions that prevailed from the 1980s to about five years ago is over. When looking for investment strategies, the appropriate period will probably be more like the 1950s or 1970s.
The current bull run in the stock market may continue for a while, but when considering the long-term results, think about whether the underlying assumptions are consistent with a slower long-term growth trend. If not, longer-term results may be disappointing.