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United States: is this the end of the cycle?


US growth has weakened. Investment and corporate profits have been in the red for several quarters, and corporate margins are worsening with the rise in unit labour costs. Meanwhile, household consumption is still solid, fuelled by brisk job creation. Behind the slowdown seen in the first half, the theme coming back to the surface is the end of the cycle. GDP has been growing steadily for seven years in the US (at an average annual rate of 2%), which makes it one of the longest cycles of the post-war period. Is this cycle coming to an end? 

From a fundamental viewpoint, there is no reason the US economy should topple into a recession. However, there is also no reason that activity should grow faster than its potential. The economists' consensus is still too optimistic for 2017. The main threat dragging down the United States is not the recession but a "weak-growth trap". Against this backdrop, it is not surprising that both candidates in the Presidential elections are putting a large-scale fiscal and/or budget stimulus at the heart of their economic plan. We will have to count on budget policy to prolong the expansion cycle after 2017.





US growth weakened significantly in the first half of 2016 (+1.2% yoy in Q2), and ISM indices for August show a concomitant slowdown in economic activity in industry and services. Quarterly setbacks don't necessarily mean a turning point for the cycle. Still, it must be noted that investment and corporate profits have been in the red for several quarters, and corporate margins are worsening with the rise in unit labour costs (slight acceleration in wages, drop in productivity). Meanwhile, household consumption is still solid, fuelled by brisk job creation. So without consumption's vigour, GDP could have contracted. Behind the slowdown seen in the first half, the issue coming back to the surface is the end of the cycle. GDP has been growing steadily for seven years in the US (at 2% on average at annual rate), which makes it one of the longest cycles of the post-war period. Is this cycle coming to an end? 

A singular cycle in post-war history 

Despite the length of the expansion cycle, it is actually the softest recovery in post-war history. More than seven years after the start of the "great recession," economic activity has yet to return to its "potential" as it is calculated by the CBO (in other words, the US still has a negative output gap). This is unprecedented in the history of post-war cycles, and we would probably have to look back to the 1930s to find an episode of this type.

Most components of GDP have taken more time than in a traditional cycle to return to their pre-crisis levels. This can be explained by the nature of the “great recession”. In fact, it takes much longer to recover from a recession if it is accompanied by a banking and financial crisis. Long-term studies by C. Reinhart and K. Rogoff on the impact of economic and financial crises go a long way in explaining this: “GDP growth and housing prices are significantly lower and unemployment higher in the ten-year window following the crisis”. In terms of cycle, we could probably translate their remarks by saying that it takes more a decade to fill the output gap.

The US economy post Lehman corresponds to the observation of empirical works. By taking the CBO’s estimates for potential GDP and its pace of growth, the output gap is still not closed in 2016. From this viewpoint, the cycle is incomplete. Nonetheless, these output gap measures are quite fragile, and we cannot do without an analysis of growth drivers.


What do statistical approaches say about growth in the third quarter of 2016?

There has been abundant empirical literature over the past 15 years to statistically infer the growth level of the current quarter using published economic data. The studies carried out by regional Feds give a good illustration of this. For now, the signals are moving in opposite directions. Specifically:

The index calculated by the Chicago Fed using a set of 85 existing monthly indicators. It is a question of extracting the "common component" from this set. This indicator (designed to go below zero when growth falls below its potential) shows that growth for the first part of the third quarter was barely at potential (estimated at 1.6% by the CBO in 2016). ISM indices for August show that growth could be even weaker.

Studies by Atlanta’s Fed, which has developed a method for statistically inferring a "real-time" estimate ("GDPnow") of growth for the current quarter using higher frequency data. The advantage over the preceding method is that any missing data do not keep the estimate from being updated quite regularly. Statistical information is continuously integrated to assess GDP growth. Today, this indicator shows growth of around 3.3% at annual rate in Q3 (with an inventory contribution of about 0.6pp).

These models are not meant to be predictive: they do not reveal the trend in economic activity beyond the current quarter, and are no substitute for an analysis of the determining factors of demand (and supply). Moreover, they are not always a highly reliable estimate of growth. But in periods of structural change, they are useful as part of the economist's toolbox for refining a diagnosis.


Investment in capital goods will pick up again, but limply 

Because the investment recovery has been soft in this cycle (despite record profits), investment spending will probably stay flat, with margins headed back down. That said, there has been no over-investment in the US outside the energy-related sectors (this over-investment's correction is the reason for its brutal drop in Q1, with the decline in oil prices). The production system is ageing, and businesses must continue to invest, even if only to maintain capital stock as is. Ultimately, everything will depend on changes in global demand. In an environment where external demand is weak (global trade contracted again in the first half, with the downturn in imports from emerging countries) and the industrial sector is weakened (in particular due to the dollar's depreciation since 2014), we should not count on a dramatic rebound in investment spending (ex-inventories). This is especially true since they have taken on substantially more debt in this cycle (non-financial corporate debt has substantially risen and makes up more than 90% of non-financial corporate GDP, which had not been the case since 2008).

Household consumption: the ultimate driver is bucking a headwind 

The key to the cycle therefore is clearly with consumer demand. The decline in corporate profits, which is largely due to the dollar's rise, does not necessarily mean the end of the business cycle. It is partly the result of a rebalancing movement by wages in added value, which benefits consumers. That said, these latter will be subject to "headwinds":

Job creation has started to lose some momentum. This is not abnormal at this stage in the cycle. As the US economy nears full employment, job creations more or less match the increase in the labor force). The indicators built by the regional Feds (Labour Market Condition Indexes), which summarise the trends in a good many variables measuring the state of the labour market, continued to improve over the recent period. As such, we see that the Kansas Fed's index returned to its long-term average for the fi rst time since 2007, and wages are beginning to accelerate (timidly): these are factors that generally show the economy is close to full employment, even if other metrics show that there is still some slack (low participation rate, high long-term unemployment, etc.).

Purchasing power is threatening to erode. Hourly (nominal) wages as measured by the jobs report are accelerating, but very slowly1. And the movement is even harder to make out if we consider the compensation component in the Employment Cost Index (ECI), which is a better measurement of what happens across the whole economy. If we factor in inflation, we see that consumer purchasing power is stagnating. Yet, if nominal wages do not accelerate further, their purchasing power will be reduced in the coming months by the rise in oil prices (base effect2) and also, possibly, core inflation's tendency to accelerate (starting from a low level).

On the other hand, consumers have deleveraged, and the wealth effects are yet to be seen. Net household wealth (as a % of disposable income) is close to its 2007 highs.

All things considered, the lack of gains in purchasing power, paired with a slowdown in job creations, should cause consumption to level off in 2017. 

The first half amounts to a real soft patch for business, which raises the question of the end of the cycle. We do not believe that the liquidation of inventory in Q2 is likely to continue, and that a mini-cycle of re-stocking could boost activity in the short term (see box). But, make no mistake, the cycle has come to a stage of advanced maturity. Investment and profits are in the red, and businesses have begun significant leveraging again. Moreover, residential investment is beginning to wane (after several years of strong growth, perhaps due to the uncertainty caused by the elections), and the only US growth driver is projected to weaken. These factors explain why the probability of recession (as measured by the Philadelphia Fed's anxiety index for instance) is rising (though remaining contained at around 20%).

Before the Fed decides to raise its key rates, it will have to make sure that household consumption is resilient, and especially that corporate investment (ex-inventories) is getting a new start. The economy is indeed much too fragile to withstand an increase in real interest rates. From a fundamental viewpoint, there is no reason the US economy should topple into a recession (barring an "external shock," or if interest rates rise abruptly). However, there is also no reason that activity should grow faster than its potential. The economists' consensus is still too optimistic for 2017 (anticipating 2.2% growth). The main threat dragging down the United States is not the recession but a "weak-growth trap" (below 1.5%) due to structural factors (insufficient investment, drop in productivity). Against this backdrop, it is not surprising that both candidates in the Presidential elections on 8 November are putting a large-scale fiscal and/or budget stimulus at the heart of their economic plan. We will have to count on budget policy to prolong the expansion cycle after 2017.

Toward a temporary uptick in growth in H2 2016, driven by inventories?

Growth slowed considerably in Q2 (+1.1% at annual rate; +1.2% yoy). Business inventories, which subtracted 1.3 percentage point from growth in Q2 (at annual rate), were the main reason for this poor showing, which led us to lower our average annual growth forecast from 2% to 1.5% for 2016 (after 2.6% in 2015).

For the fifth consecutive quarter, inventories made a negative contribution to growth, but this is the first time since 2011 that companies have reduced their inventories. That said, Q2’s poor showing was also due to capital expenditure, which fell for the third consecutive quarter. All of which occurred in an environment of negative earnings growth. The drop in oil prices early this year played a major role in these trends (with the subsequent decline in energy sector capex and earnings). Ultimately, the reason the US economy did not slip into recession was the strength of household spending. 

Two factors suggest that the Q2 destocking trend does not increase further: (1) wholesale inventories have resumed their expansion since Q2; and (2) durable goods orders rebounded sharply in July, with durable goods inventories themselves expanding.The latter factor suggests that inventories will begin expanding again in Q3, which could provide a temporary boost to GDP growth that may reach between 2.5% to 3% (at annual rate). 

It is noteworthy that there are not yet any signs that capital expenditure is turning up. Quite the contrary: shipments of durable goods, ex-defence and aircraft (which are used to calculate capex in the national account) were still in the red in July, despite the rebound in durable goods orders. Moreover, the drop in ISM indexes in August does not bode well.

All in all, the acceleration in growth that we expect at face value – from 1.5% in 2016 to 2.0% in 2017 (annual averages) – is not the prelude to a new cycle of expansion; far from it. We expect GDP growth to level off near its potential in late 2017 (i.e., at about 1.7-1.8%).


1 There are several possible explanations for the lack of reaction by wages: either the Phillips curve has fl attened in the US for structural reasons (productivity, globalisation), or the trend in unemployment does not reflect the imbalance on the labour market, or reflects it poorly (i.e. there is still some slack on the job market).

2 Oil prices, which were down 40-50% at the start of the year (yoy), will be up by about 70% yoy in early 2017 (supposing that the price per barrel stabilises right where it is). Consumers will see the difference.






Without consumption's vigour,
the economy would have
fallen into recession









Consumers have deleveraged,
companies have releveraged





Private investment will recover,
but at a slow pace




We will have to count
on fiscal and budget policy
to prolong the expansion
cycle after 2017




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BOROWSKI Didier , Head of Global Views
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United States: is this the end of the cycle?
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