Yardeni: US Operating on 2 Cylinders
The demand side of the GDP accounts shows that the U.S. economic engine has six cylinders: consumer spending, residential investment, capital spending, inventories, net exports, and government spending. In recent quarters, it seems like most of the torque has been provided by the first two cylinders, while the others have been sputtering.
On the income side of the GDP accounts, there are also six cylinders: labor compensation, dividend income, rental income, interest income, and corporate profits. Actually, there are only five cylinders on a pre-tax basis; on an after-tax basis, the sixth cylinder is income redistribution. In recent quarters, four of them have been humming along just fine, while interest income and corporate profits have been sputtering.
Ideally, all the cylinders should be well tuned. However, this rarely happens, and when it does, it doesn’t happen for very long. Nevertheless, if the economy gets enough power from enough of the cylinders, there’s no need to worry about stalling out, though the economy’s cruising speed may be somewhat disappointing. Debbie and I think that’s the current situation.
Let’s look underneath the hood:
(1) The new cruise speed. Real GDP was revised higher for Q1 from 0.5% (saar) to 0.8%. On a y/y basis, it rose 2.0%. That’s more or less what it has been doing since mid-2010, when the bears started growling that 2% was the economy’s stall speed. That was true in the past--whenever growth slowed to that speed, a recession followed. So far, 2% appears to be the “new normal” economy’s cruising speed. Today’s economy hasn’t been able to travel in the old normal’s fast lane of 3%-4% growth.
The big drag on growth during the current business cycle has been weak government spending on goods and services. Excluding this category, real GDP grew in a range between a low of 1.8% during Q2-2013 and a high of 4.0% since mid-2010, and averaging 2.9%. However, currently, it is back to the bottom of that range.
(2) Wages accelerating as profits slow. The National Income and Product Accounts (NIPA) show that the demand side of GDP must be equal to the income side of GDP, i.e., Gross Domestic Income (GDI) plus a small statistical discrepancy. GDI is equal to National Income plus Consumption of Fixed Investment. The statistical discrepancy between nominal GDP and GDI has been negative since Q1-2011, and hovering around 1.5% of GDP since 2012.
During the current economic cycle, the share of pre-tax labor compensation in national income fell from 66.2% during Q4-2008 to a low of 60.9% during Q3-2014, which matched its Q4-2011 reading--with both the lowest since Q1-1955. Over the past six quarters through Q1-2016, this share has risen smartly back to 63.1%.
Meanwhile, the share of pre-tax corporate profits from current production (i.e., on a cash-flow basis) in national income jumped from a cyclical low of 8.4% during Q4-2008 to a cyclical high of 14.5% during Q4-2011, which was the highest since Q4-1950. It remained around there, but then dropped down to 12.0% during Q1-2016, mostly over the past six quarters.
On a y/y basis, labor compensation is up 5.0% while profits are down 5.8%. Workers finally may be gaining income share as the labor market has tightened, boosting both employment and hourly pay. This development is squeezing profit margins.
(3) Consumers on a healthy joy ride. This certainly explains the strength in real consumer spending, which rose 2.7% y/y during Q1, outpacing overall real GDP growth. In current dollars, that growth has been led by consumer spending on health care, which is up 4.8% y/y, while total consumer spending is up 3.8%. The rising share of consumer spending in nominal GDP over the past four and a half decades is all attributable to health care. The overall share of consumer spending has risen from a series low of 58.5% during Q1-1967 to 68.6% during the first quarter of this year. Excluding health care, the share has been hovering in a range between 53% and 56% over this entire period!
Real consumer spending excluding spending on health care goods and services has slowed recently, and may continue to do so as the average age of the US population increases because people are living longer and the fertility rate is relatively low. Older people are likely to spend more on health care and less on everything else. Health care spending, in current dollars, now accounts for a record 19.0% of disposable personal income, up from 14.4% 20 years ago.
(4) Business tapping the brakes. The recent downturn in the profit margin and the long-term uptrend in consumer spending on health care may weigh on business spending. Nonresidential investment is driven by profits. A profits squeeze attributable to rising labor costs could dampen business enthusiasm to increase plant and equipment capacity. If the economy’s fastest growth comes from consumer spending on health care, that might not have multiplier effects on business spending as large as we would see from lots of spending on autos, say.
The recent data on nondefense capital goods orders excluding civilian aircraft have certainly been disappointing. In April, this series was down 5.0% y/y to the slowest pace since April 2011.
Inventory indicators also may be signaling an overhang of materials and merchandise. Commercial and industrial loans have soared 10.1% y/y ($190 billion) through mid-May. Intermodal railcar loadings have been seasonally weak recently, suggesting that inventory levels may be bloated. The ATA truck tonnage index, which spiked in February, reversed the jump in March and April.
Four of the five Fed business surveys are available for May, i.e., Kansas City, New York, Philadelphia, and Richmond. We average them together and found that they are relatively well correlated with the national manufacturing PMI. The latest available data for the three available surveys show that the average of the composite indexes fell from 4.5 last month to -4.2 this month (Fig. 15). The average of the orders indexes fell from 6.8 to -2.6. The employment index edged up from -5.1 to -2.6, remaining below zero for the 11th consecutive month.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research. To read more of his blogs, CLICK HERE NOW.
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