Cycling along at a healthy pace

  • Written by 

    Viraj Patel, November 2014

As fears over a global stagnation resurfaced in October, we asked ourselves where two of the world’s brightest economies – the US and UK – stand relative to their respective business cycles. While concerns over structural changes and negative external spillovers are likely to weigh on near-term growth sentiment, leading indicators in both economies show that there is yet more strength to come.

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Reasons to remain positive

Following a temporary setback in the first quarter of 2014, the recent summer has provided us with ample evidence to suggest that the US economy is in the midst of a cyclical expansion. At a healthy 3.5% annualised rate,1 third-quarter GDP grew reasonably across all segments of the economy, including consumer spending, non-residential fixed investment and net exports. (Figure 1) Despite the persistence of external headwinds, with the Federal Reserve (Fed) expressing concern over a weaker euro zone and a stronger US dollar, the underlying economic outlook remains resilient.

Figure 1: Recent US economic growth has been well-balanced

A similar vein of optimism can be found on the other side of the Atlantic, with latest figures showing the UK economy also growing at a real annual rate of around 3%, in line with its historical trend and at a level now firmly above its pre-crisis peak.2

(Figure 2) A moderation in the externally-exposed manufacturing sectors was more than offset by a small uptick in the pace of industrial production and construction growth, while the ongoing strength in domestic services continued. In fact, these latest figures highlight the well-balanced nature of both the UK and US economic recoveries. With growth predominantly reliant on domestically-oriented components, such as consumption and investment, the respective cyclical rebounds have occurred at a steady pace, remaining largely insulated from a more sluggish global economic backdrop.

Figure 2: US and UK GDP is firmly above pre-crisis levels & Figure 3: The US manufacturing outlook remains encouraging

Private sector investment gains traction

Core business activity continues to strengthen in the US, with industrial production increasing by a stronger than expected 1% over the course of September.3

During the same month, the ISM Purchasing Manager’s Index (PMI) eased from previous highs, primarily in response to a softening of demand from Europe and Asia, though the aggregate index remains firmly in expansionary territory and at a level consistent with a further pickup in activity through the second half of the year. (Figure 3)

Over the last decade, UK economic activity has been traditionally dominated by the services sector, with recent data providing little evidence to indicate any material change in this trend. However, the latest revisions to national accounts emphasise the role of business investment in the ongoing economic recovery. Survey-based measures of investment intentions remain at historically high levels, suggesting that the headline figure may well continue to grow at double-digit rates over the forthcoming quarters.4

But domestic consumers still drive the cycle

With private consumption accounting for approximately 70% of total GDP,5 the US consumer remains an essential element of the domestic economy. The acceleration in consumption growth, to levels not too far-off its pre-crisis trend, has helped to support economic growth in the aftermath of the crisis. Consumer spending rose 0.5% on the month in August, partly due to improvements in household wealth and balance sheets.

Retail sales, despite posting a small monthly decline in September, have gained substantial ground year-to-date and continue to grow at an annual rate of above 4%.6 Significantly, the recent weakness in oil prices will help ease the squeeze on real disposable incomes, with the increased purchasing power of consumers likely to spur greater domestic activity ahead of the holiday season.

Much of the elevated confidence in the two economies can be attributed to improvements in the labour markets. Since the peak of the crisis, employment has risen by 1.8 million in the UK, with year-to-date figures accounting for almost a third of this increase.7 In the US, steady non-farm payroll gains in September, consistent with the average rate of growth observed across the first nine months of 2014, suggest that the employment rebound is becoming more sustainable. With these trends likely to sustain consumer optimism, the outlook for overall demand remains positive.

Pockets of the economy are warming up

More than six years after the onset of the financial crisis, policy rates in both the US and UK remain at historically low levels. While easy monetary conditions are playing a vital role in the recoveries, encouraging economic risk-taking in the form of greater investment and consumption by firms and households, the International Monetary Fund (IMF) recently expressed concern over ultra-low interest rates fuelling excessive financial risk-taking.8 While the business cycle, on aggregate, remains relatively embryonic, some areas of the economy could be telling a different story.

The warning signs have been on the table for some time now; the unwelcome return of lower quality debt instruments and falling underwriting standards point to a degree of complacency in financial markets. Furthermore, in the UK, rising house prices earlier this year posed a significant risk to the durability of the recovery.

Despite these pockets of vulnerability, the risks have yet to materially spillover to other areas of the economy, suggesting that any concerns over a premature end to the business cycle expansion are somewhat misplaced. Over the past couple of years, the ratio of household debt to disposable income has been falling in both economies. As uncertainties over financial conditions diminish, consumers may begin to apportion less of their income towards repaying debt, instead channelling funds towards the consumption of goods and services.

Therefore despite the slight loss of momentum in September’s monthly indicators, reflecting a moderation in the pace of expansion, the US and UK are likely to continue growing above potential as we head into 2015.9 In terms of the business cycle, these economies remain firmly in the midst of an upswing, and without any significant domestic inflationary pressures, the risk of the real economy overheating remains low. Simply put, the expansion still has some distance left to run; the focus now is on sustaining the post-recovery economic momentum.

The second phase of the cycle: self-sustaining growth

Taking a step back, the overall picture for the respective economies remains broadly unchanged. When put into an historical context, real GDP has taken longer to return to its pre-crisis level, while output continues to grow below its long-run growth trajectory. (Figures 4 and 5) Consequently, the cumulative loss of output from the Great Recession may well end up being larger than that experienced in the Great Depression.

Figure 4: A slower and lower cyclical rebound for the US & Figure 5: US real GDP remains below pre-crisis trend

As documented by Reinhart and Rogoff, recessions caused by systemic financial crises tend to inflict greater damage to the underlying economy when compared to more conventional downturns, which partially explains the prolonged nature of the existing recovery. However, since the IMF’s latest downward revisions to global growth, concerns over a secular stagnation – the idea of persistent shortfalls in demand due to underlying changes in the economy10 – have seemingly extended past the academic domain, with market participants becoming increasingly concerned over future economic prospects.

Financial crises tend to inflict greater damage to the underlying economy

This theoretical concept, made all the more ambiguous when expressed as two words, is often misinterpreted as either a downturn in the business cycle or more condemningly a lower potential growth rate. Intuitively, the “secular” term implies that the depressed state of an economy is a result of supply-side factors such as lower population growth and reduced technological innovation, whereas “stagnation” suggests that cyclical headwinds to demand, in the form of deleveraging or fiscal austerity, are responsible for weak activity.

The reality is that a combination of the two factors is at play.11 It is likely that the recovery in the US and UK will continue to be slower than previously observed, but there is significant room for gains as the demand-related headwinds gradually fade away.

We may therefore be entering a crucial stage of the cycle. The pace of expansion in the UK and US has begun to moderate and may potentially diminish further in the absence of any discernible increase in the organic drivers of economic growth. The speed, and more importantly, the extent of the next expansionary phase will depend on the underlying economy’s ability to generate self-sustaining growth momentum.

While seemingly complex, the expected drivers can in fact be broadly described in the same terms as those processes responsible for the earlier stages of the recovery: (1) a pickup in capital expenditure (investment) from historically low levels and (2) an increase in household expenditure (consumption) following the eventual materialisation of real wage growth.12

The difference is that these factors, while typically correlated to the business cycle, have yet to fully shake off the more damning effects of the financial crisis. As the transitory elements of these headwinds dissipate, the US and UK could well experience a new wave of cyclical expansion from pent-up demand in the economy.

The investment anomaly: upside potential for capital expenditure

Discretionary spending, which includes residential investment, is by definition non-essential and is therefore tightly linked to the economic cycle. In an expansionary phase, when there are no material constraints, discretionary expenditure is expected to rise; yet, as Figure 6 shows, it remains at historical lows and inconsistent with a cyclical recovery.

The key to this dislocation is the housing market. The ratio of residential investment to GDP has plummeted, which is somewhat expected, given the central role played by the property market during the initial stages of the recent recession. However, after bottoming out in 2011, house prices are now starting to recover, and demand for new houses is growing. This is likely to restore some normality to the US property market and help discretionary spending return to more typical levels.

The labour market anomaly: the recovery is not yet real for workers

Leading indicators in both the UK and US suggest that underlying wage growth is in the pipeline. However, the lack of any material pass-through to headline measures means the recovery has yet to trickle down to real segments of the economy, in particular consumers. (Figure 7)

The Beveridge curve – which plots job openings against the unemployment rate – only tells half the story. While vacancies are on the rise, they remain more unfilled than usual, therefore indicating significant mismatches in the labour market. With fewer people switching jobs and employees reluctant to take on the risk of new work, both evidenced by the low “quits” rate, labour market turnover remains subdued.

Figure 6: There is still upside room for capital spending & Figure 7: Subdued real wage growth in the UK and US

The mismatch problem is indicative of a structural impediment that is likely to take some time to overcome.13 However, the inefficiencies created by the lack of turnover are also partially linked to the costly consequences of being unemployed, with individuals needing to tackle the debt accumulated during the previous expansionary phase. As we approach the end of this deleveraging cycle, we could well see some of the labour market frictions disappear, as employees begin to take on more economic risks. The result would see growth of average wages recover to pre-crisis levels, pushing incomes for many households higher.

Productivity gains will help sustain long-run growth

The economist Robert Lucas argued that the costs associated with business cycle fluctuations are minimal when compared to the loss of long-term growth. In gauging the relative strength of the economy at any point in time, one must take into account where it stands relative to its potential. Spare capacity – or the output gap – is not only a function of current growth, but also long-term estimated output.

If the latter is diminishing, as is currently the case with the US (Figure 5), then is it feasible to say that this cyclical expansion – and subsequent decline in economic slack – is a sign of a thriving real economy?

The adjustment since the financial crisis remains painful; the trade-off for greater employment and higher cyclical output has been lower wages and productivity.14 But as a result of this process, individuals and firms in the world’s two leading economies are now better placed to participate in the expansion as it gathers momentum. The next stage of the cycle will now require labour and capital to be put to more productive measures.

Beyond keeping the recovery on course, policies need to be focused on stimulating medium-term growth. In this respect, monetary policy has its limitations. The role of the two central banks will be to manage the exit from zero rates in a timely fashion, steering the economy towards its full potential in a manner that maintains price and financial stability.

It will be the responsibility of other policymakers to tackle the inefficiencies of the economy, by developing a more skilled labour force, increasing infrastructure spending and reducing public debt. This should ensure the sustainability of any cyclical expansion over the long haul.