The US leads the economic pack – here are three reasons why it won’t last
David Kelly says the US has outperformed Europe and Japan in the first quarter and probably will again in the second, but its fading fiscal stimulus, monetary tightening and dwindling labour supply mean a contraction is coming
Marathon running is not much of a spectator sport, but the key contest is usually between a hare and the pack. Can the hare hold on to the lead or will the strain of running from the front prove too much, allowing the pack to reel the hare in?
Economic growth in the first quarter, at 2.2 per cent annualised, was above the 1.5 per cent achieved in the euro zone and the minus 0.8 per cent seen in Japan. While growth in Europe and Japan should rebound in the second quarter, real GDP growth in the US could surge even more, jumping to over 4 per cent annualised and maintaining a sizeable US lead. In addition, US growth should look good relative to many emerging markets – while China and India continue to see strong growth, Turkey, Argentina and Brazil are in varying degrees of distress.
In financial markets, the S&P 500 has now risen 3.9 per cent in the year to date, delivering a healthy total return of 4.8 per cent when dividends are included. This contrasts with small declines in European and emerging market equity indices.
Last year, international economic growth accelerated, the US dollar fell and international equity indices generally beat their US counterparts. However, this year, the US hare has broken away from the pack – the question is: can the hare maintain its lead?
Perhaps – but only for the next mile or two. The US is experiencing significant fiscal stimulus in 2018, with the federal budget deficit likely to rise from 3.5 per cent of GDP in 2017 to 4.3 per cent of GDP in this calendar year. This contrasts with the euro zone, the UK and Japan, where budget deficits are falling as a share of their economies.
In addition, rising trade tensions are more negative for the rest of the world than the US. Exports are a much larger share of GDP for almost all US trading partners than for the US itself and a threat to export industries is consequently more serious for the rest of the world. This, combined with unusually harsh winter weather and a recently lower US dollar, may have contributed to the US growth lead this year.
However, in economic growth, as in marathon running, maintaining a lead is harder than establishing one and the pack is likely to catch the US in 2019, if not before.
One reason is simply that US fiscal stimulus will fade. The best quarter for tax cuts (or, putting it another way, the worst for US Treasury tax receipts) is likely to be the second quarter of 2019. Beyond that point, barring further tax cuts or spending increases, the federal government will tend to be less supportive of growth.
A second reason is that US monetary policy is gradually getting tighter. The US economy is overshooting the Fed’s growth target, undershooting its unemployment target and has now attained its inflation target. In this environment, as expected, the Fed raised rates this week and is likely to raise them twice more this year and twice further in the first half of 2019.
The cumulative effect of these rate increases could push the 10-year Treasury yield above 3.5 per cent later this year or in early 2019. In an economy now conditioned to very low interest rates, this increase in long-term rates should slow the housing market and the economy overall.
A third reason is that the US is running on fumes in terms of labour supply. The unemployment rate is at its lowest level since 1969. The working-age population is growing by less than 0.5 per cent per year and legal immigration appears to be falling. While stronger productivity growth could help, the reality is that, in the absence of structural change, US potential economic growth is probably still below 2 per cent and when the unemployment rate hits its effective lower bound, which is likely to be still above 3 per cent, US GDP growth will have to fall back relative to the rest of the world.
In the long run, the US is likely to fall back to the pack if not further. Because of this, and despite impressive short-term US statistics, it will be important for investors to make sure they are at least as invested in the pack as they are in the hare.
David Kelly is chief global strategist at J.P. Morgan Asset Management