Many commentators suggest that US economic growth will remain subdued. However, a number of indicators are suggesting it will surprise on the upside. If it does, there will be significant implications for policy, investment markets and portfolio construction.
In our opinion, a wide range of indicators point to a likely acceleration of US economic growth in 2014:
- Improvement in the US labour market is real – Jobs are being created at a rate of 2.1 million p.a., the unemployment rate has fallen to 6.6% and average weekly earnings are rising. Although some economists believe that declining labour force participation indicates that unemployment is worse than headline figures suggest, it is important to note that participation has been naturally declining since 2000 as a result of the ageing of the US population, not just since the financial crisis.
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- Housing will help drive the economy - Recoveries in key indicators such as home prices, housing starts and mortgage debt are encouraging. We believe that private residential fixed investment remains depressed at around 1.5% of GDP, below its long run level (excluding multiplier effects) and will inevitably revert to more normal levels. Furthermore, the share of residential mortgages in negative equity has fallen considerably over the past couple of years which may encourage more households to draw down on home equity for consumption.
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- Credit conditions are favourable – Household debt has fallen considerably from its peak of 96% of GDP in 2009 to 77% today (the same as 2003), providing scope for rising consumption in the future. Furthermore, US banks are well positioned to deliver credit growth with common tangible equity to common tangible asset ratios having approximately doubled since 2008.
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- The competitive position of the US is improving – US manufacturing hourly labour costs have fallen significantly relative to other countries (in USD terms) over the past 10 years. The shale boom has also provided the US with a massive energy cost advantage, while also helping to reduce the trade deficit.
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- Fiscal drag is decreasing - The government expenditure component of GDP has been contracting in recent years following the large stimulus provided during the financial crisis. Economists estimate that expenditure cuts and payroll tax increases reduced GDP growth by 1.5-2.0% in 2013. However, a dramatic recovery in the federal budget deficit suggests there is declining pressure for further cuts, and the fiscal headwind is expected to be just 0.5% in 2014.
It is our view that, in the absence of a material negative shock, the US economy will experience accelerating economic growth over the next 12 to 24 months, and is likely to surprise on the upside.
What does a US upside surprise mean for markets?
A strengthening US economy will require the Federal Reserve to reduce the unprecedented monetary policy support it has provided since the global financial crisis in order to ward off excessive risk-taking in the financial system and to protect against future inflation. The Fed’s exit from QE poses risks for equity and other asset markets (particularly currency and bond/credit markets) as long term interest rates start to move closer to pre-crisis levels, potentially causing a dramatic redistribution of global money flows. We continue to view the Federal Reserve’s exit from QE as the major current investment risk.
A faster-than-expected US economic recovery, with strong demand for credit, could lead to high inflation as banks start to lend from their massive pool of excess reserves, currently USD2.4 trillion. While the Fed has a number of tools that could reduce the size of excess reserves or neutralise their impact, there is no reliable historical precedent that can guide investors (or the Fed itself) as to what will happen to markets as QE unwinds.
We continue to believe that there are two main scenarios that could play out:
- An orderly unwinding of QE. This is our base case, predicated on a steady but not sharp US recovery, with a gradual increase in credit demand, and contained rises in short and longer term US yields. Under this scenario we would expect the US 10 year Treasury yield to rise to around 4.5-5.5% over the next one-and-a-half to two-and-a-half years. We would expect elevated market volatility and potentially some dramatic re-pricing of certain asset classes. This scenario does not overly concern us from an investment perspective.
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- A disorderly unwinding of QE. Under this scenario, longer dated bond yields could start increasing rapidly as investors lose confidence in the Fed’s ability to exit QE in an orderly manner (it is not unthinkable that US 10-Year Treasury yields could hit 8-10% over the next one-and-a-half to two-and-a-half years). This could lead to massive market dislocations, including large and rapid falls in asset prices, major moves in currency markets and the withdrawal of liquidity from certain emerging markets, as well as increase global systemic risk. A rapid rise in longer term US interest rates would also be highly likely to drive up longer term interest rates around the world, potentially re-igniting the European sovereign debt crisis.
We assess the risk of a disorderly unwinding of QE to be a ‘fat tail’, or low-probability, scenario. However, as we have repeated on many occasions, low probability does not mean zero probability.
Implications for portfolio construction
Although a rise in US economic growth presents a tailwind for businesses positively exposed to the US economy, it is important to recognise that economic growth is not the most important determinant of equity market returns. Indeed, we believe long term interest rates have historically been more important to aggregate stock market performance; higher interest rates will reduce valuations via the discount rate on companies’ expected future cash flows, leading to lower equity price-earnings multiples in aggregate. Investors should be asking themselves ‘what effect will higher interest rates have on markets?’ We are paying close attention to this critical question.
Hamish Douglass is CEO and Portfolio Manager at Magellan Asset Management. This material has been prepared by Magellan Asset Management Limited for general information purposes only and must not be construed as investment advice. It does not take into account your investment objectives, financial situation or particular needs.