Sweet Dreams (were made of these)

Five reasons why US economy is as good as it gets, and turning over

 

Partha Chakraborty

Partha Chakraborty

 

Annie Lennox and David Stewart had it like most of us in a family, puissant and pusillanimous at the same time in their coexistence. Their 1983 Album rocked the waves with Sweet Dreams.

Sweet dreams are made of this
Who am I to disagree?
I travel the world
And the seven seas,
Everybody’s looking for something.

 

This morning’s “near-perfect” Jobs report made me think of Eurhythmics one more time. As I see it, Sweet Dreams were made of these, and everybody is looking for something, a panacea that will be hard to come by. If I were not a betting man, and I am not, I would pull up my pants before shoes start to drop.

It is hard to escape the barrage of good news story. Unemployment rate is at near 50 year low of 3.7%, labor participation rate is at a very promising 62.9%. GDP growth hit 3.5% in the most recent reading, far above expectations, almost getting us to accept 3.0%+ growth as easy enough. Jobs number clocked 250,000, and at the same time, average hourly wages went up 3.1% year on year with its best showing since 2009. Even with recent gyrations US stock markets are hovering near their historic highs. Inflation seems to nudging, reluctantly, Core CPI up only 2.2% year on year. Corporate tax cuts reduced headline rates to 21%, pushing corporate profits up by over 20% across the board…the good news bear keeps growling every chance he gets it seems. And therein lies the problem.

But first a deeper dive.

GDP trends are better reflected by core-GDP, taking away short term swings of inventory changes (which added 2.1% to GDP growth headline in the most recent data) and exports (which subtracted -1.7%). Adjust for things like these, and core GDP growth is at 2.7%, still very commendable. If one looks at GDP Trailing Twelve Month (TTM) trend, another way to reduce short term swings in headline data, TTM GDP is up 3.0%, almost where it was in 2015. Corporate Sector added 2.5 million jobs this year annualized, higher than 2016 and 2017 but lower than both 2014 and 2015. The tax relief is for real, and likely permanent and was a definitely needed jolt. Without the tax effect, even in a booming economy, corporate earnings growth were more in line with their long term rate this time of the recovery.

Federal Deficits shot up from USD 780 Billion to over USD 1.4 Trillion under current government to pay for the tax cuts and other government expenses, which went up by 0.6% in the latest reading. 10 year bond rates are hovering over 3.0% consistently as a result, acting as a drag to the housing sector – US homebuilding and construction jobs in particular. Inflation is creeping up – over Fed target rate of 2.0% for three straight months. This forces the hand of the Fed which is sure to continue raising benchmark rate, already at 2.5% after three hikes this year.

Growling bear or not, there is no mistaking broad strength in the economy. The Great Recession was followed by a really long process of digging out of a hole; getting trust back in the system when the floor dropped on us was not easy. The long recovery has been inordinately long but we are there, most headline numbers for the economy are at or near their best level for a long long time.

It really is as good as it gets. And headwinds, they will keep on coming.

First the Jolt, specifically lack thereof. The Red Bull® was expensive, if necessary. And it shall not be repeated. Take away the tax relief, corporate earnings are already no better than where it would be at this time of the recovery. Absent a further relief, year on year headline comparison is sure to head south. We are all used to an individual company’s erratic fortunes, but economy –wide cooling off is surely the wrong signal to the markets.

Second, the Deficit. Like it or not, the Jolt cost money that our children will pay. Deficit at USD 1.4 Trillion is unsustainable – economic growth alone can never take care of that. With deficit comes political bickering and uncomfortable trade-offs which can affect consumer confidence and spending or business investments. No matter who decides, deficit broods unease and volatility.

Third, the Inflation. Deficit financing breeds inflation that no amount of gig economy can fix. As much as consumer confidence and spending is up fueled by higher wages, pricing power moves to producers, retailers and brands. The dual effect on inflation is unmistakable, many analysts expect it to rise further to 2.5% or higher.

Fourth, rising rates. Fed’s hands are tied after rather extended use of all the tricks it could devise. Gradual dismantling of quantitative easing had to be followed by rising rates, if not to make sure they do not run short of weapons in armory should something unthinkable happen. At 2.5%, benchmark rate has nowhere else to go but up, as the Governor repeatedly points out.

Fifth, tariffs. Trade war is costly, no matter what they say. Tariffs have been already costing the coffers USD 12 Billion directly as subsidy that could have been avoided, but that is a drop in the bucket if and when the full war breaks out. It is conceivable that China unloads its holdings of US Treasuries to teach a lesson if US hits with higher tariffs still, which will have added impact of raising rates even more when we can least afford it.

Add to that dark clouds at the horizon in the shape of geopolitical uncertainty. South China Sea is a tinderbox waiting to inflame. Traditional powers in Middle East are in turmoil, and it shows even when every effort of cover-up. Europe is at an inflexion point, turning to a spell of more internal conflict. China has cooled off significantly, and it might be just the first innings of a long game. The list goes on.

Some impacts are already visible. Business investment was up 11.5% in first quarter of the year, growth rate went down to 0.5% the next. Fed already had to increase its spending by USD 300 Billion above the earlier spending cap. Inflation is expected to be 2.5% more by mid-2019, benchmark rates might be 3.0% around the same timeframe. 2019 corporate earnings might as well fall year on year, even if at close to high historical level. For example, Amazon (AMZN) shares are down almost 15% last thirty days even when it posted 29% revenue growth year on year, simply because people are expecting good times to end in the months ahead. Even the Fed is expecting the GDP growth to slow down to 1.8% by 2021.

Yes, the goings were good – almost too good I argue. I would welcome a little air to cool off, but it is quite possible we will have a gust of bad news and unfortunate consequences.

Times they are a’changing. Be ready to face the headwind, can we?

 

[Partha Chakraborty is CEO of Switchboard Systems, an early stage Blockchain startup. Opinions expressed in this article is the author’s alone and do not necessarily reflect that of Switchboard Systems. The author is solely responsible for any error or omission.]

 

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