Every rose has its thorns

A number of economists are presenting a pretty rosy outlook for the U.S. economy over the next several quarters.  While I don’t disagree with the general positive direction of their forecasts, nor with the general contribution to those forecasts of their various underlying drivers – I must admit my own view takes some of the bloom off the rose, as it were.  Thus, I thought it might be useful to provide a more tempered view, noting some of the areas in which I believe other forecasts perhaps err on the side of optimism.  (My own reputation as an economic curmudgeon should be noted, although I am currently on the bullish side of the fence.)  Herewith, my somewhat more cautious view.

Some forecasts call for GDP growth averaging 3.0% for the remainder of 2014, after a surprising dip in the first quarter (which they argue was an anomaly due to weather and slower than expected inventory growth, an assertion with which I agree).  Projections for 2015 call for a more aggressive pace of output growth, some as high as 4.0%.  My own projections for GDP growth for the remainder of 2014 and 2015 are a somewhat more subdued 2.8% and 3.0%, respectively.

Below are the major underlying drivers that are argued to buoy the economy over the next couple of years.

Housing.  Some economists project a 25% gain in housing construction through the end of 2015.  I do believe that we’re in a housing recovery; I just don’t think it’s that robust (and, to a degree, I hope it’s not, as we don’t need another bubble).  Yes, there is some pent-up demand, but in the “new” normal (which is actually our parents’ normal), more households are renting by choice, rather than rushing into homeownership.  In addition, while new starts jumped by more than 40% year-over-year as recently as last March, they were down earlier in the year.  Again, some of that is weather-related, but it’s also due in part to rising mortgage rates, coupled with rebounding prices, which in combination are pricing some would-be buyers out of the market.  Those factors will temper demand.

It should also be noted that a good portion of the increase in housing construction has been in multi-family units, and I question just how many more apartment complexes can be built before the market reaches saturation.

Home Prices.  Housing prices are forecast to gain as much as 7-10%, fueling an associated wealth-effect driven spending spree.  That pace of home price growth, given my assertion that in general residential real estate should increase in value at a pace no greater than the inflation rate in the absence of bubble conditions, again seems optimistic.  We’ve certainly seen that pace – and more – in some markets, but it is unsustainable, and I suspect (and hope) that memories are sufficiently short that we’ll correct more quickly this time around before a bubble is reached.  And again, rising rates will temper the pace of price appreciation.

Further, there may be a disconnect now between increasing home values and spending, as the temptation to spend freely driven by the wealth effect is subdued by both recent memory and other fundamental factors – most notably a still-weak labor market – that will keep spending in check to a degree.

Auto Manufacturing.  Another factor cited to support the argument for trend growth above 3.0% is a robust pace of auto sales of about 16M units per year.  I don’t disagree with that, but would note that it’s actually the current pace of sales, and given that this pace isn’t driving 3.0-4.0% growth now, I don’t see it as a major contributor to that pace of growth going forward.  And we’re not likely to see an auto sales trend appreciably higher than where we currently are.

Business Investment.  A pickup in business spending is forecast due to pent-up demand, and on this point I agree, although businesses will only spend on replacement capacity until they foresee a tangible pickup in demand (which isn’t likely unless and until the labor market fully recovers), and much of the replacement spending has already taken place.

Energy Sector Strength.  Growth in domestic energy production, largely through fracking, is another factor that is believed to support a very bullish scenario.  I have no argument with that, other than that I disagree that it will do much to attract foreign manufacturing given our current tax code and labor costs, which are sufficient to offset any advantage we enjoy from cheaper energy costs.

Strong Health Care Sector.  Many assert that the health care sector will benefit to a degree from the Affordable Care Act.  However, its negative implications may well prove a drag on economic performance otherwise, including new small business formation and discretionary spending, as rising costs for most Americans reduce discretionary income.

Easing Credit.  I agree that credit conditions are normalizing, but I question whether in the “new,” more conservative normal, we’ll see the strength in demand for credit that we once saw.  The consumerist movement that was birthed in the ‘80s has ended (thankfully, given the ultimate outcome), and Millennials are more wary of debt than were the Boomers and Gen-Xers.  Plus there are still a lot of folks out there with damaged credit, and subprime lending likely isn’t coming back anytime soon.  In other words, the pendulum is back to the middle, but isn’t likely to swing as far as it did in the mid-2000s.

Consumer Confidence.  I also agree that confidence is up since the Great Recession, but it’s still far from robust: the recent level is about where it was during the dot-com driven recession, and it’s some 20% below where it was at the peak of the housing bubble.  Moreover, the correlation between consumer sentiment and actual spending isn’t as strong as one might assume.

Deleveraging.  The “end of deleveraging” has been cited as an indicator that Americans are ready to once again take on debt.  Household debt to disposable income has come down about 30% since the peak of the housing bubble.  However, it’s still above 100% – in other words, Americans, on average, still owe more than they earn.  Much of the “repair” of household balance sheets came through default, not conscious effort, and particularly in the face of a weak labor market and stagnant income growth (emanating from both weak employee bargaining power and rising health care costs), my estimation is that many households will remain cautious about taking on new debt.

Less Imported Oil Reducing Current Account Deficit.  I concur with this assessment, but I don’t see sufficient growth in net exports to overcome the foregoing domestic variables.

In short, I agree with the overall assertion that we’re in a recovery, and with the general underlying trends that are driving it.  However, I do see some headwinds that will temper growth, keeping it at or below 3% for the next couple of years.  Even that is a welcome respite from the recent past.