With July marking the 10th anniversary of recovery in the US – the longest period of sustained expansion in history – Daniel Casali comments.
At this point, it is logical to worry that the recovery in the US cannot continue indefinitely and that a slow-down may be imminent. However, there are two key arguments to believe that the current business cycle can be extended. First, there are no obvious signs of excesses in the US economy. For example, the cyclical (think consumer expenditure on durables like cars and private investment) parts of the economy now account for 24% of GDP, below the long-term average of 25% since 1955, and less than the previous peaks of 28% and 29% before the previous two downturns in 2000 and 2008, respectively.
And second, inflationary pressures seem contained by a marked pick-up in the rate of productivity growth. Productivity has been rising consistently for the past two years after a lengthy period of stagnation. This improvement has a number of drivers. The US has seen significant deregulation under the current administration. The Federal Register of Regulations has dropped from around 97,000 pages in the final years of the Obama administration to around 64,000 today. This is classic supply side reform, cutting red tape to improve the environment for business, along with tax cuts implemented in early 2018.
The influential US NFIB (National Federation of Independent Business) survey, which looks at labour quality and trend productivity growth for smaller companies, shows that small businesses are finding it more difficult to find skilled people. This means that they need to get more out of the skilled staff they have. This certainly creates greater pressure on individual workers, but is a driver for productivity as a whole. The natural margin squeeze as we near the end of the cycle may also see companies pushing for greater productivity from workers.
If productivity rises, unit labour costs fall, which means there is less inflation. Lower inflation provides room for the Federal Reserve to lower interest rates: indeed, the Fed Funds futures market already discounts nearly a full percentage point cut over the next year, which should boost the economy. At the same time, companies can keep hiring, which creates a virtuous circle. The role of technology is also important. Technology increases the supply of labour – by removing international boundaries, which diminishes workers’ pricing power and keeps wages rates down.
We believe that this shift in productivity has a number of implications: labour costs are generally the biggest cost for most companies and higher wages tend to squeeze profit margins. However, if productivity can be improved, profit margins can be sustained, prolonging the economic cycle.
Might Trump’s trade war disturb supply chains and threaten these productivity gains? We believe the risks may be exaggerated. There may be some marginal impacts, but companies are unlikely to move well established supply chains out of China, as a result of trade tariff hikes. That’s because other competing manufacturing hubs, like Vietnam, do not have the expertise to provide cheap gadgets on the scale required by Western markets. Moreover, companies are keen to establish a presence in China to gain access to its domestic market. The truce reached between China and the US at last weekend’s G20 meeting also reduces trade protectionism as a risk to the global economy.
A bigger risk to the improvement in productivity recovery is wealth inequality, and could become more so if wages continue to fall in real terms. Should the electorate vote in a socialist, like Democrat US presidential candidate Bernie Sanders, who has called for legislation to raise the federal minimum wage and taxes in general, it would risk an end to the business and productivity cycle. This concern will not be known until the presidential election in November 2020.
In the meantime, the US economy can continue to make progress and the economic cycle can be extended. Investors who assume that the longevity of the business cycle means that a downturn is inevitable may want to consider the alternative argument.
Sources: Datastream / Smith & Williamson as at 5th June 2019