The US economy, engine room of global economic activity, is slowing down.
Notwithstanding a Q2 2006 Gross Domestic Product (GDP) ahead by an
upwardly revised 2.9% (V’s 2.5% initial estimate) activity is slowing appreciably the delayed, but inevitable, consequence of the most aggressive period of base rate increases on record. Need proof? look no further than the US residential property market.
US GDP slows: residential property
This time exactly one year ago, former Fed Chairman Alan Greenspan made what turned out to be, in the light of subsequent events, a pretty significant observation at the annual Jackson Hole Symposium. Hardly rocket science but what Mr Greenspan actually said was “The determination of global economic activity in recent years has been influenced importantly by capital gains on various types of assets, and the liabilities which fund them”. Put very simply, financial institutions created mortgage-related products which enabled low income households to move away from renting and into their own property.
Home ownership hit a series of record highs over the past five years
as a result. Speculators saw the opportunity, piled in, and drove prices in
certain “hot spots” to record levels. Seeing big paper profits on the part of
those newly enfranchised low income households, financial institutions then
came up with products which could give the newly “wealthy” the opportunity to cash in on their new-found wealth, spend some money and put a few more cars on the drive way. All well and good while the spiral remained virtuous, but what happens when rates go up, borrowing costs go up and the circle snaps from virtuous to vicious?
Recently the National Association of House Builders’ index of construction sentiment fell to a fifteen year low and coupled with tighter lending conditions to low income households, permits (an indicator of likely demand) have fallen 23% this year, suggesting that the declining trend in US house building could continue at least until the end of 2007 (even if conditions stayed the same as they are now!). New build is taking place at its slowest rate in a decade and speculative interest in the real estate
sector continues to ebb. Residential construction is a key component of GDP. It contributed 0.5% each year to annualised growth over the past three years according to Merrill Lynch.
Even more significant was the positive effect that rising house prices, the ensuing wealth effect and consequent mortgage equity withdrawal had. We have commented on the extraordinarily low level of personal savings on many occasions. The flip side of consumer vulnerability has been the boost to overall activity levels (a stunning full 1% point each year for the past three years).
US growth slows: consumer debt
But as base rates rise, so the pressure comes on highly indebted consumers. Activity levels ebb and prices begin to fall back. The multiplier effect goes into reverse and all those factors which combined to generate supra-normal growth over the past three years, can also combine to drive growth down again. For example, housing-related employment, income and spending all added a further 0.25% – 0.5% to activity, again according to Merrill Lynch.
Knocking c2% from growth averaging 3.5% over the past few years takes output back below 2% for the first time for some time. On its own this isn’t quite a recession, however, with employment levels rising, the Fed’s Open Markets Committee had better be vigilant. To a lot of people being laid off it certainly will feel like one and the sharp downward lurch in consumer confidence levels recorded in the latter part of August may well be something that investors have to get used to.
GDP growth slows: cut rates and hope
We have a further two points to make…
Firstly, although business investment has been stronger in the US than the UK over the recent past, recent indications are that it too is weakening in the face of a slowdown in consumer spending (the two are closely correlated). A slowdown in business investment paves the way for further lay offs, quickening the pace of the downturn.
Secondly, the Fed is less well placed to act than it has been at similar stages in the past. Economists have noted the divergence that now exists in the US between the current prime rate (8.25%) and the average prime rate over the past five years (5.5%). Not only does this represent a painful awakening for those who re-fix now, but also it represents a pretty substantial gap for the Fed to make up in pretty quick time for spending not to be reined in dramatically. This compares with 2000-2001 when the
prime rate was 9.5% but the average prime rate over the previous five years was 8.5% and in 1994-1995 when the prime rate was 8.5% against the previous five year’s 8.0% average. Lucky for us that Mr Bernanke has investigated the 1930’s depression in some detail…so have we. Throw away the economic text book Mr Bernanke, cut base rates aggressively, print mountains of money and then cross your fingers and hope!
Somewhat stunningly, the US Fed Funds Futures contract still forecasts a 25% chance of a further US rate hike before the end of the year! We can’t see this happening and believe it simply to reflect residual concern in the wake of the 8th August FOMC meeting decision to retain its tightening bias. Investors should expect that bias to be removed at the September FOMC meeting at which point the financial markets should begin to think more seriously about lower, probably aggressively lower, US base rates. In the meantime, buy bonds and watch out for the dollar (particularly if central banks elsewhere are still mulling further base rate hikes).
By Jeremy Batstone, Director of Private Client Research at Charles Stanley