Wednesday, April 14, 2010

An Evaluation of the Fits and Starts Expansion Argument

On August 31 of last year, I outlined my theories regarding the upcoming expansion in an article titled The Fits and Starts Expansion. As the economy has now had two quarters of GDP growth, it seems an appropriate time to evaluate the strengths and weaknesses of that argument to see how it holds up.

I identified the following areas as those that would contribute to economic growth: personal consumption expenditures, stimulus spending, inventory adjustments, Asian consumers and manufacturing. Let's takes these one at a time.

Regarding PCEs, I wrote the following:

The general opinion of the US consumer is that he will change his overall behavior from one of spending to one of savings and frugality. This in fact has already occurred to an extreme degree. There are several reasons for this. Unemployment is high and will remain at that level for the foreseeable future. When a person does not think he will be able to find a job if he losses his current job than he will spend less today. In addition, household debt is at very high levels and the consumer -- who has been paying down debt and shunning new debt -- will continue to do so. This will lead to an increase in savings which will lower consumption.

However, there has been an underlying assumption to this argument that the US consumer will stop buying to such a degree as to be a non-factor in GDP. In other words, the consumer will move from a position of being a fundamental driver of US growth to having little to no impact. That is a radical view -- and one I believe to be incorrect for two reasons. First, from a practical side things wear out and need to be replaced. The US consumer cannot eliminate the need to replace things. In addition, as the consumer holds onto goods longer, other items need to be purchased -- replacement parts and the services to fix items. In addition, the economy will not always be in its current position; at some point the unemployment rate will return to manageable levels, salaries will increase and asset valuations will be stable. When this occurs the consumer will feel more confident and will be more willing to spend on goods and services. However, the old consumer -- the one who spent wildly on everything -- will not return.

Central to this theory is the idea that the US consumer will continue to spend, but at a lower pace. To that end, consider this chart of the year over year percent change in real (inflation-adjusted) PCEs:

Notice that since the 1980s, the average year over year percentage change in PCEs has been between 2.5% and 5%. There is no reason to think this number couldn't come in between 0% and 2.5% -- it simply never has. However, that number is currently in the 0% - 2.5% range. Only time will tell if it stays there, but, so far so good.

The reason for this pace is the death of the US consumer has been greatly exaggerated. Consider this chart of real PCEs:

Real (inflation-adjusted) PCEs have been increasing since the first quarter of 2009.

Stimulus spending is a no-brainer. According to this link of a CBO analysis, we're going to be seeing stimulus spending this year.

Inventory adjustments are another positive part of the story -- one that we're just starting to see pick-up:

Total inventories of merchant wholesalers, except manufacturers’ sales branches and offices, after adjustment for seasonal variations but not for price changes, were $393.5 billion at the end of February, up 0.6 percent (+/-0.5%) from the revised January level, but were down 7.4 percent (+/-1.1%) from a year ago. The January preliminary estimate was revised upward $1.0 billion or 0.3 percent. End-of-month inventories of durable goods were up 0.5 percent (+/-0.7%)* from last month, but were down 12.3 percent (+/-1.2%) from last February. Inventories of computer and computer peripheral equipment and software were up 2.5 percent from last month and inventories of lumber and other construction materials were up 2.0 percent. End-of-month inventories of nondurable goods increased 0.8 percent (+/-0.5%) from January and were up 0.7 percent (+/-1.8%)* compared to last February. Inventories of petroleum and petroleum products were up 3.1 percent from last month and inventories of chemicals and allied products were up 2.9 percent.

These numbers are just starting to come back. Here is a chart of total business inventories from the St. Louis Fed:

Total inventories are still at incredibly low levels. But,

The inventory to sales ratio is also low, indicating that businesses will probably have to continue restocking for the rest of the year. That means the inventory build story should continue.

Manufacturing has also been a big part of the story. Consider these charts:

The Chicago PMI index is at a very high level. In addition,

Industrial production has bounced back, as has

Capacity Utilization.

Asian consumers are doing better, so far that is not translating into a meaningful improvement in the trade deficit.

So, in general the first and starts expansion is on track with the exception of exports lowering the trade deficit.