THE past few months have not been kind to bulls on the American economy. Economic growth in the first quarter was unusually weak, dragged down by severe winter weather and a prolonged strike at ports on the West Coast that disrupted supply chains in the manufacturing sector. The weakness continued into the second quarter, even as the weather improved and the strikes ended. Industrial production continued to fall in April while other indicators were up only weakly, spurring concerns that there was something more fundamentally wrong with the US economy than just transient factors such as the weather.
Our view remains that the American economy will defy the pessimists and turn in a much stronger-than-expected performance in the second half of the year. This will have important implications for Asian economies — boosting external demand, but potentially creating disruptive capital flows.
Where is the US economy heading?
The most recent economic data suggests that the US economy is turning the corner. While 2Q2015 may still show economic growth below 2%, forward-looking indicators point to a smart pickup in the second half of the year. A major factor supporting this view is that housing, credit and labour markets are strengthening again, after losing momentum in early 2015:
• The housing sector has put the recent slowdown behind: New home sales soared 6.8%, while housing starts boomed 9.2% y-o-y in April. Home prices are rising by around 5% annualised rate, according to the latest S&P/Case-Shiller indices.
• Credit is flowing more strongly to small firms. The Federal Reserve Bank’s survey of banks’ loan officers showed that banks were easing lending standards, boosting small firms’ demand for commercial and industrial loans.
• Wage growth is showing signs of stirring as well. More and more cities in the US are implementing significant increases in minimum wages, while large companies that can influence wage trends such as Wal-Mart, McDonald’s, Target and insurance firm Aetna have all announced pay increases for staff.
As these key markets regain dynamism, the effects on the rest of the economy are profound because each market reinforces improvements in the others: Credit flows boost labour demand because they help credit-constrained small and medium-sized firms that are the main employers. Stronger labour markets enhance the confidence of homebuyers, so supporting the housing market. A stronger housing market boosts construction, mortgage lending and, through the wealth effect, even consumer spending, eventually leading to stronger labour demand and a firmer labour market. This is the kind of upward spiral that creates upside surprises to economic growth — and which then drive big financial market moves.
It is also important to understand what held the economy back in the early months of this year. There clearly were one-off factors — the West Coast port strikes and bad weather. In addition, the plunge in oil prices had a net negative effect on the economy initially: Oil-related sectors of the economy were quick to cut back capital spending and employment, delivering a blow to the economy. The stimulative effects of lower oil prices, however, take a while to feed through to the economy as consumers need time to be convinced that the fall is a permanent one. But as time progresses, the negative effect on the oil sector recedes while the positive impact on consumers becomes stronger.
Our view is that we are now entering this sweeter spot in the US economy:
• The composite lead indicator has continued to rise, suggesting that GDP growth will pick up considerable steam in the coming months.
• Capital spending, which has been weakening for several months since late last year, has started to rebound with core capital goods orders rising 1% in April, following a 1.5% gain in March. Businesses are clearly becoming more confident of demand in the non-oil sector and are spending faster than the oil sector is cutting back spending. Our view is that there could be a substantial upside surprise in capital spending over the next two years — growing confidence in the corporate sector will combine with the take-off of new technologies, such as 3D-printing, advanced manufacturing services, biotechnological advances, and social, mobile, analytics and cloud (SMAC) technologies will boost high-multiplier investment spending significantly.
• Consumer confidence is also rebounding, with the Michigan index in April at its second-highest level since 2007. An analysis of recent spending habits by credit card company Visa suggested that Americans’ propensity to spend is rising.
How will market expectations of Fed policy shift?
Federal Reserve Bank chair Janet Yellen has made it clear where she stands on rate increases: Even before this week’s positive economic data, she had stated clearly that rates were going to rise before year-end.
But, because she expected only a modest rebound, believing that the US economy faced headwinds for many years, she felt it would take many years before US interest rates returned to normal. In other words, the Fed would take its time in raising rates and that is what is priced into markets.
What we are suggesting is that this assumption on the trajectory of interest rates will change in the next few months. As economic growth in the US strengthens faster than expected, and as wage growth accelerates, concerns about downside risks to growth will ease while worries about asset price bubbles and consumer inflation will begin to be more prominent.
We think the Fed will, in the end, be more aggressive about the pace of monetary normalisation than markets currently anticipate. That means higher US bond yields and a stronger US dollar.
What is the impact on Asia?
Thus, the US economy is likely to gain momentum in the coming months, adding significantly to global demand for Asian exports. But as markets rethink their view of Fed policy and the follow-on impact on bond yields, there is bound to be a renewed outflow of capital from emerging economies to developed markets, hurting valuations in emerging-market bond, equity and currency markets. There are consequently several channels through which the US will affect Asia and the world:
• Trade: The US is the world’s largest importer of both goods and commercial services, accounting for about 12.3% of total world imports of goods and about 10% of world imports of services. About 70% of its goods imports are manufactured goods, so there will be a pretty punchy impact on demand for Asian manufactured exports. The biggest beneficiaries will be China, the European Union, Canada, Mexico and Japan. As the export processing platforms in China and Japan rev up, the demand for all kinds of components from the supply chains in the rest of Asia will rise. The recoveries in Europe and Japan will receive a boost as well from the US upswing, and as they recover more strongly, their demand for Asian products will also rise.
• Capital market downsides: Once it is clear that US rates will be rising on the back of a more promising economic outlook, there will be a substantial re-balancing of global portfolios in favour of the US over emerging economies — as we saw in May 2013, when then-Fed chairman Ben Bernanke floated the idea of monetary normalisation. Yes, these capital outflows may not be as disruptive as in 2013, but they will certainly happen since relatively safer US assets will be providing a decent yield again.
• Other financial impacts: The US dollar is likely to regain momentum and rise against its peers such as the euro and yen, as well as Asian currencies. As US rates rise, there will be some upward pressures on domestic interest rates around the world as well. As those rates move up, some asset markets could suffer. For example, real estate prices could come under pressure.
• Commodity price impact: A US recovery that also boosts the economies of Europe, Japan and other exporting nations should help stabilise commodity prices to some extent. However, the key driver of commodity prices is now China rather than the US, so this impact is likely to be modest.
• Business confidence: Because the US is still seen as key to the health of the overall global economy, a rising US economy will make businesses, not just in the US but in other major economies, feel more confident about prospects and, therefore, help raise capital spending and hiring. A stronger US economy will also signal to global businesses that the period of economic weakness that began with the global financial crisis is finally ending. This could lead to a revival of foreign direct investment flows which will benefit Asian economies.
• Global imbalances: A recovering US economy is likely to see its current account deficit grow. At the same time, as China’s investment boom slows, its current account surplus will soar. So, too, will those of other export dynamos such as Germany.
A stronger US economy will help sustain a stronger global economy. In Asia, exporters of manufactured goods will benefit: Southeast Asia, South Korea and Taiwan will gain. Within Southeast Asia, Malaysia and Singapore are likely to be the big winners. As the global recovery gains traction, foreign investment flows, tourism and demand for migrant workers as well as remittances will all grow as well, and the gains will expand to a broader set of developing Asian economies.
In the near term, gyrations in capital flows, currencies and asset markets could create some difficulties. Countries most at risk are those with current account deficits that make them dependent on capital flows.Another source of short-term risk could be in countries where real estate markets have become over-heated, or where other bubbles have proliferated. Sharp corrections can be expected in these areas.
Overall, however, a stronger US economy is a good thing and should usher in a new and brighter phase of global growth.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy
This article first appeared in Forum, The Edge Malaysia Weekly, on June 1 - 7, 2015.