US economy: More political fallout

For the first time in 17 years, the United States is on a partial government shutdown. A short shutdown would only have small macroeconomic effects. We reckon that a one week shutdown would shave off 0.1-0.3 percentage points off real fourth quarter GDP growth at an annualised rate. But uncertainty is high and the costs will accelerate with the length of the shutdown amid declining consumer and business confidence. The upshot is that the current partisan battle may resolve issues that otherwise would hang over the debt limit a few weeks from now. Our forecast assumes no failure to extend the debt ceiling. Not increasing the debt ceiling could be disastrous indeed; it would immediately require the government to balance the budget. Spending would have to be cut by 20 per cent or 4 per cent of GDP and a recession would surely follow. Moreover the credit market could freeze, the dollar could plummet and interest rates could skyrocket. A protracted stalemate to pass a new budget would likely delay the Federal Reserves tapering decision into 2014. As things now stand, however, our forecast still is for the Fed to start tapering its bond purchases in December. We expect no long-lasting market and economic impacts, and our 2014 real GDP growth forecast is unchanged at 3.3 per cent. Bellwether macro indicators are compatible with 3 per cent real GDP growth year-on-year. Amid the fiscal wrangling, such growth rates are unlikely in the short term but will materialise in 2014, according to our forecast.

MONDAY OCTOBER 7, 2013 Mattias Brur SEB Economic Research +46 8 763 85 06

Key data Percentage change

2012 2013 2014 2015 GDP Unemployment Inflation Core inflation

Source: SEB

2.8 8.1 2.1 2.1

1.6 7.5 1.6 1.8

3.3 7.0 1.6 1.8

3.7 6.2 2.2 2.1

Economic Insights

THE INDICATORS ARE ENCOURAGING The trend in consumer indicators such as the Conference Board and University of Michigan indices is pointing upward, but both measures are still relatively weak by historical standards. The brinkmanship in Washington D.C. will probably affect sentiment negatively in the near term. Since we published Nordic Outlook in August, economic data have generally surprised on the upside (Citi Surprise Index). Meanwhile the NFIB (small business) index is sitting close to its cyclical high, while the NAHB (housing market) index is at its highest level since January 2006 when housing starts were 60 per cent higher than today. Our composite ISM index (a weighted average of the ISM manufacturing and the ISM non-manufacturing indices) is consistent with 3 per cent real GDP growth year-on-year. However, such growth rates are not expected until the second quarter of 2014, according to our forecast. Initial claims are currently at six-year lows. A reduction in dismissals rather than stronger hiring is still driving the labour market. If the hiring pace would normalise by half, monthly payroll growth would easily exceed 300k. Furthermore, the current level of initial claims has historically been consistent with 3.5 per cent real GDP growth.

Economic Insights

FROM DELEVERAGING TO RELEVERAGING Consumer credit has risen for more than 20 months in a row and outstanding consumer credit has reached a new all-time high. Student debt is no longer the driving force; consumer credit excluding this segment is growing too. The current growth rate also reflects how different conditions are today compared to the massive credit growth that defined the last cycle. The pace of household deleveraging is clearly slowing and deleveraging is now confined to the mortgage market. As a percentage of disposable income, household debt is flattening out. History suggests that a typical deleveraging phase lasts between five and seven years. Since this one began in 2008 it seems reasonable we are in a mature stage. Household wealth relative to disposable income has recovered and is now well above its 20-year average. The improvement has led to easing credit standards, which in turn should support consumer spending. Moreover, owners equity as a share of real estate assets has risen for six quarters in a row and its current level of 49.8 per cent is well above the recession low.

Economic Insights

SEVERAL FACTORS UNDERPINNING A REVIVAL IN CONSUMER SPENDING It is fair to say that consumer spending is still relatively subdued, at least outside consumer durables. Consumer durables are the most interest rate sensitive category and it is interesting in its own right that durables consumption has held up well, given the upturn in bond yields. Real disposable income growth is running below spending but is trending upward. The savings ratio has risen from 3.6 per cent in January to 4.6 per cent today. We see several developments underpinning a revival in consumer spending. The job market is improving, especially for those with skills and education. Average hourly and weekly earnings are trending upward. Home price gains may have slowed, but the growth rates are still in double-digit terrain. According to CoreLogic, home price appreciation in the second quarter alone pushed 2.5 million homeowners out of negative equity which, in turn, is improving credit quality. According to our forecast, real consumer spending will grow 2.7 per cent in 2014 and 3.1 per cent in 2015. In 2013 we see spending growth ending up slightly below 2 per cent.

Economic Insights

BUSINESS INVESTMENT WEAK NOW BUT STRONGER LATER The fundamentals for business investment are good. Profit margins are high while credit availability is improving. As a percentage of GDP business investment is still low which is suggesting a considerable upside. As far as the third quarter real GDP is concerned, it looks likely that business capital spending will post another weak figure. Core capex goods shipments which go directly into GDP calculations are tracking business spending growth of -3 per cent year-on-year with one month to go. Looking ahead, however, we are optimistic on business spending. One leading indicator for business spending, the three-month trend of core capital goods orders, is 8.4 per cent higher than a year ago. Meanwhile the ISM new orders index is even loftier. Lower US energy costs relative to the rest of the world are a comparable advantage for the US manufacturing sector. Moreover, over time it should spur more energy-related investment activity. After weak growth in 2013 (3.6 per cent according to our forecast) we see business investment growth accelerating to 10-11 per cent in 2014 and 2015.

Economic Insights

HOUSING WILL CONTINUE TO SUPPORT THE ECONOMY Housing starts and new home sales are well below recent peaks. While housing always peaks early in the business cycle, it is unlikely that the peak in housing is behind us since the current rate of housing starts is well below underlying demographic trends. Our forecast is for housing starts to rise to 1.6 million in 2015. Against that backdrop, we forecast real residential investment growth of 14-15 per cent annually in 2013-1015. Higher mortgage rates have affected sales activity to a certain degree but affordability while off its extreme levels is still high. Mortgage refinancing activity has plunged, but that may not be too surprising since people have had plenty of time to refinance over the last couple of years. In any event, higher mortgage rates should be viewed in the context of the better labour market and in our view the housing recovery will ultimately prove resilient to higher mortgage rates. Excess supply of housing has been largely worked off and home prices gains are still in double-digit terrain. Admittedly, house price gains are slowing somewhat as lower affordability impacts demand. We expect home price gains of 8 per cent next year and 6 per cent in 2015. Rising home prices are helping push people out of negative equity, which in turn is improving credit quality and possibly labour mobility.

Economic Insights

THE LABOUR MARKET IS STEADILY IMPROVING The unemployment rate has come down to 7.3 per cent. While it is true that the drop in labour force participation has pulled the unemployment rate lower, whether it is appropriate to say that the unemployment rate is declining for the wrong reason is debatable. According to research from the San Francisco and Boston Fed, the drop in participation is structural for the most part; 60-66 per cent of the drop in participation over the past five years is structural, according to these researchers. What this is suggesting is that the US economy may be closer to full employment than commonly acknowledged. That said, the labour market is improving, as the 2.2 million net new jobs created in the past 12 months attest. Historically, the current level of initial jobless claims is consistent with around 3.5 per cent real GDP growth. Indeed, the downtrend in hourly earnings has reversed. Compared to a year earlier, hourly earnings rose 2.2 per cent in August significantly above the all-time-low of 1.3 per cent last October. With wage growth picking up, the key question is whether the output gap really is as large as the Federal Open Market Committee thinks. A mere 1.5 per cent real GDP growth rate has managed to drag the unemployment rate down eight-tenths of a percentage point in the past year. What this is again suggesting is that the potential non-inflationary speed limit may be much lower than most people assume, at least on a temporary basis. The late 1990s is the mirror image.

Economic Insights

INFLATION STILL WELL-BEHAVED

Inflation was 0.1 per cent month-on-month in August (below expectations) and was 1.5 per cent higher than a year earlier. Core inflation was 0.1 per cent as well and was 1.8 per cent higher than a year earlier. Our forecast is for 1.6 per cent inflation this year and the next. In 2015 we expect 2.2 per cent inflation. The consensus expects prices to increase 1.90 per cent in 2014 and 2.20 per cent in 2015, respectively. There is a dearth of qualified applicants for available jobs which, together with a very weak pace of capital formation, has led to stagnating productivity growth. This means that even low wage growth may trigger an acceleration in unit labor costs. In turn, unit labor costs command a high correlation with inflation, so this poses an upside risk to the inflation process. The dollar has weakened since the September FOMC meeting. The recent political deadlock has not been dollarsupportive either. Meanwhile inflation expectations (5Y forward BE inflation) has moved up since end-August but its current level is hardly alarming.

Economic Insights

A RELATIVELY SHORT GOVERNMENT SHUTDOWN WILL HAVE LIMITED EFFECTS For the first time in 17 years, the U.S. is experiencing a partial government shutdown, affecting some 800,000 federal workers. We reckon that a one week shutdown would shave off 0.1-0.3 percentage points off fourth quarter real GDP growth at an annualized rate. In our view the government shutdown may well imply less risk of a debt limit showdown a much more dangerous event. Having made their point, Republicans in the House will hopefully go ahead and vote to raise the debt ceiling without any drama. The key is for the shutdown to be over before the October 17 deadline when the Treasury runs out of funds. Otherwise the deadlock will bleed over into the crucial vote to raise the debt ceiling. As we understand it, big payments for Social Security, Medicare and the like are not due until the end of October, so there may be a little more time than the above deadline suggests. Moreover the CBO estimates that October 22 is the first date the government may begin missing payments. Failure to raise the debt ceiling would immediately require the government to balance the budget. Spending must be cut by 20 per cent or 4 per cent of GDP. If such a scenario becomes reality, at best the US economy will be pushed into recession. In such a scenario, the hope is that the Treasury will be able prioritise and manage cash flows in such a way that a default need not occur. According to polls and media coverage, the Republicans are taking most of the blame for the partisan battle. So if they do not want to throw away the chance to capture a Senate majority in the mid-term election next year, they had better relax their hard line-stance. In any event it is hard to imagine that President Obama will sign into law any bill that defunds his signature achievement, especially since he is not running for re-election.

Economic Insights

THE FOMC IS EXPECTED TO TAPER IN DECEMBER After convincing the market that a soft tapering was coming at its September meeting, the Fed surprisingly left the current policy unchanged. Our forecast now is for a USD 10 billion reduction in the pace of Treasury purchases at the December meeting. As for MBS, we expect no change. Our new forecast is that the program will end in September 2014. Clearly a protracted government shutdown could easily push the tapering decision to early-2014. Twentyfour out of 41 economists foresee a Fed tapering decision at the December meeting, but the longer the partial government shutdown lasts, the bigger the chance that the decision will come early in 2014 instead. The FOMC was criticised for its no-tapering decision last month; it was a huge surprise at the time and a blow to the claim that the central bank has improved its communication. But if we fast forward to today, Fed Chairman Ben Bernanke is being seen as something of a visionary against the backdrop of the partial government shutdown and the possibility that brinkmanship could bleed over to the debt ceiling issue. In any event the decision at the September meeting was likely a close call. The primary reason not to taper was tighter financial conditions (especially higher mortgages, we assume). That is a bit ironic since the main reason for the tightening was that the FOMC had allowed tapering to be priced into the market. Evidently, the FOMC is starting to feel unhappy about the (informal) 7 per cent number on the unemployment rate for stopping its current third round of quantitative easing (QE3). At the post-meeting press conference, Bernanke stated that there is not any magic number. Instead, what one should start focusing on more going forward is the employment rate (employment to population ratio), in our view.

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