Momentum To Shift From The US To Economies Abroad
John Lonski, Moody's senior economist in New York
Both the equity and bond markets have already priced in a 5.75% federal funds rate. The latest narrowing of yield spreads over
Treasuries implies that suppliers of credit market funds are not much worried over a possibly significant loss of debt repayment
capacity to some combination of higher interest rates and an ebbing of debt-financial expenditures.
The rest of the world which may be gathering enough forward momentum to boost US exports, lessen competitive pressures, lift US
corporate earnings from overseas operations, and underpin prices of tradable goods. Unless foreign economies stumble, both US
inflation risks and interest rates should rise.
The 24% average annual increase by US stock prices of the last five years is now endangered by an apparently unfinished upswing
by interest rates. Wouldn't it be ironic if the inflationary pressures arising from faster expenditures growth abroad prove to be more
damaging to the US' stock market and economy than were the once frightening overseas economic downturns of late-1998 and into
1999?
The latest batch of reports on foreign economic activity have generally been stronger-than-anticipated. As unemployment rates
abroad slide lower, household expenditures should quicken globally. If overseas spending accelerates amid a still tight US labor
market, US inflation could rise despite a slowing of US economic growth. Such a development would highlight the linkage of the US'
enviable combination of rapid economic and declining price inflation with the erstwhile uncommon sluggishness of important foreign
economies.
In December 1998, a prominent consensus forecast projected a 2.2% annual increase by US real GDP for 1999. Ultimately,
however, US real GDP has surged ahead by nearly 4%.
Further, late 1998's admonitions about price deflation proved to be exaggerations. Although the annual rate of core CPI inflation
dipped from December 1998's 2.4% to the 2.1% of November 1998, a jump by energy prices lifted the annual rate of CPI inflation up
from December 1998's 1.6% to November 1999's 2.6%.
Part of OPEC's success at adhering to production curbs can be ascribed to 1999's unexpectedly brisk pace of global economic
activity. During 1999, a steep 31% advance by our index of industrial metals prices has joined crude oil's explosive 122% price
recovery. Moody's index of industrial metals prices has tended to accelerate and decelerate with changes in the pace of global
economic activity.
When world GDP's annual growth rate climbed up from 1993's 2.6% to 1994's 4%, the year-to-year change of the industrial metals
price index would rise from the 1% of 1993's final quarter to the 42% of 1994's final quarter.
The marked acceleration of world economic activity was over by late 1994. The subsequent 4.2% average annual increase by world
GDP during 1995-1997 was nearly indistinguishable from 1994's 4%.
The industrial metals price index would then dip from January 1995's record high of 538 and, under the weight of global economic
distress, fall as low as January 1999's 376.6. Although the latest industrial metals price of 489.7 stands well above its January 1999
low, this barometer of global industrial activity still trails its June 30, 1997 -- or eve of the Asian crisis -- reading by 3.1%.
Many South American countries still struggle to escape recession's grasp while Japan's third-quarter 1999 economy rose by an
imperceptible 0.1% yearly. The global economy's recovery from the travails of July 1997 to the present has not been full enough to
bring world resource utilization to where it resided in mid-1997.
Inflation Expected To Rise In 2000
As the global economic recovery matures, more upward pressure will be put on the prices of a broader array of goods and services.
If the world economy continues to strengthen, neither a 6% federal funds rate by the March 21st meeting of the Federal Open
Market Committee (FOMC) nor a 6.5% 30-year Treasury yield may be enough to ward off an acceleration of US prices.
In 1999, retail sales should grow by 8.8% annually, for the biggest such gain since 1984's 10% advance. In conjunction with 1984's
retail sales surge, the annual rate of core CPI inflation would ascend from the 3.2% of 1983's third quarter to the 5.1% of 1984's third
quarter.
Price disinflation has been promoted by the slowing of the average annual growth rate of retail sales from the 7% of the 1980s to the
5.4% of the 1990s. Facilitating lower inflation amid an upturn by the average annual rate of real GDP growth from the 3.2% of the
three-years ended 1994 to the 3.8% of the four-years ended 1998 was a slowing by the average yearly increase of retail sales from
the 6.6% of 1992-1994 to the 5.1% of 1995-1998.
The faster growth of dollar outlays by consumers should help to nurture price growth. Changes in price inflation will be the byproduct
of the changes in the growth of demand relative to supply.
Once faster growth abroad joins a possibly still brisk pace of US household expenditures, a rise by consumer price inflation should
materialize. The annual rate of CPI inflation could reach 3% by June 2000 and, then, subside to 2.6% by December 2000. The
average annual increase should rise from 1999's 2.2% to 2.7% in 2000.
Look For A Slower Rise By US' Nonfinancial Debt
Although higher borrowing costs will probably slow the growth of nonfederal debt, the third quarter's 6.8% annual increase by
nonfinancial-sector debt was well above the accompanying 5.7% annual increase of nominal GDP. If the acceleration of
nonfinancial-sector debt were to soon end, nominal GDP's annual growth might not rise much above 6%.
Neither liquidity nor credit worth may be great enough to power an extended climb by nonfinancial-sector debt growth. In turn,
nominal GDP may not accelerate in a manner that would favor the return of a 7%-plus 30-year Treasury yield.
M2's Still Brisk Pace Signals Faster Nominal GDP Growth
Nominal GDP's growth path has tended to follow that of the M2 monetary aggregate. Accompanying the decline by the average
annual rate of M2 from the 8% of the 1980s to the 4% of the 1990s has been the paring of nominal GDP's average annual growth
rate from the 7.9% of the 1980s to the 5.3% of the 1990s.
M2's annual rise last bottomed at the 0.4% of 1995's first quarter and would more recently peak at the 8.5% of 1998's final quarter.
Third-quarter 1999's 7.5% annual increase by M2 was steep enough relative to nominal GDP's accompanying 5.7% annual increase
to preserve the possibility of a 6% annual gain for current-dollar GDP. The still significantly faster growth of M2 relative to nominal
GDP suggests that bond yields have yet to peak.
From the July 1997 start of the Asian crisis up until just recently, the 10-year Treasury yield hovered about the annual percentage
increase of nominal GDP. By contrast, during the five-years ended June 1997, the 10-year Treasury yield averaged about a
percentage point more than nominal GDP's annual growth rate.
According to what held when the world economy was relatively healthy, the realization of an expected 5.6% annual increase by
nominal GDP for 2000 should eventually give rise to a 6.6% 10-year Treasury yield. In turn, the 30-year Treasury yield could form a
top of 6.8% by 2000's second half.
Only if the 10-year Treasury yield rises by more than 1.5 percentage points above nominal GDP's annual growth rate might onerous
borrowing costs threaten to curb expenditures to an atypically sluggish pace.
Bond Yields Are Not Yet Economically Unbearable
The danger of bond yields rising to levels which are macroeconomically intolerable will be greater the more reported inflation
regularly exceeds expected inflation. Yes, 1999 was a year of many stronger-than-anticipated reports for household expenditures.
But, not once did investors agonize over back-to-back reports on inflation that were greater-than-expected.
The behavior of nominal GDP, which consists of both real economic activity and price inflation, matters a great deal to the credit
market in terms of its implications for both interest rate and credit risks. To a considerable degree, the 10-year Treasury yield's
average sank from the 9.6% of the 1983-1990 economic recovery to the 6.4% of the ongoing business cycle upturn because of a
concomitant slide by the average annual rates of nominal GDP growth from 7.7% to 5.4%. (Please note the percentage point
premium of he 10-year Treasury yield over nominal GDP growth for the now nearly nine-year business cycle upturn.)
Initially, corporate credit worth just might benefit from an unexpected acceleration of nominal GDP that includes a firming of product
prices. By contrast, the economic recovery would be imperiled and credit worth would deteriorate if the 10-year Treasury yield fails
to enter into a slide that is commensurate with any noteworthy downshifting of nominal GDP.
The US economy was being set up for a recession when, from the second half of 1989 to the first half of 1990, the 10-year Treasury
yield's average rose from 8% to 8.6% notwithstanding a decline by nominal GDP's yearly increase from 6.8% to 6.3%. For 1990's
second quarter, or the final three months of the previous economic recovery, the 10-year Treasury yield averaged an ominous 2.5
percentage points more than yearly nominal GDP growth.
72% Of US GDP To Slow From 1999's 5.3% To 3% In 2000
Any forecast of US economic activity starts by focussing on the likely behavior of household expenditures. Including residential
investment, as well as consumer spending, household expenditures supplied a record 72% of GDP in 1999.
Higher borrowing costs are expected to slow household expenditures in 2000. One of the distinguishing characteristics of 1999's US
economy was retail sales much faster 8.8% annual advance compared to wage and salary income's 6.9% annual increase, which
was between its average annual increases of 7.5% for the 1980s and of 5.6% for the 1990s.
Nineteen-ninety-nine's 1.9 percentage point deficiency of wage and salary growth compared to retail sales growth was the deepest
since 1994's 3.1 points. Accompanying the paring of the annual growth rate of retail sales from 1994's 8% to 1995's 5.2% was a
slowing of estimated real household expenditures growth from 1994's 4.1% to 1995's 2.7%.
More specifically, from 1994 to 1995, real consumer spending's annual growth rate dipped from 3.8% to 3.1%, while residential
investment was transformed from a 9.7% advance to a 3.6% contraction. Falling from 1994's 4% to 1995's 2.7%, real GDP's annual
growth all but perfectly mimicked the changes in household expenditures.
Not since 1984's 6% have estimated household expenditures expanded as rapidly as 1999's 5.3%. In effect, the US consumer
pulled the world economy from the edge of the abyss as real consumer spending advanced by 5.2% annually, while real residential
investment gained 7%.
For 2000, real consumer spending's annual increase should slow from 1999's 5.2% to 3.3%. Real residential investment's annual
change is projected to switch from 1999's 7.1% increase to 2000's 1.8% decline. In turn, the annual increase of estimated real
household of estimated real household expenditures should drop from 1999's 5.3% to 2000's 3%.
The projected decline for 2000's residential investment would be the first since 1995's 3.6%, while real consumer spending's
expected annual increase would be the smallest since 1996's 3.3%.
Average annual growth rates derived from the 30-years ended 1998, showed real GDP's 3.1% nearly matching estimated household
expenditures' 3.2%. Within the latter were average yearly gains of 3.3% for consumer spending and of 2.4% for residential
investment spending. US real GDP is expected to grow by 3.4% annually in 2000.
Household Expenditures Top Disposable Personal Income
Concern has been voiced regarding record levels of household indebtedness compared to personal income. However, the net worth
of households has climbed higher relative to personal income thanks to the equity market's gargantuan rally and the appreciation of
residential real estate.
During the three years ended 1998, just the market valuation of corporate equity shares held by households and nonprofit
organizations swelled by $3.53 trillion which was a multiple of the concurrent $1.13 trillion addition to the indebtedness of
households and nonprofits.
Never before has household spending received so much support from equity price appreciation. During 1959-1994, the price
appreciation of equities and mutual funds held by households approximated 9% of wage and salary income. Within this 35-year
span this ratio got as high as 1967's 34%. For 1995-1999, the price appreciation of household financial assets has hovered about an
unmatched 36% of wages and salaries, wherein this ratio peaked at 1997's 45% zenith.
The powerful showing by equities and a similarly low unemployment rate help to explain why 1999's average Conference Board
consumer confidence index of 134.6 so closely resembles the 136.1 of 1968. Better yet, 1999's average reading for consumer
confidence will be the highest since 1968, and who would have imagined amid 1968's horn of plenty that consumer sentiment would
not see those heights again until 31 years had passed.
In 1968, the estimated 6.2% annual increase by real household expenditures sped past real disposable income's 4.6% annual gain.
Similarly, the 5.4% yearly increase by estimated household expenditures for 1999-to-date outruns real disposable personal
income's 4% advance.
Thanks to an unsurpassed wealth effect, estimated real household expenditures can now ride above disposable personal income.
For 1999-to-date, household spending's contribution to GDP was a record 100.2% of disposable personal income.
Immediately after that spendthrift year of 1968, household spending would peak at 96.2% of disposable personal income in 1969's
first quarter. Over the next 20 years, household expenditures would average a smaller 93.7% of after-tax personal income. Again,
the record shows the current pace of consumer outlays to be unsustainable.
For the five years ended 1999, the price appreciation of equity and mutual fund shares held by households approximated 36% of
wage and salary income. The five-year moving average of financial-asset capital gains as a percentage of wages and salaries has
dipped no lower than 10% starting in 1986.
Household financial asset prices can incur protracted declines, especially if price inflation climbs higher. After earlier peaking at the
19% of the five-years ended 1968, the change in the market value of financial assets would eventually bottom at the -6.4% of wages
and salaries during the five-years ended 1977. In 1974-1975, the US suffered through one of the most severe recessions ever.
All too often the mammoth stock market rally gets too much of the credit for household spending's blistering pace at the expense of
understating the benefits still flowing from late-1998's 30-year low for benchmark bond yields. Abetting 1999's acceleration of
household spending relative to earned-income was 1998's 232% year-over-year surge by applications for mortgage refinancings to
unimaginable heights. Both the free cash flow and borrowing capacity of households were enlarged by this unprecedented rush to
refinance mortgages. The 54% year-over-year plunge by applications for mortgage refinancings of 1999-to-date warns of a slowing of
household expenditures relative to wages and salaries.
When the year-over-year change of applications for mortgage refinancings went from the 83% advance of the 12-months ended
January 1994 to the 88% plummet of the 12-months ended March 1995, the annual increase of real household expenditures would
sag from 1994's 4.1% to 1995's 2.7%.
Hiring Activity Ultimately Gives Direction To Household Spending
Hiring activity in 2000 will have much to say about the severity of an expected slowing by household expenditures. Yearly changes
in real consumer spending have been highly correlated with yearly changes in nonfarm employment. Nevertheless, despite how the
annual growth rate of employment has slowed from the 3.3% of the year-ended June 1995 to the 2.3% of the year ended September
1999, the corresponding yearly growth rates of real consumer spending rose from 3.3% to 5.1%.
Compared to its 1.2-point average of the last 25 years, the year-ended September 1999's 2.9 percentage point excess of real
consumer spending growth (5.1%) over payrolls growth (2.3%) highlights the inevitability of slower household expenditures. A further
deceleration of employment would heighten the danger of an especially jarring slowdown by consumer spending.
Fortunately, further improvements in profitability arising from a livelier world economy should prevent a further slowing of employment
and thus allow for an acceptable 3.2% annual increase by real consumer spending in 2000.
Unchanged jobs growth amid a shrinking pool of available labor implies that the unemployment rate may dip from 1999's 4.2% to
4% in 2000, where a tighter labor market would increase inflation risks. Given the Fed's intense focus on the labor market so low of
a jobless rate might eventually lead to a federal funds rate target no lower than 6%.
Business net income can profoundly influence jobs creation. As the annual increase of the 4-quarter running sum of business net
income slumped from the 16.7% of the span ended June 1988 to the 0.1% of the span ended March 1990, the annual change of
nonfarm payrolls would drop from 1988's 3.2% to the -1.1% of 1991. By the time the annual growth of business net income had
recovered to 1995's 11.2%, the yearly increase of jobs creation had already peaked at the 3.3% of the year-ended June 1995.
Business net income's yearly rise most recently troughed at 1998's 2.5%. In turn, the annual rate of jobs creation has slowed to the
2.2% of the year-ended November 1999. However, a subsequent recovery by business net income's annual increase to the 4.9% of
the year-ended September 1999 signals a potential re-acceleration of employment provided that the quickening of business net
continues.
Possible Stock Price Slump Might Be Corrected
What other than higher borrowing costs and an unsustainably rapid rate of household expenditures relative to personal income
might slow US spending in 2000? Much has been said about the danger of a crippling plunge by equity prices. For such a stock
price slide to occur, either the Federal Reserve does not quickly inject liquidity through interest rate cuts or a loss of credit worth
diminishes the stimulatory effect of lower borrowing costs.
Only a fast rising rate of price inflation might significantly slow the Fed's response time to a sickening dive by stock prices.
Fortunately, the likelihood of so steep of a climb by price inflation seems remote.
According to the "loss of credit worth" scenario, some combination of rising interest rates, dollar exchange rate weakening, and
declining profitability conspire to sink stock prices. This mix of adverse developments would probably push unemployment higher,
which, when combined with declining stock prices, could crush confidence and trim that big 72% of GDP consisting of household
expenditures.
Unexpectedly low consumer spending would reinforce both the profits slump and the stock price retreat, which would only drive
joblessness higher. Both the loss of and worry over debt repayment capacity could reduce the remedial power of lower interest rates
by enough to prevent a quick recovery by stock prices, never mind keeping the US safely distanced from recession.
Corporate Credit Worth Incurs A Manageable Retreat
Credit worth will have much to say about both stock price and economic performance. All too often assessments of the greatest
equity market rally ever overlook the critical support stemming from a reduced supply of common equity shares. The latest surge by
net stock buybacks has been attributed to M&A activity, to the propping up of ailing share prices, and to the simple compensation
of shareholders in lieu of dividend payments.
Each of the deep equity price declines of October 1987 and of late 1998 were quickly reversed, in part, by the stepped-up buyback
of common equity shares. The danger of an extended slide by stock prices and the ensuing possibility of a harsh economic
downturn will be less the greater is corporate America's capacity to buyback common stock.
Still strong aggregate measures of corporate debt protection, relatively low business loan delinquency rates, and the general health
of the US financial system suggest that the stock buyback capabilities of US companies remain ample. Nevertheless, a
comparative lack of earnings and /or cash renders the now high-flying Internet industry as being comparatively unable to defend
stock prices with equity buybacks. However, following 1999's stupendous 155% uprising, only the na‹ve have reason to be upset if
Dow Jones' broad internet stock price index slumps by 50% in 2000. Economic history is replete with examples of scintillating
industry-wide price advances being followed by shattering price declines. As a whole, internet-related stocks may be nothing more
than a speculative commodity waiting to be dumped.
Solid aggregate measures of corporate credit worth lessen 2000's economic risks. Despite how the net retirement of equity shares
approximated a near record 3.2% of GDP during the year-ended September 1999, the pretax profits of nonfinancial corporations still
quadrupled their net interest expense for the year ended September 1999.
By contrast, when a credit crunch was unfolding in 1989 and when net equity buybacks were on their way to being supplanted by
net equity issuance, pretax profits had dropped to a disturbingly thin 1.5-times net interest expense in 1989.
Further, the liquid assets of US nonfinancial corporations averaged 30% of their short-term liabilities during the year-ended
September 1999, which compares favorably with 1989's skimpier ratio of 22% and the ratio's 25% average of the last 20 years. Not
since 1976 has cash been so abundant relative to short-term liabilities.
Corporate cash was up by 10% yearly as of 1999's third quarter, which was no mean feat given how the capital outlays of US
nonfinancial corporations exceeded their internal funds by 21% during the year ended September 1999, to say nothing of how net
equity buybacks approached 38% of internal funds for the same span.
Not long ago, the FDIC voiced concern regarding how the charge-off rate for outstanding bank commercial and industrial (C&I) loans
advanced from the 0.37% of 1998's third quarter to the 0.5% of 1999's third quarter. Still, the latter remains well under 1989's
average of 1.04%. Nevertheless, all prognosticators must be cognizant of how the charge-off rates of bank business loans has
climbed up from its 0.24% mean of 1994-1997.
Also, third-quarter 1999's bank C&I loan delinquency rate of 1.89% was up from the 1.65% of a year earlier. However, panic is not
yet warranted given the much higher 5% average delinquency rate for bank business loans during 1988-1989.
The charge-off and delinquency rates of bank C&I loans, corporate credit rating revisions, and high-yield bond default rates all point
towards an erosion of corporate credit worth. Nevertheless, the latest deterioration of corporate credit worth has been less severe
compared to what transpired in 1989-1990. Of additional importance, today's much stronger financial system further reduces the
near-term risks of an enervating credit crunch.
Us Corporate Debt Speeds Up After A Lull
October's US nonfinancial-sector debt outstanding was up by 6.8% yearly, while November's M2 measure of the money supply
gained 6% annually. Because the latest available yearly increases for both nonfinancial sector debt and M2 were above the
expected 5.5% annual rise of fourth-quarter 1999's nominal GDP, neither measure suggests that domestic spending's expansion
will soon be curbed by insufficient liquidity.
Because of nonfederal debt's steeper ascent, a record federal budget surplus has not stopped total debt outstanding from
outrunning GDP and putting upward pressure on interest rates. October's 6.8% annual advance by nonfinancial sector debt was the
product of a 2.3% contraction of federal obligations and a 9.5% surge by nonfederal debt outstanding.
Third-quarter 1999's 12.3% yearly advance by US nonfinancial corporate debt helps to explain why US corporate credit rating
revisions now show more downgrades than upgrades. Nevertheless, the loss of credit worth to the latest acceleration of nonfinancial
corporate debt has been limited by the relatively short duration of the current corporate borrowing spree.
Previously, the average annualized growth of nonfinancial corporate debt outstanding corporate debt outstanding had climbed up
from the 8.9% of the 1960s, to the 9.7% of the 1979s, and, more recently, to the unprecedented 11% of the 1980s. Despite its most
recent quickening, the average yearly rate of corporate debt growth has slowed to 6% for the 1990s.
During the eight years ended 1997, corporate debt outstanding grew by merely 4.6% annualized. Because of earlier deleveraging
and reinforcement of weakened balance sheets, the 12.5% annualized rise by corporate debt outstanding over the two years ended
September 1999 has been less abusive of corporate credit worth than was corporate debt's 11.8% average annual advance of the
six years ended 1989.
The loss of corporate credit worth to the latest jump in borrowing had been muted by late-1998's drop in borrowing costs. However,
credit worth is no longer being buttressed by declining borrowing costs. In order to sustain corporate credit standing, net borrowing
ought to subside, especially if interest rates more higher.
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John Lonski, chief economist |
