Medium-term vulnerabilities in US economy

28 Jul 2017

After eight years of growth, several areas of business investment suggest medium-term vulnerabilities are emerging in the US economy.

Macquarie Securities North America economist David Doyle expects the US economy to continue to perform well over the next 12 to 18 months, fuelled by growth in residential housing investment.

But he says some structural vulnerabilities are emerging, with spending on transport equipment and office buildings now at highs that have preceded downturns in the past .

“Having structural vulnerabilities is a necessary condition for a recession to occur, but it doesn't mean one is necessarily imminent," says Doyle. “It just suggests the risks of a potential recession are now getting more elevated."

Business investment stronger than thought

Business investment has returned to levels consistent with previous economic cycle peaks in 2000 and 2008, according to Macquarie analysis. 

“Conventional wisdom suggests business investment has been subdued in this expansion," says Doyle. “But that is far from the case. It has actually been in line with what the economy requires and consistent with a lower growth environment."

US Bureau of Economic Analysis shows non-residential investment adjusted for inflation is near peaks reached twice since 1999.

Spending on equipment is now 22 per cent higher than at its previous peak in the first quarter of 2007, before the last expansion ended.

Investment in structures and intellectual property products are 17 per cent and 48 per cent higher over the same period.

Should the neutral rate fall as is our expectation, but the FOMC continue to hike, an over-tightening in monetary policy may occur.

Doyle focuses on the performance of three cyclical components of business investment – bus and truck equipment, lodging and offices – as they tend to track economic swings more closely than other indicators.

The combined share of these three sectors relative to the overall investment landscape reached a new peak in the first quarter of 2017. In previous cycles, this high has preceded recessions by about six to 10 quarters.

“These cyclical components are flashing a yellow warning light," says Doyle.

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The central bank and the risk of policy error

Doyle says there is a risk the Federal Reserve will over-tighten monetary policy in this environment.

In June, the median forecast from Federal Reserve policymakers suggested there will be three rate hikes in 2018.

Macquarie expects just one increase, on the basis that an ageing population is capping labour supply growth and will restrain economic output in coming years.

"While the Federal Reserve focuses on falling unemployment as a sign of economic expansion, the jobless rate is being depressed by an increasing population of retirees," says Doyle.

He also points to the Federal Reserve's interpretation of the neutral rate, or the level where borrowing costs neither stimulate nor constrain economic growth.

Estimates from the central bank's Federal Open Market Committee indicate the neutral rate will rise to 3 per cent from about 2 per cent currently.

However, Macquarie expects the rate will fall to 1.5-1.75 per cent, driven by demographic factors.

“Should the neutral rate fall as is our expectation, but the FOMC continue to hike, an over-tightening in monetary policy may occur," says Doyle.

Macquarie expects the central bank to lower its neutral rate estimate in coming months. 

Doyle says the immediate economic outlook remains strong, with remaining upside in some sectors and low short-term rates relative to long-term rates.

“The Federal Reserve has a strong desire to ensure the current expansion continues and inflation remains far from a concern," says Doyle. “The long durable expansion can continue – but risks are developing." 

For a copy of the report Fortress America, contact your Macquarie representative.