Depending on what news feed you use these days we should all be frightened. With the many comings and goings at the White House and tensions on the Korean Peninsula, you would think we should all be in a state of fear.
However, the economic data says otherwise. While the US economy is not growing at its potential, things still look rosy.
In previous outlook letters I expressed concern with the ongoing federal budget deficit and high outstanding public debt. White House policy issues and international tensions aside, our economy is not living up to its potential because high-levels of public debt bring about slower economic growth.
Since the financial crisis ended in 2009 US real gross domestic product has grown at an average annual rate of only 2.1 percent, compared to an average of 3.1 percent over the prior six decades.
A one percent difference may not seem like much, but it has long-term consequences. When the economy grows at 3 percent per year the living standards of the young are twice that of their parents. But when the economy grows at only 2 percent it takes two generations before living standards double. Slow economic growth leads to a “lost generation.”
This may be why we hear younger generations complaining about their prospects for a better life.
However, as we near the last quarter of 2017 economic and financial market indicators give a favorable economic outlook. Labor market conditions are strong, bond prices indicate low inflation expectations, and stock prices reflect good expectations for earnings growth.
At 4.3 percent, the U.S. unemployment rate is below what many economists consider normal. There is always some unemployment as new businesses start and old ones close, leading to displacement of some workers. Historically, a five percent unemployment rate is normal.
However, this below-normal rate has not been coupled with the normal rise in wages, and therefore living conditions. One explanation for this unusual result is that employees now receive more of their compensation in terms of benefits rather than wages. Over the past decade inflation-adjusted, total compensation has risen faster than the overall economy at 3.8 percent.
The outlook for our cost of living, i.e. inflation, is also favorable. Interest rates on U.S. Treasury bills, notes, and bonds remain well below historical levels. The yield spread, or difference between rates on short-term and long-term US debt, predicts relatively low inflation for the next decade.
Meanwhile, stock prices as measured by the Dow Jones Industrial Average are nearly 60 percent higher over the last decade. Higher stock valuations indicate expectations for either normal or higher than average economic growth.
So what should we be afraid of?
The big caveat to the favorable economic conditions described above is the ongoing presence of financial repression.
Financial repression occurs when government authorities channel funds from one area of the economy to another, most often by using the government’s own debt. Since 2008, large US Treasury debt purchases by the Federal Reserve and the continuing federal government deficit have suppressed risk measures in the stock market and created a higher than normal level of uncertainty in the overall economy.
After their most recent meeting, the Federal Reserve’s Open Market Committee (FOMC) announced plans for ending the practice of reinvesting the proceeds of US Treasuries that mature. As the Fed reduces its portfolio of bonds over time interest rates should rise, which implies stock values should fall, all else being equal. However, the FOMC said that this process would be gradual.
While the Fed keeps supporting bond prices foreign investors continue to push up stock prices. The most recent data on foreign investment shows that the US is a favored destination for capital. The value of foreign holdings of U.S. equity securities continues to rise while the value of US holding of foreign equity securities declines.
Funds are flowing to the capital markets of the United States because the outlook for economic growth is worse elsewhere. Financial repression is even higher in Japan and Europe, while also rising in the developing markets of China and elsewhere.
Indicators in the U.S. labor, bond, and stock markets may all look good relative to historical averages, but a deeper look tells a different story. For conditions in these markets to improve, and economic growth return to its 3 percent long-run average, financial repression must decline.
When government spending and public debt start declining, the labor and financial markets will reflect a truly healthy economy.
The views expressed here are those solely of the author and do not represent Northwest Nazarene University or Rathbone Warwick Investment Management.
Peter R. Crabb, Ph.D.
Professor of Finance and Economics
Department of Business and Economics
School of Business, Northwest Nazarene University
Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado. His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others. Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho.
Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman. Previous work experience includes international trade, banking, and investments.