If Federal Reserve Chair Janet Yellen were incapable of telling a lie, she might say something like, “We appear perpetually optimistic because we’re afraid of the market reaction if everyone found out what we really think.”
Dishonesty would certainly help to explain the Fed’s atrocious economic forecasts.
In December 2014, the Fed governors expected the economy to expand at a pace of 2.6% to 3.0% (central tendency of real GDP growth).
Actual 2015 growth will wind up around 2.1%. That’s below even the 2.5% expansion posted in 2014, as I warned it would be in last year’s economic outlook.
Yet, in spite of flagging GDP growth and sub-2% inflation, the Fed decided to raise short-term interest rates.
As I predicted in a recent Saturday Spotlight, long-term rates have declined since the rate hike. The bond market senses a major economic growth problem, and I think it’s correct.
Last year, I suspected that the drop in the price of crude oil and, hence, gasoline, would not be a huge boon for the economy. Many prominent economists disagreed with me.
As it turns out, consumers, by and large, didn’t end up spending their gas savings (more on this later).
Plus, the bigger story is how collapsing crude oil and natural gas prices turn the energy sector into an anchor around the neck of the U.S. economy.
According to Goldman Sachs, 30% of total S&P 500 capital expenditures (capex) came from the energy sector in the last 12 months. That’s still the highest percentage of any sector.
Add on the materials and industrials sectors, and we’re talking about 45% of total U.S. capex. Don’t let anyone tell you these sectors don’t matter anymore in our “technology- and services-driven economy.”
In 2015, capex – which serves as a powerful economic stimulus – is likely to experience its first annual decline since 2009. As I see it, lower corporate spending is still an underappreciated economic headwind.
But we have other significant problems, too…
Here are my top three risks to the U.S. economy, which help explain why I remain pessimistic about economic growth heading into 2016.
- Excess Inventories
The following chart shows the total inventory-to-sales ratio for U.S. retailers, manufacturers, and wholesalers:
The ratio experienced a dramatic decline in the 1990s and early 2000s, likely due to improving supply chain efficiencies.
Then, as sales plummeted during the Great Recession, there was a massive spike in the ratio. The excess inventory of unsold goods was worked off fairly quickly, but there was a lot of pain associated with that process.
Now, relative inventory levels are slowly inching their way back up.
By digging a bit further, we can see that declining sales is a big part of the problem:
Every single month in 2015 has seen lower total business sales on a year-over-year basis. In fact, the data appear downright recessionary when compared with the declines in the shaded areas. And the Fed is hiking rates!
Businesses are dreaming if they think a burst of sales is imminent. If you build it, they may not come.
Inventory levels will need to be rightsized, likely through a combination of slower production rates and inventory liquidation. Headline GDP growth figures will suffer as a result.
- Rising Healthcare and Rent Costs
According to the Centers for Medicare & Medicaid Services, U.S. healthcare expenditures amounted to $9,523 per person in 2014. That’s up 5.3% over the previous year. Astoundingly, the cost of prescription drugs surged 12.2% in 2014.
Insurance companies are passing these costs along to consumers in the form of higher health insurance premia and deductibles.
Ironically, the Affordable Care Act (Obamacare) is helping to make healthcare less affordable. And according to the White House, the cost of a benchmark Obamacare plan will increase by an average of 7.5% in 2016.
Naturally, if you spend more on health insurance and out-of-pocket healthcare expenses each month, then you have less money for discretionary purchases – like eating out or buying a car. Also, if you save on gasoline but spend more on healthcare, then that’s a wash.
By this same logic, rising rents are crimping discretionary spending, as well.
The U.S. homeownership rate is at its lowest level since the 1960s. More and more people are renting, and rental costs are rising far faster than stagnating wages. Average rents have increased by 3.6% over the past year and have surged 12.7% since the beginning of 2012.
According to a study conducted by Zillow, renters can now expect to put around 30% of their monthly income towards rent. That’s the highest percentage ever.
The rent (and health insurance) is too damn high.
- Impending Credit Crunch
According to Standard & Poor’s, the trailing 12-month high-yield corporate bond default rate was 2.8% in November.
The high-yield default rate reached over 10% in 1991, 2001, and 2009. Thus, we have a long way to go before the default rate peaks.
Credit distress will spread over the next couple of years because a feedback loop has begun. An increasing default frequency will lead to falling asset prices, tightening lending standards, and even more defaults.
Basically, the credit cycle has turned, and we’re now going to have a credit crunch (a crunch is somewhere between a pinch and a crisis).
An abundance of credit is necessary for our overly indebted economy to grow. Companies and individuals will increasingly find it harder to borrow money, and this impending credit contraction will deprive the economy of its lifeblood.
Many are missing this nascent economic downturn because they’re on the lookout for the next Great Recession. Rest assured that the next recession won’t look anything like the last one.
For starters, the U.S. banking system is in much better shape. However, even though there may be less contagion risk in the financial system, this doesn’t mean we shouldn’t be worried.
The probability of a U.S. recession continues to rise against the backdrop of a weak global economy.
Consumer spending makes up around 70% of the U.S. economy, and consumer spending growth peaked in January 2015. At that time, the year-over-year increase in real personal consumption expenditures (PCE) was 3.8%. As of November, real PCE growth has moderated to 2.5%.
A vicious cycle has started. Lower consumer spending will result in lower production, which will translate into fewer jobs being created. Slowing employment growth will negatively impact consumer spending, and so on and so forth.
Based on the risks and headwinds I’ve discussed, I believe we’ll see real PCE growth slow to below 2.0% in 2016. At that point, a bona fide recession will be at the doorstep.
If I’m right, the yields on U.S. Treasury notes and bonds are still extremely attractive, despite being very low.
Safe (and high-yield) investing,
Alan Gula, CFA