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Monday, October 24, 2016

Is Brexit a Risk to US Growth?

mike smitka

I made a short presentation as a component of board education for a local bank. The president was curious about Brexit, so I used that as a point of departure. What follows are thumbnails of slides; I add several at the end that (as expected) I did not get to during my talk.

First, I began by emphasizing that there is no business cycle, as emphasized in a previous posting on this blog. By chance in the immediate aftermath of WWII the US had 3 recessions with similar timing, but that's not happened since. Just because we've gone 7 years without a recession doesn't mean that one is more likely in the next year. Furthermore, the apparent causes vary, so predicting on the basis of past recessions is pointless. Now once a recession has begun, then certain changes occur – but those can also arise without a recession being underway. So it is possible to calculate recession probabilities, but those are weak and at best provide information on the next several quarters.

Still, we can think about potential threats. Is Brexit one? A quick look at recent data suggest "no". The pound has depreciated by about 25% and because the UK is relatively "open" – trade is about 1/3rd of GDP – that will result in some uptick in consumer prices. But so far that's been modest (from 0% inflation to 1% inflation). Meanwhile, unemployment is falling, not rising, and there's no evidence so far of a slump in GDP growth. Meanwhile, interest rates remain at zero. No surprise there, that's been true of the developed world thanks to the Great Recession, and the stalwart refusal of most countries to use fiscal policy.

Even if British growth does slow, that has only a modest impact on us, the US, because the UK is a modest part of the global economy, at a bit under 3%. Now if problems there hurt the remainder of the EU, then that starts to change – the EU is bigger than the US, but it's still only about 1/6th of the world economy. If we are worried about flash points, then we really need to look at the rest of the world because growth in the developed has been slower than elsewhere. NAFTA comes to only about 20% of the world economy; add in the EU and Japan and the developed countries are now less than half of the global economy. That's good news, the more the better for everyone. But we need to pay attention to China. No more on that here

Meanwhile NAFTA as a whole is doing relatively well, with the IMF projecting 2017 growth in all three member countries at over 2%, higher than the UK or any of the larger continental economies.

We do however need to set concerns about the future in context. Due to demographics, growth in the US will not hit 4%, no matter what politicians do. The baby boomers are retiring, and so we have very low labor force growth. While we still have slack, we are now – at long last – approaching historic levels of labor utilization. Indeed, I'm slightly hopeful that with the numbers of those working involuntary short hours is now close to historic levels more of demand will serve to pull those prime-aged Americans who dropped out in 2008-9 back into the labor force. So we can continue to grow at 2% for a couple years, but then things will slow, independent of whether the Fed raises interest rates.

The graphs below present several snippets. The first is the "broad" measure of unemployment (the black line, U-6) relative to the "headline" level in green. It's still high, but at least close to the level of the better time periods since 1994. (Consistent data aren't available before then.) Second, we can see the loss and now addition of jobs, all relative to my calculation of the number of additional jobs needed to keep up with population growth, net of "boomer" retirement. The third graph is a variant on the second one, looking at jobs relative to my attempt to calculation a "normal" baseline. Finally, there's age-specific participation, which continues to be well below normal – if we extend back before 2007, these curves are all flat. (That does hide other dynamics, such as a drop male participation prior to 2007 that is offset by a rise in female participation.) This graph suggests that we have further to go until full recovery – I'm hopeful of end-2017, but project participation and it's 2019.

Now the Rockbridge Virginia region is not average; we depend more on retirement and tourism, and construction. The bad news is that for the nation as a whole housing starts have been falling relative to the population for the past 50 years. We may not see an uptick at the national level. But the good news is that the CoreLogic data on mortgages shows the share with negative or near-negative equity has fallen from almost half of all homes to a quarter. Most of that has been due to the drop of those with negative equity, either because over time the combination of higher housing prices and the repayment of loan principle has pulled them into the 80%-100% loan-to-value bracket, or because due to foreclosures there are now new owners. Since as a small bank you do hold some mortgages on your books, that is reassuring, and it's even better that net homeowner equity has risen by over $4 trillion since the start of 2013.

What happens locally is however more a function of whether retirees in nearby urban areas can sell their houses and buy a new one here. House prices in the mid-Atlantic region aren't uniformly above the bubble peak of late 2006, but Charlotte and Atlanta are close or positive, and the Washington DC area looks pretty good relative to much of the country. You can find all that data on FRED. Finally, my work is on the auto industry, and car (or more accurately) light truck sales are strong, but that does imply you should not expect much upside. With only one dealership left in the county car loans may not be a big part of your portfolio, but don't look at them to grow except as you increase market share. Production is strong, too, despite the bad-mouthing of NAFTA. The plants of Lear and Dana are long gone, so that's less relevant, but it is consistent with the picture of sales near their peak, reinforced by sales per person working back around 0.14 (scaled by 1,000).

Finally, what of interest rates? We should not expect the Fed to raise them quickly, or far. For the past 25 years interest rates have been falling. Some is that for the US as a whole inflation has fallen, and expectations seem to have gradually factored that in as a permanent change. Ditto in the major trading partners with whom we're linked financially, several of whom are actually experiencing mild deflation. In addition, it seems that despite all the hype around Silicon Valley, investors aren't expecting growth to pick up, either. Long-term interest rates are at 3.5%. We should take that with a dose of salt, as they've seldom been a good predictor of things 20 years hence. But if we return to 2% inflation, that means those in the bond market are factoring in growth of at most 1.5% (we surely need to deduct a risk premium, in which case growth and/or inflation must be lower).

Now I didn't include yield differentials. Those are quite volatile – the yield curve moves around a lot – and are neither high nor low today. So if the profits of a bank come from using short-term borrowing (including deposits) to fund longer-term loans, there's nothing to indicate conditions today are unusual. Have me back in a year and I can likely talk about the empirical evidence of interest rate normalization...

October 20, 2016