Not deja vu again for the US

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

With the mid-point of 2015 ap­proach­ing it looks to be a case of “deja vu again” for a US econ­omy suf­fer­ing early year blues. As with other “soft patch” pe­ri­ods, there are plau­si­ble ex­pla­na­tions for this stodgi­ness that don’t just in­volve beat­ing up on statis­ti­cians for their sea­sonal ad­just­ment tech­niques. The US in­deed had a cold win­ter and the West Coast port strike dis­rupted trade flows. But the real ques­tion for in­vestors is whether the US re­peats the pat­tern of re­cent years, with pent-up de­mand caus­ing a surge back in ac­tiv­ity in the sec­ond quar­ter and be­yond.

Most 1Q eco­nomic in­di­ca­tors both this year and last came in weak, so it would be fool­ish to rule out a rapid bounce back. Last year saw 2Q growth surge to 4.6% af­ter con­tract­ing 2.1% in 1Q. Cer­tainly, the re­silience of US eq­ui­ties sug­gests that in­vestors ex­pect the US econ­omy to re­sume its up­ward tra­jec­tory. How­ever, we would ar­gue that there are two key dif­fer­ences this time around due to the growth-sap­ping im­pact of a strong US dollar, and the po­ten­tially neg­a­tive im­pact that ris­ing wages may have on cor­po­rate prof­itabil­ity. Taken to­gether, we think that in­vestors could face the twin chal­lenge of a eco­nomic cy­cle, and a deep­en­ing prof­its squeeze.

The strong ap­pre­ci­a­tion of the trade-weighted US dollar in the past four years has made do­mes­tic US pro­duc­ers less com­pet­i­tive as shown by their prof­its con­tri­bu­tion from over­seas hav­ing shrunk for two straight quar­ters— di­min­ished ap­petite for Amer­i­can wares is re­flected in slower ex­port growth and the ISM man­u­fac­tur­ing PMI hav­ing fallen from a perky 57.6 in Novem­ber 2014 to 52.8 last month. To be sure, US do­mes­tic de­mand re­mains de­cently strong, but this spend­ing is in­creas­ingly be­ing ful­filled by cheaper im­ported goods.

As a re­sult, we do not ex­pect a re­peat of last year’s 2Q re­bound in both the man­u­fac­tur­ing and ser­vices sec­tors. The headache for cor­po­rate Amer­ica is that it faces top-line chal­lenges from a run­away dollar at the point when the

ma­tur­ing re­cov­ery is just strong enough to boost wage growth. While head­line wage data re­mains non-threat­en­ing, the lat­est cor­po­rate in­come state­ment from the na­tional ac­counts shows that em­ployee com­pen­sa­tion, mea­sured in its to­tal­ity, is eat­ing into profit mar­gins. The net profit mar­gin for US do­mes­tic non-fi­nan­cial firms in 1Q15 had re­duced to 4.4%, down from a high of about 6% in 2011.

The “goldilocks” type sce­nario that in­vestors seem to have set­tled on is that the US la­bor mar­ket still has enough slack to en­cour­age in­ac­tive work­ers back into the work­place so that wage growth can re­main muted. Such an out­come should be sup­port­ive of steady con­sump­tion growth, but would re­sult in the Fed­eral Re­serve de­fer­ring any tight­en­ing ac­tion.

We have no magic in­sight to the US labour mar­ket dy­nam­ics, which is in an es­pe­cially hard-to-read phase. How­ever, we are skep­ti­cal that the US labour force has large num­bers of dis­cour­aged work­ers who can be re­lied upon to re-en­ter ac­tive em­ploy­ment—that, at least, is the mes­sage in­di­cated from the gen­er­ally steady par­tic­i­pa­tion rate. The corol­lary is that at some point wage growth will pickup in line with other mea­sures of com­pen­sa­tion.

Pierre re­cently made the ar­gu­ment that main­tain­ing a my­opic fo­cus on cor­po­rate profit mar­gins risked miss­ing the big­ger pic­ture of an eco­nomic re­cov­ery lift­ing all boats higher. This makes good sense, but our point is that the present value of the dollar ef­fec­tively rules out the benefits of growth ac­cru­ing to US firms. Rather, they face the prospect of shrunken mar­gins and the re­al­ity that more com­pet­i­tive for­eign ri­vals will eat their lunch.

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