Not deja vu again for the US
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.