Not only is the US economy is stronger but its expansion could continue for several years beyond 2019, according to Invesco Perpetual’s John Greenwood.
Given the state of the current business cycle expansion – which has already lasted for 108 months – the chief economist said once the normalisation of interest rates by the Federal Reserve (Fed) is accomplished, equity and real estate markets should have further gains ahead of them.
“In principle there is no reason why an economy shouldn’t continue expanding indefinitely. We have seen that in Japan in the late 70s early 80s and we have seen it in countries like Australia for many years too,” Greenwood said.
“As such, I don’t see why it shouldn’t continue for 11, 12 or 13 years just because it has already lasted for nine years.”
According to Greenwood, expansions often come to an end because of a mistake made by central banks, when these either overexpand their balance sheets leading to a rise in inflation or when these tighten too much unintentionally.
But instead of being in danger of contracting, the US economy is surging and strengthening, partly thanks to the tax cuts boosted by Donald Trump’s administration at the end of last year.
“After about eight years during which US inflation was persistently below the 2 per cent target, inflation, as measured by the index of core personal consumption expenditures (PCE), finally returned to the 2 per cent level in May 2018,” Greenwood pointed out.
US inflation over 10yrs
Source: St Louis Fed
“This return to the 2 per cent level of inflation was largely driven by the increase in energy prices (which also show up in other non-energy components of the index) and the earlier weak dollar, not by any fundamental upward shift in the inflation rate.
“This also implies – and is supported by continued low rates of money and credit growth – that inflation will not surge beyond its current levels,” he added.
In turn, Greenwood said it means there will not be any need for the Fed to continue raising interest rates once they reach “neutral” levels, which is good news for the business cycle. “When interest rates reach neutral levels, the central bank will not need to curb excess credit or money growth,” he said.
With regards to the potential challenges ahead for the next quarter, Greenwood noted there is risk in the Fed not only raising interest rates but also shrinking its balance sheet, although he believes it shouldn’t translate into a big problem as the US central bank is already “aware of it”.
“It’s been very interesting recently. What we’ve seen is that the federal funds rate has cropped up. The central market rate has cropped up above the midpoint of the Federal target rate so I think market liquidity is a bit tighter than they intend and, as a result to that, they may have to wind back on the balance sheet shrinkage,” he explained.
Noting he had already warned about the crowding out effect – which takes place when rising public sector spending drives down or eliminates private sector spending – he said: “That crowding out effect from releasing these securities from its balance sheets and requiring them to be taken up by the public would have that contractionary or tightening effect in the markets.”
US interest rates over 10yrs
Source: St Louis Fed
According to the economist, the broad economic trends – modest real GDP growth, low inflation and an extended business cycle expansion – are translating into a moderate upswing in global trade, which benefits developed and emerging economies alike.
“Whereas the upswing in 2010-2011 was largely driven by excessive expansions among emerging market economies, led by China’s extraordinary fiscal stimulus, and therefore ended abruptly with the euro debt crisis of 2011-2012 and the ‘taper tantrum’ of 2013, the current upswing appears more moderate because it is spread across more economies, but nonetheless vulnerable,” he outlined.
“The improvement in economic activity in the US and Europe has helped to underwrite the gradual upturn in China’s trade as well as the upturn in the exports of the smaller East Asian economies, but president Trump’s truculent trade war could undermine the pace of the upswing, especially if it escalates to several rounds.”
When it comes to Europe, where the EU has been grappling with Spanish separatism, the Italian crisis following the March election and a European-wide debate over immigration, Greenwood believes these issues are not “cycle-ending threats”.
“In Europe the ECB has announced that in the final quarter it will further curtail its asset purchases and then terminate them by year end,” he noted.
“If that’s the case and we were in an environment where credit was growing strongly, that will be fine, but the reality is that credit is growing very slowly in Europe and the risk in Europe is that money and credit grow relapse to a much lower rate, which will bring the inflation back down in Europe again.
“So, there is no zero risk of a central bank mistake but we must be cognisant that these problems are there.”
While in 2017 the eurozone benefitted from having unused capacity – or space to grow – the economist noted that this is now rapidly diminishing.
“I expect the growth rate to slow: to come down from something like 2.5 per cent to 2 per cent this year and something like 1.5 per cent next year,” he said.
“You have to be aware of the long-term underlying growth rate, and given the demographics and the slow growth of productivity, in Europe that rate is something like 1.6 or 1.7 per cent growth, not much more than that.”
EU GDP growth over 10yrs
Source: The World Bank
Through most of the years since the global financial crisis of 2008-2009 the key issues have been economic in nature, Greenwood pointed out since the start of 2018 economic and monetary issues have been taking second place to political events.
But while it is possible that some of these political issues could derail the upswing in some countries, it remains his view that the business cycle is “the ultimate and dominant driver” of asset prices over any extended period.