US: Government bonds have never looked less attractive
Recent US economic data indicate that the US may deliver growth of over 2% as well as modestly higher inflation for the second half of the year, for overall 2.0% GDP growth over the next 12 months. While second quarter GDP growth came in below expectations at 1.2%, real final sales (GDP less inventories) rose at a solid 2.4%, as consumer spending increased 4.2%.
Inventory destocking accounted for the major drag on second-quarter GDP, reducing total GDP growth by 1.2%. The inventory component has now reduced growth in each of the past five quarters, representing the most extended period in 60 years.
As corporations liquidated excess inventories, they saw little need for capital spending, resulting in the worrisome decline in non-residential (business) investment at -2.2%, including -7.9% for structures and -3.5% for equipment. On a contribution basis, non-residential investment reduced GDP by -0.3% and has now detracted from GDP growth for the past three quarters. Corporations may have deferred investment in the face of heightened uncertainty caused by Brexit and the upcoming US election. In addition, rig counts of US energy firms only bottomed in May. The sector has accounted for a significant portion of recent fixed investment over the past five years.
As oil prices stabilize at higher levels, and with receding risks from Brexit, we anticipate a rebound in inventories and a potential increase in fixed investment in the second half of the year. Positive Momentum Over the next six months, US GDP may advance on multiple fronts, with the US consumer continuing to drive growth. The Citi US Economic Surprise Index has reflected this positive momentum, coming off its near-term May low of -40.0 to 10.0 as of 8/23/16.
Key employment indicators suggest continued economic strength. Non-farm payrolls rebounded in July for an average gain over the past three months of 190,000 and both ISM manufacturing and services employment indices recovered to over 50.0. The four-week moving average of weekly initial jobless claims, a leading employment indicator, has fallen to near 40-year lows.
Importantly, while employment gains have decelerated as the economy nears full employment, monthly payrolls gains need not match the 230,000 average of the past few years to achieve further declines in the unemployment rate. As long as non-farm payroll employment grows by at least 100,000 per month, the unemployment rate should continue to decline.
As indicated in the chart below, the size of the labor force is a major determinant of nominal GDP growth. In July, the US labor force grew by 1.4% year over year. Adjusted for the participation rate, it grew by 1.7%, which represents the second strongest rate of change in eight years.
Rising employment, wage growth, low mortgage rates, increased household formation and easing credit standards have underpinned strong consumer spending. New and existing home sales stand at respective 8-year and 9-year highs, and housing starts have recently broken out above average 2015 levels. While down from last year, auto sales remain solid.
It is the recent surge in retail sales, however, that represents the most important current consumption-related data. Having lagged earlier in the year, retail sales came in well above expectations in June, delivering a meaningful recovery in total real consumption of 4.2% for the second quarter, compared to 1.6% for the first quarter.
Although consumption continues to drive growth, government spending may also contribute significantly to growth over the next year. Second half government spending should improve, as the benefits of the 2015 budget bill come on stream, after falling 0.9% in the second quarter.
Furthermore, both US presidential candidates, Hillary Clinton and Donald Trump, have indicated significant commitment to infrastructure spending in the next administration, which We believe that the moderating US dollar and recovering oil prices have enabled a bottoming, and even a modest recovery, in manufacturing and business investment, which reduced GDP growth in 2015 and in the first half of 2016. The June and July manufacturing ISM rose well above consensus to 53.2 and 52.9, respectively, buoyed by respective gains in new orders to 57.0 and 56.9, up from the December low of 48.0. The non-manufacturing ISM surged to 56.5 and 55.7 in June and July, with new orders even stronger at 59.9 and 60.3, respectively.
June and July industrial production came in well above expectations, reflecting in part the turnaround in mining (which includes oil exploration and production). The mining sector rose 0.7% in July compared to the prior month. Although current $47 oil prices have fallen from their recent $51 high, they have recovered significantly from their $26 low in early February.
Business investment may benefit as higher oil prices encourage higher rig counts; US rigs have already increased by 15% from their May lows. Inventory destocking was a primary cause of low second-quarter GDP. However, we anticipate that inventories may also add to growth over the next few quarters, given improved second quarter real final sales of 2.4% (they tend to lead inventories by three to six months)1 and our expectation that manufacturing and energy have stabilized.