UNITED STATES
The main events this week are political, the tax reform proposal in Congress and the continuing investigations by the Special Prosecutor on Russia’s interference in the last Presidential election. Germane to the tax debate, on Wednesday we get the final data on Q3/17 nonfarm productivity. The consensus is for corroboration of the atypically strong number, 3.3%qoq-saar. If confirmed, nonfarm productivity will have increased 1.5%qoq-saar in the four quarters ending in Q3/17, reversing the pattern of the 0.1% contraction registered in the prior four-quarter period, and well above the 0.75% trend achieved on average during this expansion. The question is, are we at the dawn of a new cycle of higher productivity growth? From the available research—and this has been one of the most examined aspects of recent economic performance—the answer, regrettably, is no. Likely, the US economy will continue along a slow productivity growth regime, consistent with its 1-1.25% trend estimate. In the U.S. data since the early 1970s, the unusual period for productivity growth was roughly the 10 years from 1995 to 2005, when growth was faster than before or since. Since 2004, nonfarm productivity averages 1.3% annualized growth. Measured spending on innovation also shows a slowdown much earlier than the recession. The low productivity regime antecedes the recession, and the cyclical component explains little of the underlying trend. A recent survey of the research, with yet another careful empirical assessment, concludes:
Output grew substantially less during the recovery from the 2007–09 recession than would normally have accompanied the observed, relatively rapid decline in the unemployment rate. It grew less than it would have given its normal relation to an index derived from many macroeconomic indicators. … An explanation for poor output growth needs to start with two key facts: Productivity grew substantially less than its historical growth rate, both in expansions and in general; and labor force participation shrank an atypical and unexpected amount. Research on both topics is active today. We conclude in this paper that the large movements in both factors were in train before the recession, and cyclical effects contributed at most modestly to them.
Hope for a pickup in productive comes from expectations of an increase in CAPEX, after the approval of the Republican-led change in the corporate tax regime. Increased CAPEX should lead to capital deepening: increasing output per hour by giving workers newer and better capital equipment to work with. As Fernald, etc. point out, after cyclical adjustment, nonresidential investment growth contributed 0.47 percentage point to GDP growth during the previous three recessions, but only 0.13 percentage point during the recent recovery. The point, however, is that the capital–output ratio in the recent recovery behaved in line with its average in the earlier recoveries. What was atypical was the low recovery in output. The shortfall in investment accompanied the shortfall in output. Currently, the capital stock is expanding at only around a 2% rate, even with the recent up tilt. To deliver a bigger boost to productivity, the increase in capital spending will need to be much stronger.
Michael Feroli estimates that
To get a 1% increase in the contribution of capital deepening to productivity would require about a 3% increase in the rate of investment relative to the capital stock. (Since the stock of private, nonresidential capital is about equal to GDP, one could also think of this as a 3%-percentage point increase in the investment-to-GDP ratio). To see this kind of capital deepening by the end of 2020 would require sustained real capex growth of around 10% per year.
This has rarely happened in a year, let alone in a sustained period, and is, presently, especially unlikely. As he also notes,
The principal means by which the tax reform bills being contemplated should spur greater capital spending is through immediate expensing of capital outlays. In principal this should reduce the user cost of capital, thereby stimulating greater investment spending. The current tax code already goes a long way toward lowering the user cost of capital by accelerating depreciation allowances, including through so-called bonus depreciation. This means that for most types of equipment, the present discounted value of depreciation allowances is around 97 cents on each dollar of acquisition cost. Immediate expensing will raise this PDV to 100 cents, so the change to the user cost of capital won’t be huge.
The conclusion is that, most likely, the tax legislation will not change the regime of low productivity growth. Thus, it is unlikely to spur a faster expansion in supply. What it could cause is a temporary uplift in demand which, given its expected inflationary impact, could well be neutralized by monetary policy. The upshot would be a very substantial increase in the fiscal deficit.
- Monday, December 4: Durable Goods New Orders—October (Actual: -0.1%momsa; Shipments: +0.6%momsa). New orders were down following two consecutive monthly increases. Shipments were up ten of the last eleven months, and increased again, 0.6% to $484.2 billion. The key component for GDP accounting, shipments of capital goods ex-defense and aircrafts, was up 1.1%momsa (4.2%yoy) continuing a strong performance, as discussed above.
- Tuesday, December 5: ISM Non-Manuf. Composite—November (Consensus 59). The ISM manufacturing index fell half a point to 58.2 in November, and the expectation is that the Non-Manuf. index will drop as well, after increasing in the previous two months. The composition of the manufacturing report was favorable, with increases in the New Orders and Production components. The same should be the case for its sister index, with underlying growth in the service sector continuing at a solid pace.
- Wednesday, December 6: Nonfarm productivity—Q3/17 final (Consensus +3.3%qoq-saar, Unit labor costs, +0.3%qoq-saar). See above. Unit labor costs – compensation per hour divided by output per hour – could be revised down to 0.2%.
- Friday, December 8: Nonfarm payroll employment—November (Consensus +200k, Average hourly earnings +0.3%momsa, +2.7%yoy, Unemployment rate, 4.1%). November data should be free of the hurricanes effects and, additionally, benefit from an early Thanksgiving this year. The arrival of over 200k Puerto Ricans in Florida (following Hurricane Maria) could also increase payrolls this month. Since late 2016, the economy is in full employment with the unemployment rate trending down below NAIRU—a clear signal for more active monetary policy. We expect the Fed to increase its rate in December, followed by four other quarterly increases in 2018.
- University of Michigan consumer sentiment—December preliminary (Consensus 99.0). Sentiment in the Conference Board index increased to a cycle-high reading in November, and this suggest that the UMich survey should remain strong, if not stronger. Data this week should point to a strong economy buoyed by consumer spending. Q4/17 tracking is around 2.4-2.6%qoq-saar.
BRAZIL
With the efforts to bring the Social Security Reform for a vote in Congress all but dead, and attention focused to the whims of the 2018 political season, where it looks ever more likely that Lula will indeed be a candidate (or a deep shadow) in the Presidential election, the focus this week will be on monetary policy—the yearend COPOM meeting. The October minutes suggested a 50bp rate cut to 7%. The communication followed an established pattern, the committee signaling a single conditional option for its next decision. As such, as in the last meeting, there is unanimity in this expectation. Inflation and its expectations remain under control, now with expectations stretching to 2020 when the target is set at 4%. Meanwhile, despite the low rate of potential GDP growth (perhaps only 1.5%pa) the output gap remains sizeable after 12 quarters of recession and a recovery that began only last quarter. The base case for COPOM action remains in place: pursuing accommodative policy. The question now is what the committee will say about its following meeting, in February 2018. Most likely, it will change its tone. We doubt very much that it will telegraph forcefully another cut, even at a reduced pace of 25bp. Instead, we expect it will keep this possibility open while signaling that a 7% terminal rate would be adequate. By its own estimates the neutral real rate hovers around 4%. Thus, with 12mo-forward inflation expectations near 4%, at 3% real, the current rate is highly stimulative. Yes, the real neutral rate could drop. But these expectations are now on hold until the outcome of the elections, at end-2018. It may be prudent, therefore, to pause and wait—and that is what we expect the COPOM to do, after this final cut.
- Tuesday, December 5: Industrial Production—October (Consensus 0.2%momsa; 5.3%yoy). The recovery in manufacturing continues, now extending to capital goods in addition to consumer durables.
- Wednesday, December 6: COPOM Monetary Policy Decision (Consensus 50bp cut to 7.00%). See above.
- Friday, December 8: IPCA(CPI) Inflation—November (Consensus 0.35%mom; 2.9%yoy). Though inflation is still at a cyclical low, the outlook is for sustained increases in the months ahead. Nothing alarming, but suggesting that the ease with which monetary policy could act will soon be over. First, the positive effects of the agricultural supply shock are waning. Second, energy prices—notably, electricity, are on an upswing. Reservoir levels should remain low in Q1/18. Rationing could be avoided but only by continuing to adopt the current policy of “flagged” prices. The red flag should remain active. This suggests price increases in the order of 6%yoy for 2018.
IMPORTANT NOTICES:
This report is a general discussion of certain economic and geopolitical trends and forecasts. It does not constitute investment advice of any kind or constitute a recommendation to buy or sell any security or other financial instrument. Investors may not rely upon any of the conclusions or other statements contained herein.
Certain of the factual information contained herein was obtained from third party sources which the author considers reliable, but the accuracy of such information cannot be guaranteed.
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