Deutsche Bank's chief US economist thinks the economy has a lot of problems and very few solutions
Joe LaVorgna, the chief US economist for Deutsche Bank, had been fairly upbeat on the economy up until a little over a year ago.
Then, upon reexamination and revisions to important data, LaVorgna turned downbeat on the economy.
We caught up with LaVorgna to ask him why he switched his outlook, where he thought the economy was falling short, and how US politicians could help improve economic growth.
Check it out:
Bob Bryan: One of the biggest themes of your research is the use of corporate profits as an indicator of a coming recession. You've noted a few quarters in a row of negative year-over-year earnings growth comes before a recession. Looking at the current quarter, S&P 500 earnings per share is expected to recover and be near positive. Is that a sign there was a false signal from profits or is it delayed?
Joe LaVorgna: I'm a big believer that profits tend to be an indicator of economic activity, but I don't just look at profits. I actually look even more closely at profit margins, which are even better than looking at profits per se. Because, you can have profit growth increase a bit but if employment - the big input into the production process - actually increases at a faster pace the margin actually comes under further pressure. And what we see in the data is that if you look at broad profits - not S&P [500] profits or earnings but rather economywide NIPPA profits - what we see there is margins peaked in the fourth quarter of 2014. While they do not suggest a recession is necessarily imminent, the data do suggest the business cycle is certainly a little long in the tooth, certainly it's not in the early stages. So therefore we need to be more aware of possible evidence that demand is weakening and the economy is even more fragile then we thought. But at the moment we're still growing, it's just a serious flashing yellow sign for me.
Bryan: In terms of demand, you've written that "everything except the consumer is in recession" and I'm wondering how long you think the US consumer can bear the weight of pulling along economic growth?
LaVorgna: The consumer is important to the economy, but a weakness in consumer spending is not necessary for there to be an economic downturn. There have been numerous business cycles where consumer spending has actually not gone negative either on a year-over-year or more importantly a sequential basis. We saw that in the very brief downturn of 2001. The notion that the consumer - which has been strong, but I would argue only strong in relative terms - is pulling the weight and therefore obviates recession risk is overplaying history, it's misstating history.
The other point which is key, is that if you look at GDP and you go back prior to the last recession in which economic growth peaked in December of 2007, we had reasonably strong GDP growth at the time. These numbers were initially reported close to 4%, they've since been revised down. To give you an example, the second quarter of 2007 GDP [growth] was 3.1%, in the third quarter it was 2.7%, but the peak of economic activity ended up being in the fourth quarter at 1.4%. The fact that GDP printed 2.9% and it looked good on the surface, that to me doesn't tell you anything because it is not a leading indicator and is in fact sometimes considerably backwards looking.
Bryan: Shifting from consumers to corporates again, capital investment has been lackluster. Is there anything that could spur an increase in capital investment and may even lead to a bounce back in the non-consumer sector of the economy this business cycle?
LaVorgna: The trend in capex has been moderating since early 2012, which at the time people used the excuse of the election and the impending fiscal cliff. Here we are again, hearing the same arguments although its been three plus years. To me, the weakness in business spending is more troubling because it's probably due in large part to what's happening globally. We've had a very weak global economy, that's meant that we have a lot of excess capacity and companies don't typically invest a lot when there is excess capacity.
We've also had the issue of the Fed. The Fed has kept interest rates too low for too long, which has misallocated capital and caused corporations to do more financial engineering which you see through a combination of buybacks and merger and acquisition activity. The fact that they see rates as low as they are has gotten people nervous. CEOs, purchasing managers and so on because if rates are so low things must not be that good.
Then of course, the inability for Washington to come up with a tax plan that would arguably benefit US industry. There's bipartisan support for corporate tax reform, but nothing has gotten done and I think that's a factor. So if you ask me what can change that the US has control over to get the economy moving, certainly something on the corporate tax side would go a long way and at least galvanize business sentiment - the "animal spirits" if you will - this business cycle which have been lacking for awhile.
Bryan: There appears to be a noticeable pick up recently in both CPI and PCE inflation. Do you think this is a longterm trend? Do you think inflation is here and we're moving towards the Fed's goals for inflation?
LaVorgna: No, inflation has been undershooting the Fed's target for roughly four years. We've had a little bit of an increase recently, the question is: is it likely to sustain itself? My answer is no, because I don't see the strength in services continuing.
We're seeing things like the vacancy rate for rentals edge higher and that's typically a sign that rents will weaken. Rents are a big piece of inflation. Moreover, if you look at the various discretionary components of inflation you don't see a whole lot of pricing power. That's consistent, broadly speaking with consumer spending. If you isolate the spending on discretionary and nondiscretioary, you don't see a whole lot of discretionary spending. To me, if you fit it all together we're probably close to core inflation peaking and the Fed should still be much more worried about disinflation rather than an inflation boogeyman that I don't believe will manifest in this cycle.
Bryan: The last one is a combination question, both positive and negative. You made a pivot towards being downbeat on the economy roughly a year and a half ago and I'm wondering if you think there are any positive catalysts that could turn it around for US economy growth? And I'm wondering if you have a timeline for a possible recession?
LaVorgna: The reason I became pessimistic on the outlook is because the benchmark GDP revisions showed that the economy was actually much weaker in this cycle than we had though previously. That had been running counter to what was happening with employment which had been showing steadily upwards revisions. Instead of revising away some of the productivity slowdown to make things look better, which had been the pattern of what the government was doing, they did the opposite. They showed even less productivity because they were revised down. So that to me was a very important turning point in, what it said about the economy and in particular how fast it can grow.
So when we look at the data now, we have not had a 3% GDP year since 2005. And the best year for GDP we've had this cycle has been 2.7% in 2010 and 2013. This has been a weak cycle.
What changes it would have to be... you need the corporate sector to expand at a rate we really haven't seen in some time and the problem is with the unemployment rate as low as it is, that's hard to do. I almost think that in this cycle it is going to be very tough for us to attain the type of growth we've become accustomed to. The issue is can we even get growth to 2%?
That depends in part with what happens in the election. Is there a divided government? Or more importantly, if there is a divided government is there some bipartisanship? Can both parties work together to create something positive?
Normally, I'd say yes but I'm not sure that's possible given the current situation over the past year or so. I'm not sure Washington is going to get the things done that need to be done to get the economy back up to a 2% pace. I hope I'm wrong, but that's kind of what I think.
Longer term? We need to do things about productivity, demographics - which we can change if we tackle immigration reform - and certainly if we increase efficiency of the corporate tax code that will lead to more capital investment. That's more five to 10 years forward.
For now, I think we're stuck in this world where stagnation is more of the norm than the exception. I'm note sure it's secular - that's the optimist in me - so I only agree with half of what Larry Summer said. I think we can fix it, but the way to fix isn't necessarily infrastructure spending. Instead we need things that encourage more buy in form the private sector combined with the sense that our political system is functioning and can work.