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Yellen offers hostage to fortune on US growth

Economic growth
By Paul Hodges on 21-Jul-2015

US auto home Jul15Previous chairs of the US Federal Reserve had a poor record when it came to forecasting key events:

  • Alan Greenspan, at the peak of the subprime housing bubble in 2005, published a detailed analysis that emphasised how house prices had never declined on a national basis
  • Ben Bernanke, at the start of the financial crisis in 2007, reassured everyone that at worst, the cost would be no more than $100bn

So we must hope that current chair, Janet Yellen, has better luck with her forecast last week that:

“Looking forward, prospects are favorable for further improvement in the U.S. labor market and the economy more broadly”

The chart above will be key to the answer, as the outlook for the economy greatly depends on developments in the auto and housing markets:

Auto markets.  From the outside, these seem to have recovered well since the 2008 financial crisis.  But the National Auto Dealers Association suggested this month that sales have likely peaked, warning – “This is a cyclical industry, and there is no escaping the consumer cycle”.  Prices also look to have peaked, with JD Power reporting these averaged $30,452.  Buyers are only able to afford these prices due to the combination of low interest rates and extended loan terms, which now average a record 67.9 months.

A further threat to the market comes from increasing availability of used cars.  Around 40 million of these are normally sold each year, dwarfing the new car market.  But used cars have been in short short supply until recently, due to the post-Crisis collapse of new car sales in 2009-10.  Today, however, used car availability is booming after the bumper new car sales of recent years, as a major dealer told the Houston Chronicle:

Right now there are a substantial number of cars coming off lease, which is very good for us because at long last we have a nice supply of what we call lower-mileage pre-owned cars.

Housing.  As the chart confirms, home starts have not recovered to previous levels, but are less than half previous peaks.  The reason is demographics – the purple period from 1973 – 1984 saw vast numbers of BabyBoomers buying their first houses, having children, and then buying larger houses.  Greenspan’s ill-advised low interest rate policy in the 2000s failed to replicate this type of sustainable demand – instead, it simply allowed poorer people with poor credit ratings to buy houses they couldn’t afford, and ended up losing to foreclosure.

The latest data confirms that now a new trend is underway, where the Boomers downsize and move back into the cities from the suburbs.  41% of new home starts in June were multi-unit rather than single family, a near-record high, as Boomers and young people found condominium living more affordable.  Even worse from Ms Yellen’s viewpoint is that the home ownership rate continues to fall, and at 63.7% is back at levels last seen 20 years ago.  The rate for minorities is even lower at just 47.2%, and for Afro-Americans it is only 43.8%.

Ms Yellen’s problem is therefore two-fold:

  • She desperately needs to raise rates in September, to avoid becoming involved in the political debate when the Presidential primary season starts new year.  Yet both the IMF and World Bank have warned this would put the recovery at risk by causing the dollar to rise even further, thus reducing exports
  • Her underlying theories on the economy continue to take no account of demographic changes.  Common sense tells us that the arrival of a generation of 65-year-old Boomers with 20 years’ life expectancy must considerably change US growth potential.  Equally important is that US fertility rates have been below replacement level since 1970 – meaning there are now relatively few people in the peak spending 25 – 54 Wealth Creator generation.

It therefore seems very likely that Ms Yellen has offered a hostage to fortune when forecasting that the economy will now finally recover.

Past performance is not always a good guide to the future, but it is the best that we have.  Prudent companies and investors will therefore want to ensure they are not caught out a 3rd time if the Fed’s forecasts turn out to be wrong again.