Breaking towards Equilibrium

April 16, 2013

Even as the U.S. economy shows some signs of faltering in the last few weeks, it is worth remembering that competitive economies tend to “break” towards equilibrium. 
-David Kelly, chief global strategist, J.P. Morgan Funds

I spent yesterday afternoon sitting on the couch, watching the last round of the Masters.  Watching golf is a wonderfully relaxing pastime, requiring the lowest brain activity possible, short of sleeping.  However, even in my semi-comatose state, I did hear something that I thought was mildly interesting.  On the Augusta National golf course almost every green breaks towards Rae’s Creek, a body of water near the 11th, 12th and 13th holes.  On a dry day, they breakfast.  With some rain, as was the case yesterday, they break slowly.  But all other things being equal, that’s the way the ball will tend to roll.


Even as the U.S. economy shows some signs of faltering in the last few weeks, it is worth remembering that competitive economies tend to “break” towards equilibrium.  That is to say, baring shocks, the unemployment rate will tend to drift down towards full-employment while the capacity utilization rates will tend to drift up towards full capacity.  Essentially, this is because, at any point in time, there are millions of Americans who would like to work more, consume more and generally get ahead.  Recessions are caused by shocks that push the economy away from equilibrium.  But as the shocks and after-shocks die down, the economy will tend to break towards equilibrium.


The speed at which it does this, of course, depends on economic “weather” conditions at the time.  At this time, there is a strong headwind in the form of fiscal drag.  The end of the payroll tax cut, along with higher taxes on upper income individuals and the sequester, is having a major, positive impact on the federal budget, with the deficit falling from 7.0% of GDP in fiscal 2012 to an estimated (with six months of the fiscal year behind us) 5.0% of GDP in fiscal 2013, the biggest decline in the deficit/GDP ratio in over 40 years.  However, this progress is coming at a cost in terms of reduced federal spending and some drag on consumer spending (as was indicated by a weak retail sales report last week).


There are also tailwinds, in the form of higher stock market wealth.  In this regard, it is worth noting that stocks are far more important for the U.S. economy than other global economies -  in 2012, the market capitalization of U.S. stocks was 86% of U.S. GDP compared to just 29% for non-U.S. stocks as a share of non-U.S. GDP.  The economy is also being helped by a rebound in home-building, as will likely be confirmed in this week’s Housing Starts report. 


For the moment, however, the economy’s progress is slow.  While the Empire State and Philly Fed indices may show a slight rebound in manufacturing in April, the March Industrial Production report could well show no increase in output at all.  Consumer Prices, due out on Tuesday, could see a headline decline, reflecting general slack in the global economy and confirming the soft patch seen in recent U.S. employment and retailing data.


However, for investors, it is important to remember which way the economy breaks. Domestic fiscal conditions and international economic conditions are unusually challenging.  However, with plenty of pent up demand and a revival in wealth and housing, the economy should have what it takes to continue to roll forward and, as the headwinds abate, break towards equilibrium.  As it does this, confidence will likely rise, boosting stock multiples while diminishing Fed intervention and pushing interest rates higher.  For this reason, long-term investors should still likely be somewhat overweight equities relative to cash and fixed income.