Prospects for US real GDP growth remain encouraging during the first half of 2004, supported by tax breaks and an ongoing recovery in business investment. For the first half of 2004, growth of 5% is expected. However, uncertainty clouds the outlook for late 2004 and 2005. SG Private Banking (Asia Pacific) expects 2004 average growth to stay at 4.7%, but to slow just below potential in 2005 as the impact of past policy stimulus wanes and negative effects from rising interest rates gradually emerge. SG Private Banking (Asia Pacific) believes that 2005's US GDP growth will be forecast at 2.9%.
The healthy employment reports for March and April with non-farm job creation rising by 337,000 and 288,000 respectively have confirmed an eventual pick-up in the job market, which is crucial for the economy to maintain its momentum into 2005. To achieve decent level of consumption for the long term, non-farm payroll is required to grow at a 1.6% pace, or 2 million jobs a year, or 173,000 jobs on average per month.
Along with firmer growth, there will be a normalization of core-CPI, which is expected to return to 2% in 2005 compared to close to 1% at the end of 2003. Against this backdrop, the Fed is expected to implement a first rate hike in June or August and then pursue a gradual tightening cycle which should bring the Fed fund rate back to 2.5% - 3% by the end of 2005.
SG Private Banking (Asia Pacific) foresees the driving components of growth in 2004 and into early 2005 will come from business investment and a rebuilding of inventories. Business investment in equipment and software averaged growth of 16.3% in the second half of last year.
Production needs suggest a 10% pace will continue through much of 2004. Inventory building has not yet begun. To date, we have only seen evidence that the depletion is subsiding. As business confidence builds, and as reports of slowing deliveries and inventory backlogs broaden, businesses will be completed to raise inventories.
Consumption and housing will be steady sources of growth in 2004, but not necessarily adding to growth. Consumption gains have been stronger in the spring when tax benefits reached their peak.
It is likely that consumption spending and residential investment growth will subside later in the year as tax benefits diminish and interest rates cap housing demand. According to SG Private Banking (Asia Pacific), wealth gains have been a recent development on the consumer that offer some upside risks.
In the final quarter of 2003, US household net wealth jumped $2.2 trillion, a record gain. The concern about the consumer has been whether there will be sufficient income to support consumption and debt servicing, but the extraordinary jump in net wealth could be a factor encouraging more consumption and even greater debt loads.
SG Private Banking (Asia Pacific) also sees the export sector as an ongoing drag on US growth. Recent rebound in the US dollar does not help in slowing the deterioration in US trade accounts. After a massive widening of the US current account deficit from 1998 to 2003, we are expecting it to stabilize at a 4.8% - 5.0% ratio to US GDP.
Government spending is expected to remain a net drag on US GDP. As a driver of US growth, Federal government spending is peaking. The run-up in defense spending remains strong, but is no longer accelerating.
Offsetting spending on the Federal side will be weak local government spending. State and local government spending growth is likely to register a mild up-tick to 1.1% from 0.5% in 2003, but recoveries in this sector normally lag.
Weak local government budgets are benefiting from corporate profit gains, but will not fully return to a strong position until private employment posts a more meaningful recovery.
Consumption gains have been modest to strong since 2000 due to falling interest rates and tax breaks. The recovery in the capital markets in 2003 generated record increases in household net wealth of $2.2 trillion, which exceeds its previous high in September 2000. SG Private Banking (Asia Pacific) believes there are several implications of that. Consumption is running slower than wealth might suggest. Current wealth implies consumption could be greater. Going forward, the wealth position makes the consumer more resilient to interest rate rises and to diminished tax benefits.
Real business investment soared at the end of 2003, posting an average pace of 16% in the second half of the year. SG Private Banking (Asia Pacific) expects double-digit growth rates to continue in 2004. Order and shipment data for capital equipment exhibit strength.
Stronger cash flows and greater access to capital, either from the banks or from capital markets, is providing the means for such investment. Both the cash flows and the improved financing options are the result of earlier cutbacks and balance sheet adjustments that have resulted in very narrow credit spreads, falling default rates, and finally, looser bank lending standards as reflected in recent Federal Reserve surveys.
SG Private Banking (Asia Pacific) sees the ability to invest but highlights that we should also focus on the growing need for investment. Industrial output is currently running at a 6% pace, and is likely to strengthen to 6% - 7% to meet current consumption demand and replenish inventories. Since US capacity is growing at just a 1% annualized pace, the difference suggests a rising capacity utilization rate and a growing need for future investments.
Inflation trends remain moderate for the next several quarters but the levels of the US dollar and commodity prices will have some impacts. At various stages of production, price trends have bottomed and are making some acceleration. Consumer price trends remain steady, but increasingly, as signaled in various price surveys among the ISM, the New York and Philadelphia Fed surveys, and the small business confidence survey, businesses are having modest success in raising prices.
Core-CPI posted 1.1% in 2003, but is more likely to rise to 1.5% - 2.0% in the next 12 months. This is hardly an inflation problem but it should prompt a change in the risk assessment at the Fed, and be a factor behind raising rates.
In light of the strong GDP readings and with non-farm payrolls demonstrating consistent strength in recent months, the Fed will move to raise interest rates. The timing of the elections will be a short-term hurdle for the Fed. Only an overwhelming need for tighter policy - stemming from rising inflation expectations and brisk job growth - would prompt the Fed to hike rates. Currently, with core inflation running at a 1.0% - 1.5% trend, we view a neutral Fed fund rate to be 2.5%, but expect it to rise to 3% over the course of 2005.
Tax cuts from the 2001 and 2003 fiscal packages are having a peak impact on the economy in the second quarter of 2004 as refunds grow and tax payments on 15 April are cut. A considerable portion of these benefits stems from the retro-active tax cuts at the start of 2003 that are now being realized.
As a results of tax cuts, a moderate economy and large spending increases, particularly for defense expenditures, the fiscal deficit in 2004 is expected to be close to $500 billion. The deficit should peak in the current year and fall to $425 billion next year.
The drop reflects the realization of tax cuts in 2004 stemming from 2003. In addition, the lack of any further tax cuts will allow faster growth in household tax revenues in 2005. Lastly, we assume still large expenditures will subside from the $87 billion in 2004. Deficits in the next few years are likely to shrink if the President and Congress can slow the increase in spending that have plagued the budget in recent years. Strong statements have been made to hold the increase in discretionary spending to the rate of inflation.
Financial Market Outlook
SG Private Banking (Asia Pacific) believes that financial markets will be jittery when the Fed is about to tighten.
As market fears on interest rates calm, the focus will return to fundamentals, which remain favourable for equity markets. First, economic growth will remain strong in 2004, upside surprises could even be in store for certain areas.
Second, corporate profits growth is expected to grow in excess of GDP this year, although a gradual narrowing of this growth differential is seen over the forecast horizon. Third, equity valuation levels are in fair value ranges and still look attractive compared to bonds even after recent rise in bond yields. Our investment strategy maintains a preference for equities, both in absolute terms and relative to bonds.
SG Private Banking (Asia Pacific) maintains the under-weight strategy on bonds and would suggest short duration on portfolio in light of imminent Fed tightening.
On the currency front, SG Private Banking's (Asia Pacific) view is that while the medium-term could see further structural weakness of the dollar against the major currencies, the near-term cyclical factors, notably tighter US monetary policy, will favour the dollar.
By Daniel Truchi, Chief Executive Officer, SG Private Banking (Asia Pacific)
Extracted from Summer 2004 issue of Asian Private Capital Magazine