Positive Outlook Amid Global Headwinds

The situation looks less encouraging in other parts of the world, according to the International Monetary Fund’s recently updated estimates. Economic growth in Europe has been sluggish and is projected to remain so. After contracting in 2012 and 2013, the Euro area’s economy is expected to grow only 0.8 percent in 2014 and 1.3 percent in 2015 (see Table 1). These rates are considerably slower than IMF projections for U.S. economic growth, at 2.2 percent in 2014 and 3.1 percent in 2015. Japan’s growth is expected to languish as well, at 0.9 percent in 2014 and 0.8 percent in 2015. In addition, economic growth in China is down-shifting — to an estimated 7.4 percent in 2014 and 7.1 percent in 2015 from much higher rates historically.

A slowdown in the economic growth of our trading partners may seem like bad news for the U.S. economic outlook. After all, lower foreign demand depresses U.S. exports, restraining GDP growth. But a number of other developments are likely to offset the effects of slower global growth on the U.S. economy. As a result, it is unlikely that much danger to U.S. growth will come from international quarters. AIER’s statistical indicators of business-cycle conditions suggest that the U.S. economy’s growth is likely to continue.

Economic Outlook
AIER’s Business-Cycle Conditions (BCC) indicators softened somewhat last month. The percentage of leaders expanding in October fell to 80 percent (eight out of ten indicators with a discernible trend), down from 88 in September. The cyclical score for the leading indicators, based on a separate, purely mathematical analysis, changed little, rising to 85 from 84 in September.

Both values remain far above 50, indicating that continued expansion is likely in the coming quarters.

Key takeaways from the latest reading of AIER’s BCC indicators include:

Leading: Among the 12 leading indicators, five were appraised as “clearly expanding” and three as “probably expanding.” Two were judged to have no discernible trend; one was deemed “clearly contracting,” and one “probably contracting.” All five leaders that were judged to be clearly expanding reached new cyclical highs in October. They are: M1 money supply, yield curve index, new orders for core capital goods, index of common stock prices, and initial claims for state unemployment insurance (inverted).

New data and revisions in earlier data prompted us to upgrade the cyclical status of two leading indicators: the ratio of manufacturing and trade sales to inventories and the average workweek in manufacturing. For both series, the cyclical status changed from indeterminate to probably expanding. Two indicators were downgraded: New orders for consumer goods changed from clearly expanding to probably expanding, and the change in consumer debt went from expanding to probably contracting (part of the reason for this was significant revision in data for July). Two indicators that were indeterminate last month remain so: the index of manufacturers’ prices and new housing permits.

Coincident: Five out of six coincident indicators are appraised as expanding in October, as was the case in September as well. The remaining indicator — the ratio of civilian employment to population — is judged to have no clear trend. All five indicators that are expanding also hit new cyclical highs: nonagricultural employment, index of industrial production, personal income less transfer payments, manufacturing and trade sales, and gross domestic product.

Lagging: All five lagging indicators with a trend are appraised as expanding, and four of them hit new cyclical highs. They are: average duration of unemployment (inverted), manufacturing and trade inventories, commercial and industrial loans, and the ratio of consumer debt to personal income. The composite of short-term interest rates remains appraised as indeterminate, as interest rates remain near zero.

Conclusions: The majority of the leading indicators and virtually all of coincident and lagging indicators are appraised as expanding or probably expanding. Such behavior among the indicators is typical of the mature stage of a business-cycle expansion. When an expansion has lasted as long as this one has, coinciders and laggers should be on a clear upward trend. So only the leaders can undergo changes of importance at this point in the cycle. A widespread weakness among the leading indicators would be the first sign of a potential slowdown in the economy. There are no signs of such weakness at this time. With all three diffusion indexes remaining well above 50, our statistical indicators continue to point to further economic expansion (see Chart 1 on page 2).

Gobal Forces
Looking at the linkages between the U.S. and the rest of the world helps us to understand how global developments might affect the U.S. economy. Two important economic links between the U.S. and other countries are the flow of goods and services and the flows of financial assets. We observe the flow of goods and services through trade, and financial flows are most visible through changes in the value of currency. Furthermore, these two linkages are interconnected.

Trade linkages transmit the slowdown due to lackluster growth in major economies, such as Europe and China, through export demand. In theory, slower growth of GDP in other countries, and therefore of income in those countries, depresses their demand for U.S.-produced goods and services. This can lead to slower growth of U.S. exports, which can potentially reduce the growth of GDP since exports are included in the GDP calculation. But in practice, other factors modify this transmission mechanism.

Trade Flows
The strength of the effect of changes in foreign demand on U.S. exports depends on how large the trade flows are. In recent years, exports of goods and services have constituted about 13 percent of GDP, which is close to an all-time high (see Chart 2). A large part of U.S. exports, however, is destined for America’s immediate neighbors — Canada and Mexico — and these economies are not expected to slow (see Table 1 on page 1). So far in 2014, Canada and Mexico combined have accounted for about a third of the total U.S. exports of goods and services.

Exports to the European Union account for about 20 percent of the total U.S. exports of goods and services in 2014, and exports to China are even smaller, at around 7 percent. Therefore, even if U.S. exports to the Euro area and China were to fall by a factor of two — an unlikely magnitude — the U.S. would lose only about 13-14 percent of total exports, which would cut GDP growth by about 1.8 percentage points. Even that extreme scenario would not derail the economic expansion, since GDP is expected to grow faster than 1.8 percent. So we remain sanguine that any realistic (i.e., considerably smaller) reduction in exports would not be enough to significantly endanger the pace of U.S. economic growth.

But even this effect on exports and GDP may be offset by other factors.

Rising Dollar
Faster growth of the U.S. economy compared to other countries (as well as the Fed’s move to a less accommodative monetary policy) leads to the appreciation of the U.S. dollar relative to other currencies. In fact, since July, the U.S. dollar gained about 4 percent in value relative to the broad set of currencies of U.S. trading partners. Against major international currencies, the dollar gained even more — almost 6 percent (see Chart 3).

As the value of the dollar appreciates, foreign-made goods become cheaper for American consumers to buy; this can increase demand for imports. On the flip side, appreciation of the U.S. dollar makes American products more expensive for foreigners to buy, potentially reducing exports. These effects alone would tend to depress U.S. economic growth. But these effects are not alone. Appreciation of the dollar also makes one very important product cheaper—oil.

After reaching a recent peak in June 2014, the price of oil fell by more than 20 percent (see Chart 4). The retail price of gasoline followed, falling about 18 percent. Cheaper oil and gasoline reduce all kinds of intermediate and final costs, from energy and heating to transportation, thus stimulating production. Lower costs also restrain the growth of consumer prices, extending the purchasing power of incomes and supporting consumer spending. All of these trends help to stimulate domestic demand and thus U.S. economic growth.

The world price of oil is quoted in dollars, and when the dollar appreciates, the price of oil falls, regardless of whether that oil is produced in the United States or elsewhere. But the recent fall in the oil price did not result from the strengthening dollar alone. In its October Oil Market Report, the International Energy Agency points to growing supply and slowing global demand for oil as the major factors behind the recent fall in price. These factors are expected to keep the downward pressure on the oil price in the near future as well.

The slowdown in economic growth in major oil-consuming nations like China has two offsetting effects on the U.S. economy. While slowing economic growth depresses U.S. export demand, it also reduces the global oil price, which stimulates U.S. consumer demand. The exact net effect on the U.S. economy is difficult to determine, but it is not likely to be large.

Labor Market Trends
Encouraging domestic trends are yet another reason why unfavorable global developments are not likely to be detrimental to U.S. economic growth. Data in recent months show promising signs in the labor market.

Initial claims for state unemployment insurance, which approximate the number of people who recently lost jobs, fell to 266,000 in the second week of October. The four-week moving average of initial claims—a more reliable measure, less prone to random fluctuations—has fallen to 281,000 in late October. Such a low reading for initial claims has not been seen since 1973, a time when the labor force in the United States was about half its size today. (See page 7 for the chart on initial claims, one of our leading indicators.)

Unemployment claims suggest that job loss has fallen to historically low levels. A different data source supports this view as well. Data from the Job Openings and Labor Turnover Survey collected by the Bureau of Labor Statistics show that layoffs and discharges fell in August to 1.1 percent of the workforce, or about 1.6 million (see Chart 5). This is the lowest level since 2000 when the data were first collected.

Employers respond to increased demand first by reducing layoffs and then by increasing hours. The average workweek in manufacturing, one of our leading indicators, has remained above 42 hours since May. We have to go back to World War II to find a time when American factory workers have put in longer hours (see Chart 6).

When the average weekly hours worked exceed the full-time load, it suggests expanding production and a substantial demand for labor. For whatever reason, companies are choosing to meet that demand by extending hours of the existing workers instead of hiring new ones. But this cannot continue indefinitely. At some point, new workers will have to be hired, and employment will receive a boost, spurring further growth of the economy.

Conclusions
The U.S. economy continues to grow, and recent data suggest that steady growth will continue. International developments — slow growth in Europe and China, the strengthening dollar, and falling oil prices — all affect the pace of growth in the U.S. economy. But these factors offset one another to some extent. As a result, we can rest assured that the global forces do not pose much danger to U.S. economic growth in the immediate future.