Friends, the long-awaited sequel to our global economic overview is finally here! In the previous installment, we discussed the complexities of Japan's economy and the burgeoning strength of India's. Today, we'll shift our focus to the economic landscapes of the United States and Europe over the past two years.
As a bonus, I'll share some insights and methodologies I use to analyze the economic performance of these countries, offering you a glimpse into my little tree of knowledge.
But enough with the preamble, let's dive right into the U.S. economy.
The U.S. Economy: A Picture of Perplexing Strength
Let's start with a comparison of GDP growth among G7 nations since 2019, using pre-pandemic levels as our baseline.
The U.S. is the clear frontrunner, leaving the others in the dust. Trailing at the bottom, unsurprisingly, are those two old chums, Germany and the UK.
So, how would I describe the U.S. economy? "Strong" or "robust" might spring to mind. But my term? "Perplexing."
Why perplexing? While a stable economy is generally positive, the U.S. exhibits a stability that defies logic, even challenging the predictions of seasoned economists.
Take this Bloomberg article from 2022, which confidently asserted a 100% probability of a short-term recession in the U.S. Yet, data from 2023 reveals a U.S. economy as steady as a rock, defying even the Phillips curve and leaving the market bewildered.
Imagine punching someone, and instead of reacting with anger or retaliation, they shower you with warmth and kindness. That's the perplexing sensation the U.S. economy evokes.
Today, we'll unravel the enigma of the U.S. economy.
As always, let's begin with an overview. In 2023, the U.S. GDP is projected to grow by around 2.5%, with inflation receding from its 9% peak in 2022 to under 4%. Unemployment remains at historic lows, hovering below 4%, while wage growth persists at a healthy 5%. The stock market, fueled by the rise of generative AI, has soared by nearly 30%. The Federal Reserve's quantitative tightening and interest rate hikes are nearing their end, with a return to normalcy anticipated by 2024.
However, the U.S. economy is not without its challenges. The escalating national debt, with its ever-increasing ceiling, is a pressing concern. The commercial real estate sector is also facing turbulence, a topic we'll delve into later.
Let's revisit that 2022 Bloomberg article and dissect why the market was so convinced of an impending U.S. recession. Picture the scene: inflation skyrocketing, the Federal Reserve aggressively raising interest rates, a global energy crisis and supply chain disruptions, and the U.S. stock market plummeting by 20%. Add to that escalating geopolitical risks, and you have a recipe for economic pessimism.
Predicting a recession under those circumstances seemed like a no-brainer. Then came the early months of 2023, marked by a wave of bank failures, including the collapse of Silicon Valley Bank and Signature Bank, seemingly confirming the market's bleak outlook.
But what transpired next took everyone by surprise. The banking crisis failed to spill over into the real economy, inflation miraculously tamed itself, and despite the Federal Reserve's aggressive rate hikes, GDP and employment remained robust.
This remarkable resilience, despite the persistent risks and challenges, can be attributed to one powerful driving force: consumption.
Americans, it seems, are incredibly adept at spending money. You see, despite the complexities of an economic system, with its myriad factors like exports, chip manufacturing, and mortgages, the most potent engine driving it all is the everyday consumer.
Every dollar you spend becomes someone else's income, potentially fueling further spending and setting in motion a virtuous economic cycle.
The U.S.'s robust consumer spending would likely be the envy of Europe and Japan, which have struggled for over a decade to stimulate spending despite various policy measures. Their citizens simply aren't opening their wallets.
The U.S., in stark contrast, remains a consumption powerhouse. Interest rate hikes seem to have minimal impact, with consumers continuing to spend with gusto. Just look at the U.S. consumer spending data – it's soaring, defying any notion of a slowdown.
Retail sales figures tell a similar story. Even during periods of slight decline, the underlying trend remains positive. But what exactly are Americans buying? While spending on services experienced a pandemic-induced dip, a particular category witnessed explosive growth in the U.S.: durable goods.
This category encompasses items like electronics, fitness equipment, and bicycles. The question remains: why, despite the Federal Reserve's best efforts, is U.S. consumer spending so stubbornly high?
The truth is, even experts haven't pinpointed a definitive answer. The market lacks a consensus, particularly given the previous year's confidently incorrect recession forecasts.
However, several potential explanations, each with its own merits and limitations, have emerged. Let's examine three of the most compelling ones.
First, current U.S. consumers display remarkably low sensitivity to interest rates. How so? Well, instead of opting for a straight rate hike, the Federal Reserve initially responded to the pandemic with a massive wave of monetary easing, slashing interest rates to record lows.
This move incentivized companies and individuals to load up on debt, locking in those ultra-low rates. I, for one, have several friends in the U.S. who took advantage of this environment to purchase homes with low-interest mortgages.
This strategy effectively front-loaded loan demand within the economy. So, when the Federal Reserve eventually initiated rate hikes, their impact was muted for those who had already secured favorable rates. Their monthly mortgage payments remained unchanged, rendering further rate increases inconsequential.
This phenomenon, known as reduced interest rate sensitivity, stems from the initial rate cuts followed by subsequent hikes. The initial cuts acted as a buffer, mitigating the impact of later increases. In essence, the economy had already absorbed a significant portion of the potential impact.
The second major explanation attributes high U.S. consumer spending to the depletion of excess savings. For years leading up to the pandemic, the U.S. enjoyed a low-interest-rate environment coupled with robust economic growth. This resulted in a substantial accumulation of excess savings among consumers.
Then came the early stages of the pandemic, when the U.S. government injected even more money into the economy through various stimulus packages, further boosting consumer savings.
Consequently, despite facing headwinds from rising interest rates and inflation, consumers had the financial cushion to maintain their pre-pandemic spending habits. This explains why many economists anticipate a moderation in U.S. consumer spending in 2024, as these excess savings dwindle. The accompanying chart clearly illustrates this trend, revealing that consumers are nearing the bottom of their savings pool.
Even the Federal Reserve has acknowledged the role of excess savings in its economic analyses. While acknowledging its influence, the Fed doesn't consider it a primary driver.
The third explanation points to the continued impact of U.S. government fiscal stimulus measures, particularly those related to infrastructure. This is a fairly straightforward concept.
Several other explanations have been proposed, such as the market-energizing effect of artificial intelligence, the wealth effect of a booming stock market, and a post-pandemic shift in consumer psychology towards embracing spending.
Ultimately, the surge in U.S. consumer spending has undoubtedly fueled GDP growth. But the story doesn't end there.
If the Federal Reserve's rate hikes haven't significantly dampened demand, it suggests that their primary objective – curbing inflation – has been ineffective. This explains the sustained demand but raises another question: how did inflation manage to fall?
See how these economic puzzles are interconnected? It's quite fascinating.
The answer lies in the fact that neither demand nor the Federal Reserve deserves sole credit for taming inflation. Instead, the primary driver was supply.
Let's deconstruct this inflation cycle. On the demand side, we had governments printing money and consumers armed with stimulus checks, eager to spend. This surge in demand inevitably led to price increases.
However, supply-side constraints also played a significant role. Think back to the oil crisis, the 2022 chip shortage, and the myriad supply chain disruptions – all contributed to rising prices.
So why did inflation subside in 2023? Not because demand cooled off but because supply chains recovered. Production resumed, people returned to work, and the flow of goods normalized.
Moreover, the U.S. government wisely shifted its focus from stimulating demand to bolstering supply. Instead of handing out direct payments to consumers, they implemented subsidies and incentives for factories and companies. They enacted legislation like the Infrastructure Investment and Jobs Act, the Inflation Reduction Act, and the CHIPS and Science Act – all aimed at strengthening supply chains and infrastructure.
What we're seeing is a fascinating interplay of factors, where the Federal Reserve's rate hikes might not be the primary force behind lower inflation. The U.S. government's supply-side reforms and subsidies, or even the natural post-pandemic recovery of production and employment, could be equally, if not more, influential.
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Now, back to the U.S. economy.
Let's shift our attention to some potential risks and vulnerabilities looming on the horizon. At the forefront is the real estate sector.
A closer examination of U.S. economic data over the past two years reveals a stark underperformer: real estate investment. This decline is hardly surprising, considering the dramatic surge in 30-year mortgage rates from around 3% in 2021 to roughly 7% today. Such a steep climb in borrowing costs inevitably cools down the housing market.
However, the residential real estate market, while facing challenges, isn't the primary concern. Demand remains relatively stable, and prices haven't plummeted.
The elephant in the room, the risk that has dominated economic discussions over the past year, is the U.S. commercial real estate sector.
Why the heightened concern? It's not just about high interest rates. The pandemic triggered a fundamental shift in work dynamics, with many discovering the merits of remote and hybrid work models. This shift has led to a significant and potentially permanent decline in demand for commercial real estate, resulting in a sharp depreciation of property values.
Observe the historical trends of commercial real estate prices during previous Federal Reserve rate hike cycles. The current decline is the most pronounced, with prices tumbling by over 10% since the rate hikes began.
Major metropolitan areas like Manhattan and Los Angeles have witnessed some high-profile cases of distressed sales, with office towers being unloaded at fire-sale prices.
The implications extend far beyond property owners absorbing losses. These commercial properties are often collateralized by massive loans, and a significant portion of these loans, roughly 25%, are set to mature within the next two years.
With interest rates remaining elevated and demand for commercial real estate in freefall, banks and financial institutions holding these mortgages face the daunting prospect of substantial losses, potentially triggering a cascade of defaults.
In essence, through leverage obtained via bank loans and securitized instruments like mortgage-backed securities (MBS), the commercial real estate market has intertwined itself with the broader financial system. A wave of defaults in this sector could ripple through the financial markets, impacting not only the U.S. but potentially the global economy as well.
This explains why, despite a seemingly calm facade, particularly among smaller banks, balance sheets within the banking sector have begun to deteriorate.
The extent of this deterioration and its potential consequences remain uncertain. We can only wait and observe the Federal Reserve's response.
Over the long term, the U.S. government faces another potential risk, arguably its most significant challenge: its ballooning national debt.
This is not a uniquely American problem; governments worldwide are grappling with rising debt levels. However, rising interest rates only exacerbate this issue, increasing the cost of servicing that debt.
While not an immediate crisis, as the U.S. and other major economies can still manage their interest payments, the long-term sustainability of this trajectory is questionable. Relying on borrowing to address every economic downturn is not a viable long-term strategy.
Despite attempts to rein in debt, such as through political gridlock and government shutdowns, the U.S. has struggled to make meaningful progress. The issue, while significant, lacks urgency.
For governments, it's easier to pay lip service to fiscal responsibility than to implement concrete spending cuts. There always seems to be a more pressing need for stimulus or expenditure.
The challenges facing the U.S. economy, from its national debt to its commercial real estate woes, are complex and multifaceted. Our discussion today merely scratches the surface, and we'll delve deeper into these issues in future videos.
To recap our exploration of the U.S. economy:
- We discussed why the predicted recession failed to materialize, attributing it to robust consumer spending.
- We examined several factors driving this consumption, from low-interest rate sensitivity and excess savings to government stimulus.
- We explored how falling inflation, despite strong demand, could be attributed to supply chain recovery and government intervention on the supply side.
- Finally, we highlighted potential risks, including the precarious state of the commercial real estate market and the long-term threat posed by a mounting national debt.
Looking ahead to 2024, the general consensus among market analysts is that U.S. economic growth will moderate compared to 2023. Whether the U.S. can achieve a soft landing and avoid a recession altogether remains to be seen. The IMF projects a 2.1% growth rate for the U.S. economy, while the World Bank forecasts a more modest 1.6%.
Regarding the Federal Reserve's interest rate policy, their dot plot from December 2023 seemed to signal a 75 basis point reduction in 2024. However, the market remains skeptical.
At the time, the futures market predicted a more aggressive 150 basis point cut, highlighting Wall Street's perception of a more dovish Federal Reserve.
Fast forward to early 2024, with inflation showing signs of a potential uptick, Wall Street appears to have reconsidered its stance. The futures market has realigned with the Federal Reserve's projection of a 75 basis point reduction, suggesting a likely scenario of three rate cuts throughout the year.
A more cautious approach from the Federal Reserve in an election year seems prudent. By avoiding any actions that could be perceived as politically motivated, they aim to maintain their independence and credibility.
The European Economy: A Case Study in Stagnation
Let's shift our focus to Europe, encompassing both the Eurozone and the UK. I'm not sure about you, but discussions of the European economy tend to elicit a sense of drowsiness. So, we'll be swift in our analysis, keeping things engaging.
One word captures the essence of the European economy: "stagnant."
With a GDP growth rate of just 0.4% in 2023 (updated), Europe narrowly averted a recession. However, this modest growth came at a cost. The 2022 energy crisis dealt a significant blow to the continent, particularly those heavily reliant on Russian energy.
On a positive note, inflation has been tamed, falling from a peak of 10% in early 2023 to 3% currently. However, this decline can be partly attributed to the significant economic slowdown, which effectively extinguished inflationary pressures.
Unemployment across Europe remains historically low, and wages have even increased in many countries. However, instead of fueling spending, Europeans are opting for caution, choosing to save rather than consume.
This behavior is a natural response to economic uncertainty. When the outlook appears bleak, it's only rational to prioritize saving over discretionary spending.
A closer look at German consumer spending reveals a nuanced picture. While not disastrous, spending is primarily concentrated on essentials like energy and food, rather than the industrial goods, chemicals, and machinery that drive Germany's economic engine. This lack of investment and business spending hinders economic growth, increasing the risk of recession.
Compounding these challenges is the lingering impact of the energy crisis. While most of the world has moved on from the 2022 energy crisis, its effects on Europe, particularly Germany, have been profound and long-lasting.
As we discussed in our previous video on the energy crisis, Germany was heavily reliant on Russian natural gas, with a pipeline delivering fuel directly into the heart of its industrial sector. The sudden halt of this energy flow had a devastating impact.
Imagine a lifeline abruptly severed – that's the magnitude of the shock experienced by Germany. This wasn't a matter of simply buying energy from elsewhere, even at a premium. The energy supply simply vanished, forcing industries to scale back production.
Chemical giant BASF, for example, was compelled to lay off 2,600 workers due to soaring energy costs.
Adding insult to injury, Germany's crown jewel, its automotive industry, is facing a triple whammy of challenges. Demand from its two largest export markets, Europe and China, has weakened. Simultaneously, it's grappling with the disruptive force of the electric vehicle (EV) revolution.
China's EV exports have surged fivefold in just three years, intensifying competition in a sector already grappling with slowing demand. Consequently, German car exports have plummeted by 40% compared to pre-pandemic levels.
The very factors that propelled Germany to economic stardom – insatiable global demand for its industrial goods, cheap energy, and seamless globalization – have either vanished or reversed. Avoiding a recession under these circumstances is a Herculean task.
In my personal opinion, the German government's approach to fiscal policy, while commendable in the long run, might be exacerbating its short-term woes. They are incredibly, perhaps excessively, disciplined in their approach to spending and debt.
Now, I'm not referring to personal discipline, like early rising and daily exercise. This is about fiscal discipline – an unwavering commitment to minimizing borrowing and government intervention.
Faced with a global economic shock of this magnitude, most governments would step in with aggressive stimulus measures and targeted investments. Not Germany. They cling stubbornly to their debt-to-GDP ratio, refusing to budge beyond the 50-60% range.
Imagine a group of cars speeding down a highway. The U.S. and Japan are practically airborne, while Germany, already moving at a snail's pace, slams on the brakes, engages the handbrake, and fusses with its seatbelt.
This fiscal prudence, while beneficial in the long run, can be a hindrance during times of crisis. It's like refusing to seek medical attention for a broken leg because you're committed to a healthy lifestyle.
The challenges confronting the European economy, particularly Germany, are deep-rooted and systemic. While we can point to the immediate triggers like the Eurozone debt crisis and inflation, the underlying causes run far deeper.
Innovation, demographics, aging populations, inflexible labor markets, and bureaucratic hurdles all play a role. Frankly, after much deliberation, I've concluded that dissecting these issues further is a futile exercise. Let's leave those headaches for the Europeans to solve.
Looking ahead, the EU forecasts a modest 0.9% GDP growth rate and 3% inflation for 2024. A slight improvement over 2023, but nothing to write home about. The fundamental issues plaguing the European economy will require time, effort, and perhaps a bit of luck to overcome.
So, do you agree with my assessment of the European economy as stagnant? Let me know your thoughts.
Building Your Economic Knowledge Tree: A Simplified Framework
We've covered a lot of ground in this two-part series on the global economic outlook, exploring the complexities of various economies and their interconnectedness. I sincerely hope you found it insightful and engaging. Personally, I find the process of dissecting economic data and reports to be quite the mental workout.
The jargon, the endless statistics, the sheer volume of information – it's enough to make anyone's head spin. So, I'd like to share some of the techniques I use to make sense of this complex world and how I approach analyzing national economies.
Last year, I created a video discussing the importance of building a "knowledge tree" – a structured framework for learning and understanding. Today's discussion serves as a practical example of this concept in action.
Even if you have no prior knowledge of economics, I believe this framework can be incredibly valuable.
At its core, analyzing an economy boils down to understanding three fundamental elements: economic output, prices, and employment. These correspond to three widely used economic indicators: GDP, CPI, and the unemployment rate.
Central banks and governments typically aim to keep these three indicators looking healthy, as they reflect the overall well-being of an economy. While not always explicitly stated, I believe income inequality is another crucial factor influencing people's lives.
Think of these elements as the trunk of our economic tree. Our analysis of each country's economy, regardless of its unique characteristics, ultimately revolves around these three pillars.
However, these indicators provide a high-level view, like a final exam score. Knowing your score is just the first step. To improve, you need to identify your weaknesses by analyzing individual questions.
This is where secondary data comes in. We delve deeper, examining indicators like the Purchasing Managers' Index (PMI), core inflation, wage growth, retail sales figures, and more. These provide a granular perspective, allowing us to pinpoint areas of strength and weakness within an economy.
The specific indicators we focus on will vary depending on the country and the prevailing economic climate. For instance, in recent years, the U.S. has placed significant emphasis on employment data, particularly the non-farm payrolls report. More recently, inflation has taken center stage, but simply tracking CPI isn't enough. We need to dissect its components, analyzing trends in housing costs, oil prices, food prices, and more.
By analyzing these secondary data points, we gain a deeper understanding of the forces shaping an economy and can start formulating solutions. This is where government fiscal policy and central bank monetary policy come into play.
We assess their actions, considering their impact on asset prices – stocks, bonds, real estate, foreign exchange, and more. This interconnected web of factors forms our analytical framework.
The complexity arises from understanding the intricate relationships between these elements. The more expertise you acquire, the deeper you delve into these nuances. However, at its core, the framework remains remarkably simple: economy, prices, employment.
It may sound deceptively easy, but this framework has been instrumental in my own attempts to understand the global economic landscape.
When faced with an overwhelming deluge of economic data, it's easy to get lost in the weeds. This framework provides an anchor, a way to zoom out, rise above the noise, and identify the primary drivers and challenges.
Without this structured approach, consuming economic news can feel like a futile exercise in information overload. You're bombarded with statistics on consumer confidence, savings rates, youth unemployment, and more, but it all blurs together, leaving you with no clear takeaways.
However, armed with this framework, even without a background in economics, you can begin to connect the dots. Each news article, each economic report you encounter contributes to a more comprehensive understanding. You're no longer overwhelmed by isolated data points but can place them within a broader context.
This ability to discern primary from secondary factors is crucial when analyzing complex systems like economies. It's about understanding the relative weight and influence of different variables.
For instance, analyzing the Indian stock market's surge solely through the lens of investor enthusiasm and its positive impact on the economy would be misleading. While logically sound, it overlooks a crucial detail: the relatively small proportion of retail investors in India.
Data suggests that retail investors make up a mere 5-15% of the market. While their participation contributes to market momentum, it's not the primary driver of the Indian economy.
In contrast, applying the same logic to the U.S. might be more appropriate. The U.S. is heavily reliant on its financial markets for capital formation. With a large proportion of the population invested in stocks, directly or through retirement accounts, stock market performance carries significant weight in shaping the U.S. economy.
Similarly, attributing the Netherlands' economic performance solely to the success of ASML, a company with a global monopoly on high-end lithography machines, would be an oversimplification. While ASML's contributions are undeniable, viewing it as the sole driver of a trillion-dollar economy ignores other crucial factors.
Despite ASML's stellar stock performance in 2023, the Dutch economy faced headwinds from a slumping real estate market and weak consumer spending. These factors far outweighed the positive contributions of a single company, even one as dominant as ASML.
It's like claiming that the performance of a single company, however large, dictates the fate of an entire country's economy. The logic might seem sound on the surface, but it lacks nuance and fails to capture the complexities of a diversified economy.
These examples highlight the importance of looking beyond superficial correlations and digging deeper into the underlying factors driving economic performance. A robust analytical framework helps us cut through the noise, identify the primary drivers of change, and develop a more nuanced understanding of the complex interplay of forces shaping our world.
Just like a tree needs a strong trunk to support its branches and leaves, a robust economic framework allows us to organize and connect seemingly disparate pieces of information, leading to a more comprehensive and insightful understanding of the global economic landscape.
And that, my friends, is the power of structured thinking.