When I was visiting institutional equity portfolio managers in Europe at the beginning of September, the number one question was about the sustainability of the U.S. economic and profits recovery. This is the number one question among investors in the U.S. as well, based on my recent conversations with several of them in recent months. I share their
concern and started to write about it in the August 5 issue of my weekly commentary titled “Leaky Multiplier.”1 The difference is that I think that stalling economic and profits growth could be a problem for the stock market during the second half of next year, while many investors seem to believe that the market may be starting to discount this scenario already.
Big Boost From Big Brother. The federal government is currently providing a big boost to the economy with a huge tax cut. Another round of fiscal stimulus is coming during taxfiling season next year, when we all retroactively will receive the proceeds of the tax cut during the first half of 2003. According to the Commerce Department’s personal income
report, personal taxes (at a seasonally adjusted annual rate) plunged in July and August by $101 billion and $52 billion, respectively, to $933 billion. This is the lowest since January 1997 and $410 billion below the record of $1,344 billion during March 2001.
According to the report:
A reduction in federal income taxes accounted for the decreases in August and July. Provisions of the Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the level of withheld taxes by $45.8 billion at an annual rate ($3.8 billion at a monthly rate) in August and in July. The reduction in withheld taxes reflected new marginal tax rates, an expansion of the 10-percent tax bracket, and an acceleration in “marriage penalty” relief. In addition, the level of federal nonwithheld taxes (payments of estimated taxes plus final settlements less refunds) was reduced by $109.5 billion at an annual rate ($9.1 billion at a monthly rate) in August and $55.5 billion at an annual rate ($4.6 billion at a monthly rate) in July.
The reductions in nonwithheld taxes reflected the pattern of advance payments of the child tax credit that were paid in August and July.
Meanwhile, government transfer payments in personal income rose to a record $1,382 billion in August. So the gap between transfer payments and personal taxes rose to a record deficit of $282 billion in August from a record surplus of $217 billion during January 2001. That’s an enormous swing that is helping to prop up consumer incomes and spending. It is also the major reason why the overall U.S. federal budget deficit has swung from a record surplus of $277.6 billion over the 12 months through April 2001 to a record deficit of $358 billion through August of this year.
Without this enormous deficit-financed windfall, consumers’ after-tax incomes wouldn’t be growing at all, and most likely neither would consumer spending. Personal income before taxes adjusted for inflation and on a per-capita basis has been stuck around $28,000 for more than three years now, i.e., since May 2000. Over this same period, real disposable real per capita incomes are up 7.2% to $25,172, and real personal consumption expenditures are up 7.2% to $23,572.
The drop in real personal interest income has contributed to the weakness in personal income since the start of the decade. At a seasonally adjusted annual rate, it was down to $952 billion in August from a peak of $1,026 billion during November 2000.
Interestingly, real average hourly earnings have been rising rapidly since the mid-1990s and continued to do so even over the past three years, when the economy was relatively weak. Real average hourly earnings rose 4.1% over the past three years to $13.60 per hour. This makes sense, since productivity has been growing rapidly. Workers’ real wages are mostly determined by their productivity. So why have inflation-adjusted wages and salaries per payroll employee been relatively flat for the past three years around $34,500?
In my opinion, companies have slashed bonuses and overtime pay over the past few years. Indeed, many workers are probably working longer hours and receiving less pay for their efforts.
Temporary Fix? Obviously, the consumer is on a temporary high thanks to a heavy injection of deficit-financed tax cuts and strong doses of transfer payments. Stock market investors are rightly worried that the federal government’s ability to continue to provide even more such stimulants to the consumer will be constrained by federal budget deficits that may soon
approach $600 billion. Ideally, the so-called “Multiplier Effect” will come to the rescue.
Consumer incomes should become less dependent on tax relief as employment starts to expand in response to the initial government-financed pickup in consumer spending. Companies should respond by restocking inventories and increasing capital spending.
This explains why investors are so obsessed with employment data. Rebounding employment isthe key variable needed to generate a self-sustaining economic and profits expansion.
The China Syndrome. The prospects for employment remain challenging. Companies still have plenty of capacity. The capacity utilization rate has been stuck around 75% since October 2001. The unemployment rate is closely tied to the utilization rate. When the utilization rate is low the jobless rate is high. The “resource utilization rate,” which is simply the average of the capacity utilization rate and the employment rate (100 less the unemployment rate) stood at 84.3% during August 2003, well below the latest cyclical peak of 89.8% during April 2000.
Many companies face enormous global competition and pressure to cut their costs while boosting their productivity. The pressure is mostly coming from Asia, in general, and China, in particular. Over the past year through the second quarter, productivity was up 4.1%, 4.9%, and 3.5% for nonfarm businesses, nonfinancial corporations, and manufacturing firms, respectively. These big gains in efficiency explain why there have been no gains in resource utilization.
While overall capital spending remains weak, outlays on productivity-enhancing technologies are soaring. On an inflation-adjusted basis, high-tech capital spending rose 18.4% during the second quarter from the same period a year ago, while low-tech capital spending fell 14.2%.
The Jobs and Growth Tax Relief Reconciliation Act of 2003 provides several incentives for companies to increase their capital spending, including the ability to expense 50% of capital outlays before the end of 2004 rather than depreciate the expenses over several years. The problem is that there is nothing stopping U.S. companies from buying capital equipment from
foreign sources and there is nothing that requires them to keep the equipment in the United States. So when Intel builds a plant in China, the company can still take advantage of the tax incentives on their tax returns in the U.S.
The China Syndrome helps explain why high-tech capital spending is soaring at home, while low-tech capital may be soaring abroad rather than domestically. It also explains the weakness in employment. The total number of unemployed workers in the United States was 8.9 million
during August. By some estimates, this is approximately how many new jobs China must create every year to employ the rapidly growing labor force!
Now Or Later? The recent weakness in stock prices seems to be heightening concerns that once the latest burst of fiscal stimulus runs its course by the end of next year’s tax season, the China Syndrome scenario may start unfolding. Again, I do share these concerns. However, for
now, I believe it is too soon to conclude that the Multiplier Effect won’t prevail over the China Syndrome. In any event, I expect that better-than-expected earnings during the third and fourth quarters should sustain the cyclical bull market in stocks through the middle of next year.
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