Those sanguine about U.S. recession risk aren't looking in the right place.
While standard measures of the real economy — from inflation to the labor market — nurture the Fed's optimism that the U.S. economy can withstand the impact of rate hikes, Deutsche Bank AG's chief economist Joseph LaVorgna sounds the alarm on financial excesses.
Specifically, a negative feedback loop from financial markets to the real economy could push the U.S. into recession, he says. He cites the ratio of U.S. household net worth to disposable personal income, which is now close an all-time record high, indicating net worth is growing faster than expendable earnings.
The elevated level underscores how rampant post-crisis asset-price inflation has flattered the purchasing power of the average Joe — and the corresponding risk that a downturn in the stock market crimps U.S. consumption, with the latter in inflation-adjusted terms already weak relative to history.
"The upshot is that the macroeconomic community could be underestimating the extent of imbalances in the financial sector and therefore implicitly underestimating the risk of recession," LaVorgna and his team warn.
The net-worth-to-disposable-income ratio has staged an uptick since September last year, rising from 625 percent to 638 percent in the second-quarter of 2016.
While that is down from its cyclical high in the first quarter of 2015 — and the record high of 650 percent notched late 2006 — a ratio firmly above 600 percent portends turbulence, according to the analysts.
They cite the risk households would react negatively to any negative shifts in their net worth — triggering a contraction in output.
"In the past, when the ratio rose above 600 percent, trouble was lurking," U.S. economists at the German bank write in a report on Tuesday, citing a collapse in the threshold during the bursting of the stock-market and housing bubble in 1999 and 2008, respectively. In this cycle, its increase has been principally driven by soaring stock prices, with house prices still 2 percent below their previous-cycle peak, the economists observe.
For the Fed, rising equity prices are effectively a feature, rather than a bug, of its post-crisis bid to reflate the U.S. economy through positive wealth-effects — stimulating asset prices to incent consumption. But the elevated net-worth-to-disposable-income ratio now complicates its bid to normalize the monetary cycle if equity prices tumble, LaVorgna and team warn.
"No doubt some (most?) of the rally in equities has been due to exceptionally easy monetary policy. Therefore, if the Fed remains very cautious in raising rates, it is possible that stock prices will stay elevated for a substantial period of time." The analysts conclude, "However, we cannot rule out the risk that market valuations become more excessive and eventually fall under their own weight."
The Fed is alive to the risk that financial shocks — emanating from high corporate leverage, falling profits and rising input costs — may sully the health of the labor-market or reduce wealth-effect-inducing consumer spending. But the extent to which U.S. consumers — and their lenders — have made a slew of financial decisions on the basis of positive wealth-effects, rather than the availability of current income, will only be clear until the credit cycle turns.
One thing is clear: consumer spending has undershot the rise in households' net worth, reflected by an uptick in the personal savings rate from 2013. The latter might underscore how the post-crisis deleveraging cycle has yet to fully run its course, and, as Fed officials have observed, the impact of income inequality and an ageing population.
"Consumption has been on a weaker path than implied by historical relationships with income and wealth, leading to savings," Bank of America Merrill Lynch U.S. economists, led by Michelle Meyer, wrote in a report on 21 October.
The Fed, therefore, might have the worst of both worlds: the U.S. economy hasn't fully enjoyed the benefits of rising wealth-effects, and U.S. households — which has done all the heavy lifting this year to boost U.S. GDP in light of a weak investment cycle — could sharply constrain their spending if stock-market valuations stage a downturn.
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