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The Structural Underpinnings of the U.S. Economy Compared to FOMC Projections

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Structural Underinvestment in Old Economy Sectors | FOMC Forward Projections

As I've written about in the past, markets move relative to expectations and as the anticipations of economic data, monetary policy and fiscal change, so do markets. I thought it was a helpful exercise to zoom out in today's article, look at the structural underpinnings of the U.S. economy and compare those underpinnings with the FOMC's economic projections. Are the FOMC's assumptions realistic or will rethinking and therefore market re-pricing have to occur?

1.) Old Economy Sectors Constraining The Economy

In nominal terms, the US economy has seen high economic growth rates to the tune of 6.6% in Q1, 2022 and 7.8% in Q2, 2022. If we turn to Real GDP (a function of nominal output corrected for inflation), however, the picture is turned upside down; Q1, 2022 showed a contraction of 1.6% followed by another contraction in Q2 of 0.9%. The decline is largely a function of the fact that production capacity hasn't been able to keep up with nominal spending, resulting in higher prices. The prime example of that divergence are "old economy" industries such as: energies, construction (housing, cement) and materials. While supercharged by geopolitics, Germany's producer prices rose 5.3% M/M (37.2% Y/Y) on Friday. It was arguably the suspension of disbelief that led to the current conjunction; it is a reality that will likely exist in some form (doesn't mean that disinflation can't occur and gas prices can't drop) until capital flows back into underinvested sectors of the economy, at which point long lead-time project investment picks back up, which in turn leads to sufficient supply in the distant future. That doesn't mean the economy can't grow; it does mean, however, that economic potential is constrained by real world factors.

Evidence of constraints can be observed from the IEF's oil & gas investment outlook, which provides us with an understanding about upstream's investment needs. The group's assessment states that upstream oil & gas capex will have to return to $525bn/year by 2030 in order to sufficiently meet demand -- that compares against $341bn of investment in 2021. 

The shortfall in capital spending can be clearly illustrated when we look at energy companies investing less than they depreciate/amortize. Using Exxon Mobil as an example of the industry's overall state, we clearly observe a lack of investment driven by a lack of policy clarity and investors' demands to remain disciplined with capital allocation.

The lack of spare capacity, not only as it pertains crude production itself, but also the economy at large is spurred by the volatility that underinvestment creates. Volatility, in turn, creates a sense of unrealiability in the persistence (or lack thereof) of prices, which is the usual solution to undersupply. 

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The lack of participation volatility creates is clearly illustrated by the open interest of WTI Crude Oil, Natural Gas and Copper futures.

It is, again, the constraints of production that put limits on economic growth and therefore the appreciation of financial assets over a sufficiently long enough time horizon. While Real GDP is shown to be below potential, the economy will likely have to reckon with underinvestment for quite a while: we are possibly in transition and in the areas where investment is desperately needed, we are likely in excess of potential output already.

Production constraints are ultimately a function of a lack of prior fixed capital investment. If this is a world of systematic underinvestment, a tug of war between forces seems inevitable -- a world in which active management of portfolios is critical for investment success.

2.) Contrasting Economic Underpinnings with Fed Projections & Market Pricing

Fed Real GDP Projections:
As we think about the Fed's response to economic conditions (maximum employment mandate), the FOMC's economic growth projections are as follows:

• Q4, 2022 Real GDP growth at 1.7% (median); ranging from 1% - 2%.
• Q4, 2023 Real GDP growth at 1.7% (median); ranging from 0.8% - 2.5%
• Q4, 2024 Real GDP growth at 1.9% (median); ranging from 1.0% - 2.2%

Economics 101 teaches us that inflation is a phenomenon that occurs because there's a mismatch between quantity supplied and quantity demanded. Unless the supply or the demand curve shift, the disequilibrium persists.

Taking the commentary about economic growth & economic output potential to its logical conclusion, underinvestment in areas of necessities spurs higher prices. Unless investors become more comfortable with the expected return, demand is either temporarily subdued due to interventionist policies, or demand destruction occurs as a result of unsustainably high prices.

Fed Inflation Projections:

• Q4, 2022 PCE at 5.2% (median); ranging from 4.8% - 6.4%.
  • Core PCE 4.3% (median); ranging from 4.1% - 5.0%
• Q4, 2023 Real GDP growth at 2.6% (median); ranging from 2.3% - 4.0%
  • Core PCE 2.7% (median); ranging from 2.5% - 3.5%
• Q4, 2024 Real GDP growth at 2.2% (median); ranging from 2.0% - 3.0%
  • Core PCE 2.3% (median); ranging from 2.0% - 2.8%

Given inflation expectations have remained well-anchored for the time being, the assumption of policy makers is that the issue of high inflation is still more transitory than not. They may be right, they may be wrong, but we do know that upside surprises over the long haul will require repricing of risk assets.

We will pay attention to policy makers at Jackson Hole and Jay Powell's speech on August 26 as the Fed and global policy makers continue to set expectations.

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Until next time, good luck & good trading.

Be sure to check out prior writings of Top Things to Watch:

• Markets Move with Macro Expectations and Expectations Change - Aug. 14, 2022
• Risk Asset Pricing is a Function of Flows - Aug 7, 2022
• The Reality of Negative Real Rates - July 31, 2022

 

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Economic Calendar
 

U.S.

 

Data Release Times (C.T.)

China

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Eurozone

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More Of The Upcoming Economic Data Points Can Be Found Here.

 

Food for Thought

 

Earnings

Macy's (M) reporting before the open on Tuesday:

• Consensus: EPS est. $0.85; Revenue est. $5.50bn

Commentary on the following will be monitored:

• Retail inventory levels and destocking
• Consumer spending
• The state of brick & mortar

 

Nvidia (NVDA) reporting after the close on Wednesday:

• Consensus: EPS est. $0.58; Revenue est. $8.10bn

Commentary on the following will be monitored:

• Chip inventory cycle
• Potential Neon gas shortages
• Customer demand

Note: Nvidia already cut earnings projections before this report

 

Snowflake (SNOW) reporting after the close on Wednesday:

• Consensus: EPS est. ($0.02); Revenue est. $467.05 million

Commentary on the following will be monitored:

• State of the cloud sector (implications for competitors)

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