NEW YORK (TheStreet) -- The economic crosswinds have suddenly begun to blow harder. Even though consumers have stepped up their spending and housing activity has firmed, fallout from the decline in oil prices and the struggling global economy has intensified. A related ill wind created by the tightening in financial conditions via weaker stock prices, wider credit spreads, and greater volatility across financial markets has also picked up.
Overall growth has thus slowed, but this should prove temporary. The American consumer will prove resilient, while the rationalization of the energy industry will soon wind down, and the key Chinese economy should stabilize in response to additional fiscal and monetary stimulus. Financial markets should also steady.
The U.S. economy remains on track to return to full employment by mid-2016, which should soon convince the Federal Reserve to begin normalizing interest rates.
Consumers Step Up
It isn't hyperbole to say that near-term global growth prospects significantly hinge on the American consumer. Fortunately, consumers are spending with as much gusto as they have since before the Great Recession.
Most notable is the steady ramp-up in vehicle sales, which outside of a few incentive-juiced months, are as strong as they have ever been. Low gasoline prices are surely boosting sales, and so too is a normalization in auto lending standards. But the consumer revival goes well beyond the vehicle market. Total real consumer spending is growing at a consistently healthy more than 3% per annum pace. Spending on everything from clothing and jewelry to home improvement and healthcare is increasing solidly.
Underpinning the spending gains is the steadily improving job market. Job growth has slowed in recent months, but even at the slower pace, the economy is fast approaching full employment. The underemployment gap-the number of unemployed and underemployed above that consistent with a fully employed economy-has narrowed to an estimated 0.75% of the labor force. A year ago, the gap was more than 2%.
As full employment comes into view, wage growth should meaningfully pick up from its current just over 2% annual pace. If history is a guide, the current record number of job openings presages wage growth of closer to 3.5% a year from now.
This is roughly what wage growth should be in a full-employment economy: equal to the sum of 2% inflation and 1.5% trend productivity growth. Stronger wages will boost consumers' purchasing power and should also unlock the psychological shackles they've been struggling with since the recession.
Consumers' balance sheets look about as good as they ever have. Household debt growth continues to lag income gains, and debt burdens, as measured by the share of income used to make interest and principal payments to remain current on that debt, are as light as they have been in the 35 years of available data. Credit card and auto loan delinquencies have never been lower, and even mortgage delinquencies have rarely been better.
Consumer spending has also received a big boost from rising household wealth. National house prices are almost back to where they were before they crashed, and stock prices have soared since their recession lows, the recent correction notwithstanding. When combined with lower debt loads, household net worth-the difference between what households own and owe-has surged. Net worth is close to a record 6.4 times household disposable income.
Since the impact of changes in household wealth on consumer spending can't be observed directly but must be estimated econometrically, just how much the increase in wealth has boosted spending is a matter of much debate. Most estimates of this wealth effect are relatively small; somewhere between 1 cent and 5 cents. That is, for every $1 change in household wealth, consumer spending changes by less than a nickel over a period of up to two years.
Of course, given that stock wealth has increased by $12 trillion since its recession bottom and housing wealth has increased by almost $6 trillion since its nadir, even a wealth effect of a couple of pennies can add up to lots of additional consumer spending. Indeed, doing a simple back of the envelope calculation, assuming the wealth effect across stocks and housing is 2 cents would suggest that the increase in household wealth has accounted for almost one-sixth of the growth in consumer spending during the recovery.
The recent stock market correction thus arguably poses a serious threat to consumers, but only if it unravels into a full-blown bear market. While just over $1 trillion in stock wealth has evaporated since the market peaked this past summer, this is a modest pullback given the preceding gains. The stock market is expected to remain volatile, but it is not expected to suffer further big losses, at least not on a sustained basis.
Key to this expectation is that the Chinese economy will soon find its footing. China's problems are weighing heavily on the global economy, particularly emerging economies in Asia and Latin America. An uncomfortably large part of the global economy is in recession or at risk of sliding into one.
For context, based on simulations of our global models, a 1 percentage-point deceleration in China's real GDP growth ultimately reduces global real GDP growth by approximately 0.5 percentage point. Although it is difficult to know how much China has slowed given the poor quality of its economic data, a conservative estimate is that it has weakened from close to 7% last year to about 5% (annualized) during the first half of this year. If so, China has cost the global economy a consequential full percentage point of growth so far this year.
The most direct channel through which China's struggles become the world's is weaker trade and commodity prices, as the country is a big buyer of energy, metals and agricultural products. A bigger issue for the U.S. economy is the resulting hit to the sales and earnings, and thus stock prices, of U.S. multinational corporations.
Adding to the agita surrounding China's slowdown are the botched attempts by Chinese authorities to stem it. Most disconcerting was their handling of the wild swings in Chinese equity markets this past summer. They finally contained the downdraft in stock prices, but only after forcing some investors to stop selling their shares and requiring others to buy them. Their recent de-linking of the yuan from the U.S. dollar, and resulting devaluation, was a reasonable response to the country's eroding exports, but the way it was done was ham-handed.
Having said this, it now appears that Chinese authorities are fully engaged in arresting the slide in their economy's growth. They have shown a consistent willingness to use fiscal and monetary stimulus to boost the economy, and this time is no different.
Since the start of the year, the Chinese central bank has cut interest rates and bank reserve requirements. Macroprudential tools such as increasing allowable loan-to-value ratios on mortgage loans are being used to revive property markets. Local governments are getting financial help and a green light to finance more infrastructure and commercial development. And there is the yuan devaluation.
The Chinese financial system also remains largely closed. Chinese authorities are working to integrate it with the global financial system, but that will take years. China won't be a true economic power until its financial system is plugged in, but the current benefit of being offline is that there is thus no possibility that China will suffer the capital flight that has precipitated financial crises in emerging economies in times past. A financial crisis like that which struck Asia in the late 1990s is hard to envisage in today's China.
China's economy will continue to slow, but this is by design. Authorities recognize that they must throttle back growth now that the country's working-age population is declining and productivity gains will be harder to come by. Their real GDP growth targets appear set to slow from 7% this year to less than 5% in a few years. Our working assumption is that while managing this slowdown won't be especially graceful, Chinese authorities will roughly pull it off, at least in the near-term.
If everything sticks more or less to this script, the Federal Reserve will soon begin to normalize interest rates. With the U.S. economy fast approaching full employment and relative stability expected to prevail in the global economy and financial markets, the Fed is under increasing pressure to end its zero interest rate policy.
The first rate hike of 25 basis points is expected at this December's Federal Open Market Committee meeting, although it may take until early 2016 before policymakers feel sufficiently confident to make this move. Additional 25-bps rate increases are expected at alternating meetings in 2016, and at each meeting in 2017. The federal funds rate should reach its estimated long-run equilibrium rate of 3.5% by early 2018. It will have been a long time coming.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.