What sugar high? Economy has pent-up energy to burn

The economy has performed quite well so far this year. Real GDP growth averaged better than 3 percent in the first half of 2018, bolstered by a solid rebound in consumer spending in the spring and robust gains in business fixed investment.

Many skeptics suggest that the economy is on a sugar high, boosted by the temporary effects of last December’s tax reform package. Surveys of economists expect a substantial slowdown in the second half of this year and next year.

There are several reasons why that is unlikely to be the case. First, the composition of growth in the first half of the year does not point to a one-off blip in economic growth.

{mosads}In particular, consumer spending, despite the rebound in the spring, only averaged 2.2 percent real growth in the first half of the year (the rough winter significantly depressed household expenditures in the first quarter), a weaker performance than the 2.7 percent increase in 2017 and the 2.8 percent rise in 2016.

So, the consumer is certainly not on a sugar high. Businesses have ratcheted up the growth in their investment outlays since early last year, but the pace of advance has only inched somewhat higher in the first half of 2018 vs. 2017, so there would appear to be no sugar high here either.

Another detail from the GDP statistics in the first half of the year that bodes well for continued growth is that inventories contracted outright by a significant amount in the second quarter, an exceedingly rare occurrence.

In essence, firms were likely caught flat-footed as demand was firmer than anticipated, and they saw their stocks drawn down. A replenishment of shelves and warehouses throughout the economy is likely in the second half of the year, boosting near-term growth prospects.

Finally, the “sugar high” hypothesis does not fit the current situation anyway. The notion of “fiscal stimulus” creating a short-lived “sugar high” applies to the classic type of fiscal measures usually taken to help lift the economy out of a recession.

The cleanest example is the rebate checks that were mailed out to households in 2001 and again in 2008 and 2009. Consumers were given a one-time windfall. They spent a portion of it in the ensuing months, and then the economic impact (aside from the increase in government debt to pay for the largesse) quickly disappeared.

The December 2017 tax reform package was a far different type of “fiscal stimulus.” The bulk of the changes were to the corporate income tax code, not to households. Moreover, the main impact of the tax reform should be to encourage companies to invest (and hire) more in the U.S.

This is not a one- or two-month lift to consumer spending. The impetus to investment will play out over years, not months. Moreover, greater investment should, over time, lift productivity growth, which should in turn raise the speed limit of the economy, i.e. trend growth and boost real wages.

In contrast to the classic “sugar-high” effect seen in the past, the 2017 tax reform is likely to continue boosting growth for several years (though, of course, the magnitude of “fiscal stimulus” will inevitably begin to fade at some point).

With businesses enjoying a massive tailwind from tax reform, investment outlays should remain strong for the foreseeable future. Moreover, the consumer outlook is upbeat as well.

Robust labor markets are generating solid income gains, households are also enjoying a modest tax cut this year, and household balance sheets are in great shape, boosted by conservative borrowing since the financial crisis and a run-up in asset prices (mainly for stocks and homes).

The picture for consumers looks even better given that the recent benchmark revision to GDP “found” hundreds of billions of dollars’ worth of income that had not been previously recorded (the new information that the government statisticians used came from IRS tax return data).

As a result, the household savings rate, which was previously thought to be a little over 3 percent, near the bottom of the historical range, was revised to above 6 percent, a hearty level that suggests households have had the wherewithal to both spend and save in recent years.

Putting these pieces together, after averaging just above 3 percent in the first half of the year, real GDP growth could approach 3.5 percent in the last six months of 2018, putting this year on track to be the best for the economy since the 2003-2005 period.

Barring a shock to the U.S. economy (trade war, geopolitical tensions, a volatile political environment, etc.), I would expect growth in 2019 to exceed recent trends as well, likely closer to 3 percent than to 2 percent.

While the consensus view of economists looks for a sharp slowdown in 2019, I believe that the positive underpinnings for the economy will continue to boost growth over the balance of 2018 and next year as well.

Stephen Stanley is the chief economist for Amherst Pierpont Securities, a broker-dealer providing institutional and middle-market clients with access to fixed-income products.