The financial world seems to be fixated on “How far into this economic cycle are we?”
Our outlook on the economic cycle is relatively straightforward. We are still early in the economic cycle. In order to properly dissect and understand the U.S. economy, it has to be first divided into the industrial and consumer economies, without ignoring the technology economy (of which the U.S. is the undisputed world leader).
The Industrial Economy - The 2009 through 2014 period was the first industrial-led economic recovery in the U.S. since 1961. The advent of fracking technology as advanced by the U.S. oil and gas exploration companies drove a massive buildup in domestic industrial activity. Beyond the direct inputs into this activity (pumps, pipe, sand, concrete, steel, trucks, railcars, etc.), there was a dramatic build-up of petrochemical assets (8 new refineries and 22 new plastic resin plants). The U.S. surpassed Saudi Arabia and became the world’s largest oil producer, and the U.S. plastic industry grew from $229 billion in 2009 to over $404 billion in 2017. This drove a positive ‘ripple effect’ throughout the rest of the industrial economy and there was and an even larger investment in and expansion of industrial infrastructure throughout the U.S. This came to a screeching pause in late 2014 as the price of oil fell from over $100 a barrel in July 2014 to $45 a barrel in January 2015 and as low as $26 a barrel in February 2016.
Throughout the U.S., there were thousands of DUCs (Drilled UnCompleted wells), because the value of oil that would be produced once those wells were fracked was below the then-market value. We estimate that the marginal cost of production of oil in all fracked fields is above $40 (~$43 in the Permian, ~$46 in the Eagle Ford, and ~$54 in the Bakken). As a result, the U.S. industrial economy went into a recession until oil began to rise back above those levels in mid-2016. As oil finally broke above $50 in October 2017, the industrial economy quickly shifted back into gear and growth returned first in the Permian, then the Eagle Ford, and finally in the Bakken. Activity has now returned to even the minor shale fields across the country. The industries that support oil and gas exploration returned to growth in early 2017, which in turn drove expansion across industrial America more broadly. As long as WTI oil stays above $60 a barrel, we predict that this part of the U.S. economy will continue to thrive. Two factors boost our confidence in this view. We are still early in the cycle (it began in October 2017), and the Trump corporate tax cuts.
The simple, straightforward effect of the Trump tax cuts is that they lower the cost of capital for corporations (for most it dramatically lowers the cost of capital), boosts the incentive to invest capital in hard assets which produce capacity and technology which boosts productivity, and raises the competitive position of the U.S. economy in the global economy. We understand that this is an ‘all other things’ being equal statement, and in economics ‘all other things’ are never equal. Since the passage of the tax reform, there have been significant changes in the value of the U.S. dollar, changes in compensation strategies, and ongoing changes in trade policies (which are still being sorted out). All of those ‘other things’ aside, the lower corporate tax rate is a boost to the U.S. economy which just began and should stimulate outsized growth for the next 2 to 3 years. Bottom line: we are early in the industrial recovery and the tax cuts should produce a boost to both the rate of growth and nominal size of the industrial economy when it does reach its peak size.
The Consumer Economy – The 2009 through 2016 period was a period of extremely slow growth to no growth for the U.S. consumer. Headlines frequently featured a revolving list of reasons for the lack of growth: e-commerce is killing brick and mortar retailing, millennials will never move out of their parent’s basements, investment accounts were still recovering from the 2008-2009 market crash, Millennials consumed experiences not hard goods, etc. All these headlines spread fear but lacked a simple understanding of demographics and long-term sociological trends.
Our grandparents married at an earlier age than our parents who married earlier than we did. As we live longer lives and pursue higher levels of education, is it a surprise that we wait longer to get married?
There are more Millennials than Baby Boomers and as they have finally begun to marry in sizable numbers there has been a steady increase in new household formation. Nothing spurs household formation and the acquisition of household goods like getting a spouse, and Millennials have started that process in earnest in the last 18 months. Inflation in the value of the Baby Boomer’s retirement accounts is also serving to boost their ability and willingness to assist their grandchildren in the down payment for that first house.
Low unemployment is driving steady growth in consumer income and nothing drives consumer spending stronger than growth in consumer income and growth in new household formation. Bottom line: we are still in the first 18 months of the consumer recovery and the size of the Millennial demographic could drive the consumer economy for several years without interruption.
Stay invested and stay tuned, we are just getting started…