US economy in Strengthening Mode Since 2011

The 2008 global financial crisis resulted in US Fed reducing its interest rates and indulging in a series of Quantitative Easing (QE) to ease the volatility and fall in capital markets across the world. It was aided by other central banks such as ECB, BoE, etc. to inject a massive USD 12 trillion into the world economy, almost 1/6th of global economic GDP.

The process was aimed at inflating asset prices across categories such as equities and real estate. Through this, as asset prices begin to improve, the holders of those assets would experience a positive wealth effect which in turn would improve spending and consumption. The initial measures helped avoid the deep depression like situation of the 1930s. But US GDP failed to grow after that and it necessitated further measures from US Fed such as QE2 and QE3 in addition to other stimulus components.

Eventually, measures have started to positively impact US GDP as the recent readings of US economic indicators show.

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The US housing has made a strong comeback in terms of permits and starts.

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The US equity markets have also become stronger on the back of strong balance sheets of US companies and improving earnings profile. Both DJIA (1st chart) and S&P 500 (2nd chart) have shown gradual improvement since the crisis.

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US economy till now was mainly dependent on foreign oil. Discovery and commercialization of shale gas deposits across US have reduced this dependence and are expected to become a larger portion of total crude requirements in future. This automatically reduces the wasteful defence expenditure on Middle East. This is already evident from the lower direct involvement in recent ME problems such as Syria, Arab Spring, etc.

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In addition, US doesn’t have a strong rail road network like that of India or China. It has been traditionally dependent on roads for transportation of goods and people. US government is planning big infrastructure projects such as new railroads to connect various towns and cities. The Passenger Rail Investment and Improvement Act (PRIIA), 2008 plans to spend USD 200 bn in upgradation of existing rail network and new rail lines including the High-Speed Intercity Passenger Rail (HSIPR) program.

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Also, gas infrastructure pipelines to transport the shale gas and ports for possible export of surplus gas have been developed in last few years. Many more of such projects are in pipeline.

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Large infrastructure projects help generate a variety of jobs. This coupled with Recovery Act, 2009 and several other job creation initiatives has resulted in steady addition to the US non-farm payroll additions since the recession. It is nearing pre-crisis levels. US unemployment rate is expected to reduce from current levels going forward. Once employment indicators improve, the US consumer becomes more confident of his future and hence starts leveraging.

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Reduced crude and natural gas imports coupled with focus on domestic economy and consumption also help bring fiscal deficit under control and which becomes supportive of long term US GDP growth.

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The massive Fed actions over the past few years resulted in suppressed bond yields for a long time. However, recent positive indicators coupled with low inflation levels have resulted in real positive interest rates which are reflected in improvement in US Treasuries. For instance, US 10 year treasury yield has increased to ~ 2.6%, an increase of ~ 45% in the last 1 month itself. The upward movement in yield curves over past 6 months is reflected in the chart below

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Hence US GDP is expected to grow from here on at a reasonable rate of ~ 3% over the next 5 years. For such a large economy, GDP growth at ~ 3% results in employment generation in several of these new growth areas and sufficient to maintain low inflation levels.

Since US economy is on a rise and unemployment numbers are expected to come down, US Fed has taken the correct step of tapering the QE and eventually winding it down. While Fed hasn’t decided on the exact timing of tapering, the very mention of that word indicates its intent. Hence, the easy money and liquidity that was floating in the world economy will go away. While Fed balance sheet shrinkage does cause temporary fall in the equity markets, it eventually begins to improve again as shown in the chart below. With the eventual rise in GDP, US equity markets will become stronger.

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The period from 2013-18 could be similar to 1995-2000 when US economy improved significantly beating all expectations of the time. During 1995-2000, significant investments and advancements in semiconductor industry resulted in growth opportunities for IT, communications, biosciences, and other IT-using industries. The cheaper IT prices reduced costs and improved performances across sectors such as automobiles, aircraft, scientific instruments, retail, banking, etc.

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Consequently, USD strengthened by ~ 38% against INR in this period. Even against other currencies like JPY and GBP, it was strong for most part of the period – at one point, USD appreciated by ~ 85% against JPY and ~ 15% against GBP. A similar period of productivity led growth is expected in the US in the next several years. This coupled with improvement in yields and equity markets will lead to USD strengthening from current levels. Some of it has already happened in recent months as shown in the chart below.

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Basic Relations between Equity, Debt and Currency markets

The bond, equity and currency markets of an economy move based on fiscal (GDP growth, fiscal deficit, CAD, etc.) and monetary policies (inflation, interest rates, etc.) in addition to global liquidity scenario and prevailing policies in other major economies. At a broad level, the following table holds true.

Quadrant

GDP Growth rate

Inflation rate

Yield rate Moves

Equity Indices Move

Currency

I

High

Low

Up

Up

Strengthens

II

Low

Low

Down

Sideways

Sideways/Weakens

III

High

High

Up

Up

Strengthens

IV

Low

High

Up/Stable

Sideways/Down

Weakens

A slump in economic growth can be tackled through 3 major avenues –

1. Fiscal policy – through a fiscal expansion (government spending)

2. Monetary policy – cutting benchmark interest rates, improving domestic liquidity in banking system

3. Currency – increasing exports and cutting back on imports

A big currency movement happens when transition occurs from one quadrant to another. Currency movement depends on the fiscal and monetary policies of the country. In case of contractionary fiscal policy and accommodative monetary policy, exchange rate will tend to be weak.

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