7/29/2019 Economist Insights Deferential equation

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Economist Insights

Deferential equation

4 February 2013Asset management

The US economy officially contracted in the fourth quarter of

2012. The market quickly looked through the decline, noting

that it was all down to a drop in inventories (much of which is

due to Hurricane Sandy) and cuts to military spending by the

Department of Defense. Behind all this, consumption, businessinvestment and residential investment actually all increased. The

headline was worse than the underlying data, but the underlying

data was by no means strong. This may reflect the impact of

political uncertainty on the economy.

Both households and firms react to uncertainty in three main

ways. Firstly, they defer big ticket expenditures that may be

necessary but do not need to be bought immediately. If you

are worried that your taxes are about to go up, you are likely to

decide that you can put up with your old, worn out sofa rather

than buy a new one after all, you can always buy the new one

later once your tax situation becomes clear. Similarly for a

company, you could choose to put up with the old pressingmachine or the old version of the software for a bit longer.

A common characteristic of these deferrables is that they are

durable goods or physical (or software) investments.

The second way in which households and firms react is to trade

down. Households eat at home rather than eat out or buy a cheaper

car than they might otherwise have done, if they cannot defer their

car purchase. Firms can use older technology or replace machines

with more workers (because it may be easier to fire someone than it

is to get your money back on a machine). The third way is simply to

cut back do not buy so much, or scale down your production.

People will generally prefer to defer a purchase rather than trade

down, and generally prefer to trade down rather than cut back.

When a recession hits, the first thing that happens is a collapse

in expenditure on deferrables, while the impact of trading down

and cutting back on non-deferrables is far smaller. Firms tend to

have the same preferences as people: minimise the change that

you need to make by deferring investment first, then trading

down to older equipment or more labour and then cutting back

on existing capacity. The exception would be inventories: firms

find it easiest to cut back on their inventories first when theyexpect sales to be lower.

Sure enough, the contraction in GDP from the great recession (see

chart 1) was entirely due to a drop in deferrables and inventories

(excepting a very small initial decline in non-deferrables in Q4 2008).

The logical consequence has been that most of the recovery has also

been down to deferrables and inventories. Cumulatively, spending on

non-deferrables has added just under 2% to GDP since the start of

the recession. In contrast, non-deferrables have added virtually zero,

after first taking off 4% and then adding it back.

Joshua McCallum

Senior Fixed Income Economist

UBS Global Asset Management

joshua.mccallum@ubs.com

Gianluca Moretti

Fixed Income EconomistUBS Global Asset Management

gianluca.moretti@ubs.com

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Q2 2008 Q4 2009 Q2 2011 Q4 2012

Non-deferrablesDeferrables Change in Inventories GDP

Source: Bureau of Economic Analysis, UBS Global Asset Management.

Note: Deferrables are defined as consumer expenditure on durable goods and private

fixed investment spending (residential and non-residential). Non-deferrables are the

remainder of GDP except change in inventories.

It is official the US economy contracted in the fourth

quarter of 2012 according to data released last week.

The headline was worse than the underlying data, but

the underlying data was by no means strong, most likely

impacted by the ongoing political uncertainty in the US.

Households and firms tend to defer expenditure (or trade

down) when faced with uncertainty. Households are also

worried about future job prospects and income, fuellingthe conditions in which they will once again cut back

spending on deferrables. The best hope for better data in

the second half of 2013 is that there is a rapid resolution

of the fiscal cliff situation, providing some certainty to

households and firms.

Chart 1: Overdue deference

Cumulative contribution to US real GDP growth since Q2 2008,expressed as % of Q2 2008 GDP

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Spending on deferrables may have driven the recovery but the

spending has not recovered. After four years it is unlikely that

households and firms would want to have the same level of

spending on deferrables that they had before the recession. In

other words, there is plenty of room for durables to continue

to recover provided that firms and households feel confident

about the future. With all the turmoil going on in Washington, D.C.

confidence is the last thing anyone is feeling.

Fear today, gone tomorrow?

There is pretty clear evidence that the worries about the

fiscal cliff are feeding through to households. Not only are

households becoming increasingly worried about future job

prospects, they are also becoming increasingly worried about

prospects for their income (see chart 2). Normally they are

more worried about jobs than income, but in the face of tax

hikes fears about future income are fast heading towards the

lows seen during the recession.

These are exactly the conditions under which households

will cut back spending on deferrables. The best hope for the

second half of 2013 is that there is a rapid resolution of the

fiscal cliff situation which at least provides some certainty.

After all, households have long known that there is going

to be fiscal austerity. They know that this will mean higher

taxes and/or lower spending, so they have already increased

their savings rate. Unfortunately households do not know

how much of the austerity they will suffer. Will their taxes go

up more or less than others? Will spending cuts affect their

industry in particular and their job prospects? As long as

uncertainty persists, everyone will need to price in the risk, so

the negative effects of uncertainty about policies can actually

be worse than the negative effects of the policies themselves.

While spending may be deferred, anticipated tax increases can

also bring things forward. Household income was boosted in

the fourth quarter by a huge rise in dividend payments no

surprise that high income earners wanted companies to pay

out dividends early in order to avoid higher taxes. Households

saved this windfall, both because it was seen as temporary and

because of the increasing policy uncertainty.

The ongoing uncertainty suggests that consumption in

the first quarter could disappoint and it is quite likely that

the weakness could be in deferrables. On the other hand,

inventories are likely to bounce back and there is unlikely to

be another sudden drop in defence spending. So whereas

the underlying economic growth in the fourth quarter was

better than the headline, in the first quarter the headline will

likely be better than the underlying momentum. Growth in

the rest of the year will be dependent on a resolution of the

uncertainty the worst outcome could well be to kick the

can down the road again.

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Source: Conference Board

Chart 2: Feel the fear

Conference Board survey of consumer expectations, proportion of

respondents responding positively minus those responding negatively

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Income higher in 6 monthsJobs plentiful in 6 months

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