The word “stable” is not usually associated with the economy these days, but it fairly accurately describes U.S. economic growth over the past two years. In nearly any other period, such steady expansion might have led to speculation that a solid recovery had taken hold and growth was poised to accelerate. However, this is 2012, and a host of domestic and global issues suggest that growth is unlikely to reach a pace that will alleviate all concerns about prospects for the U.S. economy.

Below, Capital Strategy Research economist Darrell Spence discusses the changing mix of positive and negative economic forces and how they may keep the nation’s growth from reaching a pace normally associated with full-speed recoveries.

Slow and steady

The U.S. economy may not be booming, but it is doing fairly well. Since the recession ended in 2009, U.S. real gross domestic product growth has averaged 2.5%, with less volatility than occurred in the previous two economic expansions. Under more normal circumstances, this would be the stage of the cycle in which one might expect positive momentum to kick in and allow growth to accelerate to a more robust pace. But domestic and global challenges will likely keep the economy from firing on all cylinders for the foreseeable future. As a result, the next year or two could look a lot like the past two years with the economy chugging along at a slow (relative to past expansions) but largely steady pace.

Under the surface, though, the drivers of growth are likely to be changing. An improving labor market is allowing more people to form new households, which could lead to a pickup in long-moribund residential construction activity (see Figure 1 below). However, a still-high residential vacancy rate may mean that any improvement will happen at a slower pace than occurred in previous cycles. Similarly, a falling vacancy rate, growing employment base and solid corporate profitability suggest that non-residential (i.e., commercial) construction could move into more positive territory as well.

Business investment in machinery and software has been an important contributor to growth since the recession ended and could remain a significant factor because investment is still fairly low relative to the level of depreciation (shown in Figure 2 below). This suggests that companies aren’t replacing, repairing and replenishing capital equipment at the pace that perhaps they should be.

It may be worth noting that the last time investment was this low relative to depreciation was in the mid-1990s, and in the ensuing four years non-tech business investment grew by more than 9% per year. Growth may not be quite as strong this time around, largely because profit growth is likely to slow in coming quarters, but this could be at least partly offset by rising capacity utilization. At the end of the day, all of this suggests a moderately slower but still healthy pace of business investment in coming quarters.

Finally, ongoing improvement in the labor market should support 3.5% to 4.0% growth in nominal consumer income. The extent to which this translates into an increase in purchasing power—and  thus affects the 70% of real GDP made up of consumer spending—will largely depend upon what happens with inflation. Presently, the level of resource utilization in the U.S. economy suggests that inflation, excluding food and energy prices, is likely to fall from its current 2.3% pace. Based on this alone, real consumer spending growth should accelerate from the 1.7% rate seen over the past year. However, rising energy prices, as well as increasing import prices—the lagged effect of a weakening dollar—could cause inflation to fall less than the level of resource utilization might otherwise suggest. All else being equal, this could limit any potential acceleration in consumer spending.

Beware of the unexpected

In any economic environment there is always at least some risk of a downturn. Recessions are generally caused by imbalances in the economy, shocks to the system or significant changes in policy. Currently, the types of imbalances (such as excess inventories or rampant inflation) that have led to recessions in the past do not appear to be present. But there are certainly shocks, and policy changes, that could potentially impact the U.S. economy.

First and foremost is the situation in Europe. A recession in Europe does not by itself have to result in a recession in the U.S., because exports to Europe represent a relatively small portion of the U.S. economy. However, a full-blown financial crisis in Europe would almost certainly transcend all borders and could have effects on the global economy, just as the U.S. subprime crisis did. Even if the European sovereign debt situation remains largely limited to Greece, there is still the question of how the Eurozone will deal with the errant country. Sovereign debt challenges have put the European Union into uncharted territory, and the global repercussions of an eventual outcome are unclear.

Another event that could impact U.S. growth is a potential energy price shock stemming from uncertainty in the Middle East following the Arab Spring uprisings and a standoff over Iran’s nuclear capacity. Although the extent of potential damage to the U.S. economy depends on how high and how quickly gas prices rise, the simple fact remains that, in the short term, spiking gasoline prices rob consumers of their purchasing power.

On the domestic front, fiscal restraint looms large on the horizon. Though lawmakers have reduced the potential drag from fiscal policy in 2012 by extending the payroll tax cut and emergency unemployment insurance programs until the end of the year, they have merely added to the litany of changes that could be a drag on economic activity in 2013. In fact, a reversal of the payroll tax cut, an end to the emergency unemployment insurance programs, the expiration of the Bush tax cuts, automatic “sequestration” (i.e., spending reductions) that resulted from the failure of the deficit Supercommittee, and cuts in discretionary spending mandated by the Budget Control Act of 2011 are all set to occur at the start of 2013. In total, they could add up to more than 3% of GDP. Of course, it is certainly possible that legislators will hold off on enacting these changes in 2013. However, if they are truly committed to deficit reduction, these steps will have to occur at some point. Otherwise, the most recent estimates from the Congressional Budget Office suggest that the U.S. debt-to-GDP ratio will be more than 94% in 2022.

Concluding thoughts

If the U.S. manages to avoid the more significant economic shocks and the potential blows from fiscal policy are tempered, the U.S. will probably see another few years of positive, albeit modest, economic expansion. In a slow-growth environment still filled with a reasonable amount of macroeconomic uncertainty, bond yields are likely to remain low, earnings growth may be below historical norms, and equities overall are unlikely to receive premium valuations. This makes careful research to find the most compelling investments around the world all the more important. n

The thoughts expressed herein are current as of the publication date, are based upon sources believed to be reliable, reflect the views of one individual and are subject to change at any time. There is no guarantee that any projection, forecast or opinion in this paper will be realized. Past results are no guarantee of future results. This material is provided for informational purposes only and does not take into account your particular investment objectives, financial situation or needs. You should discuss your individual circumstances with your Investment Counselor. © 2012 Capital Group Private Client Services. Any reproduction, modification, distribution, transmission or republication of the content, in part or in full, is prohibited.