Four key takeaways
✔ The new administration’s goal is to boost U.S. growth to 4%, a much higher rate that has not been seen in decades.
✔ Achieving 4% growth over the long-term appears challenging given the current U.S. demographic outlook.
✔ Shorter-term growth acceleration is possible, although it would likely require a healthy dose of fiscal stimulus.
✔ Against the maturing—although still healthy—nature of the U.S. business cycle backdrop, global equities and inflation-resistant assets are favored, though smaller asset allocation tilts are warranted.
Why the U.S. economy remains strong
The pace of real (inflation-adjusted) economic growth in the U.S. has slowed structurally in recent decades, and the new presidential administration has stated a goal of boosting growth to a much higher rate of 4%. This article investigates how the secular and cyclical backdrops may affect the quest for much higher U.S. growth.
Long-term U.S. growth is likely to continue to slow
Over long periods of time, the pace of real (inflation-adjusted) GDP growth in an economy can be approximated by the sum of two things: labor force growth (new workers added to the economy) and productivity growth (increased production from those workers). As seen in the chart, both U.S. labor-force and productivity growth peaked decades ago and have since slowed. Since 1996, the labor force has grown roughly 1% a year, while productivity has increased about 1.5%, resulting in real GDP that has averaged just below 2.5% for the past two decades.
Going forward, our long-term projection is for both labor-force and productivity growth to continue to slow. Much of this is due to the continued aging of the U.S. population. Fewer young job entrants imply slower labor-force growth, and aging societies may also experience lower innovation, risk-taking, and human-capital investments, which would depress productivity growth rates.
As a result, we anticipate labor force growth slowing to a mere 0.5% a year going forward and productivity growth falling to 1.1%, resulting in real GDP growth averaging just 1.6% long term. (For more details on our outlook, see Viewpoints: "Expect slower world growth, lower yet positive returns")
What would it take to reach 4% real GDP growth over the long term?
If the demographic outlook for the U.S. doesn’t change materially, achieving 4% real GDP growth on a long-term basis would require worker productivity rates reaccelerating back to peak levels of 3% per year. This rate of productivity growth has not been seen in developed economies for nearly 50 years, and was only sustained in the U.S. in the aftermath of World War II when the nation converted from a military-industrial-based economy to a consumer-based one.
Even if 3% productivity was reached, the U.S. would need to generate higher participation from its working-age population. The participation rate—or the share of people in a working-age population that are actively employed or seeking employment—has experienced a multi-decade decline dropping to 63%, from its peak of 67% in the early 2000s (see chart). The fall is due to a rising share of retirees and a structural decline in participation of prime-age men (25-54) and young workers (see chart). To get just 1% labor-force growth (needed to achieve 4% growth, assuming 3% productivity), the overall participation rate would need to rise back to 65%—the equivalent of 25 million workers re-entering the labor force. This dynamic is unlikely, as it would not only require the participation rates of prime-age men and young workers rising back to their previous peaks, but also the participation rate of retiree-aged workers to stay at record levels.
Another way U.S. growth could accelerate to a higher rate would be if demographic trends reversed in the United States. This would require an explosion in population growth similar to what was experienced when the baby boomers entered the labor force en masse in the early 1980s, which pushed labor force growth to a peak of 2.3% per year. Given that the domestic workers that will enter the labor force over the next two decades have already been born, the only way to achieve this magnitude of reacceleration would be a surge in immigration.
Such a policy change to dramatically increase the flow of foreign workers into the U.S. economy seems highly unlikely in the current political environment. Even if it did happen, productivity growth would need to reaccelerate substantially as well. In other words, all of these constraints make a long-term move to a much higher level of real GDP growth an extremely challenging proposition.
Any cyclical boost in growth could be tempered by low multipliers
On a cyclical basis, changes to economic policy always have the potential to create sharper, shorter-term swings in growth. The lighter regulatory tone set by the new administration has already boosted small business and corporate sentiment, which has the potential to unleash business investment. However, even if deregulatory action overrides any anti-growth uncertainty about more restrictive trade or immigration policies, a jump from today’s roughly 2% growth to a sustained 4% would likely require a healthy dose of fiscal stimulus.
For the new leadership in Washington, stimulative tax-cut and infrastructure spending policies have been part of the early discussion. However, the impact of any fiscal stimulus may be inhibited by potentially low multipliers (i.e., how much growth is generated by easier fiscal policy). First, multipliers tend to be highest (the biggest growth bang for the fiscal buck) when the fiscal mix is more heavily weighted toward new spending, such as infrastructure.
Tax cuts, especially for entities such as corporations and high-income individuals that may not spend the money immediately, tend to have lower cyclical multipliers (see chart). While the policy outlook is highly uncertain and can change at any time, the early Republican plans have placed a heavier emphasis on corporate tax cuts and appear to give less priority to new spending.
Second, fiscal multipliers tend to be higher when the economy is running below its potential rate of growth and the Federal Reserve does not respond with tighter monetary policy. These conditions are most consistent with an early-cycle dynamic. This implies that fiscal stimulus boosts growth the most when the economy exits recession, as there is high unemployment and excess capacity, and the Federal Reserve is holding interest rates at a low level. More than seven years since the end of the last recession, the economy does not generally exhibit these early-cycle characteristics, meaning a lower fiscal multiplier might be expected (see chart, below).
Specifically, the economy exhibits elements of a more mature phase (mid to late) of the U.S. business cycle, with tight labor markets, monetary and credit conditions that are no longer easing, and peaking profit margins in the business sector. As a result, there is near-term upside potential if pro-growth policies are implemented, but a sustained acceleration may be difficult due to the constraints presented by the more mature U.S. business cycle (see Viewpoints: "Why the U.S. economy remains strong").
Asset allocation implications
Potential changes in U.S. economic policies continue to be a key focus for the financial markets. Some progress on regulatory relief has helped boost business optimism, but legislative plans for tax reform and other measures continue to lack clarity and may take some time to pan out. In this environment, the synchronized global expansion provides a solid growth backdrop for riskier assets. However, the potential upside from more stimulative U.S. fiscal policies may be constrained by the mature nature of the U.S. business cycle.
From an asset allocation standpoint, we continue to favor global equities. However, smaller asset allocation tilts are warranted due to the advanced stage of the U.S. business cycle, fuller valuations for many riskier assets such as U.S. equities, the wide distribution of potential policy outcomes, and rising geopolitical risk. As the U.S. proceeds further toward the late-cycle phase, exposure to inflation-resistant assets may become even more valuable to provide portfolio diversification.
- Read: Viewpoints: "Business cycle update: U.S. economy remains strong."
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A Purchasing Managers’ Index (PMI®) is a survey of purchasing managers in a certain economic sector. A PMI over 50 represents expansion of the sector compared to the previous month, while a reading under 50 represents a contraction, and a reading of 50 indicates no change. The Institute for Supply Management® reports the U.S. manufacturing PMI®. Markit compiles non-U.S. PMIs. The Consumer Price Index (CPI) is a monthly inflation indicator that measures the change in the cost of a fixed basket of products and services, including housing, electricity, food, and transportation. The S&P 500® Index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance. S&P 500 is a registered service mark of The McGraw-Hill Companies, Inc., and has been licensed for use by Fidelity Distributors Corporation and its affiliates.
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