Key Perspectives: Economic Outlook
It is very difficult to navigate the sort of economic conditions we are currently experiencing. Positive leading economic indicator readings assure us recession is unlikely, but there is no guarantee the current slowdown will stop short of that. As growth slows, therefore, recession anxieties may drive more market volatility.
Fears of recession rise when important leading indicators turn negative, like inverted yield curves (where short-term interest rates rise above long-term rates). Although indicators with solid historical records should not be ignored, they need to be confirmed by other indicators. The breadth and timing of the descent into recession allows us to wait for multiple warnings rather than having to react quickly to the first few. At present, while some indicators have softened, comparatively few show strong evidence of the conditions that normally lead to recession.
Consumers cut back on spending in December and have remained cautious into the first quarter. To this point however, surveys do not indicate a serious loss of confidence. That makes it likely stronger spending will resume once reserves build and we get a little more distance from the recent market drop. Strong labor markets provide both job security and improved income. If employment remains solid, consumers should make up for lost spending later this year.
Business confidence has not rebounded, particularly at firms with international exposure. A resolution of the trade disputes is essential, but it will likely take more to revive strong international growth. China has implemented a major stimulus program, which should have a stronger impact on international growth later this year. However, until some of the questions about domestic and international growth are resolved, businesses will likely remain careful about what they spend.
On the positive side, inflation remains well contained. The prospect of slower economic growth should reduce inflationary pressure even more. Aside from what that does for buyers of goods and services, it gives the Federal Reserve (Fed) added flexibility.
That flexibility certainly made it easier for the Fed to decide to hold interest rates steady in 2019. At current levels of inflation, lower rates probably would not hurt, but the modest indications of recession thus far also suggest significantly lower rates are not needed. For the next few months, it seems best to avoid any major moves.
People were unnerved by the stock market drop in December, so it is not surprising consumer spending was weak at that time. But consumer spending weakness has continued into the first quarter. Traditional channels of retail sales and auto sales both showed weakness as consumers cut back.
Yet consumer surveys showed a solid rebound in confidence. Apparently, people are simply not confident enough to spend aggressively. However, core consumer confidence stems from job and income security. Thus, once the economy shows stronger signs of stabilizing, spending should improve.
In the meantime, consumers are building spendable reserves. That means improved confidence should unleash a period of strong catch-up spending. That may not happen in the next few months, but it should be an important source of growth later this year.
Business sentiment has not recovered appreciably. Declining domestic growth and an uncertain outlook for trade have weighed on the confidence of most businesses, particularly those exposed to international markets.
Industrial production weakened slightly and remains vulnerable, at least shorter term, to lower business sentiment. Manufacturing started the quarter on a particularly weak note. Although oil production increased, drilling activity declined. Were it not for surging utility production, industrial production would have been even weaker.
While capital spending (capex) improved into the summer of 2018, it then declined through the latter months of the year. This has been the weakest investment cycle since the late 1940s. The reluctance to invest suggests firms face intense competition or other issues that limit returns on investment.
At the same time, increased capital spending is vital to the longer-term productivity improvement that will be needed as the baby boom generation retires. Productivity has improved modestly over the last year but remains well below what we have achieved historically.
Inflation has subsided in recent months and tends to decline as the economy slows. Some economists have therefore worried that the slowing economy will turn weak inflation into deflation, where prices fall dangerously. That seems like a remote risk, however, and the benign level of inflation gives the Fed flexibility with respect to its rate policy.
The Personal Consumption Expenditure (PCE) indices both fell below the Fed’s target rate of 2.0%. The headline index rose only 1.4% year-over-year (YOY), down from a gain of 2.4% last summer, due largely to lower oil prices. While oil prices have recovered part of their decline, the increase so far has not caused much concern. The core PCE index, which excludes food and energy prices, was up 1.8% over the last year. The high-water mark for that index over this cycle was 2.1%.
Wages have accelerated, reflecting the tightness of the labor markets. Average hourly earnings for private industry workers rose 3.4% over the last year. Still, the 1.8% YOY gain in non-farm labor productivity should offset much of the inflationary impact of wage gains. Business surveys report pricing power is limited, but if firms cannot pass costs along to customers, wage gains do not generate inflation.
Trade and Overseas Economies
Global economic activity has moderated over the last year despite very accommodative monetary policies. Some of the weakness, such as with German auto production, should be resolved soon. Other weakness, like Chinese slowing, depends more heavily on trade agreements and government stimulus that will take time to impact growth.
Eurozone growth slowed through year end. At a reading of 47.5, the Eurozone’s Purchasing Manager Index (PMI) indicates manufacturing will continue to struggle over the next few months. Recession seems unlikely, however, and growth should improve. The emissions changeover in the German auto industry limited production in that critical industry last year, and growth should improve as auto production normalizes. The lack of a clear agreement on Brexit has undoubtedly discouraged some European activity. Although that uncertainty has dragged on, it should be resolved eventually. Finally, China’s economy has historically had a strong impact on Europe. The potential for stronger Chinese growth therefore offers potential upside for Europe as well.
Brexit continues to hang over the United Kingdom (UK), and the political impasse makes it difficult for businesses to plan. Although UK growth was only 1.3% over the last year, growth has remained more stable than in other parts of the global economy. At 55.1, the UK’s Manufacturing PMI is one of the strongest in the world. The strength may partly reflect the advantage of a relatively weak currency.
Japan grew very little in the last half of 2018 despite continuing efforts to stimulate stronger growth. Legislation was recently passed, however, that should encourage consumer spending. That may be particularly effective in the coming months, as an increase in the Value Added Tax (VAT) will take effect this fall. In the past, spending has increased as consumers sought to avoid the higher VAT costs.
China is attempting a major economic pivot, like the one they achieved in 2015/2016, through a massive stimulus. The early signs are encouraging, although it takes the better part of a year for stimulus to work through an economy. If the earlier experience holds, improved Chinese growth should help generate stronger global growth as well.
The Fed has vowed to be patient this year. That is good advice for the rest of us as well. While US growth is slowing, a recession still seems unlikely. And there are early signs of improving growth overseas. We need to cautiously monitor the indicators, but serious deterioration takes time to develop. The financial markets may find it difficult to patiently wait and watch, but at present that seems the right thing to do.
About Bruce McCain, Ph.D., CFA®
Bruce McCain is the Chief Investment Strategist for Key Private Bank, where he monitors the economy and the financial markets and serves as part of the team that formulates investment strategies for clients. He supplies frequent insights to media throughout the region and around the country. His comments and interviews have been featured in such publications as The New York Times, The Wall Street Journal, Investor’s Business Daily, and Business Week, as well as on television outlets such as CNBC and Bloomberg TV. He is also a regular source for wire services such as the Associated Press and Reuters and is a Contributor on Forbes.com.