Key Perspectives: Economic Outlook, October 2018
Some believe the strong second quarter gross domestic product (GDP) report proves the US economy has finally overcome the sluggish growth of this economic cycle. Certainly, the combination of lower taxes, reduced regulation, and increased federal spending have provided a strong tailwind for the economy this year.
Yet the question is not whether the economy has strengthened, but whether this growth rate can be sustained. Higher interest rates should reduce growth in the coming months. Longer term, limitations of labor and other critical resources will govern how fast the economy can grow without a breakout of inflation. Labor constraints suggest a 4% GDP growth rate is unsustainable longer term.
While inflation has remained contained so far, recent comments from the Federal Reserve (Fed) members suggest they still fear inflation more than recession. That implies they are willing to risk raising rates higher than many economists expect in 2019, increasing the odds of a significant downturn further out.
Yet for now, the economy remains vibrant. Consumer spending bounced back after a weak first quarter and remains strong. Income growth has improved. Given tight labor markets both income growth and spending should continue to accelerate. That should provide a firm base for economic growth in the coming months.
In addition, capital spending in 2018 has continued to grow roughly twice as fast as it has over the full cycle. Energy development and improved labor productivity remain important drivers of new investment.
Admittedly, labor shortages pose a major challenge. Job candidates with specialized skills are particularly hard to find. At the current rate of job growth, the pool of employable persons will eventually run dry.
Wage rates are trending higher and will eventually put more pressure on inflation if employers pass that extra cost along. Fortunately, so far, inflation remains at levels the Fed should tolerate.
The trade deals struck with Mexico and Canada, and signs that a deal with European countries may be possible, should allow businesses worried about trade to breathe a little easier. Despite concerns about the potential end of this economic expansion, there are no indications it will end soon. Moreover, if the economy can slow modestly without sliding into recession, this cycle could continue for some time.
Consumers are confident, and with good reason. Jobs are plentiful, particularly for those with the right skills. And incomes are rising, especially after the tax reductions. Not surprisingly, spending has been strong.
Strong confidence can encourage consumers to spend more than they earn shorter term. Longer term, however, spending grows in line with incomes. Personal income grew 4.7% over the last year and 4.5% year-to-date (YTD) on an annualized (AR) basis. The broad measure of consumption grew roughly the same amount, 4.6% AR YTD.
Both the broad consumption numbers and the retail sales data reveal a weak first quarter followed by an abnormally strong second quarter. Accordingly, while the growth rate achieved over the first half seems sustainable, the spending rates of the second quarter seem unlikely to be maintained longer term. The sustainable rates of income growth and spending seem more consistent with 3% GDP growth than with 4% growth.
Capital spending has risen roughly twice as fast this year as it has over the entire expansion. That is particularly impressive, given that fears of trade conflict, the aging cycle, strong competition, and the difficulty of finding enough skilled employees have likely restrained some investment.
New capital spending (CapEx) orders illustrate the strength of investment spending. Over the last year, orders rose 7.5% while the annualized growth YTD is up 9.0% AR. That is well above the 3.5% AR rate of growth over the course of this cycle.
Industrial production certainly has improved as the year advanced, rising 2.6% AR in the first quarter and 3.6% AR in the second. And the third quarter shows signs of even faster growth. Energy exploration and development has been a major part of that strength, so rising energy prices suggest that part of industrial production will remain strong.
Most economists expect, however, that U.S. economic growth will moderate in the coming months. That is consistent with the trend of the Markit Manufacturing PMI, which has slipped 1.8 points over the last three months. The 54.7 reading still indicates a strong outlook, but more on a par with other regions of the world (e.g., the Eurozone).
The Personal Consumption Expenditures (PCE) core index hovered right at the Fed’s 2.0% target in the last report. Year over year, the Consumer Price Index (CPI) actually eased a bit. The year over year (YOY) Producer Price Index (PPI) for final demand also declined this month. As yet, therefore, the level of inflation has not made the Fed too uneasy.
However, energy remains a strong driver of inflation costs. While “direct” energy costs are excluded from the “core” statistics, “indirect” energy costs are imbedded in the prices of other core goods and services with a lag. With the rise we have seen in oil, that will remain an indirect pressure on core prices over the coming months.
And while wage growth has accelerated sharply, the measures have steadily trended higher. At a minimum, that suggests rising wages will put pressure on corporate profits. Whether it also puts pressure on inflation depends upon the pricing power companies have. If competition limits businesses’ ability to pass increased costs through to customers, inflation may remain milder than wage growth would suggest.
Trade and Overseas Economies
In 2018, U.S. growth accelerated while overseas growth slowed modestly. The favorable US differential should shrink, as US tax and fiscal benefits wane and as rising interest rates slow domestic growth. It also appears overseas economies should be less restrained by resource shortages than the US economy will likely be.
Short term, the export-sensitive Eurozone growth has deteriorated as the euro strengthened. This is relative to most other currencies, and as global growth eased. Growth in the Eurozone eased to 2.1% YOY in the second quarter, softening modestly from last year’s growth rate. The 2.9-point decline in the Markit PMI over the last year affirms a softening outlook, although the current 54.6 reading for the Eurozone still indicates favorable growth.
The outlook for the UK also declined, due in part to rising prospects of a hard Brexit. UK GDP grew only 1.2% YOY, which was significantly slower than last year’s growth. The Markit Purchasing Manager’s Index (PMI) dropped to 52.8, suggesting moderate growth, and is down 4.1 points over the last year.
Japan’s economic cycle seems mature, and despite strong monetary stimulus, they still are locked in very sluggish growth. Japanese GDP grew only 1.3% YOY. It also recorded a modest PMI of 52.5, which is essentially flat over the last year.
The emerging economies have felt the stress of slowing global growth. Trade tensions have also posed major concerns for some of the emerging economies. And a stronger US dollar has also impacted a number of the emerging economies. Yet for many of those countries, the Markit PMIs and outlook have not deteriorated radically. As a group, in fact, the emerging economies seem less subject to adverse global trends than they have been in past.
To learn how October’s economic outlook impacts your portfolio, contact your Key Private Bank Advisor.
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.