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Key Perspectives: Economic Outlook, December 2016

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Conventional wisdom held that a change of political control,and a largely unknown candidate, would cause equities to drop. Instead, they rose sharply after the election. While the market gains were interpreted as enthusiasm for political change, the rally probably also reflects improving economic conditions.

Economic outlook chart 

The U.S. economy has improved markedly this year.

Early on, as the energy complex contracted, the industrial economy seemed to be sliding into recession. Industrial activity is still limited by sluggish growth, but the exceptionally slow start to 2016 opened the door to faster growth in the second half. 

As markets speculate about the potential for a significant surge of government and private spending under a new administration, some economists question that too much spending would cause the economy to overheat. Labor markets have tightened, causing some to fear that the economy might not be able to absorb a major spending increase without unleashing significantly higher wage inflation. 

Realistically, the new administration must overcome several significant hurdles if it wants to implement major tax and spending legislation. And that cannot happen quickly. Given the realities of Washington, we should not overestimate how much tax or spending stimulus the government can provide over the next year. 

The number of people unemployed for long periods of time and capacity utilization statistics or operating rate suggest the economy may have more ability to absorb increased demand than some fear. Weakness in the manufacturing sector and an aging cycle may also give the economy some slack to handle new demand. Rising interest rates and a higher dollar will also tend to create a little more room in the production system for increased demand.

As we enter the mature phase of what has been a sluggish economic cycle, the good news is that the economy has put a lot of people back to work and is still growing at a respectable pace. The ability to grow the labor pool and the productivity of that pool limits the ability of the economy to grow without generating inflation. Some slack still remains, but at this stage, surging demand could generate wage inflation if firms have to scramble for employees to meet new demand. Extending the cycle, by respecting the economy’s natural limits, may be the best way to move it forward.

Consumer spending

Tightening labor markets are starting to produce stronger wage gains for consumers and in the last two months consumers have started to spend more liberally. Part of that spending may reflect a catch-up for weaker spending earlier in the year, but a number of consumer confidence surveys indicate consumers feel more optimistic. 

This should be the sweet spot in the economic cycle for consumers, where income gains improve, and inflation is still contained. Thus, while there are signs that service prices have started to accelerate, consumers have seen some improvement in the inflation-adjusted income they have to spend. Health care, college tuition, and other significant budgetary costs remain concerns. Still, improving income trends combined with conservative spending earlier this year could allow consumers to provide a little

Business activity

The strength of manufacturing, which tends to be more sensitive to the economic cycle than many business services, often indicates the health of the business sector. Using the ISM Manufacturing Index as a gauge, the manufacturing sector has clearly improved this year. The strength of manufacturing, which tends to be more sensitive to the economic cycle than many business services, often indicates the health of the business sector. Using the ISM Manufacturing Index as a gauge, the manufacturing sector has clearly improved this year.

January’s reading of 48 indicated a modest contraction of manufacturing, as the economy absorbed the downsizing of the domestic energy complex. November’s reading of 53.9 shows that the manufacturing economy is again growing at a moderate pace.

That still leaves room for improvement, but realistically, manufacturing growth moderates as economic cycles age. With the recent reading at 53.9, the index stands well below its peak of 59.2 in March of 2011 and the more recent peak of 58.1 in August of 2014. While rising interest rates and a higher dollar will make it harder for manufacturing to accelerate significantly, solid growth still seems possible.

Shorter-term, businesses have seen a better balance of sales and inventory growth. The latest figures show that business sales rose 0.7% while inventories increased only 0.1%. Although inventory levels remain elevated, they are coming down. Once inventories come under control, production levels should expand.

The prospect of regulatory overhaul under a new administration has generated a surprising amount of optimism. Businesses have often complained that the costs of understanding and complying with government regulation have kept them from expanding their operations. That is particularly true for smaller businesses, which provide a large share of business growth. Regulatory relief may take more time than investors anticipate, but reduced restraints may help to improve U.S. growth.

Overseas economies

As has been the case for the U.S. economy, the global economy has also improved. The Global Purchasing Managers Index (PMI), which focuses on manufacturing activity, rose to its highest level in two years. Moreover, 75% of the world’s economies that have PMIs are currently expanding. We have clearly seen an improvement in 2016. Growth rates are still not extraordinarily strong, but most international economies are at least moving forward. 

Still, many international economies face hurdles that are not an issue for the United States. Europe still faces the implications of the Brexit vote, as that region works out the details of the United Kingdom’s departure from the European Union. There are also concerns over rising political opposition to the Eurozone in Italy, France, and some other European countries. The political uncertainties in that region make it harder for businesses to plan for the future, and make businesses more reluctant to drive economic growth with significant new investments. 

Economic growth has also improved in Japan, despite the appreciation of its currency. With signs that recent strength may not be sustainable, however, the Japanese government worries that it is running out of policy options to generate stronger growth. Japan lacks the domestic economic strength of the United States and Europe’s monetary options. That leaves their economy more dependent upon the growth of the global economy and the strength of their currency. 

Australia continues to show solid economic growth, as that country and other countries in the Pacific region have benefited from strong government spending in China. There are signs that the stimulative effects of the Chinese spending are waning, and that may weigh on many of the Pacific region economies. 

A number of the emerging markets also seem to have been leveraged to China’s spending, especially as it helped support the price of commodities. Dollar strength also tends to weigh on many of the emerging economies. Given those factors, 2017 may not be as good for the emerging economies and markets as 2016 has been.

For questions, please contact your Key Private Bank Portfolio Manager.

About Bruce McCain

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 Bruce joined a predecessor of Key in 1987, after spending six years on the business faculty of the University of Iowa’s Henry B. Tippie College of Business. Bruce earned a PhD in Business Administration from the University of California at Berkeley, and undergraduate degrees in Psychology and Accounting from Boise State University.

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