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Key Perspectives: Economic Outlook

As we have often seen, political and geopolitical anxieties are making investors nervous. It seems unlikely Congress will fail to raise the debt ceiling, or that Kim Jong Un will provoke a major military clash. But nothing is certain, giving investors room to worry.

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Unless these worries translate to meaningful economic damage, however, the selloffs that often accompany such anxieties usually provide buying opportunities rather than reason to sell. With signs that a period of synchronized global growth has begun, the economic growth should fuel continued equity gains.

Yet while growth has broadened across the world, there are few signs of the excess that end growth cycles. Tight resource utilization usually drives inflation higher, which monetary authorities fight with higher interest rates. So far, this cycle has not reached that stage.

Inflation has, in fact, been much lower than expected. The seasonally adjusted Consumer Price Index (CPI) posted a 1.7% annualized increase over the first half of 2016, and then accelerated to 2.7% over the second half of last year. For the six months ended in July, however, the CPI was essentially flat. That falls significantly short of the Federal Reserve's long-term 2.0% target. With inflation measures low and falling, the Federal Reserve members are reportedly rethinking how quickly they should tighten monetary policy.

Often, wage and salary increases help drive inflation at this stage. While total employee compensation rose at a solid clip in June and July, average hourly earnings rose only 2.5% over the last year. Weak productivity gains are not offsetting wage increases like they have in the past. That may have made firms slower to add new hires.

Still, labor markets continue to tighten. Recent jobs data show that the number of job openings rose 8% while the number of actual hires declined slightly. And the National Federation of Independent Business reported that a net 35% of businesses have job openings they cannot fill.

Wage pressures may simply be building. One major survey reported that a record percentage of Human Resource professionals say they are paying more for new employees. Anecdotally, we also hear that many employers would gladly pay higher wages if they could simply find people to hire.

On the positive side, accelerating wages would give consumers more money to spend. Consumer spending has been notably anemic this year, even though consumer sentiment remains very positive. Improved income growth could be a strong catalyst for increased spending growth, which in turn could open the door to even stronger economic growth.

U.S. Consumer Spending

Judging by retail spending numbers, consumers were more cautious in the early part of 2017. Retail sales grew 3.5% over the first six months of 2016 and 4.6% over the last six months. This year, however, sales have risen at an annualized rate of only 2.0% over the first seven months of this year. That falls below the 2.6% average retail sales have grown since the end of the last recession.

Some of that may reflect reduced spending on large ticket items. Auto sales hit a 16.7 million unit annual rate in July, which is down from the 18.1 peak rate last year. The current level is still robust, but the decline makes a significant difference to total spending.

The housing sector also tends to be a strong driver of consumer spending, and we have also seen some weakness there. Existing home sales were down again in July. Lack of inventory has reportedly reduced sales. Yet housing starts and permits have also weakened. That suggests builders are not filling the gap. Affordability of homes has also played a role, as prices and loan rates have both risen.

Reduced income growth may also have slowed spending. Personal incomes have grown 3.9% since the end of the last recession, but rose only 2.7% over the last year. Much of that slowing seems to have occurred in categories other than wages & salaries, but faster wage growth could help offset weakness in other areas.

Over time consumption tends to parallel income growth. Consumer sentiment remains very positive. If income growth improves, we should see better spending growth.

U.S. Business Activity

Industrial activity has recovered nicely since the early months of 2016. Durable goods orders for July showed an 8.1% y/y increase. Core business orders advanced at the strongest rate in several years. At 52.8, the U.S. Markit Purchasing Managers Index (PMI) is not as strong as in some overseas economies, but does indicate solid manufacturing growth.

July's 5.8% y/y rise of exports was respectable given the competitive disadvantage of the dollar's value. The gain probably reflects the improving health of major world economies. If the dollar continues to weaken, U.S. exports may start to provide a more-significant contribution to growth.

Overseas Economies

Overseas economies continue to show improved growth. The Eurozone grew in line with the U.S. economy over the last year, with a 2.2% growth rate. The growth there also seemed nicely balanced, with industrial production up 2.6% and retail sales rising 3.1%. The Markit PMIs also show the balance, with the Manufacturing PMI at 57.4 and the Services PMI at 55.4.

The United Kingdom exhibits signs of weaker growth, but that economy has held up fairly well given the political turmoil. The y/y GDP growth rate was a respectable 1.7%, although quarterly growth slowed to a 1.2% annualized rate. Industrial output was down roughly 3.6% over the last three months and manufacturing output fell 0.4%. That may reflect some of the Brexit strain.

Japanese growth has improved. Quarterly GDP rose 4.0% (annualized), markedly more than in most economies. Japanese exports also showed double-digit growth in recent months, while y/y retail sales have risen from close to 1.0% at the beginning of the year to roughly 2.0%. Conversely, industrial output and machinery orders still look weak. With a PMI of 52.2, the outlook for manufacturing is positive but modest.

The emerging economies are growing, but they have not accelerated as much as the world's developed economies. Many Chinese statistics do not show enough variation to draw strong conclusions, but exports have improved this year. The Manufacturing PMI has remained steady, but at 51.7 shows a modestly positive outlook. Brazil has more somber prospects. GDP is up just 0.3% y/y, with industrial output growing only 0.8% over the last few months. Retail sales growth was positive, but just barely. Still, a Manufacturing PMI reading of 50.9 indicates that manufacturing should continue to grow.

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 Forbes.com. 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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