Key Perspectives: Economic Outlook
With annualized GDP growth of 4.2% in Q2, most segments of the U.S. economy posted solid gains. The coming months will likely not be as strong, but current conditions suggest some cooling of the economy would be positive for the longer-term outlook.
Consumer spending contributed an exceptionally strong 2.6% to GDP growth in Q2, rebounding from a comparatively weak contribution in Q1.
Investment spending also contributed heavily. Tax incentives and efforts to improve labor productivity should support continued investment, but the aging economic cycle and uncertainty about trade have recently made businesses more cautious about spending.
Net trade, which typically subtracts from growth, was also particularly strong, contributing 1.2% to GDP growth. A rising dollar, the imposition of tariffs and the recent widening of the trade deficit all suggest that trade will contribute less in coming months.
Inventory liquidations subtracted 1.0% from Q2 growth. Once inventories have been drawn down, however, the reduced drag on GDP can offset lower growth in other areas.
Adding up the parts, U.S. growth for 2018 should range between roughly 2.7% and 3.0%. While that may not overtax resources shorter term, longer-term, that level of growth seems unsustainable. Given the underlying labor force growth and productivity gains, higher inflation seems likely if long-term growth markedly exceeds 2.0%.
But if the Federal Reserve can slow growth to a sustainable rate, the current expansion could continue for some time. That is easier in theory than in practice, but it is possible. Currently, the economy shows little risk of a major downturn over the next year. In 2019, we should see whether the Fed can make the transition that would allow an extended cycle.
Consumer spending strengthened markedly in Q2, contributing 2.6% of Q2’s 4.2% growth. In part, that strength compensated for the exceptionally weak Q1. Over the 1st half, spending’s 1.4% (annualized) contribution was very close to the 1.6% average contribution over the entire recovery.
As one important part of consumer spending, retail sales growth has remained strong, rising 6.3% y/y through July. That suggests the consumer will continue to contribute solidly to GDP growth in Q3.
Yet consumption will likely moderate in the coming months. YTD, consumption grew 4.4% (annualized), largely in line with the 4.8% (annualized) increase of personal income. Because Q2 spending made up for weak Q1 growth, however, it seems very unlikely consumers will sustain the very strong 6.2% (annualized) spending growth of the 2nd quarter.
Business investment also contributed heavily to GDP this year. The annualized contribution to GDP of 1.3% is roughly twice the 0.7% contribution over this recovery. Some argue an investment renaissance is under way, however a large share of the surge may reflect the shorter-term release of pent-up replacement demand.
Industrial production grew a strong 4.2% over the last year, with the strongest contribution coming from the energy segment of mining. While energy extraction continued to grow last month, that growth was diluted by contractions in other segments of mining.
Factory orders also showed solid industrial growth, as orders rose 7.7% y/y. Durable goods orders rose 7.2% and core business orders, a more direct reflection of capital expenditures, rose 7.8%.
Purchasing manager surveys, on the other hand, have lost some momentum. The ISM Manufacturing PMI declined 2.1 points to 58.1, although that still indicates a strong outlook. Respondents were clearly worried about trade, which suggests progress on negotiations could reinvigorate sentiment.
The ISM Non-Manufacturing (services) Index rebounded to 58.5, which indicates strong services growth. The Markit survey’s reading was weaker, however respondents also indicated they were passing higher costs along to customers, which suggests they have strong customer demand.
Small business surveys remain extremely strong. Both the Gallup Small Business Index and the NFIB Small Business Optimism Index remain at or near record highs. Smaller firms do particularly well when U.S. growth accelerates, as it has this year. Many small firms also benefitted heavily from lower tax rates. Small firms still report intense difficulties meeting staffing needs, but many trends remain favorable.
Inflationary pressures continue to build, although not yet to levels that would force stronger Fed intervention. The PCE headline index rose 2.3% over the last year, while the core index rose 2.0%. That leaves the core index exactly in line with the Fed’s long-term target.
The Consumer Price Index (CPI) typically shows higher readings than the PCE indexes, so although the CPI indexes both rose more than 2%, the readings should not pose major concerns for the Fed.
Rising input costs have certainly raised pipeline inflation pressures, but firms along the production pipeline have absorbed some of the cost increases rather than passing them all along to customers.
However, widening shortages of labor suggest wage increases could still become a catalyst for higher inflation. Economists estimate the labor force could sustain economic growth of 1.5% to 2.0%. Growth of 3.0% or 4.0%, however, seems unsustainable once people still on the employment sidelines have accepted jobs.
Trade and Overseas Economies
The U.S. dollar has been comparatively strong against overseas currencies, rising roughly 4% YTD. The index currently stands about 8.5% below the high of late 2016. The dollar typically rises when the U.S. economy is stronger than overseas economies. That argues the dollar should continue to rise. Trade conflict also suggests the dollar will be stronger than other currencies.
In the Eurozone, growth has slowed, although the 2.2% y/y GDP gain indicates few signs of an oncoming recession. A Markit PMI of 55.1 also suggests a strong outlook. The Eurozone’s PMI reading is almost identical to the 55.3 reading for the United States, but U.S. growth (2.9% y/y) has been much stronger.
The United Kingdom’s GDP growth eased to 1.3% y/y. That is 0.4% lower than it was last year and 1.3% lower than before the Brexit vote. Manufacturing has held up relatively well, due partly to a weaker currency, as a 52.8 reading on the Markit PMI confirms. Global slowing and Brexit uncertainties, however, have clearly impacted the broader U.K. economy.
Japan’s Q2 GDP growth slowed about 0.7% from last year, to a 1.0% y/y increase for Q2. The Markit PMI reading of 52.3 suggests a moderately positive outlook for manufacturing. Household spending has weakened this year but is not out of line with what has occurred in the past.
China’s Markit Manufacturing slipped to 50.8, showing a modestly positive outlook for growth. Exports grew 11.2% in the last report, having rebounded from declines from 2015 through early 2017. U.S. tariffs pose a threat to that growth, but the Chinese government has moved aggressively to offset their impact with stimulus measures.
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.