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Key Perspectives: Economic Outlook, March 2017

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Currently, the economy presents some contradictions. Growth remains sluggish by historical standards, as the economy continues to suffer from significant excess manufacturing capacity. Yet, both here and abroad, economic growth improved markedly over the last year. That economic acceleration and the expectations created by the changes in Washington have raised hopes for even stronger growth going forward.

The partial recovery of energy prices is a large part of what stabilized the economy. Not only has that lifted energy activity, but renewed exploration and production has also helped boost manufacturing activity.

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The downside has been higher inflation, with the rise in energy prices propelling the Consumer Price Index markedly higher. Since energy prices seem unlikely to continue rising, we may have seen the worst of the inflationary pressure. Notably, however, the index that excludes energy and food rose by 3.8% in January, which means that other areas are also adding inflationary pressure.

Consumer spending has remained comparatively strong, helped no doubt in part by the general anticipation of economic improvement. But since spending growth has run well ahead of income gains over the last year, spending growth seems vulnerable to moderation in the coming months.

Expectations of improving growth are clearly running high. Major new spending programs and tax reductions seem less likely than regulatory reform, but potential improvement is certainly there. Improvement may not occur quickly, however, and the economy has benefited from several trends that may wane in the coming months. Accordingly, while we retain a positive outlook, we are concerned there may be setbacks along the way.

U.S. consumer spending

Consumer confidence measures remain at or close to major highs, although there are signs the positive momentum is weakening. To this point, the public has taken the promise of improvements on faith. Now, they may need to see results.

Consumers increased their spending faster than their incomes grew for a good part of 2016 and that trend seemed to continue into 2017. Retail sales rose sharply over the last two months, although admittedly, higher gasoline prices were an important part of the increase. At some point, however, spending needs to come back in line with incomes.

Rising costs of living could also weigh on discretionary consumer spending in the coming months. The Consumer Price Index (CPI) jumped a very strong 6.8% (annualized) as energy prices surged. Since the index that excludes energy and food prices also rose a strong 3.8%, however, basic living costs are clearly rising faster as well. The 3.6% annualized rise in the Services Producer Price Index also suggests that stronger inflationary pressures will continue.

U.S. business activity

The business outlook has improved significantly over the last year. After bordering on contraction in early 2016, February’s U.S. ISM Manufacturing Index rose to 56.0 (a reading over 50 indicates economic growth while a reading of 56.0 shows strong manufacturing momentum).

Business owner sentiment improved over the months leading up to the election, and then skyrocketed as that group considered the potential for new government policies. In January, the NFIB Small Business Optimism Index edged up to the highest level in over a decade.

U.S. industrial production has largely stabilized on the energy rebound, even though January’s reading edged lower due to reduced utility output that resulted from the comparatively warm weather. Manufacturing output rose modestly while mining output shot up 2.8% on the rise in energy production. Industrial production still remains below its peak during the height of the energy boom, but has recovered about 36% off the low last year.

Overseas economies

Most overseas economies have seen improving growth, but growth is still not overly strong in many areas.

Economic growth in the Eurozone has remained modest, rising at an annualized rate of 1.6% in the fourth quarter of 2016. Leading indicators, however, suggest further improvement. The Markit Purchasing Manager Index (PMI) provides a gauge of manufacturing trends. For February, the Eurozone PMI stood at 55.2, which is consistent with improved economic growth.

The U.K.’s economy grew at a robust 2.8% (annualized) in the fourth quarter, which is a sharp acceleration from the 1.4% growth recorded over the prior year. Given the uncertainty about how Brexit will affect the United Kingdom’s economy, the acceleration of growth is somewhat surprising.

The Asian economies have not fared quite as well. Japan’s economy grew only 0.5% over the prior year for the fourth quarter. The preliminary Markit Manufacturing index rose to a modest 53.5 as the Services index fell to a sluggish 51.9. Japan’s industrial production rose only 0.7%.

Growth in Australia has also decelerated. That economy grew 2.0% year over year, but reported only 0.9% growth (annualized) last quarter. Moreover, capital expenditures fell 2.1% in the last quarter after falling 3.3% in the previous quarter, which indicates deteriorating growth in the economy.

Indicators for Hong Kong’s economy have been mixed. In the fourth quarter, the economy grew a relatively strong 3.1% year over year. In contrast, retail sales posted significant declines for each of the last two months.

China’s economy staged a strong revival over of the course of 2016, illustrated by the Markit Manufacturing index’s rise from 48.0 (indicating contracting activity) to 51.6 in February (indicating modest growth). For the first time in almost twelve months, exports rose over the year ago level, while imports rose over the last three months compared with the prior year numbers. China remains challenged, but at least it is showing improvement.

Domestic export growth will depend heavily upon the dollar’s trend. After rising sharply on high expectations after the election, the dollar pulled back somewhat in January. While significant weakness seems unlikely near-term, the dollar’s path in the coming months will depend in part upon whether Washington can live up to the lofty expectations of the financial markets.

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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