Economic Update QuarterlyLawry Knopp, VP-Funding & Hedging
For the most part, the major U.S. equity indexes have been on the up escalator since February of last year. The Standard & Poor’s 500 index was up over 10 percent prior to the election on Nov. 8, 2016, and up another 10 percent since. Investors and traders have adjusted to the large drop in oil prices that started in mid-2015 and have acclimated to the strongest dollar in over a decade. Some analysts do not believe this type of performance can be sustained, especially on increased policy uncertainty from the Trump administration and elections in Europe.
The Trump administration continues to generate policy uncertainty as it contends with excessive debt loads, less accommodative monetary policy and burdensome regulation while working to implement changes to tax policy, adjust trade policy and expand infrastructure spending and jobs.
Last week, we received the final report on Q4 real Gross Domestic Product, which indicated the economy expanded by 2.1 percent for the final quarter of 2016. On a year-over-year basis, the economy expanded at a modest 1.9 percent. Looking deeper into the report, consumer spending, which accounts for about 70 percent of GDP, fueled growth along with residential investment compared to Q3. Inventories also added to growth. Government spending, capital spending and net exports either lost momentum or were an outright drag on growth. GDP growth for Q1 2017 is projected to be similar to Q4 with the consensus forecast calling for economic expansion of about 2 percent, with the outlook for all of 2017 expected to be 2 to 2.3 percent.
Recently, the financial press has made a distinction in economic reports between “soft” data and “hard” data. Soft data often refers to surveys such as those conducted by the Institute for Supply Management (ISM manufacturing index) or The Conference Board (consumer confidence). Examples of hard data include reports on employment, GDP, industrial production and retail sales. Typically, surveys or soft data are viewed as leading indicators while reports on employment or economic growth are lagging indicators.
Soft data has recently been a little more optimistic while the actual hard data presents a more pessimistic view. This is the situation we’re facing when we look at the Q1 GDP projections from the New York Federal Reserve and the Atlanta Federal Reserve. The New York Fed’s Nowcast report, which is more heavily weighted toward soft data, is projecting Q1 GDP growth of 3 percent. The latest Atlanta Fed GDPNow report, which includes some survey data but more hard data – employment statistics, foreign trade reports, housing and retail sales analysis and durable goods orders – expects the economy to grow by 0.9 percent. Meanwhile, a survey of economists by Bloomberg projects Q1 growth of 1.9 percent. We will get our first look at the quarter in late April. Reality likely lies somewhere in the middle.
The February employment report from the Bureau of Labor Statistics indicated the unemployment rate fell by 0.1 percentage points to 4.7 percent, which was up from 4.6 percent in November, but near the lowest it’s been since mid-2007. New non-farm payrolls have been stronger lately with 235,000 new jobs in February and 238,000 in January. This compares to the six-month average of 194,000. While these are both positive signs, continued job growth exceeding the 230,000 level is likely not sustainable. In addition, structural issues remain as 94 million people are without a job and the labor force participation rate is hovering near a multi-decade low of 63 percent. Contributing factors to the sluggish employment outlook include the aging baby boomer generation and the skills gap for new hires. Nevertheless, economists are looking for the unemployment rate to gradually move down to 4.5 percent later this year.
Inflation is getting more airplay with overall consumer prices on the rise. Compared to a year ago, February consumer prices are up 2.8 percent with very little change in food prices while gasoline is up over 15 percent. The services sub-index, which includes housing, medical and transportation, is higher by more than 3 percent. Stripped of volatile food and energy components, the so called “core” rate of inflation is up 2.2 percent year over year. Economists are looking for overall inflation to finish 2017 around 2.1 percent and possibly 2.4 percent for 2018. The core rate of inflation is expected to end the year near 2.5 percent with similar indications for 2018.
Last month, the Federal Reserve’s Federal Open Market Committee (FOMC) tightened monetary policy by 25 basis points, which raised the target range for the Federal funds rate to 0.75 to 1 percent. The FOMC indicated the increase was warranted due to the expected improvement in labor market conditions and elevated inflation outlook. They went on to say, “The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.” Their preferred measure of inflation is based on the St. Louis Fed’s report Personal Consumption Expenditures, and typically runs about 0.4 to 0.7 percentage points below the consumer price index metrics. The Committee’s outlook calls for economic conditions to improve to a level that will warrant gradual increases in the funds rates, potentially two or three more 25 basis point rate hikes this year. Based on Fed funds futures, the market sees two possible rate increases this year with an 80 percent chance of an increase by September and a 50 percent probability of another rate hike in December.
The economy is nowhere near overheating with GDP growth projected to remain below 2.5 percent while inflation is expected to run between 2 and 2.5 percent over the next few years. Despite modest growth and moderate risk of inflation, the Fed continues to talk about normalizing policy rates, which some believe is their desire to keep some powder dry for the next downturn. The Fed believes the best approach is to gradually raise rates over the next few years. This may be possible, but policymakers must tread carefully to avoid tightening policy to the point of pushing the economy into a recession. Ultimately, the Fed would like to see the Federal funds rate get to the 2.5 to 3 percent range by 2019.
Some market analysts do not believe we will make it to 2019 without a recession occurring first. The risk of the economy slipping into a recession over the next 12 months, as defined by the New York Fed, is just over 4 percent. Their analysis is based on the slope of the Treasury yield curve, which is the difference between yields of the 10-year bond and three-month Treasury bill. When the yield on the three-month bill is greater than the 10-year Treasury yield, the curve is said to be inverted and the likelihood of a recession greatly increases. Going back to the 1960s, an inverted curve preceded every significant downturn in economic activity or full-blown recession.
Inverted yield curves are usually the result of the Federal Reserve tightening short-term rates to combat unacceptable levels of inflation or worries over an overheating economy. As short-term rates move higher, businesses find it more difficult to finance inventories, production and temporary storage, which drives companies out of business and increases unemployment. As job losses mount, worried consumers slow spending. As spending contracts and demand falls, more businesses fail, which leads to more job losses and the start of a “vicious cycle.” With the outlook for the economy and inflation moving lower, longer-term yields begin to fall. Typically, the Fed is slow to react as it waits for assurance that the economic issue that caused them to raise rates has been sufficiently addressed. Nevertheless, the yield curve eventually inverts and the economy soon after enters a recession.
Other people look at the length of time of an expansion and say the likelihood of continued growth lessens with each quarter of positive growth. These folks believe everything that goes up must eventually come down and would say recessions are event driven and the result of something breaking. A recent example would be home prices rising to unsustainable levels and borrowers extending debt levels beyond their ability to service or repay. Another example would be a geopolitical event (e.g., 9/11) which caused significant turmoil in the financial markets.
There are some measures that seem to precede recessions. We’ve already talked about an inverted yield curve. Another metric is consumer confidence. When consumer confidence gets very high, like it is now, sometimes a recession will follow within a few months to a year. Again, we don’t know what the trigger is, but some event usually starts the slide in economic output.
Despite various types of uncertainty, the U.S. economy has weathered many geopolitical events that have threatened financial market stability. Current potential threats to market stability include elections in France and Germany, ongoing extreme measures by foreign central banks to stabilize their economies, renewed sovereign-debt concerns involving Greece and Italy, and terrorism and turmoil in the Middle East. On March 29, the British government invoked Article 50 of the European Union treaty, which started the departure of the United Kingdom from the EU. Policymakers will work to maintain market stability through the process, but the risk of unintended consequences is elevated.
View on Interest Rates
Since year-end, U.S. Treasury yields have been mixed with the two-year yield up about three basis points to 1.22 percent, while the 10-year yield is down to 12 basis points at 2.32 percent. Trading ranges have been 1.14 to 1.38 percent for the two-year and 2.31 to 2.63 percent for the 10-year. Last month the Federal Reserve tightened monetary policy rates by 25 basis points, which pushed the prime rate up to 4 percent from 3.75 percent. This follows a 25 basis point rate hike in December 2016.
For now, the risk of a U.S. recession within the next 12 months seems low, likely in the 10-15 percent range. However, watch the yield curve and remain alert for potential triggers of an economic downturn. Short-term rates continue to be driven by anticipated Federal Reserve monetary policy while longer-term rates respond to inflation, economic growth, equity market volatility and geopolitical events. The consensus forecast has the two-year U.S. Treasury yield finishing 2017 near 1.85 percent with the 10-year yield near 2.9 percent.
The above commentary is a summary of select economic conditions prepared for Northwest FCS management. It is being shared as a courtesy. As with any economic analysis, it is based upon assumptions, personal views and experiences of those that provided the source material as well as those that prepared this summary. These assumptions, conclusions and opinions may prove to be incomplete or incorrect. Economic conditions may also change at any time based on unforeseeable events. Northwest FCS assumes no liability for the accuracy or completeness of the summary or of any of the source material upon which it is based. Northwest FCS does not undertake any obligation to update or correct any statement it makes in the above summary. Any person reading this summary is responsible to do appropriate due diligence without reliance on Northwest FCS. No commitment to lend, or provide any financial service, express or implied, is made by posting this information.