April 03, 2018
A Weaker Start to the New Year Amid Increased Market Uncertainty
Lawry Knopp, VP-Funding & Hedging
The Bureau of Economic Analysis is getting ready to release its final revision to the Q4 2017 Gross Domestic Product, which is expected to come in around 2.5 percent. This compares to real growth rates of 3.1 and 3.2 percent for the second and third quarters, respectively, and indicates economic activity is continuing to expand, albeit at a slower pace. The economy remains near full employment with the latest reading showing an unemployment rate of 4.1 percent. Job growth remains moderate with non-farm payrolls expanding at an average of about 200,000 a month. Economic and financial themes mentioned last quarter remain in place, which include decent synchronized global growth despite elevated volatility, modest inflation and a gradual withdrawal of monetary stimulus with a handful of geopolitical concerns.
Headline inflation, expressed as the consumer price index (CPI), is running at 2.2 percent compared to a year ago February. At the same time, the Federal Reserve’s preferred measure of inflation – year-over-year core personal consumption expenditures (PCE), which excludes food and energy prices – is expanding at a rate of 1.5 percent. Differences between CPI and PCE are related to slight differences in the composition and weightings of the items included in the indexes. The Fed’s target for core-PCE is 2.0 percent.
Many of the headwinds for 2017 have carried over into 2018 as the Federal Reserve continues to tighten monetary policy, while excessive debt loads and aging demographics tend to limit growth. Adding to these concerns are rising interest rates, greater uncertainty in the equity markets and the potential for increased tensions between the U.S. and its trading partners. Meanwhile, tailwinds benefiting the economy include increased use of robotics and automation; relatively low oil prices; decent consumer confidence and spending; and tax reforms and regulatory relief.
The economy likely grew by 1.5 to 2.0 percent during the first quarter as consumer spending and business investment slowed with the advent of 2018. However, economists are optimistic tax reforms will provide a boost to the economy for the remainder of the year with GDP for 2018 projected to come in around 2.75 percent. Consumer spending is expected to expand by 2.7 percent while higher interest rates and tax reforms will likely slow the rate of growth for the housing sector. Business spending is forecast to be near 5.0 percent. Potential wildcards for growth in 2018 include net exports, which could be negatively impacted as the Trump Administration takes a more aggressive stance on trade and tariffs while dollar weakness could boost U.S. competitiveness in foreign markets.
The market is looking for continued gradual improvements in the labor sector as the unemployment rate is forecast to slip below 4 percent later this year. As mentioned earlier, job growth continues at a modest pace while wages are growing at about 2.6 percent, which is barely above the overall headline rate of inflation. Compared to a year ago, employment is up 1.6 percent with over 2.3 million new jobs created.
Meanwhile, inflation remains a concern as pressures appear to be building at the consumer level. The three- and six-month average annualized percentages are now up over 3.5 percent. A deeper look at the numbers indicates services-based inflation, i.e., housing, transportation and medical, are the primary drivers. While gasoline prices are up 12.6 percent compared to a year ago, the relative weighting on the index is less than 4 percent.
As for the Federal Open Market Committee (FOMC), the policy-setting group for the Fed, the threat of rising inflation is a concern as both CPI and core-PCE are expected to see modest increases during the first half of the year. Look for the inflation metrics to ease somewhat during the second half of the year as the outlook for month-over-month inflation stabilizes.
Last week, in a move largely expected by the market, the FOMC increased its federal funds target range by 25 basis points to 1.5 to 1.75 percent. Commercial banks followed suit and raised the prime rate to 4.75 percent. Based on recent performance of the economy, the FOMC believes the labor market continues to strengthen while economic activity is expanding at a moderate pace.
However, the latest reports indicate the growth rates for consumer spending and business investment have slowed somewhat, while the rate of inflation remains below the committee’s 2 percent target. Some market analysts believe the Fed is looking past recent signs of softening and the FOMC will continue gradual “adjustments in the stance of monetary policy.” The committee appears confident the economy will grow at a moderate pace in the medium term while labor conditions will remain strong. Policymakers see the near-term risks to the outlook as “roughly balanced,” but will monitor inflation metrics closely. The Federal Reserve will continue unwinding its balance sheet at a pace of $20 billion per month, which will increase to $30 billion per month in April.
In addition to the increase in rates, the projected pace of future rate hikes was steepened and accelerated for 2019 and 2020. The Fed may be assuming a greater impact from tax reform for this year and next. Nearly half of the committee members projected four rate hikes this year while the remaining forecasted two to three increases. Projections for the federal funds rate for the end of 2019 averaged 2.9 percent, which implies four to five more rate hikes over the next 12 to 24 months. The next 25-basis-point rate hike could come as early as June.
Other short-term rates are moving higher along with monetary policy rates. LIBOR has moved up in anticipation of more Fed rate hikes. Also contributing to the increase is the large amount of new supply in the market, specifically T-bills by the U.S. Treasury. Credit market concerns are also pressuring LIBOR rates as investors look to reduce exposure to weaker credits and focus on quality, which is pushing high yield spreads to their widest levels in about six months.
The Trump Administration’s stance on tariffs on Chinese imports continues to get airplay as President Trump recently signed an Executive Order instructing U.S. Trade Representatives to levy at least $50 billion of tariffs on goods imported from China while additional tariffs remain on the table. In addition to the tariffs, the President directed the Treasury Secretary to propose new investment restrictions on Chinese companies to safeguard technologies viewed as strategic.
For some perspective, the U.S. economy is $19.7 trillion with exports amounting to $2.4 trillion while imports total $3.0 trillion. The current tariff on cars imported from China is about 2 percent while Chinese tariffs on cars imported from the U.S. are around 25 percent. The Administration is seeking a level playing field for U.S. businesses and protections for intellectual property. Fears of a global trade war have escalated with business executives and some foreign central banks weighing in with negative responses. China’s response, as anticipated, was that retaliatory measures would be taken against U.S. goods imported into China, with speculation that aircraft, industrials and agriculture will be the sectors targeted. Meanwhile, U.S. officials have downplayed the potential for an escalation from here on predictions the strong U.S. stance will bring concessions through negotiation rather than retaliatory actions.
Investors and traders are contending with multiple forces bearing down on the markets. It was hoped that tax reform would provide a boost to the economy as tax burdens would be reduced while other provisions would reform the tax code. However, a Federal Reserve worried about rising inflation and a strengthening economy continues to apply the brakes as it removes liquidity by raising policy rates and reducing the amount it reinvests from maturing holdings. Despite solid corporate earnings, the equity markets remain cautious as fears of a trade war add to investor unease. Also contributing to market anxiety is the recent 2018 Omnibus Spending Bill approved by Congress, which left most lawmakers holding their noses as they voted for the legislation. President Trump signed the bill as he expressed much frustration with the shortcomings of the spending plan. The bill funds the government through September.
View on Interest Rates
U.S Treasury yields are up 30 to 45 basis points since year-end with the two-year yield near 2.30 percent while the 10-year yield is around 2.85 percent. Short-term rates continue to be driven by anticipated Federal Reserve monetary policy while longer-term rates respond to inflation expectations, the economic growth outlook, equity market volatility and geopolitical events. The consensus forecast has the two-year U.S. Treasury yield finishing 2018 near 2.80 percent, as the Fed continues to push short-term rates higher. The 10-year yield is expected to end 2018 near 3.10 percent as market uncertainty remains elevated and investors worry over a tentative growth outlook.
For now, the risk of recession within the next 12 months seems modest, likely in the 15 to 20 percent range. Remain alert for potential triggers of an economic downturn, which could push longer-term rates below short-term rates, resulting in an inverted yield curve.
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 who provided the source material as well as those who 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.