Quarterly Market Update
Fair to Middling Economic Growth Remains in the Forecast
Mediocre GDP Growth Continues
The U.S. economy got off to another weak start this year, continuing the seven-year trend of rather mediocre growth since bottoming in 2009. Weighed down by seasonal factors and other headwinds, first-quarter GDP was revised to 1.0%. GDP is expected to pick up in the second quarter, although lingering uncertainties tilt risks to the downside. Estimates for the year remain around 2%.
Employment Numbers Trend Downward
Non-farm payroll numbers for the first two months of the second quarter turned down sharply compared to the first quarter. According to initial reports, the economy added 160,000 jobs in April and only 38,000 jobs in May, dashing hopes for both a stronger economic recovery and a Fed rate hike this summer. However, the June employment report and first revision to the May numbers (issued shortly after the close of the second quarter and prior to the publication of this document) indicate that U.S. employers stepped-up hiring in June after a sluggish spring. Nonfarm payrolls rose by a seasonally adjusted 287,000 in June, the strongest month of hiring since last October. Payroll increases have averaged 147,000 over the past three months, 172,000 over the past six months, and 204,000 over the past 12 months according to the Evercore ISI Daily Economic Report. However, given that the economy is grinding toward full employment, the downward trend in monthly payroll increases is not particularly unexpected.
The unemployment rate rose from 4.7% to 4.9% in June while May wages and salaries were up 4.6%. June average hourly earnings rose 2.6% year-over-year versus a cycle low of 1.8%. Once average hourly earnings begin to accelerate, they can double in as little as two to three years. Although earnings have improved markedly, they are still not sufficient to generate the kind of wage-push inflation that is indicative of an economy that has reached full employment. California recently increased the minimum wage and could subsequently experience a degree of wage inflation in some sectors, but by and large, this is not happening across the country. Another early indicator of potential wage inflation, the capacity utilization rate, stands at 74.9%. That level is well below the 82%-83% mark where significant wage pressures have emerged in the past.
Inflation Still a Long Shot
We continue to see little pass-through to core inflation, and the timeline for reaching the Fed’s 2.0% inflation target appears to be extending into 2018 or later. Stabilizing oil and commodity prices have moderated the slide in overall inflation, but there is uncertainty as to how long that trend will last in the face of global doldrums.
Housing Sector Could See Boost as Foreclosures Roll Off the Books
The largest economic driver remains consumption. Things that are more domestic in nature including retail, housing, and restaurant sales are doing fairly well and sustaining the current anemic growth rate. Consumption reports released in May were encouraging, pushing back fears of a further slowdown in household spending.
In the important housing sector, which can account for as much as 10% of GDP, new home sales surged 16.6% in May, the highest annual pace since 2008. On another positive note, consumer credit reporting agencies typically retain delinquent debt, including home foreclosures, on a consumer’s credit report for seven years. Given that foreclosures peaked seven years ago, the black marks on credit reports from these foreclosures are now starting to roll off credit agency reports. This could lead to an uptick in the number of individuals getting back into the housing market.
Manufacturing Still Struggling
To a large degree, employment is down because exports are down, and exports are down because global growth is so weak. Whenever manufacturers struggle, exports are often the culprit. For example, the U.S. has experienced tremendous auto sales this year and last year, but car company stocks have not done particularly well because overseas sales have been so disappointing.
Nevertheless, the ISM Manufacturing Index, a gauge of U.S. manufacturing activity, still managed to climb to its highest level in 16 months in June. The recent strength reflects improvement in oil prices, signs that China’s economy may be on the mend, and a slight weakening of the dollar versus much higher levels in the first quarter. Because the data was collected before Great Britain voted to leave the European Union (a.k.a., Brexit), it remains to be seen how the Brexit vote will impact manufacturing over the longer term.
Oil Prices Rebound from Two-Year Rout
Oil prices rebounded in the second quarter after a two-year long struggle initiated by a supply glut and weakening global growth. During the second quarter, a weaker dollar contributed to the rebound, helping West Texas Intermediate crude reach $48.33 per barrel, up 30% for the year.
Oil production, as measured by rig count, has historically begun to accelerate about three months after oil prices bottom. The U.S. rig count indeed turned up in June, although the global measure continued to decline. Sharply falling oil prices earlier in the year led to a reduction in supply (rig count), but that trend will reverse if prices continue to rise. However, we do not anticipate a return to fracking or significant production increases until oil prices stabilize at or above $60 per barrel.
U.S. Dollar Strengthens and Pound Plunges Following Brexit
Although we frequently speak about a “strong dollar,” it is really the change in the relative value of the U.S. dollar, more so than its purchasing-power, that is important. As the dollar goes up in relative value, it drives oil prices down, creating a headwind for the industry since oil is priced globally in U.S. dollars. A strong dollar is essentially a headwind for any U.S. export, although it obviously makes travel abroad cheaper for U.S. citizens.
At the time of the Brexit vote, the Bank of England’s short-term benchmark interest rate was 0.50%, affording the country a tiny bit of dry powder that could be used to lower interest rates and bring the yield curve down should the country vote to leave the EU and the economy deteriorate. Recall that although the U.K. has long been a member of the E.U., it refused to adopt the euro and continued instead to use its own currency, the British pound. Even though Great Britain voted to leave the EU, the Bank of England does not want the pound obliterated, so it will be a bit cautious as to how much it eases monetary policy in an effort to spur growth.
The value of the British pound took a sharp hit following the Brexit vote. While many British citizens are worried about how this devaluation may affect their future financial positions, a bright spot for Great Britain is the potential for an economic boost from increased tourism and more attractive exports resulting from the devalued currency. The largest negative is that British stocks will become less attractive to foreign investors due to the currency headwinds which could negate organic stock appreciation.
Summary of Risks to the Economy
On the domestic side there are a number of threats to economic growth including the Fed’s exit strategy, confidence shock, regional/industry pressures, uncertainty surrounding the national election, and financial market volatility. On the global side, potential headwinds include further showdown in China and emerging market countries, deflation/recession in Europe, financial tensions, and geopolitical threats.
On a more positive note, the surprisingly strong June employment report signals that the labor market is stronger than the May employment report indicated. The May report may very well prove to be a one-off event, not a trend. Certainly the June employment report, a gradually improving manufacturing sector, and solid consumer data should help to ease some of the fears surrounding a U.S. slowdown at a time when the rest of the developed world is struggling to keep its economies afloat.
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