Economic Outlook

Pace of Economic Growth Potentially Accelerates in 2017

Third-Quarter GDP Results at Higher End of Historical Average

Buoyed by consumer spending, the U.S. economy expanded at a 3.5% annualized rate in the third quarter, up from 1.4% in the previous quarter, its best performance in two years, according to the Bureau of Economic Analysis (BEA). The rate was above prior estimates as personal consumption, investment in structures and intellectual property products, and government expenditure rose faster than anticipated. Conversely, investment in equipment and in residential housing declined. By way of comparison, the GDP growth rate averaged 3.23% from 1947 until 2016, reached an all-time high of 16.90% in the first quarter of 1950, and a record low of -10.00% in the first quarter of 1958, according to the BEA.

The current consensus is for growth to decelerate to 2.5% in the fourth quarter, and to average 2.5% for 2016. Going forward, the economy may see a lift from President Trump’s proposed stimulus programs including tax reform and infrastructure spending. The BBVA Research outlook for the 2017 annualized growth rate is 2.30%.

Wage Growth Continues to Outpace Inflation

Total nonfarm payroll employment rose by 156,000 in December, according to the U.S. Bureau of Labor Statistics, with an increase in health care and social assistance. The December numbers brought the fourth-quarter total to 495,000 and the annual total to nearly 2.2 million jobs, almost 22% lower than the 2.7 million jobs added in 2015. Monthly gains averaged 180,000 versus 229,000 in 2015. In comparison, payrolls averaged 123,290 from 1939 until 2016, reached an all-time high of 1,115,000 in September, 1983, and a record low of -196,700 in September, 1945, according to BEA.

The 4.7% U3 unemployment rate and the 7.50 million unemployed persons held steady for much of the year, but were both down slightly in the fourth quarter. The current unemployment rate is at the low end of the historical range. The U6 unemployment rate, which includes all workers who are only employed part- time for economic reasons, dropped significantly from 9.93% to 9.3% during the one year period from November 2015 to November 2016. The labor force participation rate held steady for much of 2016 and stood at an historical low of 62.7% in December while the U6 unemployment rate declined to 9.2% in December.

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The U.S. Economy at a Glance

Wage growth continued to outpace inflation. Average hourly earnings for all employees on private nonfarm payrolls rose year-over-year in December by 2.9% to $26.00, a new post-financial crisis high. Wage growth edged lower by two cents in November.

Payroll numbers have been running generally near expectations for several months. However, there are concerns that the headline unemployment rate may not accurately reflect the true employment situation. Because the 4.7% figure is low, there is the question of whether or not the economy is about to breach full employment whereby wage inflation ensues. However, as the broader U6 unemployment rate indicates, there are many people who are “underemployed” whereby they are in part time jobs or would prefer to be in higher paying jobs that better fit their qualifications.

Nonfarm Payrolls & Unemployment Rate

OPEC Agreement Limits Oil Production

Oil prices closed the fourth quarter at $53.72 per barrel, supported by an OPEC agreement in December to reduce production by around 2%. Other non-OPEC oil producing countries, including Russia, also participated in the agreement. The agreement is expected to push oil prices to as high as $60 per barrel, a price that has not been seen since mid-2015. After two years of crude glut that drove Brent to a multiyear low of $28 in January 2016, supply and demand may finally be leveling out. In addition, as expectations for economic growth increase, so do expectations for increased fossil fuel consumption.

Because U.S. fracking and other forms of production become profitable at around $60 per barrel, prices near that threshold can quickly throw additional supply onto the market. Indeed, the OPEC agreement is viewed by some as a “gift” to U.S. producers who can be more responsive to price increases than their counterparts abroad. The $60 per barrel level probably represents a strong resistance level for the price of oil. That said, it appears the lows for the cycle have been reached and are unlikely to be revisited anytime soon. The outlook for oil prices in 2017 is between $50 and $60 per barrel.

Manufacturing PMI Reflects Business Confidence

Boosted by increased new orders and production volumes and the fastest upturn in payroll numbers since June 2015, the U.S. Manufacturing Purchasing Managers Index (PMI) increased to 54.3 in December, its highest reading since December of 2014 as new orders, production and employment all registered new highs for the year 2016.

Recent surveys indicate that business owners’ attitudes about the economy and their businesses have been gradually improving for the past few years, although much of the gain in “animal spirits” (a Keynesian concept that describes human emotions that drive consumer confidence) in the fourth quarter was attributed to the election outcome and the potential for future fiscal stimulus.

The ISM Non-Manufacturing Production Index also increased for the 83rd consecutive month. Nine of 12 industries reported growth in December with only three industries reporting contraction – Public Administration; Wholesale Trade; and Agriculture, Forestry, Fishing & Hunting. Although economists follow both measures, the non- manufacturing sector does not influence perceptions as much as does the ISM Manufacturing PMI.

Retail Sales Are Strong

Early reports indicate that the Christmas season was one of the best in several years for online and brick and mortar stores, although the official report will not be available until after Market Outlook’s publication. Retail sales edged up 0.1% month-over-month in November 2016. The so-called core retail sales, which correspond most closely with the consumer spending component of gross domestic product, also rose 0.1%. Compared to the same month of the previous year, sales grew by 3.8 %. In comparison, month-over-month U.S. retail sales averaged 0.36% from 1992 until 2016, reached an all-time high of 6.70% in October 2001 and a record low of -3.70% in November 2008.

Inflation and Interest Rate Hikes Appear to Head North Together

Domestic inflation has begun to trend higher, and the trend is expected to continue due to wage pressure, rising energy prices, and economic growth. The strong U.S. dollar is a headwind for inflation, but this is probably a positive as it will slow the pace of inflation growth enough to keep the Fed from becoming super aggressive with rate hikes.

The consensus calls for between two and three Fed rate hikes of 25 basis points each in 2017, pushing the Fed funds rate from the current band of 0.50 to 0.75% to 1.50% by the end of the year. The Fed is not insensitive to the global impact of a strong dollar so a significant increase in the dollar may constrain the Fed’s plans.

It is interesting to note that in January of the past three years, we have projected three Fed rate hikes, while ending the year with only one. We are of a mind that 2017 will see the Fed break from that pattern and we will finally be successful in this particular projection.

In Conclusion

While the economy is no doubt strengthening, there does not appear to be a great deal of wage-push inflation yet. But that is what the market is anticipating with respect to interest rates. Indeed, interest rates have spiked because there is a great deal of concern about inflation in general and wage push inflation in particular. (The economy was improving and employment was fairly full even before President-elect Trump’s announcements regarding fiscal spending and tax cuts.)

We begin the New Year with a new president-elect and new policy initiatives,hence the sense of optimism and “animal spirits.” However, we have seen significant upward moves in the stock market and in interest rates since the election. The question now becomes how much of this good news on fiscal spending, tax cuts, deregulation, and keeping jobs at home has already been discounted into stock prices and bond prices?

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