Divergence from synchronized global growth
Recently, investors have been wary of the U.S. economy over growing concerns around global growth and Federal Reserve policy. The Fed’s reaction appears to have become much more nonchalant given the continued strength in the U.S. economy. Growth was solid in the third quarter, up 3.4%, but it is expected to moderate in the fourth quarter to around 2%-2.4%. BBVA Research anticipates GDP for 2019 is likely to be lower than 2018’s estimate of 2.8% at around 2.5%.
For all of 2018, the labor market continued to tighten and shows little signs of weakening. In December, the U.S. economy added 312,000 jobs - far higher than the three-month average of 254,000. The unemployment rate rose to 3.9% in November, up from 3.7%, due to the increase in the number of people looking for work. The unemployment rate only captures the number of people that are unemployed but are actively seeking opportunities. Moreover, wage growth continued to rise - slowly but steadily.
Average hourly earnings of private-sector employees reached a new high for the current expansion at 3.2% in December. The labor market is expected to remain strong in the first quarter, but if job growth weakens it could be a result of employers having a harder time filling roles at their current wage level, rather than paying a premium.
Other parts of the economy continued to expand throughout the final months in 2018, albeit at a more modest pace. The Institute for Supply Management’s Nonmanufacturing Index, which gauges a range of industries in the service sector, fell to 57.6 in December from 60.7 in November. The index reached a 21-year high of 61.6 in September. It’s important to note that any reading above 50 indicates expansion, and despite the decline, the business outlook remains positive. In fact, the new orders component of the index increased slightly suggesting more momentum may be ahead. This is particularly optimistic as service activity is a good indicator of domestic demand since few services are imported. Moreover, a large chunk of consumer spending, which is the primary driver of the U.S. economy, is spent in the service sector.
In a similar report, the ISM’s Manufacturing Index declined to 54.1 in December from 59.3 in November. The manufacturing sector, particularly new orders, has weakened as of late, largely due to the trade war between the U.S. and China. Still, a reading above 50 indicates growth in factory activity. While the trade war has yet to leave any notable influence on U.S. economic growth, its impact is starting to trickle through. Exports are showing little growth, while U.S. businesses are facing an uptick in prices for imported inputs affected by tariffs. Business investment, which was supposed to surge under President Trump’s fiscal policy plan, has been faltering as producers struggle with uncertainty around the global supply chain. In the first quarter of 2018, the Commerce Department recorded that business investment increased 11.5%. It later slowed to a more modest growth rate of 2.5% in the third quarter. Combined with the drop in oil prices, which curtails investment in the energy sector, business investment is unlikely to pick back up until there is more clarity over global trade.
Another factor influencing future growth is that the Federal Reserve could tighten monetary policy beyond what the economy can handle. However, last month’s decision to raise short-term interest rates 0.25% for the fourth time in 2018 has Fed officials believing they are getting closer to their neutral rate. In fact, the Central Bank made a significant change to its policy forecast by projecting two rate increases instead of the three proposed at their September meeting. The futures market suggests investors expect no interest rate hike at all in 2019, while BBVA Research anticipates at least one interest rate hike to occur. It appears that officials believe “the extent and timing of further policy firming is less clear than earlier” based on recent market volatility and weakening growth abroad. Still, the Fed has signaled they expect the economy to perform well enough in 2019 to justify “further gradual increases” but the bank “could afford to be patient.”
Inflation has been subdued recently with the core personal consumption expenditure (PCE) index, the Fed’s preferred measure that strips out food and energy prices, coming in at or just below the target rate of 2%. Another gauge of inflation, core CPI, remained unchanged in December at 2.2%. This gives the Fed more room to be lenient in their timing to raise short-term rates. If the Fed raises rates in 2019, they are likely to hold off until the Spring, once they’ve seen proof that the economy has remained stable.
The central bank is also cognizant of its balance sheet. While the Fed isn’t selling its holdings of mortgage and Treasury securities, it has been passively shrinking its balance sheet by allowing the securities to mature every quarter
The Fed did not come to a decision as to the future pace or the potential pause in ending its quantitative easing, but the central bank did indicate that it does not want to use the portfolio to impact the economy in any way.
Perhaps one of the biggest uncertainties affecting the economy is fiscal policy. The current government spending bill, which planned to boost spending by $300 billion, is set to expire in September. In a divided Congress the outlook for government spending is rather unknown, particularly as the partial government shutdown continues. While some government agencies are fully funded through the end of September, many departments have had to go without since December 22nd. In the short-term, the shutdown will cut U.S. economic output by approximately 0.1% every two weeks according to the chairman of the White House Council of Economic Advisers. Eventually furloughed government workers will be awarded back pay once the shutdown ends. As such, growth in the first quarter of 2019 is likely to tick lower, but second quarter growth may snap back from first quarter weakness.
Although the economy accelerated in 2018 and is merely expected to moderate in 2019, fears of a recession have intensified. Many have cited the yield curve as their main source of panic. Previously, the inversion of the yield curve, which is when long-term yields drop below short-term yields, preceded the past few recessions. Investors were spooked in December when the yield spread between 3 and 5-year Treasuries inverted, but a 3-5 year inversion is not a good predictor of recession. It is also important to note that short-term interest rates are set by the Fed, while the longer-term rates are determined by the market. In the short term, we are not expecting a recession to occur.
However, economic growth abroad has been stagnating. In 2018, Europe, Japan, and China all encountered problems that weakened their economic growth. This trend is likely to continue in 2019. Europe is facing sluggish growth in Germany, fiscal issues in Italy, and Brexit. China, one of the largest economies in the world, is also beginning to face a slowdown. In December, exports declined to their lowest rate in over three years. However, not all of the decline can be attributed to the trade war. A large part of the problem is declining domestic demand. Two of China’s purchasing managers’ indices (PMI) fell below 50, suggesting contraction, and profits at industrial firms fell for the first time in nearly three years in November. The Chinese government has been trying to get ahead of the weakening growth by implementing stimulus efforts, but it is unclear if growth is declining faster than the government can curtail.
In 2018, countries appeared to be no longer in sync in regards to growth. That trend is likely to continue into 2019. The U.S. economy is still expected to continue to expand albeit at a more modest rate. Geopolitical concerns, an overly hawkish Fed, and the budget showdown in Congress could undermine some of the strength in the U.S. economy. An alleviation of trade war issues, an end to the government shutdown, and a more dovish Fed should aid in private investment and consumer spending.
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