Economic Update QuarterlyLawry Knopp, VP-Funding & Hedging
GDP growth for Q2 2017 is projected to be stronger with the consensus forecast calling for real GDP growth near 3 percent, which matches the forecast from the Atlanta Federal Reserve, yet is much higher than the New York Federal Reserve projections of 1.9 percent. The market forecast for the second half of the year is an average of 2.25 to 2.50 percent.Last week we received the final report on Q1 real Gross Domestic Product, which indicated the economy expanded by 1.4 percent during the opening quarter of 2017. Year over year, the economy expanded at a modest 2.1 percent. Looking deeper into the report, consumer spending grew by 1.1 percent, which accounts for over two-thirds of the economy, compared to a 3.2 percent growth rate for 2015 and an average of 2.3 percent for the past five years. Contributions from business spending and housing added to the expansion while government spending dragged on growth.
We continue to see improvement in the employment situation, but further gains will likely be more difficult. The May employment report from the Bureau of Labor Statistics indicated the unemployment rate fell by 0.1 percentage point to 4.3 percent, which is the lowest it’s been since July 2008. New non-farm payrolls rose by 138,000, which was much weaker than expected with March and April numbers being revised down a total 66,000 jobs. While the jobless rate is at a nine-year low, recent weakness in the growth of payrolls is troubling as a stronger job market fuels economic growth. The number of people not in the labor force exceeded 95 million in May and will likely continue to trend higher as more baby boomers look to retire.
Without stronger economic growth, it’s difficult to forecast any significant gains in the labor sector going forward. Moreover, we typically see the low point in the unemployment rate just prior to the economy entering a downturn, which may occur within the next 12 to 18 months. Nevertheless, economists see the possibility of a 0.1 to 0.2 percentage point decline in the jobless rate over the next 12 months.
Consumer inflation, on a year-over-year basis, has rolled over and is trending lower from a high of 2.7 percent in February to 1.9 percent in May. Projections indicate the overall Consumer Price Index could finish the year around 1.5 percent higher. Items exerting downward pressure on the index include housing and energy as the rate of increase in rent costs and Owners’ Equivalent Rent have slowed while lower crude oil prices have allowed gas prices to drop. The OER is an estimation by the Bureau of Labor Statistics of what a homeowner would pay to rent their home in a competitive market. Lower prices related to the commodities sub-index are also contributing to the decline.
Much is happening on the monetary policy front, not only with the Federal Reserve, but also with foreign central banks including the European Central Bank, the Bank of Japan and the Bank of England.
Last month, the Federal Reserve’s Federal Open Market Committee tightened monetary policy by 25 basis points, which raised the target range for the Federal funds rate to 1.00 to 1.25 percent. Commercial banks responded and raised the prime rate from 4.0 to 4.25 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.” The Committee’s outlook calls for continued improvement in economic conditions to a level that will warrant gradual increases in the funds rates, potentially two or three more 25-basis-point rate hikes this year.
One of the lingering questions has been when the Fed will begin trimming its investment holdings. Starting in 2008, in an effort to stabilize and stimulate economic growth, the Fed initiated quantitative easing, which amounted to the Fed buying agency and Treasury securities for the intended purpose of lowering interest rates. This process expanded the Fed’s balance sheet from about $1 trillion prior to the recession, to $4.5 trillion today. At the June FOMC meeting, the committee laid out a plan to gradually reduce its investment holdings, possibly starting within the next three to six months.
Despite Fed officials talking more rate increases this year, the market remains skeptical. According to the Fed funds futures, there is about a 50-50 chance of a 25-basis-point rate hike before year-end.
The commentary from foreign central bank officials from the European Central Bank and Bank of England has taken on a more hawkish tone in recent weeks while the Bank of Japan policy stance continues to lean toward continued monetary stimulus. The outlook for the eurozone has improved over the past few months and political risks have likely eased as recent elections in Europe have gone to more “establishment” candidates. Similarly, hints of removing stimulus by Bank of England Governor, Mark Carney, have pushed the sterling higher despite elevated uncertainty as the UK moves forward with Brexit.
Risk of Recession
The possibility of a recession continues to receive considerable airplay as market observers watch various indicators for signs of a downturn. The risk of the economy slipping into a recession over the next 12 months, as defined by the New York Fed, is just over 7 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.
Others look at employment or consumer confidence metrics. Recessions usually start shortly after the unemployment rate bottoms and sometimes a peak in consumer confidence surveys precede a recession.
As we mentioned in the last quarterly update, other people look at the duration of an expansion and say the likelihood of continued growth lessens with each quarter of positive growth. These folks believe recessions are triggered by events. These events usually take the form of an asset collapse or credit bubble. In addition, geopolitical events that create significant financial market turmoil can be a trigger.
Despite various types of uncertainty, the U.S. economy continues to plod along with meager economic growth of about 2.0 percent while inflation runs between 1 and 2 percent. Geopolitical concerns to watch include tensions between the U.S. and North Korea and its recent test of a long-range intercontinental ballistic missile. Unrest in the Middle East remains a destabilizing factor while terrorism continues to threaten financial markets in various ways.
Russia and China recently signed a Treaty of Friendliness and Cooperation, which will lead to increased collaboration as the two countries work together on global problems and enterprises. China’s “one belt, one road” initiative, which includes trade deals and infrastructure projects from Eastern China to Western Europe is likely part of the agreement. Some $1 trillion has already been invested with more to come. This initiative is said to span 68 countries and encompass 4.4 billion people. Depending on its success, don’t be surprised to see it expand into the Western Hemisphere.
Domestic issues with pension commitments and government debt levels are growing concerns at state and local levels. Illinois and Puerto Rico are currently getting unfavorable headlines as potential credit-rating downgrades are being priced into existing debt securities and current borrowing costs.
View on Interest Rates
U.S. Treasury yields have been mixed over the past three months with the two-year yield higher by 15 basis points to 1.41 percent, while the 10-year yield is down six basis points to 2.32 percent. The major U.S. equity indexes have added to gains from earlier in the year with mid-year returns of around 8.5 percent for the Dow Jones Industrial Average and the S&P 500 index. The NASDAQ is up over 14 percent. Advances in the indexes have been driven mostly by large technology companies and the energy sector. As we said in the last economic update, some analysts do not believe this type of performance can be sustained, especially on policy uncertainty from the Trump administration, modest consumer spending and economic growth.
For now, the risk of a U.S. recession within the next 12 months seems low, likely in the 10 to 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 1.70 percent with the 10-year yield near 2.7 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 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.
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