Spring 2018 Perspectives and Planning: Economic Outlook
April 13, 2018
There are no major changes to our forecast. The U.S. economy remains in solid shape and we maintain our call for real GDP to expand at a 2.5% to 3.0% pace in 2018 with the upper end of this range now looking more likely1. Inflation is gradually accelerating and is likely to hit the Federal Reserve target of 2.0% (as measured by core PCE) this year as the Fed now concedes2. Hiring continues to be robust and we acknowledge that job creation could exceed our 1.8 million estimate1. As such, we expect a rebound in consumer spending after sluggish growth in the first quarter.
Given the above, as well as more hawkish commentary from Federal Reserve officials, we are revising our interest rate forecast higher. We now expect that the most likely scenario is for the Federal Reserve to lift the Federal Funds rate by 0.25% four times this year, rather than three. We also adjust our year-end target range for the 10-year Treasury note higher by 0.25% to 2.75% to 3.25%. Bond returns will, thus, be modest.
The return of equity market volatility after an unusually placid 2017 was widely expected. The initial bout of volatility in February was linked in part to rising interest rates and bond yields as well as quantitative trading algorithms. More recently, market skittishness has ratcheted higher as trade tensions have escalated.
We still view a trade war as a low probability event but should it transpire, it would be most unwelcome. In the past 70 years, the United States has prospered with open markets. This is not the same as saying that everyone has benefited equally but it is estimated that the average family’s purchasing power has been enhanced 25% (or in excess of $10,000) by the availability of cheap imports3.
One could argue that our current era of low inflation has largely been made possible by globalization generally and the integration of China into the world economy, in particular. From an investment perspective, a trade war would have adverse consequences. S&P 500 profit margins have expanded sharply over the past decade or more as companies have dramatically lowered costs by sourcing globally. Furthermore, global supply chains are now so complex it would be no mean feat to smoothly disentangle them.
It is indisputable that China has engaged in widespread unfair trading practices4. While the U.S. economy has benefited from access to inexpensive goods, there have been social costs and legitimate national security concerns. However, a more targeted approach to international trade would be less disruptive to markets and the economy.
The widening U.S. trade deficit has deeper causes than a flood of cheap foreign products. Americans are prodigious consumers and notoriously bad savers. It is by definition that faster economic growth and a burgeoning Federal budget deficit combined with an extremely low savings rate, will result in an expanding trade deficit. Simply put, we consume more than we produce. Most economists would concur that if the rest of the world is willing to send us their stuff largely in exchange for our Treasury bonds and bills, then our end of the bargain is not so bad.
Our presumption is that cooler heads will prevail over trade and, indeed, the domestic political calculus will dictate an end to the brinksmanship. In the meantime, the pullback in the stock market coupled with rising earnings estimates (helped by corporate tax reform) has substantially improved equity valuation. As such, we continue to find stocks relatively attractive versus bonds. As stated above, the consumer remains the linchpin of our optimistic outlook. While declining stock prices could impact consumer behavior, optimism over the availability of jobs has easily offset concern over market gyrations in terms of consumer confidence thus far.
- 2017 ended on a firm note with Q4 growth of 2.9% after two quarters of 3%+ GDP5
- Q1 2018 GDP likely to have dipped below 2% on soft consumption, following typical seasonal pattern
- Slowdown belies underlying strength of the economy and rebound likely in Q2 and beyond
- Hiring continues to be strong in early 2018, our forecast 1.8 million new jobs in 2018 could be conservative
- Wage gains likely given difficulty of attracting qualified workers; improving participation rate encouraging
- Robust labor market has boosted consumer confidence and income growth should buoy consumer spending
- Record profits and need to control labor costs will support strength in capital spending
- Fed to hike Federal Funds rate by 0.25% four times in 2018 as inflation hits Fed 2% target
- Yield on 10-year Treasury note moves modestly higher to a range of 2.75% to 3.25% by year-end
- Maintain 2018 U.S. GDP forecast of 2.5% to 3.0% growth with increasing probability of hitting the upper end of the range
Positives for U.S. economy:
- Growth to remain consumer driven
- Disposable income will increase, helped by stronger wage gains
- Housing starts, rise supported by favorable demographics and lack of supply
- Capital spending continues to rise as companies seek to boost productivity
- Tax cuts supplemented by higher government spending provide increment to growth
Negatives for U.S. economy:
- Possibility of higher inflation creates monetary policy risk amid high personnel turnover at Fed
- Political uncertainty as midterm elections loom and trade tensions worsen
- Synchronization of growth in major economies will lead to further gains in global GDP to 3.8% in 20186
- Eurozone and Japan now in the midst of self-sustaining expansion, some concern that growth has peaked as Q1 slower
- Emerging market economies continue to strengthen as Chinese growth relatively steady
- South and Southeast Asian economies all growing in excess of 5%, led by India at 7.5%7
- Recovery in resource dependent economies including Russia, Brazil, and Nigeria
- High teens earnings growth for S&P 500 in 2018 appears very achievable as tax reform boosts after tax earnings
- Corporate tax reform to add approximately 7% to S&P 500 earnings1
- U.S. equity market valuation less challenging after Q1 2018 pause in rally
- Expect modest fixed income returns as interest rates and bond yields rise
- Corporate and municipal bonds appear richly valued as spreads remain narrow; Treasuries, Government Agencies, and CD’s attractive
- TIPS (Treasury Inflation-Protected Securities) have some appeal as an inflation hedge
- Foreign central banks likely to curtail quantitative easing in latter part of year, removing some liquidity
- Return to normal volatility as rates rise and liquidity reduced (end of financial repression)
- Dollar relatively steady after weak 2017 as Fed tightens and European recovery discounted
- U.S. political risk, especially concerning trade policy
- Geopolitical risk high around the globe; Europe, Middle East & East Asia all vulnerable
- Wage gains accelerate toward 4% resulting in even faster pace of rate hikes
- Synchronization of monetary policy; foreign central banks become more restrictive
- Return of market volatility harms consumer confidence and consumption slows
- Increasing supply of U.S. Treasury debt disruptive to fixed income market
- Notable improvement in productivity allows for noninflationary wage growth and higher profit margins
- Greater political stability in Europe
- Steadier exchange rates and commodity prices
- Trade issues recede on better growth
- Washington Trust Wealth Management
- Federal Reserve Summary Economic Projections, March 2018
- U.S. Chamber of Commerce
- American Enterprise Institute
- Bureau of Economic Analysis
- The International Monetary Fund (IMF)
The views expressed here are those of Washington Trust Wealth Management and are subject to change based on market and other conditions. Investment recommendations and opinions expressed in these reports may change without prior notice. All material has been obtained from sources believed to be reliable but its accuracy is not guaranteed. Investing entails risk, including the possible loss of principal. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions. Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments, including floating rate bonds, involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. Past performance does not guarantee future results. The S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock-market performance. In addition, the S&P 500 Index cannot be invested in directly and does not reflect any fees, expenses or sales charges. Further, such index includes 400 industrial firms, 40 financial stocks, 40 utilities and 20 transportation stocks. The information we provide does not constitute investment or tax advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. Please consult with a financial counselor, attorney or tax professional regarding your specific investment, legal or tax situation.
Investing entails risk, including the possible loss of principal. Past performance does not guarantee future results. This information does not take into account any investor’s particular investment.
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This material is presented for informational purposes, and nothing herein constitutes legal, accounting, or tax advice. Please consult with an attorney or tax professional regarding your specific financial, legal or tax situation.
The views expressed here are those of Washington Trust Wealth Management and are subject to change based on market and other conditions. Investment recommendations and opinions expressed in these reports may change without prior notice. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed.