Investment Outlook

Last month we mentioned a synchronized global growth and recent data make it even more evident that is spilling into the US economy. The US is indeed receiving a “significant tailwind” from faster growth abroad. Net trade, and inventories, have both made significant contributions to growth. Indeed, the US posted its best six-month growth in several years, rather remarkable given the expected negative effect of hurricanes on Q3 growth. Solid consumer and business spending, plus improved exports, have certainly played a key role.

The WSJ referred to the appearance of Keynes’ “animal spirits” as being in some measure responsible for the improved confidence that has spurred consumer and business spending. The quick recovery in the goods sector more than offset the summer’s weather effects. US activity remains on a solid footing. Capital spending is leading growth, suggesting productivity looks to be on the rise, and current data suggest gathering momentum entering Q4.

The Fed cares about GDP growth, but it probably cares most now about growth tied to productivity increases, fueled by increases in capital spending. While capital spending has increased, it could and should do even better as the growth outlook continues. Much depends on business investment which is central to boosting worker productivity and sustaining robust gains in corporate profits and wages. This is how to extend an economic expansion that is mature by some measures.

The surprising element is lack of price pressure. September’s important PCE inflation measure remained essentially flat and below investor expectations. It would appear that improved business investment and resulting improved productivity could keep a lid on inflation’s pressures even assuming improved GDP and employment growth. Indeed, gradual core price pressures should allow the Fed to continue a cautious policy normalization approach. The usually below-the-radar Employment Cost Index reported one of the better sequential reads of the cycle, suggesting wage growth may at least be firming, though gradually at best, while one of the best leading indicators of wage growth is consumer income expectations and they continue to print fresh cycle highs. Surging consumer confidence, as measured by the Conference Board consumer confidence index and driven by strong gains in both the present situation and expectations indices, is reported at a 17-year high, supporting the growth outlook.

Americans are saving less and spending more, and a buoyant stock market is a positive influence here, of course. The US saving rate is actually at a 10-year low, 3% in September, down from a recent peak of 6% in October 2015, probably driven by low unemployment and rising stock prices, and rising household net worth. This should normalize over the next several years amid what is still a rather benign economic cycle. Meanwhile, despite the noise inflicted in manufacturing data by the hurricanes, the ISM manufacturing index remains healthy and points to continued expansion. And with global growth strong and a weaker dollar, prospects for the manufacturing sector remain good. ISM suggests manufacturing activity remains good and this is not a hurricane result. There is momentum in the manufacturing space supporting perhaps the sector’s best half-year capex pace in three years (when it was supported by $110/bbl oil). September construction spending was better than expected, through driven by state and local government spending.

Bottom line, GDP data indicate the economy is back on track. Now, though, the rate of growth is probably not the target so much as increases in productivity, the real source of future non-inflationary growth, fueled by business investment. This would fuel increased worker productivity to the benefit of wages or compensation. Improved productivity should ultimately foster employment and labor force growth. History would seem to suggest productivity improvement has a way to go, supporting the growth outlook this year and next.

So-called soft-data growth has shown the kind of important strength that predated previous hard-data recoveries, e.g. 2004, supporting the hard growth outlook. Current data suggest gathering Q4 momentum that should support the Fed’s planned 25bp move at the December meeting, perhaps setting the stage for a 2% Fed funds rate by June. The December move is priced in the markets, and 2% by June could be managed as well so long as growth supports it. That, however, could be near the ceiling of the new range for a while. Not a bad thing coupled with an improving outlook and productivity growth.

The October labor report suggested reduced labor force slack with the unemployment rate falling to 4.1% the lowest since 2000. Service Sector ISM was strong, with business activity and new orders at multi-year highs and the important labor component at a five year high, confirming underlying strength, further supporting the growth outlook.

Still, not surprisingly, there were no major changes to the FOMC policy statement. The tax bill has its share of divisive components, suggesting its legislative progress will be gradual, at best, like perhaps year end. The new Fed Chair should be a relative non-event, following as he does so closely to Chair Yellen’s positions; however, he does favor relative financial deregulation.

Growth accelerated the first half of this year without generating inflation, suggesting the economy is not getting “long in the tooth” or overheating. The Fed is well suited to proceed toward policy normalization (portfolio and rate) on a gradual basis. Stay tuned.

Douglas J. Robbins

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