The below summary was compiled during December 2017. Since this report was published, the Tax Cuts And Jobs Act was passed and signed into law despite its serious disregard for causing very large increases in our national debt with attendant negative economic consequences.
|The second estimate of economic growth for the third quarter 2017 (Q317) was revised upwards to 3.3% (annualized) from its first estimate of 3%. Private Consumption Expenditures (PCE), Non-Residential Investments, Changes in Inventories and Government Expenditures all made positive contributions to growth, while Residential Investment remained in the negative column. Further analysis shows that the main contribution to growth was the very strong acceleration in Inventories and Net Exports. PCE and NonResidential Investment both showed signs of deceleration. As a result, Final Sales to Domestic Purchasers (GDP, ex. Inventory Changes and Export, but including Imports) slowed to 2.0%, their slowest pace in six quarters (Note that the government will revise these numbers once more before the end of the fourth quarter).
Figure 1: Economic Performance
Data releases confirm the resilience of the economy. Industrial production and Manufacturing rose by respectively 0.9% and 1.3% (month-on-month, m/m) in October. Durable goods fell by 1.2% m/m (+0.4% ex-transportation) in October. Factory orders fell by 0.1% (m/m) in October. Early November surveys were down, but remained positive. The Empire State measure fell from 30.2 to 19.4, while the Philadelphia Index declined from 27.9 to 22.7. End-November surveys showed the same trend. The ISM-Manufacturing fell slightly to 58.2 from 58.7 at the end of October, the Markit PMI-Manufacturing slipped from 54.6 to 53.9 over the same period, while the broader-based Chicago PMI ended November at 63.5 down from 66.2 the previous month.
Figure 2: Households
Driven by low unemployment and strong market gains, consumer confidence rose to record levels. The Conference Board Index increased to 129.5 at the end of November from 125.9 the previous month, while the University of Michigan-Reuters measure rose from 97.8 to 98.5 over the same period. However, these gains did not fully translate to gains in the real economy, as households maintained a cautious stance. Personal Income and PCE rose by respectively 0.4% and 0.3% m/m in October. The services sector slipped somewhat, but remained strong: the ISM-NonManufacturing index ended November at 57.4 down from 60.1 the previous month, and the Markit PMI-Services went from 55.3 to 54.7 over the same period.
October Exports were flat and Imports rose by 1.6%, causing the Trade Deficit to balloon to its highest level since January. This raised the 10-month (Jan-Oct) trade deficit to $666.3 billion from $620.8 billion over the comparable period in 2016. The dollar index lost ground, falling by 1.6% in November, almost 10% lower than its high point last January.
The soft patch in housing is fading and the housing market is recovering momentum, with Housing Starts, New Home Sales and Existing Home Sales all registering increases in October. Housing prices, as measured by the Case-Shiller 20-city index, rose by 0.5% m/m (6.2% y/y) in September. Construction spending surged by 1.4% in October, reflecting in part, post-hurricane activity.
Oil Prices Momentum: Oil prices (west Texas Intermediate, WTI) have increased consistently for the last five months, rising by 5.35% in November to $57.29/barrel (bbl)—33.8% higher from their mid-year low. Stronger-than expected demand, and the extension of the OPEC and non-OPEC output cuts—by about 2% of global oil supplies—to the end of 2018, have sustained this rise. High prices are a positive for U.S. oil production, which reached 9.48 million barrels per day (mbd) in September, a 10.8% increase over the previous year. It is estimated that U.S. shale production is profitable at about $55/bbl, a level already exceeded in the past month. Oil prices (WTI) have become choppy in the past two weeks though, retreating from their November 24th high of $58.95/bbl, and settling at around $56/bbl. OPEC actions should however establish a floor of around $50/bbl for oil prices.
Figure 3: Labor Market Trends
Steady Labor Markets: November establishment and household surveys underscored a labor market growing at trend. Total payrolls increased by an above-expectations 228,000 (Private sector gained 221,000), with a downward revision of 3,000 for the previous two months. This brought the three-month moving average in at 170,000. If we exclude the September number, the year-to-date (ytd) average is at 188,000 jobs. The job gains were broad. The Goods Producing sector gained 62,000 jobs: 7,000 in Mining, 24,000 in Construction and 31,000 in Manufacturing. In particular, the manufacturing sector has been strong, with a gain of 63,000 over the past three months. Private Services added 159,000 positions and Government 7,000. Average weekly hours worked rose by 0.1, to 34.5, and average hourly earnings rose by 0.2% m/m (2.5% y/y). The separate Households Survey showed unemployment (U3) steady at 4.1%, unemployment and underemployment (U6) slightly up to 8.0% from 7.9% the previous month, and the labor participation rate steady at 62.7%, roughly the same level as November 2016. High frequency data also reflected the strength of the labor markets, with weekly initial jobless claims falling to 236,000 at the end of November. Overall, we are seeing continuing strength in the labor markets, with jobs growing at trend of 180,000 to 200,000 over the past few months. Yet, the tightening labor market still fails to translate into stronger wage inflation.
The Fed in Transition: The last meeting of the Federal Open Market Policy (FOMC) on December 12th-13th was the last one presided over by Janet Yellen, whose term will end on January 18, 2018. As expected, the FOMC increased the Fed Funds rate by .25% (25 bp), to 1.25-1.50%. The FOMC Statement cited the strong economy and labor markets, underlining however, the fact that both inflation and inflationary expectations remain low. While the Fed did not address the issue directly, it implied that the policy of a gradual tightening of monetary policy remains on track, which means two to three rate increases in 2018. In addition, the pace of balance sheet normalization should accelerate from the current $10 billion, increasing to $20 billion/month in January.
The new Fed Chair-designate, Jerome (Jay) Powell has committed himself in public statements to maintain policy continuity. (Powell’s nomination was approved by the Senate Banking Committee and is expected to be approved by the full Senate). Janet Yellen also resigned from the Fed’s Board of Governors, leaving four vacancies for President Trump to fill. So far, Trump has made one appointment to the Board, Carnegie-Mellon professor Marvin Goodfriend, an orthodox monetary economist and frequent critic of Fed policies under both Bernanke and Yellen. In any case, the new Fed leadership will face the same puzzle of rapid economic growth, record low unemployment and underperforming inflation. The latest inflation reading show the core PCE Deflator (the Fed’s preferred measure) flat at 1.4% (y/y) in October, significantly below the 2% Fed implicit target.
The Fed’s interest rate path for the Fed Funds rate targets the “neutral” rate, estimated at about 2.75%. With the latest rate increase, the Fed Funds rate is at 1.50%, which means that we should anticipate five or six more 25bp rate increases over the next 4-6 quarters. Of course, with the economy close to full employment, the pace of interest rate normalization could accelerate further. One of the Fed’s concerns is to allow itself policy room to maneuver when the next recession arrives. From this point of view, the sooner monetary policy is normalized, the better positioned will the Fed be when the economy falters.
Figure 4: Soft Inflation
The 10-year Treasury bond yield has remained at around 2.35-2.40% in the past few weeks. At the same time, the yield curve has flattened further, with the 10 year to 2 year spread at only .59% at the end of November, a .73% (73 bp) drop from its level in mid-December 2016—and the flattest since 2007. Usually, the flattening of the yield curve is considered one of the advance signals of a recession. In this case, however, the flattening of the curve is mainly the result of an increase in interest rates at the short end of the yield curve.
Global Momentum: The latest projections of global growth by the Organization for Economic Cooperation and Development (OECD, a grouping of the major advanced and emerging countries) are positive. According to the OECD, easy monetary policies and fiscal stimulus underpin a broad-based and synchronized growth in most countries—but remains subpar relative to the pre-20008 crisis levels and other past recoveries. Global economic output is expected to grow by 3.7% this year, 3.8% next year, and 3.7% in 2019. At the same time the OECD notes that the economic recovery has failed to produce solid wage growth, and high levels of leverage at the household and corporate levels are a source of vulnerability.
The eurozone economy, in particular, continues to exhibit strength, driven by accommodative monetary policies, an improving employment picture, a rebound in consumer and business confidence and strong external demand. Real GDP rose by 0.6% (quarter-on-quarter, q/q) on 3Q17, after increasing by 0.7% q/q in 2Q17, and is set to grow this year at the highest fastest pace since 2007. Growth is led by Germany, but the other major core economies are also showing robust growth. The Eurozone momentum is reflected in the latest PMI-Composite readings, which reached a 20-year high of 57.5 at the end of November. In contrast, the UK economy is hampered by uncertainties tied to Brexit, and the slowdown is expected to continue through 2019. China’s Caixin PMI Manufacturing and Composite indices were both at 51 in November, indicating continuing, but tepid growth.
The U.S economy has accelerated over the past three quarters, growing at an average of over 3% in the middle quarters of the year. The U.S. expansion is now the third longest in the post-War era, and does not show signs of ending soon. Moreover, the latest Fed data shows that household net worth, driven by gains in the both equity and housing prices—has reached a record level of $96.9 trillion at the end of 3Q17. The forces that sustained the U.S. economy in 2017—sustained PCE growth and a recovery in business spending—should continue over the short term. However, a softening of PCE growth and widening current account deficits in the past month could lead to a slowdown of 4Q17 growth to around 2.5%. The economy is well positioned to continue to grow at trend over the next two to three quarters. However, with the economy close to full employment, the main threat to a continued expansion would be a rebound in inflation leading to a sharper tightening of monetary policy by the Fed. The implications of the tax cut for economic growth, if enacted, are likely to be modest both in the short and longer term. If anything, a tax cut could actually increase inflationary pressures in the short term. Furthermore, most economists remain skeptical about a short or medium-term supply side impact. For one thing, corporations are already sitting on $2.4 trillion in liquid assets. While capital expenditures have been on an upswing, it is unlikely that these assets will translate into a faster pace of investment.
“God Created Republicans to Cut Taxes” (Credit Swiss Analyst): The Senate followed the lead of the House of Representatives and passed a controversial tax overhaul bill on a fully partisan basis—all Democrats and one Republican Senator voted against the bill. However, the GOP in the Senate and the House are working at reconciling the two versions, and a bill is likely to be voted on and approved before Christmas. While the legislation cuts the corporate tax rate from 35% to 20%, it could also add at least $1 trillion to the deficit over the next 10 years, according to the Joint Committee on Taxation—the non-partisan Congressional tax scoring body.
The tax cuts, which fulfill a long-time goal of the GOP, are likely to be the prelude to another long-term goal of the Republicans: shrinking the Federal government and drastically curbing the entitlements programs—the current legislation will automatically cut Medicare by $400 billion over the next 10 years and successfully undermine the Affordable Care Act.
Political Risks: The past few weeks have been busy ones on both the domestic U.S. and global political affairs.
North Korea: The launch of a more powerful ICBM by North Korea has once again roiled East Asia and raised tensions in the region. The lack of a diplomatic approach and tough talk by both Washington and Pyongyang and the binary nature of the crisis have once again raised the possibility of a military confrontation.
Germany: Chancellor Merkel is still struggling to form a coalition or minority government. A failure to do so would lead to new elections, and possibly the ouster of Europe’s most durable and consequential leader.
Middle East: While President Assad of Syria and his allies have declared victory in the Syrian civil war, the Middle East remains in chaos. Tensions between Israel and the United States on one hand and Iran and its regional allies on the other, remain high. The war in Yemen is raging on and the political situation in Lebanon is tense. Consequently, the risk of stumbling into conflict between the United States and Iran, or Hezbollah and Israel remain a cause of concern. Bold, and some say reckless moves by the Saudi Crown Prince (Mohamed bin Salman, aka MbS) have unsettled the Kingdom and the region.
Figure 6: The Bull Run Continues
From Record to Record: The equity markets soared to new heights in November. The S&P500 gained 2.7% over the month—and registered a 16% ytd gain. The equity index broke through 2,400 on May 15, 2017. It took four months for the index to break through 2,500, and only another six weeks to surpass 2,600. The market has done well by other measures also. S&P500 earnings per share jumped from $106 at the beginning of 2017 to $118 at the end of November, with the Price/Earnings ratio at 22.2 at the end of the month. Global markets did equally well: the MSCI-EAFE (developed markets outside North America) and the MSCI-EM (emerging markets) gained respectively 2% and 0.8% in November—and 32.4% and 19.8% ytd. The recovery was broad, with both cyclical and defensive sectors gaining ground. The markets responded strongly to the Senate approval of the tax cut bill, with the S&P500 rising by almost 1.8% in the few days preceding the approval of the Senate version of the bill. The strong performance continued in December, with the S&P500 gaining a further 1.4% between December 5th and December 13th, when it reached 2,666.
Paradoxically, the Democratic victory in the special senatorial election in Alabama could favor a quick passage of the tax overhaul legislation, as the GOP leadership want to ensure a vote before their razor-thin Senate majority dwindles further. The tax overhaul bill most likely has been already baked into market valuations, details of the legislation will have profound differential effects at the sectoral level. However, much of the impact will be longer term, particularly since the tax cut might not be introduced until 2019. In the shorter term, an amnesty on repatriating overseas profits is likely to lead to a surge of special dividends and stock buybacks, providing a short term rush to the markets.
Figure 7: S&P500 SubIndices
The key questions are: first, what justifies these high valuations; and second; are the current trends sustainable? Macroeconomic fundamentals remain strong at both the U.S. and global levels. S&P500 profits gained 8.5% y/y in 3Q17. However, the markets have settled down in what has been called “Irrational complacency,” characterized by record low volatility (the VIX is at its lowest level since its inception), and record high earnings forecasts (both for the U.S. and on the global corporate scene), with S&P earnings per share estimated to reach $140+ at the end of 2018. The markets momentum has been driven by easy money, herding and record-low volatility. Yet, significant tail risks remain, first and foremost overvaluation. Furthermore, markets’ performance over the past few years has been tied in part to easy money and liquidity. As the liquidity is drained from the system, the markets will lose that crutch, returning to more sustainable levels.
November Data Releases