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Economic Review and Outlook - Q3 2014

After winter’s deep freeze and 2.9% contraction in the first quarter, U.S. GDP has snapped back, possibly reaching a growth rate of 3.5% in Q2. This is obviously good news, but the arithmetic is simple. First half GDP taken as a whole was very sluggish. For the full year, GDP growth may lag the low end of our forecast range of 2.5% to 3.0%. Given that growth in China has also slowed and recovery in Europe is barely perceptible, it is little wonder that the World Bank recently downgraded its full year 2014 global GDP forecast to 3.4% from 3.7%.

We expect that the U.S. can maintain a growth rate of about 3% for the balance of the year. The U.S. economy reached a major milestone in May when nonfarm payrolls exceeded the prior peak of January 2008 as the economy at long last recovered the job losses of the Great Recession. After four consecutive months of employment gains in excess of 200,000, it appears that job creation has moved up a notch.


Our relative optimism hinges on consumer spending also perking up, supported by income growth resulting from a stronger labor market. Wage gains during the recovery have been slight. On an inflation adjusted basis, average wages have increased only 2.5% in the past six years. However, as job openings increase and slack in the labor market declines, businesses are more likely to boost pay to attract workers. Furthermore, rising household net worth and better availability of credit should also support consumer spending. We would note that based on leverage ratios, American consumers actually appear to be in better financial shape than their counterparts in Canada and Germany.

Entering 2014, we assumed that energy, autos, and housing would continue to provide solid underpinnings to the expansion. While energy production continues to surge and auto sales remain robust, the momentum in housing seems to have fizzled. In fact, in the first quarter, housing actually subtracted from GDP growth. Our bullishness on housing was based in large part on demographics, but household formation and fertility rates have still not recovered from their recession lows despite indications that many millenials are at long last able to move out of their parents’ basements.

While data for housing starts has shown improvement after the brutal winter, it is interesting to note that it has been heavily skewed towards multifamily, i.e. rental, units. These homes on average cost less than 50% of the typical single family home and have a more muted impact on GDP. Further, our prediction of housing starts easily exceeding 1 million units for the year is suspect given the soft start. We have seen consumers in increasing numbers replace aging autos. In a similar vein, the housing market should trend higher over time given the lack of new supply relative to population growth over the past six years.

The government sector has also contributed somewhat less to growth than originally forecasted. Tax increases, spending cuts, and a brief government shutdown at the federal level made for highly restrictive fiscal policy in 2013. The absence of fiscal drag of this magnitude has been positive for growth in 2014. The budget deficit, however, continues to decline more rapidly than expected. While a falling deficit by definition restrains growth, most would view this as a healthy development. Despite improving finances, spending at the state and local level has picked up rather slowly. Even in the bluest of blue states, California, the emphasis has been on fiscal discipline.

Fortunately, macro fiscal policy surprises on the order of what was experienced in 2013 seem off the table. Congress will not have to revisit the debt ceiling until March of 2015. We are also hopeful that other antics such as a broad government shutdown are now viewed as politically inexpedient and do not recur. On a micro level, however, many members of Congress seem willing to sacrifice growth in the interest of ideological purity. For example, Congress may not reauthorize the self-funding Export Import Bank on grounds that it is infringing on the private sector. That may be the case, but our competitors overseas are unlikely to follow suit and withdraw government support for their exporters.

The trajectory and contours of monetary policy seems well telegraphed. The recent confirmation of several appointees to vacancies on the FOMC should reinforce the primacy of Federal Reserve Chairperson Yellen. Monetary policy remains very accommodative but is on a gradual path to neutrality. Tapering of long term bond purchases by the Fed is underway, and quantitative easing will end completely in the latter part of the year. The Fed remains unlikely to raise the Fed Funds rate before the June-September time frame next year as inflation is quiescent. The recent rise in the two year Treasury yield indicates that investors now view a June 2015 initial rate hike as increasingly likely.

However, risk to our forecast may be skewed to the downside. Skeptics point out that perhaps 1.5% of second quarter GDP was merely the release of pent up demand after the harsh winter. They argue that the underlying rate of Q2 growth was roughly 2% or less and is likely to remain there.

Lackluster international growth is another negative, and external trade may be at best neutral. Geopolitical tensions have been on the rise. The turmoil in the Ukraine appeared out of the blue in March and continues. Instability in Iraq has been a shock although it could hardly be called a surprise. Unlike Syria, Iraq is a major oil exporter, and as a result, that conflict may have broader economic consequence. China is adjusting to new economic realities, and its foreign policy seems increasingly aggressive. Investor sentiment tuned very bullish on India in the past quarter due to the election of a market oriented candidate as prime minister, but now comes the task of implementing reform.

Nonetheless, with economic policy and financial market conditions supportive, our expectation of a modest acceleration in U.S. growth seems reasonable. The U.K. economy is actually performing well, and the Euro zone has a central bank that is priming the pump (or running the printing presses) at full bore. Absent an oil shock, the developed economies generally should continue to make progress with the U.S. in the lead.


Sources: St. Louis Federal Reserve Database, Bloomberg, Factset

The opinions expressed in this document are those of the authors and may not reflect those of Washington Trust. The information in this report has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. Any opinions expressed herein are subject to change at any time without notice. Any person relying upon this information shall be solely responsible for the consequences of such reliance. Past Performance is No Guarantee of Future Performance.

The opinions expressed in this newsletter are those of the author and may not reflect those of The Washington Trust Company. The information in this report has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. Any opinions expressed herein are subject to change at any time without notice. Any person relying upon this information shall be solely responsible for the consequences of such reliance. Performance is historical and does not guarantee future results.

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