Economic & Financial Market Review and Outlook
July 12, 2016
- A continuation of moderate U.S. growth in the range 2.0% to 2.5% for the foreseeable future
- Growth to remain consumer led as incomes rise
- Improvement in housing likely to extend for another 2 or 3 years
- Weakness in capital spending to persist as capacity utilization is low
- Fed policy to remain accommodative with interest rates abnormally low due to conditions overseas
- We remain relatively positive on U.S. equities
After a soft finish to 2015 and a weak start in 2016, U.S. GDP growth appears to have rebounded in Q2 2016 to 2.5% or better, a welcome improvement from the 1.25% average of the prior two quarters. We continue to forecast 2%+ GDP for the remainder of 2016 and our full year view of 2% to 2.5% growth, accordingly, remains intact. The probability of recession over the next twelve months still appears low, although one could argue, risks are slightly more elevated due to soft global growth and slowing job gains.
The consumer continues to be the engine of U.S. economic growth. Consumption grew by only 1.6% in the first quarter 2016 but likely accelerated in the second quarter to approximately 3.5%. Residential investment is another driver of growth and could possibly post mid-teens improvement annually over the next couple of years given favorable demographics and the dearth of new home construction in the aftermath of the housing bubble. Mortgage rates at historical lows are supportive of the housing market.
Consumer finances are strong, with debt manageable, and the savings rate is healthy at approximately 5%. Household net worth is at a record high boosted by the stock market and home prices. Inflation-adjusted incomes are also rising, helped by employment growth, wage gains, and low inflation. While consumption may slow somewhat from the 2Q 2016 pace, it is clear that consumers have the wherewithal to spend either by dipping into savings or taking on additional debt.
Of some concern has been the recent slowdown in payroll growth. With nearly 6 million jobs in total added in 2014 and 2015 and the economy close to full employment, our expectation was that job gains would slow to approximately 2 million in 2016. We continue to hold this view, as we believe at some point, it becomes more difficult to match skills with job openings. In a sense, this is a high class problem as it may at long last spark growth in stagnant wages.
For the first five months of the year, nonfarm payrolls grew at an average of 150,000 per month or at a 1.8 million annualized rate. May 2016 payrolls were weak at only 38,000 (although reduced by a strike at Verizon) and followed a moderate gain of 123,000 in the prior month. In contrast, other labor market indicators remain robust. Unemployment claims are hovering near record lows and job openings have soared. Therefore, it would seem premature to assume that this slowdown will persist to the extent seen in April and May 2016.While we are not overly worried about the soft patch in employment, capital spending has been consistently underwhelming over the course of the recovery. This has only been exacerbated by the downturn in energy and a soaring dollar. Not surprisingly, productivity has begun to slip.
There are glimmers of hope that the headwinds from a strong U.S. dollar and weak energy prices are ebbing. The dollar index is below the level where it began at the start of 2016 in spite of the divergence in central bank policy. Rising oil prices may boost energy exploration; however, until the price of oil ensconces itself above $50 per barrel, we would not expect any dramatic increase in U.S. based exploration. Despite a recent uptick, the U.S. oil rig count is a full 50% below already weak year ago levels. With overall capacity utilization below 75%, a sudden capital spending binge would seem unlikely.
Nonetheless, with the consumer representing almost 70% of the economy, the outlook for a continuation of moderate growth seems well supported. Furthermore, sluggish global growth and the uncertainty shock from Brexit will result in more accommodative policy here as well. “Lower for longer” will remain an apt phrase to describe interest rates and bond yields as central banks including the Federal Reserve seek to reassure nervous investors. At most, we now expect one 25 basis point rate hike from the Fed this year versus our pre-Brexit expectation of two rate hikes. Fiscal policy is also more stimulative with modest increases this year in defense and domestic spending after the 2015 budget compromise. We suspect that voters may be tiring of austerity, and fiscal policy is likely to be more expansionary post-election, regardless of the outcome.
While the economy is progressing according to the contours of our outlook, financial markets have been less cooperative. Equities have been subject to bouts of volatility, most recently as a result of the Brexit mini-panic. U.S. stocks fell over 5% after the U.K. referendum but have recovered nearly all of their post-Brexit losses. Despite a true correction in February 2016, the S&P 500 Index still managed to return 3.8% in the first half of 2016. Thus, our forecast at the start of the year for high single digits S&P gains in 2016 remains achievable.
Our projection for the fixed-income market has, frankly, missed the mark, although we have ample company in this regard. We started the year with the expectation that the Federal Reserve would increase rates two or, at most, three times, somewhat more dovish than the consensus view of four rate hikes. Instead, the Fed has found itself constrained by developments overseas, including the recent Brexit vote and the resulting political instability in the EU and slowing growth in China. At this juncture, we expect only one rate hike in 2016, especially as we are in an election year.
Over the past six months, we have steadily trimmed our initial estimate for the yield on the 10-year Treasury note at year end 2016 from a range of 2.5% - 2.75% to our current view of 1.75% - 2.0%. With bonds in much of the developed world saddled with negative yields and the U.S. 10-year presently at a “lofty” 1.45%, we may have to cut our forecast yet again. With core inflation having moved up to 1.6% and energy prices no longer at rock bottom, the environment is just plain miserable for investors seeking safe, real returns. For several months, we have suggested that fixed-income currently serves investors more as a diversifier in a portfolio by providing stable value, rather than a driver of absolute returns. With inflation likely to edge higher over time, we will look to add to inflation protected securities on weakness.
The good news for investors is that lower yields, in addition to aiding interest sensitive sectors of the economy such as housing and autos, also provide support for equity valuations, which are no longer at bargain levels and hovering near historical averages. This is particularly important when profit margins may have peaked and earnings have been under pressure. While earnings growth has been elusive this year, the outlook for 2017 is hopeful, especially if energy prices hold or move higher and the U.S. dollar remains steady. Investors are also likely to continue to favor stocks with decent dividend yields in order to replace shrinking interest income.
The most prominent risks to our outlook are policy related or geopolitical in nature. Brexit is a case in point and the election calendar remains busy across the globe. While the economic risk of Brexit may have been exaggerated and the impact on the U.S. is likely de minimis, Britain may well flirt with a recession as a result and Eurozone growth may be diminished just when a recovery was starting to take hold. Japan is also struggling to cope with a rising yen. As a result, we remain wary of heavy exposure to international developed equities.
Brexit is also a reminder about voter frustration with the status quo, and suggests that political contagion across countries is a distinct possibility. In the U.S., candidates on the right and left have attracted large followings with unorthodox economic views, particularly concerning international trade. It is unlikely that restricting imports through high tariffs or other means would have a meaningful impact on jobs and, in the long run, would result in a less efficient, productive economy. The last thing a faltering global economy needs is a trade war. One hopes the majority of voters understand this.
As implied from the discussion above, risk from overly stringent monetary policy is reduced. The pace of Federal Reserve tightening has moved from gradual to glacial. Foreign central banks continue to flood the market with liquidity by almost any means possible. The Bank of England is likely to cut its base rate by 50 basis points to zero to provide support in the wake of the Brexit vote. Systemic financial risk remains a concern, but major U.S. banks just received a clean bill of health and appear strong. Concerning fiscal policy, the U.K. referendum may have diminished the allure of austerity in the eyes of political elites and the likelihood of higher government spending is increasing which would at least provide a near term lift. Finally, it is clear that disruption from terrorism is still a concern that will not disappear.
The views expressed are those of Washington Trust Wealth Management and are subject to change based on market and other conditions. The information provided is solely for informational purposes and has been obtained from sources believed to be reliable but its accuracy is not guaranteed. All information is current as of the date of this material and is subject to change without notice. The information should not be considered a solicitation to buy or an offer to provide investment advisory or other wealth management services. The information provided does not constitute investment, legal, accounting or tax advice and it should not be relied on as such. 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 risks, including possible loss of principal. Past performance is no guarantee of future results. 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.