Recent economic data reports have helped to fill in the picture of the economy in the first half of the year. However, investors should be more concerned with the prospects for the second half of the year. No surprise, economic expectations remain sharply divided along political lines. Optimists and pessimists should both be wrong, as the economy muddles along in the second half. A mediocre pace of growth ought to be as good as it gets in the new normal. There are some downside risks, reflecting possible policy mistakes.
Real GDP growth rose at a 1.4% annual rate in the 3rd estimate for 1Q17, up from 1.2% in the 2nd estimate and +0.7% in the advance estimate. Most of the upward revision to growth was in consumer spending (which accounts for nearly 70% of GDP), and most of that was in healthcare (detailed figures on services are reported with a lag). Note that unseasonably warm temperatures lowered household energy consumption in 1Q17, and a seasonally adjusted rebound will add to 2Q17 expenditures (ex-energy, consumer spending growth appears to be lackluster-to-moderate). Higher gasoline prices also had a dampening effect on spending in 1Q17, but lower prices at the pump should provide some support in the near term. Business fixed investment, at a 10.4% annual rate, was not quite as strong as estimated earlier, but 41% of that surge was due to a partial rebound in oil and gas well drilling. Lower oil prices are likely to dampen the recovery in energy exploration. Monthly data on capital goods orders and shipments point to a more moderate pace of business investment in the second quarter.
Inventory growth slowed sharply in the first quarter, subtracting 1.1 percentage points from headline GDP growth, and a rebound was expected to add significantly to second quarter GDP growth. However, while we have an incomplete picture, the pace of inventory growth does not appear to have picked up much in 2Q17. Imports and exports both rose in the first quarter, but improvement appears to have stalled somewhat more recently.
Putting it all together, GDP growth for the first half of the year is likely to have been about 2%, roughly in line with the trend of the last few years and consistent with the labor market dynamics (a reduction of slack, but also reflecting slower labor force growth). Note that this view is based on current information. Monthly figures are subject to revision and annual benchmark revisions to the National Income and Product Accounts will arrive on July 28.
While stock market participants remain optimistic, the Trump agenda is facing some pressures. Large-scale infrastructure spending would be supportive, if we were in a recession and it were financed by deficit spending, but what we have so far (privatization of air-traffic control) isn’t much. The repeal and replacement of the Affordable Care Act has been a precursor to tax reform, but tax reform is inherently difficult (as nobody wants to give up their tax breaks). Congress should still be able to cut tax rates later this year, but on a much smaller scale than was hoped for earlier. The budget and the debt ceiling should be easily surmountable hurdles, but you never know.
One of the main worries has been a possible misstep on foreign trade. The White House is reported to be close to stepping up trade conflicts. Economists on the left and right are horrified about the possibility of a trade war and rightly so. The focus on trade deficits with specific countries is misguided and dangerous. Already, some firms are reportedly looking to secure alternative supply chains (at added expense).
Federal Reserve policy is also prone to errors. While the Fed has made progress on normalization, the current policy stance is still accommodative. That’s harder to justify given the tightness in job market conditions -- hence, a consensus to continue raising short-term interest rates in the months and quarters ahead. Balance sheet reduction is expected to begin by the end of the year, most likely in October, and the Fed has indicated that this will start slowly. Inflation figures were heating up at the start of the year, but have since rolled back. The sharp drop in the price index for wireless telecom services in March pushed year-over-year inflation down, but Fed officials continue to expect a trend toward the 2% goal in the quarters ahead. Still, as the late Rudi Dornbusch noted, economic expansions never die of old age, asleep in their beds – the Fed kills them. It’s well known that monetary policy affects the economy with a long and variable lag. Mistakes are always possible, but the balance of information (credit still expanding, tighter job market) suggests that the Fed is on the right track. Expect to hear more in Yellen‘s monetary policy testimony to Congress (July12).
Even in the best of economic times, conditions are mixed across sectors and regions. With sharply divergent views and different sets of “facts,” perceptions vary considerably. Most financial market participants are Republicans and remain optimistic about the Trump agenda and the prospects for economic growth. Workers tend to be Democrats, and fear that standards of living will continue to deteriorate. Indeed, some of the recent softness in consumer spending appears to reflect a variety of strains on household budgets.
In the end, the optimists may be disappointed with the pace of growth, which will be limited by a tighter job market. At the same time, the pessimistic view appears to be overdone, at least in the near term. With the little amount of remaining labor market slack being taken up, there’s room for a bit better GDP growth in the second half, but not much beyond 2%.
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All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.
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