Crunch Time

In the next few weeks, economic reports that were delayed due to the partial government shutdown will continue to trickle in, helping to piece together the fourth quarter picture. That’s fine but investors are more interested in the future. Will stalemates on the budget and trade policy be resolved? In his Monetary Policy Testimony to Congress (February 26 and 27), Fed Chairman Powell is likely to arrive with a comforting demeanor, but will the markets accept that?

Fear was a critical factor in January. Consumer and business expectations took a tumble, made worse by trade policy uncertainty and the partial government shutdown. With the shutdown ended (at least temporarily), expectations should rebound but probably only partially.

Earnings reports have been important, but on a day-to-day basis, the stock market has reacted closely to shifting perceptions on U.S./China trade negotiations. Recall that the 10% tariffs on $200 billion in Chinese goods are set to rise to 25% on March 1 if an agreement is not met. President Trump has also threatened to impose tariffs on the remaining $267 billion or so of Chinese exports to the U.S., mostly consumer goods. Tariffs are a tax paid by U.S. consumers and businesses. They have invited retaliation (tariffs on U.S. exports) and disrupted supply chains. The president may impose tariffs on imported motor vehicles (beyond those exempted in the U.S.-Mexico-Canada Agreement). There is clearly a potential of more serious disruptions to the U.S. economy.

The partial government shutdown, the longest ever, was a colossal failure. Federal workers will recover and any slowdown in spending should be short-lived, but some economic activity was lost forever. Real GDP growth for 1Q19 is likely to be a few tenths of a percentage point below what it would have been otherwise. An “initial” estimate of 4Q18 GDP growth (something that is effectively between the usual advance and 2nd estimates) will arrive on February 28. That’s likely to be a mixed bag. Expect some noise in inventories and foreign trade related to the Chinese tariffs. Consumer spending, 68% of GDP, ought to have remained relatively strong. While the drop in expectations is a concern, that should prove temporary. Strong job gains, the pickup in wage growth, and the increase in purchasing power related to the decline in oil prices should support consumer spending growth in the first half of 2019.

Business fixed investment, on the other hand, is likely to be a bit soft. The academic literature had suggested that the corporate tax cut would be more likely to boost share buybacks and dividends than capital spending – and evidence is consistent with that outcome. The drop in oil prices should lead to a softening in energy exploration, which is capital intensive and has accounted for a large share of the growth in business fixed investment in the last two years. December’s data on durable goods orders will arrive on February 21. Figures through November showed lackluster trends in orders and shipments of capital goods. Expectations matter a lot for business investment. Talk of recession could become self-fulfilling as firms curtail expansion plans. Softer global growth and trade policy uncertainty aren’t helping.

Residential construction accounts for a relatively small portion of GDP (less than 4%) but has often been an early indicator of broader economic weakness. The housing sector slumped in 2018, but that was not a reflection of weak demand. Instead, home price appreciation added to affordability issues. Mortgage rates rose, peaking in the first half of November, but have since retreated, which should lead to a pickup in activity heading into the important spring housing season. Consumer expectations have been a negative, but that shouldn’t last. As expected, the recovery in housing following the financial crisis was gradual. However, the one missing element has been a rebound at the lower end of the market. Higher building costs had made that recovery difficult.