Business conditions continue to improve. Our index of Primary Leading Indicators rose for the third straight month, reaching its highest level since September 2015. Contributing to the increase were improvements in consumer expectations and real new orders for core capital goods.
Business Conditions Monthly
Consumer spending slowed to a 2.1 percent annual rate in the third quarter from a strong 4.3 percent pace in the second quarter, according to the latest data on real gross domestic product from the Bureau of Economic Analysis. On a year-over-year basis, personal consumption expenditures, a measure of real consumer spending, grew at a 2.6 percent rate, down slightly from a 2.7 percent pace in the second quarter (Chart 1).
Excessive debt played a major role in the Great Recession, from December 2007 to June 2009. In the seven years since the recession ended, home prices have rebounded, and households have significantly reduced their debt load. Only recently have households begun to increase their overall debt, which has inched up just 2 percent from when the recession began. Debt growth for corporate and small businesses has been more significant, rising 36.5 percent and 29 percent, respectively.
The U.S. economy continues to expand at a pace below its long-term average. Revised data show the economy grew at a 1.1 percent annual rate in the second quarter compared with a long-term average annual rate of 3.2 percent. Consumer spending, a key driver, rose 4.4 percent and contributed 2.9 percentage points to overall economic growth. Business fixed investment remains weak, hampered by poor performance in the domestic energy industry, but our conclusion remains that it may well improve in the second half of 2016.
The latest data on real gross domestic product, or GDP, show that the economy expanded an anemic 1.2 percent in the second quarter of 2016. That is the first time the U.S. economy has posted three consecutive quarters of growth below 1.5 percent since the time of the Great Recession.
The U.K.’s surprising June 23 referendum vote to leave the European Union (Brexit) caused dramatic moves in global capital markets. In the days that followed, politicians from around the world offered a wide range of comments, from support for Brexit and independence movements in other European nations to anger and threats. In the U.K. protesters against Brexit took to the streets, while a string of political resignations left a leadership void.
AIER’s Business-Cycle Conditions model rebounded in May to 50, a neutral position, following two months at 38, a level that had indicated economic weakness. This uptick supports our expectation that a strong labor market would boost consumer sentiment and spur further gains in consumer spending. It also justifies our reluctance to assert that a recession was likely when our index first fell below neutral. With our Leaders back at the 50 threshold, AIER researchers judge the risk of recession has receded, although it is still slightly elevated.
The AIER Business-Cycle Conditions model shows the Leaders index unchanged at 38 for a second straight month (Table 1). While a reading below 50 reflects significant economic weakness, we believe it remains too early to conclude that a U.S. recession is likely in the next six to 12 months.
The data we track to monitor economic trends indicate a weakening economy in the coming months. The latest update of the AIER Business-Cycle Conditions model shows a decline to 38 in our index of Leaders, its first drop below the neutral 50 level in 110 months. While this reflects spreading weakness and suggests caution, it is too early to call a recession for two reasons.
AIER founder Col. E.C. Harwood believed that business cycles matter and should be taken into account when making personal financial plans. He wrote his classic, “Cause and Control of the Business Cycle,” (https://www.aier.org/sites/default/files/Documents/Research/pdf/eeb197409.pdf) published in 1932, to help people understand their significance.
The U.S. economy has struggled with inconsistent performance for much of the current expansion, which began halfway through 2009. That inconsistency reared up again in the last three months of 2015. The initial estimate for gross domestic product, or GDP, the broadest measure of economic activity, shows that growth slowed in that period. Future revisions based on more complete data may show a different picture, but the first take puts real GDP rising at a meager 0.7 percent annual rate compared with a 2 percent pace in the third quarter and 3.9 percent in the second.
U.S. consumers are supporting growth, while credit tightening at the Federal Reserve and moderate economic expansion in the U.S. contrast with a sluggish global economy and generally stimulative central bank policies. Dollar strength and commodity weakness continue. Despite a roughly flat year for the broader market, commodity-related equities sharply underperformed the S&P 500 Index. Looking ahead, interest rates are likely to rise slowly, while the risk of recession remains relatively low.
Despite some risks, the U.S. economic outlook for 2016 appears favorable.
Despite some risks, the U.S. economic outlook for next year appears favorable. Consumer fundamentals continue to improve while household and corporate balance sheets are generally healthy. However, the prospect of rising interest rates poses a risk. Fed policy makers have indicated a gradual path is likely for future rate increases, suggesting a keen awareness of the risks to growth from overly aggressive tightening.
Global economic expansion is also a concern. While the U.S. depends less on exports than many other nations, the combination of slow growth and a strong dollar weighs on some sectors.
Our Leader’s index rose to 56 in the latest month from 50 in the prior month. Combined with our cyclical score of 70, we see the probability of recession in the next six to twelve months as relatively low.
The CPI rose in October after falling in the previous two months, helped by a slight increase in energy prices. The latest AIER Inflationary Pressures Scorecard points to a neutral reading, with 10 indicators supporting rising inflationary pressure and 11 suggesting pressure is falling. Two are stable. The major change this month came from wages and productivity. Rising private compensation levels and higher labor costs, along with lower growth in productivity, put upward pressure on inflation. But this was offset by a decrease in other producer costs. Overall, there is no evidence that inflation will change significantly in either direction in the coming months.
The Fed is expected to raise its target for the overnight lending rate between banks by a small amount this month, the first increase in almost a decade. Since this move is widely anticipated, it is unlikely to have significant economic effect.
At the same time, legislation pending before Congress would impose a new requirement that the Fed publicly disclose its interest-rate strategy and its reasons for any deviations. The bill, which has passed the House and is unlikely to pass the Senate, raised objections from the Fed, which is worried about its independence.
With bond yields near 60-year lows, it’s difficult to justify expected total returns in the high single-digit range, as we have seen since 1982 for this asset class. Investors should carefully review asset allocations and be prudent in estimating future gains.
U.S. equities have struggled this year as the effects of falling commodity prices and slow global growth weigh on the economy and earnings for some sectors. However, earnings are expected to rebound in 2016. Valuations remain close to the long-term average, especially given the low inflation environment. Overall, that suggests a neutral to slightly positive outlook for stocks. Investors may look to maximize exposure to domestic sources of growth such as consumer spending and capital investment outside of commodity-related industries.
Steady improvements in consumer fundamentals combined with still-solid consumer expectations provide a positive outlook for holiday spending, which can make or break retailer earnings. The strength of fourth-quarter consumer spending is likely to play a critical role in sustaining overall economic growth. However, our Leaders index fell back to a neutral 50 in the latest reading, adding a note of caution to the outlook. Despite that decline, our cyclical score remains solidly positive, suggesting a relatively low risk of recession ahead.
The CPI fell this month, the second back-to-back monthly decline this year. The latest AIER inflation Scorecard points to further downward pressure on inflation for the months ahead. Only seven out of 23 Scorecard indicators support rising inflationary pressure, while 14 suggest falling pressure. The decliners reflect many forces: demand and supply, money, banking and credit, and costs and productivity.
The Federal Reserve held off raising short-term interest rates at its October meeting. Yet, its follow-up public statement indicated that consideration of a hike will be on the table at the next meeting in December. Markets expect an increase, but some disappointing economic data have left room for doubt.
Congress adopted a budget bill that resolves immediate budget challenges. These include suspending the debt limit and setting parameters for government spending through September 2017. The measure also saves the Social Security disability program from collapse and limits for many Medicare participants an increase in Part B premiums that would have been the largest in history. But long-term fiscal challenges remain.
Investors are favoring stocks over bonds as the prospect of interest rate increases tempers the outlook for returns on fixed-income securities.
While the plunge in crude oil prices has begun to affect U.S. production, current rates of refining and high gasoline inventory levels are still helping to push pump prices lower.
Retail stocks have been strong performers throughout the current cycle, and our economic outlook suggests continued support for fundamentals, but valuations may raise concerns.
Unusual demographic shifts currently underway and slated to last for many more years may be affecting the overall economic growth rate as well as creating pockets of relative strength and weakness. One example is in housing, where multifamily construction has rebounded more robustly than single-family homebuilding following the housing boom and subsequent bust that helped usher in the Great Recession.
Our Leaders index improved slightly in the latest reading, while cyclical scores changed little. Taken together, the AIER data suggest that the risk of recession in the coming six to 12 months remains low.
The Consumer Price Index slipped month-to-month for the first time since February 2015. This is consistent with last month’s report that inflationary pressure was easing. The latest AIER inflationary Pressures Scorecard points to further downward pressure on inflation for months to come. Only eight indicators out of 23 show rising inflationary pressure, compared with 12 last month. The easing resulted from a recent slowdown in consumer demand and fast growth in supply. A decline in energy prices was another important contributor.
The Fed kept interest rates unchanged at its September meeting, in line with market expectations. But the central bank’s projections continue to indicate that the first rate hike in more than nine years is likely to occur by the end of December. After holding rates near historic lows for so long, anticipation of the initial step toward normalization in monetary policy may actually stimulate borrowing in the short run as people try to get ahead of future increases.
Demographic change is slowing growth in the labor force and gains in educational attainment. The fastest way to reverse this—skill-based immigration—is unlikely to garner political support in Washington. Alternative but slower solutions include making it easier for American youth to continue their education beyond high school.
Yields on mortgage-backed securities are about in line with their historical relationship to U.S. Treasurys. An improving economy and healthier finances for borrowers would boost overall loan quality and help narrow yield spreads slightly. However, the prospect of Fed interest rate increases is likely to boost pressure on yields across the fixed-income spectrum.
Lumber futures prices have fallen more than other housing-market indicators would suggest.
A bubble in stock prices of U.S. homebuilders from 2000 through 2005 was worse than the better-known tech-stock bubble of the late 1990s. Following the bust in homebuilder shares and the Great Recession, homebuilder stocks since 2011 have slightly outperformed the broader market.
Global equity markets have struggled in recent months, reeling from a worldwide economic slowdown, the effects of potentially higher U.S. interest rates, a strong U.S. dollar, and ongoing military conflicts that have created arefugee crisis. For those with a high tolerance for risk, these times can create opportunity.
Headwinds from China’s slowing growth and a devalued yuan may curb the U.S. expansion, but the risk of a recession remains low. Our Leaders index remained solidly above 50 percent in the latest month, suggesting the probability of a domestic slump is still low.
The CPI, compared with a year earlier, continued to advance for a second straight month in July, but future inflationary pressure has eased. In the latest AIER inflation scorecard, 12 indicators support rising inflationary pressure, compared with 17 in the last month’s report, and eight point to falling inflationary pressure, compared with just three last month. The pullback mainly came from a stronger U.S. dollar pushing down import prices and from improving business productivity. Going forward, should the Fed tighten credit by raising key interest rates, it would amplify downward pressures on prices.
Fed policy makers have long telegraphed their intention to raise short-term rates from near zero this year, but recent market turmoil may have raised fresh concerns about the timing of the first increase in almost a decade. The focus now turns to the mid-September meeting and whether the Fed will use the occasion to begin the normalization process and what policy makers might reveal about the central bank’s future plans.
The recent sharp fall in oil prices, driven both by China’s slowdown and rising U.S. crude output, is creating pressure to lift the long-standing U.S. crude export ban. Proponents say ending the policy would raise U.S. prices, stimulating investment, spurring domestic production, and cutting gasoline prices. In July, the U.S. Senate Energy Committee passed a bill to lift the export ban. Whether the measure will pass Congress and how the Obama administration may react if it does remains uncertain, but an end to the 40-year-old policy may be closer than ever.
Slowing growth in China coupled with a devalued yuan and improving U.S. consumer demand all suggest a widening trade gap with China. That, in turn, may lead China to buy more U.S. Treasury securities, helping to restrain gains in long-term yields just as Fed tightening approaches.
Commodities are still struggling with no short-term relief in sight. But over the medium term, better global growth and a stable dollar combined with the deep price declines that have already occurred suggest that there may be light for raw materials at the end of a long tunnel.
U.S. equities are still getting fundamental support from profit growth. Risks from rising labor costs and higher interest expense may threaten profit margins, but productivity may be the magic bullet that facilitates profit growth and higher wages that can, in turn, boost future spending.
Global equities have been volatile and U.S. investors gave mixed signals with their new investment dollars ahead of the worst declines in Chinese markets. New cash would help support markets, while additional withdrawals from global market mutual funds and ETFs would hurt. Fed tightening remains on the horizon as a potential new source of volatility, especially for emerging markets.
While the latest data confirmed our reading at the start of the year that economic weakness was temporary, and despite accelerating growth in the second quarter, the more complete and detailed information released last month show that the recovery since 2012 has been slower than previously reported. Today’s GDP value is almost one percentage point lower than earlier estimates led us to believe. This means the current business-cycle expansion, whether measured by output or employment growth, has been the slowest in U.S. postwar history.
Strong CPI growth in June underlined AIER’s analysis last month pointing to rising inflationary pressures. The latest scorecard shows that 17 out of 23 indicators support rising inflationary pressure, compared with 15 in our previous report, indicating a higher likelihood of future price increases. Anticipated policy firming on interest rates may moderate rising inflationary pressures.
Fed policy makers did not provide any new signals on the timing of an increase in short-term interest rates following their July meeting. and despite the weaknesses highlighted in the revised report, the Fed continues to indicate that its policy remains on track for a liftoff this year.
With still-modest growth and inflation, bond yields remain very low. However, a slowly improving U.S. economy and declining unemployment may support the Fed’s first rate hike in almost a decade. That, in turn, may pressure bond yields higher, but the question of how high yields may rise remains open.
Weak global growth and a strong dollar have sent most commodity prices tumbling to multi-year lows. Add to that a price war in crude oil and the decline in demand for gold as a haven and the environment for commodities remains unfavorable.
While some U.S. labor market measures are at record levels following six years of expansion, others hold room for improvement compared with past performance in previous recoveries. Our view is that the economy remains resilient, growth is reaccelerating from a temporary first-quarter weakness, and the likelihood of recession in the next six to 12 months remains low.
AIER’s inflationary pressures scorecard suggests an increase in May as 15 of 23 indicators showed rising pressure compared with six that displayed declines, suggesting that prices may rise in coming months. Among CPI components, energy climbed at a fast pace in May, contributing to strong growth in the index, while food prices stayed unchanged. In the labor market, more jobs were created, but productivity growth slowed and labor costs rose, putting upward pressure on inflation. Stubbornly high rates of underemployment and discouraged workers are areas showing room for further improvement in a market closely watched by Fed policy makers poised to raise short-term rates for the first time in nine years.
First-quarter weakness, though seen as temporary, led to scaled-back growth projections from the Fed in June. While policy makers left short-term rates unchanged at their June meeting, a majority of FOMC members expect an increase later this year rather than a delayed take-off in 2016. At the same time, they expect the pace of normalizing policy to be slower than previously anticipated.
Employment and incomes are not expanding as robustly in this recovery as both did in earlier cycles. As long as uncertainty in jobs and earnings persists for large parts of the population, political attitudes are likely to favor protectionist tendencies in trade, immigration, and on other issues.
Federal budget deficits remain large by historical measures but have narrowed substantially in recent years, curbing the Treasury’s need to issue new debt. Combined with ongoing geo-political risks and uncertainty, the resulting reduction in issuance could partly offset the negative effects of anticipated rate hikes.
In the world of precious metals, gold prices have outperformed silver by a wide margin in recent years, suggesting that silver will be the better performer in coming years, based on historical patterns.
Further improvement in labor markets should begin to push compensation costs higher, supporting consumer spending but also potentially squeezing corporate profits. Companies will need to either pass along higher costs, boost productivity, or both, to maintain earnings growth.
Globally, market performance has been quite divergent. U.S. equities have performed admirably, particularly compared with developed markets. Greece and China had roughly similar histories until the Great Recession. Since then, Greek shares have languished while Chinese indexes have posted large gains, only to suffer recent sharp declines.
The recovery’s accelerating credit growth provides a positive sign for the economy and the financial sector.
Our business-cycle leader’s index picked up in May, jumping to 64 following three months at the neutral 50 level. Despite a poor first-quarter performance amid unusually harsh weather, we expect real GDP to return to a moderate pace of growth, with private domestic demand faring even better. We base our analysis on sound fundamentals seen in key areas, including consumer spending, business investment, and to a lesser degree, residential housing. An improving economy should encourage moderate credit growth and an opportunity for lenders to boost income. Commercial bank lending has expanded in key categories for several years as financial institutions capitalize on interest rates that have remained near historic lows.
Recent data suggest a reemergence of inflationary pressures. Overall, 12 out of 23 measures tracked by our inflationary pressures scorecard point to rising price pressures, up from nine last month. Energy prices have rebounded from the plunge in the last half of 2014, while the coincident rally in the U.S. dollar tailed off in March. Since then, the depreciating value of the currency has pushed up import prices.
The Consumer Price Index rose in April for the third straight month. The increase in food prices, which lasted throughout 2014, has stalled this year. At the same time, energy prices have firmed. These two forces largely offset one another, resulting in only a mild increase in the overall CPI. The increase in core CPI, which excludes volatile food and energy prices, remains close to its long-term historical average.
Fed officials continue to explain their thinking and current views on the economy while laying out their framework for reaching a decision on “liftoff.” They need to see continued improvement in the labor market and they need to have “reasonable confidence” that inflation is headed back up to the 2 percent goal. Projections by Fed members for the outlook for inflation suggest confidence has weakened recently.
Fed Chair Yellen noted in a recent speech that the FOMC would proceed cautiously during the period of policy normalization, that she and her colleagues at the Fed are data-dependent, and that interest rates are not on a predetermined course. We expect the first rate increase later this year but only periodic increases after the initial “liftoff.”
Credit growth is typical for a healthy and expanding economy and is a positive development for financial stocks. For some financials, the rebound in equity markets and the improving economy have been positive supports. The low interest-rate environment can benefit issuers of debt but can be a challenge for lenders who earn income on spreads, or the difference between what they charge borrowers for loans and what they pay for the money they lend.
Financial stocks in the U.S. have trailed the rebounding S&P 500, which has marched to fresh records at least 10 times this year, yet conditions suggest support for further gains. Global financial shares have performed best in emerging markets and Asia outside Japan. Sector stocks with the biggest growth potential—and the greatest risk—may be found in Europe and Japan.