What to watch in the second half of 2016: the Fed, the dollar, crude oil prices, and corporate profits.
The current expansion has weathered several slowdowns over the past six years. Contributing factors are easily identified. The strong dollar and weak global growth have held down exports, the collapse in energy prices has stalled U.S. energy-sector business investment, and falling consumer sentiment has restrained consumer spending (Chart 2). Despite periods of weakness, the economy continues to grow, and the labor market continues to tighten.
We believe four key items will be particularly important in determining the strength of growth in the second half of the year, and we will watch them closely: the Fed, the dollar, oil prices, and corporate profits.
Watch the Fed. Fed policymakers have hinted that the target for federal funds interest rates may increase again soon. They have indicated it is in the economy’s best interest to return to a more neutral policy stance and that, in their view, it is strong enough to absorb another rate increase. A rate increase could have wide- ranging effects whose magnitude could vary significantly. Among the more susceptible areas are big-ticket items like houses and autos, where an interest rate hike could result in reduced residential investment and consumer spending.
Watch the dollar. A rate increase could also lead to a stronger U.S. dollar, exacerbating the already difficult competitive position of U.S. exporters. Making U.S. exports more expensive could further reduce export growth.
Watch crude oil. Crude-oil prices have rebounded to nearly $50 a barrel. While that is still likely below the break-even price for many U.S. oil drillers, if prices continue to climb, increased investment by oil drillers could help reverse overall declining business investment.
Watch profits and profit margins. Corporate profits are vital to business decision making. Reasonable prospects for future gains can lead to faster hiring and stronger business investment. Conversely, a weakening profit outlook can result in layoffs and spending cutbacks.
The recovery to the neutral 50 percent threshold in our Leaders index after two consecutive monthly readings at 38 percent supports our view that continued strength in the labor market will encourage further gains in consumer spending and faster real GDP growth overall and will help the economy avoid a recession. Of the five changes among the Leaders, four improved in the latest month while one worsened. In total, four were trending higher: real new orders for consumer goods, the average workweek in manufacturing, real retail sales, and the Treasury-yield spread. Among the remaining indicators, four were trending lower, while four were neutral.
Among the four Leaders that are trending higher, two are consumer related: real retail sales and real new orders for consumer goods. Favorable trends in these two indicators are particularly reassuring, as consumers represent about two-thirds of the overall economy. Together, they suggest that a virtuous cycle of spending gains leading to higher production could result in additional hiring, faster income growth, and subsequent future gains in consumer spending.
The percentage of expanding coincident indicators held steady at 75 percent for the fourth month in a row. Among the coinciders, four were trending higher while one was trending lower and one was neutral. The proportion of lagging indicators expanding rose to 92 percent from 83 percent in the prior month (Chart 3). Among the laggers, five were trending higher, while one was neutral.
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