December 2016 Economic Commentary and Capital Market Update

Recap: Retail sales started the fourth quarter with a bang, rising 0.8% on top of an upwardly revised September reading. Strong auto and gasoline station sales provided a lift to the headline, but even excluding these components retail sales rose a solid 0.6% in October and 4.3% over the past year. The consumer appears well-positioned to make further gains in the fourth quarter, and it is expected that real consumer spending growth will settle in at around a 2.5% rate in the quarters ahead. Housing starts also surprised to the upside in October, surging 25.5%. Building permits rose less dramatically than starts, suggesting some payback may be in order. With a month remaining in the year, single-family starts are up 10.1% year to date.

In manufacturing, industrial production was unchanged in October. The weakness was confined to the utility sector which fell last month amidst the warmest October since 1963. Output in the manufacturing and mining sectors, better bellwethers of production trends, increased over the month. Durables production was up 0.4%, aided by another strong month of production in the auto sector, while nondurable goods output was flat. Even with the gains of recent months, the trend in manufacturing was essentially sideways; total manufacturing production was only even with its year ago level.

Inflation continued its slow but steady rise toward the Federal Reserve’s 2% target in October. The Consumer Price Index (CPI) rose a strong 0.4% in the month, bringing the year-over-year pace to 1.6%. Rising energy and shelter prices contributed to the monthly gain, while prices for food fell for the sixth consecutive month, marking the largest year-ago decline since December 2009. Inflation expectations, an area which the Fed has closely monitored, have also shown recent signs of firming. Inflation compensation based on Treasury Inflation-Protected Securities (TIPS) was on the rise.

On balance, the economic data were supportive for a Fed interest rate hike in December. On the inflation side of the Fed’s mandate, prices have been accelerating amidst steady core services inflation and fading energy effects. The unemployment rate has been below 5% for some time now. Both the real GDP and wage growth has been on the rise. The Fed will likely seize the opportunity and raise the fed funds rate in December, followed by more hikes in 2017.

Real GDP: Gross domestic product expanded at an inflation- and seasonally adjusted annual rate of 3.2% in the third quarter of 2016, the strongest growth in two years. U.S. economic growth accelerated in the third quarter following modest growth in late 2015 and early 2016.

Quarterly Update December 2016

Consumer spending, which accounted for more than two-thirds of U.S. economic output, rose at a 2.8% annual rate in the third quarter. That report was up from an earlier estimate of 2.1% growth, though still a slowdown from the second quarter’s robust 4.3% growth rate for household outlays. Compared with a year earlier, after-tax corporate profits rose 5.2% last quarter, the strongest annual reading since the fourth quarter of 2012.

Corporate profits have been pressured in recent years by various forces including weak global growth, a strong dollar that dampened demand for U.S. exports and slumping commodity prices that battered the energy and agriculture sectors. But business earnings have shown signs of stabilization this year as some of those headwinds faded.

A measure of business spending, fixed nonresidential investment, rose at a weak 0.1% pace last quarter versus an earlier estimate of 1.2% growth. Business investment in structures rose more than earlier estimated. Net exports and inventories helped boost GDP growth in the third quarter, while a pullback in residential investment was a drag on the broader economy. A rise in federal-government outlays was mostly offset by a decline in spending by state and local governments.

Personal Income: Personal income rose 0.6% in October. Personal consumption however rose a meagre 0.3% in nominal terms, but the disappointment was negated by a considerable upward revision to spending in September, now reported at 0.7% (from 0.5% previously).

Real spending on both durables and non-durable goods advanced 0.8%. These relatively strong gains were offset by a 0.3% decline in services spending. The personal saving rate jumped to 6.0%, from 5.7% in September. Inflation, as measured by the year-on-year change in the personal consumption deflator, accelerated to 1.4% in October from 1.2% in the previous month. Core PCE inflation (ex food & energy) remained steady at 1.7% for a third straight month.

Spending slowed in October, but consumer fundamentals remained robust. For example, real personal disposable income growth looked to rise by around 3.0% in the fourth quarter, giving continued support to spending growth. Much of the weakness in services spending was likely attributed to declining utilities spending due to an abnormally warm October, with this drag likely to reverse in the months ahead. With strong income gains over the past several months and a hefty saving buffer, the outlook for the holiday season is bright.

Inflationary Expectation: The sharp adjustment in government yields following the U.S. election has spread globally. While the U.S. 10-year yield has been the big mover – up nearly 50 bps and now exceeding the S&P 500 dividend yield – similar experiences have been mirrored by government bond yields in Germany, the UK, and Canada.

The current level of 10-year yields, at approximately 2.2%, is consistent with U.S. economic fundamentals, but the speed of the sell-off in bonds prices would certainly qualify as a jaw-dropper. The quick adjustment now leaves Treasuries accurately pricing an economy moving towards inflation targets and some normalization of excessively low term premiums. With the Presidential election over markets could no longer discount domestic economic fundamentals that will likely to be reinforced by policy initiatives under the new government. The potential implementation of trade barri¬ers, fiscal spending initiatives, and tighter immigration are all inflationary, especially within an economy that is approaching full employ¬ment. What is certain is that markets have been keenly aware of the potential threat of an inflation overshoot.

Housing: Data on housing have been more mixed, with new home sales falling more than expected, but existing home sales surprising to the upside and reaching the highest level since February 2007. The recent climb in interest rates will likely pull forward home sales as consumers try to lock in rates, while having a dampening effect on activity in subsequent quarters. The recent back-up in mortgage rates may slow, but is unlikely to derail the U.S. housing recovery. Rising employment and wage growth should continue to be the dominant factor in driving future home sales.

Quarterly Update December 2016

Labor Market: By most measures the U.S. labor market is quite close, if not already at, full employment. There remains some slack at the margin among those working part-time for economic reasons and individuals on the fringes of the labor force, but the pool of available labor has diminished to a level consistent with full employment.

So, what should be expected when the labor market achieves full employment? For job growth, nonfarm payrolls will continue to gradually moderate as the supply of job seekers dwindles. The labor market only needs about 110,000 new jobs a month to hold the unemployment rate steady, even accounting for a cyclical rebound in participation. Further tightening in the labor market should prompt a continued strengthening in wage growth. In the absence of a pickup in productivity growth, rising unit labor costs will force companies to either accept lower profit margins or pass the costs onto consumers through higher prices.

Small Business Optimism Index: The NFIB’s small business optimism index rose 0.8 points to 94.9 in October. Despite the uptick, the current confidence level was still almost 3 points below the long-term average. Five of the ten sub components rose in the month, three fell and two remained unchanged. Notably, plans to increase inventories saw a clear improvement, while expectations about the economy fell back into negative territory. Labor market indicators remained generally supportive as hard-to-fill job openings rose, while the share of firms planning to increase employment remained unchanged.

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Last month, the NFIB introduced a new index to gauge the level of uncertainty among small businesses. This index rose to 88 in October, a level that was an all-time high and more than twenty points above its long-term average. Small business confidence has generally lost some steam in recent months. Much of this moderation in optimism was due to the uncertainty surrounding the Presidential election, which made it harder for owners and managers to make key decisions – such as hiring additional staff or making capital investments. The NFIB’s newest measure would suggest that uncertainty is at an all-time high, adding credence to this view.

Moreover, some uncertainty is likely to linger on well into the new session of the next U.S. Congress set to begin in early January. Additionally, a resumption of the gradual interest rate-hiking cycle in December could add a further layer of near-term volatility. Going forward, sustained improvements in confidence are unlikely to be felt until well into 2017 subject to events that unfold.

Holiday Sales: The holiday shopping season is here, but with slow growth to start the year many retailers are wondering if this holiday season will be something to celebrate. Consumer confidence has remained roughly unchanged from the year-earlier period; however, consumers’ assessment of current economic conditions has been more upbeat. A slight pick-up in inflation has led to flat readings of real disposable income; however, job growth has remained robust. Holiday sales are expected to rise 3.8% this year compared to the 2.9% last year. While the absence of inflation pressures last year held back the pace of holiday sales, this year’s sales growth forecast should receive a slight boost from somewhat higher prices this holiday season. Net of inflation effects, real consumer spending is expected to grow around 2.5% in the fourth quarter on an annualized basis, matching the pace of growth in the fourth quarter last year.

Fiscal Stimulus: A unique point to consider is the potential for large-scale fiscal stimulus under a Trump administration. President-elect Trump has proposed a sizable fiscal policy prescription rather late in the business cycle, a dynamic for which there is not much recent precedent. Were this plan to come to fruition, wages would accelerate more briskly, inflation would run faster than currently anticipated, unemployment would drop below the natural rate and the Fed would have to weigh a more rapid tightening of monetary policy.

FED: The market is now fully pricing in a rate hike in December with a probability of higher than 90%. Rising inflation expectations in the aftermath of the election have strengthened the case for a hike, while December’s payrolls report should provide further support. With both its inflation and employment mandates in sight, the Fed’s focus will shift from the degree of monetary policy accommodation to determining the ‘neutral’ fed funds rate and how rapidly the Fed should move toward this equilibrium. In other words, the relevant question should shift from whether the Fed would hike to how fast it would hike going forward.

Still, with the unemployment rate quite low, there is a possibility that the economy could run a little hot, especially with the fiscal stimulus that has been pledged by the new administration. If that were to materialize, the hiking cycle would likely run a little faster as well. As such, the path of interest rates beyond December is perhaps even more uncertain now than before the election. More clarity is likely to come in late January when the new administration begins to implement its agenda, while the Fed adjusts accordingly.

Oil Market: The anticipated OPEC meeting ended with a deal to cut production to 32.5 million barrels per day (a cut of roughly 1.2 million barrels/day according to OPEC), beginning on January 1, 2017. The agreement is for six months, and extendable for another six months depending on market conditions. Under the agreement, Saudi Arabia, Iran and Iraq’s oil production would be capped. The deal was reached following an understanding that key non-OPEC countries, e.g. Russia, would also reduce production.

The fact that OPEC member countries have signaled their intent to help bring the market into balance is a positive for oil markets. The deal is for six months, or possibly a year, suggesting that after that timeframe, production could shoot back up as OPEC producers resume their fight for market share. What’s more, OPEC members have been notorious for producing above target levels, which would prolong the rebalancing process. Until markets see an actual cut in production, prices will be hard-pressed to gain much further ground on a sustained basis.

Russia’s supposed agreement is also a positive for markets, but the country has already been producing at record levels. A cut of half a million barrels per day would bring it back to the then-record output levels seen a year ago.

The U.S. is not part of this deal, and if prices were to rise to above US$50 per barrel, hedging activity would likely pick up, helping to prop up production domestically. Moreover, that would likely be enough to trigger investment in the shale sector, also leading to higher production levels, and limiting any oil price increases.

If OPEC could adhere to these quotas, it would help to reduce the glut that has plagued the market over the last two years. Some production could be scaled back, but perhaps not the full amount. As such, prices would be expected to trade in the US$45-55 per barrel range over the next year, reaching the higher end of that range by mid-2017 as the market shows some signs of rebalancing.

Outlook: The current macroeconomic backdrop alone is enough to justify a gradually higher fed funds rate and slowly normalizing term premium. Wage growth is accelerating and employment growth will continue to eat into slack. The fundamentals for higher inflation have been in place for some time. The election has very quickly solidified this reality in the eyes of investors and futures markets have now moved toward solidifying this view.

With unemployment hovering around 5% for more than a year and long-sluggish U.S. inflation appearing to firm, it is believed that the Federal Reserve will raise short-term interest rates at its upcoming Dec. 13-14 meeting, barring unexpected developments in economic data or financial markets.

However, this is not the only story. Future policies, namely the potential for greater fiscal deficits, as well as increased tariffs and reduced immigration has been suffi¬cient to move inflation expectations from below the Federal Reserve’s 2.0% target to above it. As long as these risks are at the forefront investors should look for interest rates to continue to move higher and the U.S. dollar to remain strong.

Index Performance as of 11/30/16

Quarterly Update December 2016

Sources: Department of Commerce, Department of Labor, National Federation of Independent Business, National Association of Realtors.