November 2016 Economic Commentary and Capital Market Update
Recap: U.S. economic growth accelerated in the third quarter of 2016, easing fears of a near-term slowdown but doing little to change the trajectory of this long but weak expansion. Real gross domestic product expanded at a 2.9% annual rate in the third quarter. That was stronger growth than the second quarter’s pace of 1.4%, and the fastest recorded in two years. The third-quarter acceleration largely reflected increased exports and a buildup of inventories, while consumer spending increased at a slower rate. The latest data do not point towards a new growth path but rather a strong rebound following one year of soggy growth.
The improvement could give Democratic presidential nominee Hillary Clinton more latitude to position herself as the candidate to continue Obama administration policies that have led to a long modest expansion. Still, the most recent economic gain was a part of the weakest expansion in recent memory, a point Republican candidate Donald Trump has made frequently. Since the recession ended in mid-2009 the economy has grown at roughly a 2% annual rate, making the current expansion the weakest on record dating back to 1949.
The latest data suggests the economy this year won’t top 2015’s 2.6% growth rate, the best annual reading of this current expansion. The economy has failed to grow better than a 3% in any year since 2005. And while economic output advanced at a quicker rate last quarter, hiring was also stronger than in the second quarter which could restrain improvement in worker productivity. Worker productivity has decreased for three straight quarters, through the midpoint of this year, and has been weak for much of the expansion.
The acceleration in growth in the third quarter, as well as continued improvement in the labor market and indications of higher inflation are likely to lead the Fed to raise the federal funds rate in December.
GDP: Real GDP grew by 2.9% during the third quarter of 2016. Americans buying cars, furnishings and durable goods offset another quarter of underwhelming business investment to give the economy a modest lift after a year of about 1% growth. Consumer spending contributed 1.47%, or more than half of the quarter’s growth. A burst of exports chipped in another 1.17%, offsetting a smaller increase in imports. The disappointment again was private business investment, which contributed 0.52% to GDP. That follows three quarters of negative investment contributions and has been the best showing since the first quarter of 2015. Business spending on oil wells, buildings and the like increased suggesting the recession in the oil patch may be over.
The GDP contribution from overall fixed investment was a negative 0.09%, the fourth straight quarter in which it subtracted from growth. This has continued the investment gap that has made this the worst expansion since World War II. The lack of investment would suggest the third quarter probably signals only a modest rebound, more than liftoff to a higher economic growth plateau.
Inflation: Headline inflation rose 0.3% in September helped by a 2.9% jump in energy costs. The strong September increase lifted the annual inflation rate up to 1.5%, marking the fastest pace in nearly two years. Services have been a key source of inflation so far this year, and that trend continued in September as annual services inflation ticked up to 3.0%.
Core inflation rose only 0.1% in September. On an annual basis core inflation sat at 2.2% in September, continuing its oscillating pattern between 2.0% – 2.3% as the strong U.S. dollar has kept core goods prices in deflationary territory, helping to offset increasing price pressures emanating from services like housing and medical care. Core prices should not get too much stronger over the coming months though headline inflation is expected to rise in the coming months as the downward pressure from the past drop in energy prices falls out of the year-over-year calculation.
Consumer Confidence: Consumer confidence slipped 4.9 points in October to 98.6. Even with the slight pullback in confidence, the overall level is consistent with consumer spending serving as a key support to growth. A bit more concerning has been the downward trend in the expectations component of the index which could suggest a downshifting in real spending behavior could be on the horizon. With consumer spending serving as the one consistent support to GDP growth over the past few quarters, any downshift in spending could have a dramatic negative effect on headline GDP growth.
Housing: Low mortgage rates, solid job growth and rapidly rising rents across the country have continued to support the single-family market. Multifamily housing starts had plummeted in September, dragging total starts down. Healthy buyer traffic and house price appreciation are likely to boost construction in the coming months, as the inventory of homes for sale has remained exceptionally tight. Higher than-expected building permit activity in September would support this notion. Moreover, home builders appeared encouraged by market fundamentals. Builders across all four regions in the country would seem to share in the optimism, with the six-month average for all four regions at a healthy level.
Existing home sales also rose across all the regions in September, the first gain in existing home sales since June. First time homebuyers made up 34 percent of purchases in September, which was the largest share since 2012 and an encouraging sign for future activity. Inventory increased 1.3% though the 4.5-month supply has continued to reflect an exceptionally tight market.
Improvement in inventory as well as an increase in activity among first-time home buyers – both long awaited positive trends – were welcome signs. In the coming months, first-time home buyers should continue to benefit from a healthy job market, rising wages, and low mortgage rates. Moreover, new construction would appear to be shifting towards more affordable houses, which should help the availability of starter homes. Overall, the gradual recovery in the housing market should continue.
Industrial Production: Industrial production increased by 0.1% in September. Production rose at a 1.8% annualized rate in the third quarter, the strongest quarterly gain in a year as manufacturing and mining activity stabilized somewhat. Despite another unseasonably warm month, utility production fell 1.0% in September. Therefore, September’s uptick in production could be traced to the mining and manufacturing sectors.
Output in the mining sector rose 0.4% in September. Manufacturing, which would account for just over three quarters of total industrial production, rose 0.2%. That put manufacturing production for the quarter up at a 0.9% annualized rate, which was an improvement over the prior three quarters, but still relatively weak. September’s stronger than expected reading for manufacturing was due to a 0.5% gain in nondurables, while durables production was flat.
Non-Manufacturing Index: The Institute for Supply Management’s (ISM) non-manufacturing index staged a healthy comeback in September, rebounding by 5.7 points to 57.1. Gains were broad-based with nine out of the ten sub components rising on the month. The largest increases were seen in the important business activity and new orders sub components, both of which have recovered after falling sharply in August. Employment also fared well, rising for the first time in three months to the highest level since October 2015.
Alongside an increase in industrial production, the performance of the non-manufacturing sector helped to alleviate concerns about the health of the U.S. economy, pointing instead to rejuvenated economic activity.
Global: Data released in October showed that real GDP in China in the third quarter of 2016 rose 6.7% on an annualized basis. It was identical to the growth rate that was registered in the second quarter. The slowdown that occurred in China over the past few years largely reflected significant deceleration in investment spending over that period. However, growth in overall investment spending has now stabilized as residential construction has accelerated due, at least in part, to more accommodative financial conditions. That said, Chinese GDP growth should slow further in the coming quarters as growth in investment spending downshifts again.
Economic indicators out of the United Kingdom added to the evidence that, despite the shock of the Brexit referendum on June 23, economic activity in that economy has continued to expand in the third quarter (Q3). For example, real GDP in the United Kingdom grew at a sequential rate of 0.5% (2.0% on an annualized basis) in the third quarter, which represented a modest slowdown from the 0.7% rate that was registered in Q2. Real retail sales rose in Q3 relative to the previous quarter and the unemployment rate held steady at an 11-year low of 4.9%. However, there were also signs that the British economy lost a bit of momentum as it entered the fourth quarter. Following a surge in July, real retail sales were flat in August and September. The number of workers filing for unemployment insurance stopped declining. Industrial production in the first two months of Q3 stood 0.3% below its Q2 average.
Real GDP in the UK is still expected to contract modestly in coming quarters. Consequently, the Bank of England is likely to ease monetary policy further in the coming months.
The European Central Bank recently decided to keep its accommodative policy stance unchanged until it saw a sustained increase in the rate of inflation back toward 2%. Specifically, the Governing Council left all three of its policy rates unchanged and maintained the size of its quantitative easing (QE) program at €80 billion per month. The ECB will likely decide to extend the QE program beyond next March, when it is expected to end.
Outlook: While the pace of economic growth in the United States is expected to pick up in the second half of this year, the breadth of the recovery remains narrow—the consumer and housing will lead the way, while the tensions of gradually rising inflation, a Fed move, and weak profits set a ceiling on the pace of improvement. A stronger U.S. dollar and still disappointing global growth will limit the gains in trade beyond the current quarter. Real economic growth of 2.2 percent for the current quarter with real final sales at a comparable 2.3 percent are reasonable targets.
For the year ahead, improvement in business equipment spending, non-residential construction and less of a drag, or even a modest gain, from inventories is expected. Inflation will equally continue its slow drift upward toward 2 percent, but will this pace provide enough for the FOMC to follow its intentions of one rate increase in December and two more in 2017?
All in all, with near-term market expectations for monetary policy converging to those of the Federal Reserve and the economic data remaining supportive, the door for a rate hike this year remains wide open. It is anticipated that the Fed will increase the federal funds rate one quarter percentage point at its December FOMC meeting.
Index Performance as of 10/31/16
Sources: Bureau of Economic Analysis, Department of Commerce, Department of Labor, Institute for Supply Management, National Association of Realtors, S&P Dow Jones, The Conference Board.