Notes on the Week AheadContributor Dr. David Kelly
A Better Way to Forecast Growth
In years gone by, wise fishermen would look out at the sky to divine the weather. A red sky at night was a good omen; a red sky in the morning forecast storms. If smoke rose straight up from a fire, the weather would be good. But if it curled and wisped its way to the heavens, you should beware, as you should if cows gathered in a corner of a field or if sea birds were seen well inland.
Today, when fishermen want to forecast the weather, they whip out their smartphones and open their weather app. The meteorological forecasts displayed in these apps summarize the output of the scientific processing of enormous amounts of relevant information and have become extremely accurate. It’s just a smarter way to forecast.
Like the fishermen of old, many investors today are looking at relatively crude indicators such as recent market volatility or the shape of the yield curve to forecast the path for the U.S. economy and they have become worried by the behavior of both in recent weeks.
However, investors would be wise not to rely too much on either indicator.
In the case of market volatility, the wild swings in the equity market in recent days seem divorced from either positive or negative news on the economy. Moreover, a gradual shift towards passive strategies on the one hand and momentum-driven algorithms on the other is gradually diminishing the role of rational money managers who in the past might have provided some information about the economy by their asset allocation decisions.
In the case of the yield curve, a flattening yield curve does indicate that investors believe that the Fed tightening cycle is drawing to a close. However, as we note in our latest Weekly Market Recap, historically there has been a long and variable lag between the point at which the yield curve inverts and the point at which the economy enters recession. In addition, the yield curve is likely a less reliable indicator than in the past due to heavy Fed ownership of long-term bonds and a lack of inflation which may allow the Fed to stop tightening at a far lower level of real interest rates than in the past.
More to the point, there is a better way of forecasting economic growth and that is by taking a long, hard look at the components of demand in the U.S. economy. Even a short look can tell you lot.
The first place to start is with consumer spending which accounts for about 68% of US GDP. After a slow start to 2018, consumer spending has picked up, logging 3.8% annualized growth in the second quarter and 3.6% annualized in the third. While light-vehicle sales have picked up in the fourth quarter, this Friday’s Retail Sales Report for November could look ominous with a decline in nominal sales expected. However, some of this just reflects lower gasoline prices, which fell almost 20 cents a gallon in November, hurting nominal gas station sales. This, in fact, is a positive for real consumer spending which still appears on track to log a roughly 3% annualized gain for the fourth quarter.
In 2019, we expect consumer spending to grow by a little over 2% annualized. It should continue to be boosted by strong confidence, low energy prices and somewhat stronger wage gains, although the lack of fresh tax cuts and an inevitable downshift in employment growth should hold it in check.
Home-building only accounts for about 4% of total demand in the U.S. but it is one of the more volatile sectors. Recent housing data have been soft with 30-year fixed rate mortgage rates rising to close to 5% after starting the year below 4%. However, it is important to recognize that housing is really very suppressed for this stage in a cycle, with housing starts in the third quarter running at 1.225 million, less than 60% of their pace of 2005. In addition, home prices have been rising more slowly this year, so that in both the fourth-quarter of this year and in 2019, home-building should be able to make a modest positive contribution to GDP growth.
Business fixed investment accounts for about 14% of demand and can be broken into four sectors: equipment, intellectual capital, energy structures and other structures.
The two biggest sectors, equipment and intellectual capital both appear to have grown at a solid but not spectacular 7% pace after inflation this year and should see further growth next year. Companies still have access to cheap financing and favorable tax treatment. However, uncertainty about both trade rules and long-term U.S. economic growth appear to be preventing a bigger surge. The same problem appears to be hampering non-residential structures ex-energy which now appear likely to be flat for 2018, but should pick up, from a low level, in 2019. Energy structure investing, by contrast, appear to have surged by over 25% this year in the wake of a revival in oil prices. However, in 2019, with recently lower oil prices, we expect this boom to stall. All told, business fixed investment appears to have grown by about 6.5% this year and should moderate to about 4% growth in 2019.
Inventories have surged recently, rising at an $87 billion annualized pace in the third quarter. They appear to be rising strongly in the fourth quarter also, as retailers and wholesalers stock up in advance of further potential tariffs on Chinese goods. However, in the long run, inventories should grow a little slower than GDP. This being the case, a more reasonable long-term growth rate for inventories should be between $40 and $50 billion annualized and just getting back to this growth pace could subtract about 0.2% from real GDP growth over the next year.
The U.S. trade deficit is continuing to worsen slowly and this trend is likely to continue into 2019. Regardless of our tariff policy, a large and growing U.S. budget deficit is contributing to this growth in the trade deficit as is a dollar which appears too high for trade balance. This, on its own, could subtract 0.5% from U.S. economic growth over the next year.
The final component of demand is government spending. While the federal deficit continues to grow and should top $900 billion this fiscal year, most of the growth in the shortfall is coming from the impact of tax reform in reducing revenues and higher transfer payments to individuals. Actual government purchases in the economy, across federal, state and local governments appear to have grown by about 1.5% this year and should match that pace in 2019.
Adding it all up together suggests that real GDP will have grown by 2.9% year-over-year in the fourth quarter of 2018 and should grow by about 2.0% year-over year over the next 12 months. In other words, a slowdown not a stall.
For investors, it is important to continue to rebalance. A slower-growing U.S. economy, in itself, makes U.S. equities look a little less attractive, reduces the risk in core fixed income and increases the relative attractiveness of international equities. But while the markets are volatile, economic trends appear much more stable and it is these economic trends that, in the long run, should determine investment returns.