The U.S. economy roared back in the first quarter, growing at a rapid pace despite multiple headwinds, and suggesting the current expansion has more room to run. U.S. real GDP rose at a 3.2% annual rate from January through March, the strongest rate of growth for the first quarter in four years. Helping to drive growth were a rise in exports, a decline in imports, and higher inventory investment that helped offset weaker growth in consumer spending and business investment.
The GDP figure marked a turnaround -2.0 from a gloomy start to the year, when the economy looked close to stalling due to challenges, including a partial U.S. government shutdown, market turmoil, and slowing global growth. But the outlook brightened as the Federal Reserve shelved plans to raise interest rates this year, the shutdown ended in late January, stocks started climbing toward new highs, China’s economy strengthened, and steadily improving U.S. economic data trickled in, much of it delayed by the shutdown.
While the first quarter boost from net trade as well as state and local government spending seems unlikely to be repeated in the second quarter, the underlying fundamentals have remained supportive of stronger growth in consumer spending in coming quarters. The labor market has remained strong, consumer confidence has remained high, and household balance sheets have been generally healthy. Moreover, the recent drop in mortgage rates has breathed new life into the housing market as investment spending continues to grind higher.
A narrower U.S. trade deficit in February and stronger-than-expected economic growth in China suggested the global economy’s outlook could be brightening heading into the spring. The U.S. deficit on trade in goods and services narrowed in February from the prior month, thanks in large part to a pickup in exports. Meanwhile, with Chinese efforts to spur economic growth and a U.S.-China trade deal in sight, China’s economic growth held to a better-than-expected 6.4% rate in the first three months of the year.
Taken together, the data has provided reassuring signs that the world’s two largest economies started 2019 on sounder footing after a rough patch late last year. The remaining caveat has been that major economies in Europe appeared to be continuing to lose momentum. The PMI (Purchasing Managers Index) for the eurozone fell to 47.5 in March from 49.3 in February, the biggest fall in output in nearly six years.
American manufacturing production was flat in March after falling in the first two months of 2019, showing the global slowdown has squeezed a key sector in the U.S. economy. Though manufacturing accounted for only a small share of GDP, the sector has been highly sensitive to shifts in global demand, making it a bellwether for the broader U.S. economy. Based on PMIs a continued pullback is expected this year which could be attributed to global trade pressures. Europe’s manufacturing sector has appeared particularly hard hit by trade pressures.
Small Business Optimism Index
Small business optimism was virtually unchanged in March. Despite the stock market having recovered from its end-of-year rough patch and the government shutdown firmly in the rear view mirror, the index has remained noticeably below the current cycles high reached back in August. The lack of a rebound would suggest that small businesses have been feeling the economy’s recent slowdown. Small businesses’ expectations for sales have come down since the fourth quarter, and fewer respondents have indicated now is a good time to expand. Hiring plans have come down as a result, although difficulty finding workers in such a tight labor market may, on its own, be reducing expansion plans.
Amid the hurrah over strong real GDP growth, the one segment of the economy that continued to underperform was housing. Residential investment contracted in all four quarters of 2018, and pulled back again in the first quarter. Early indications have suggested a mixed start to the second quarter. Existing home sales fell in March following a strong gain in February, but the level of sales has shown little overall progress over the past several months. Fortunately, the news was better on the new home sales front. New single-family residential sales rose, building on even stronger gains in January and February. In contrast to the existing market, new home sales have been just a touch below the recent cycle peak.
A number of economic factors that slowed sales in 2018 have eased or even reversed in recent weeks. Mortgage rates have been falling, home inventory has risen in many once-tight markets and the pace of home-price growth has been slowing. With affordability improving – a function of both lower mortgage rates and accelerating income growth – the demand drivers for housing has appeared to be solid. The supply side appears to be the constraining factor. The inventory of existing homes available for sale has continued to hover near historical lows. Unless supply constraints are alleviated, the upswing in demand could reverse the recent deceleration in home price growth.
The global economic slowdown earlier this year, coupled with fears about escalating trade tensions have tempered expectations of further interest rate increases by the Federal Reserve. Furthermore, the inflation data has not supported a rate hike at this time. The price index for personal-consumption expenditures (PCE) increased at a 0.6% pace in the first quarter, compared with 1.5% in the final quarter of 2018. Core prices rose at 1.3% rate. With price indices below the Fed’s objective of 2%, why would the FOMC raise rates? In short, the FOMC will likely keep its target for the fed funds rate in its current range of 2.25% to 2.50% for the rest of the year.
Rising Oil Prices
Volatility has been picking up in oil markets. Oil prices have staged a comeback in 2019 after tumbling at the end of last year. Gasoline prices at the pump have typically moved higher this time of year as refiners have shifted to producing more expensive, summer-grade fuel. But the seasonal rise has been even more pronounced after flooding in the Midwest, dwindling oil production out of Venezuela, and U.S. decision to end waivers that permitted eight countries to continue importing Iranian oil despite sanctions.
Gasoline prices may get even more volatile toward the end of the year due to the IMO 2020, a shift in marine sulfur regulations that will take effect next year. The new rules will force refiners to blend lighter products into heavier fuel oil grades to meet new sulfur specifications, potentially disrupting markets like gasoline and diesel.
The recent inversion of the yield curve has some observers wondering if a recession in the United States is right around the corner. Most observers believe talk of an imminent U.S. recession is a bit overdone because the underlying fundamentals of the U.S. economy have been generally solid. Bond yields have reflected the view that future growth will be moderate, interest rates will be lower than they used to be, and price pressures will not be a problem.
The U.K.’s Brexit saga has continued as the European Union extended the U.K.’s exit deadline until the end of October, avoiding a devastating cliff-edge divorce but settling none of the issues that have plunged British politics into chaos, dysfunction and recrimination.
While the extension might be a short term positive in that it removes the immediate risk of a no-deal Brexit, it is potentially a longer-term negative given that uncertainty about the U.K.’s future relationship with the other European Union countries will persist. The path ahead is still dotted with explosive issues like a possible attempt to topple Theresa May’s government, a general election or a second Brexit referendum – or some combination of the three.
Even against this backdrop of Brexit uncertainty, the early part of 2019 has seen relatively resilient growth in the U.K. February’s GDP rose 0.2% month-over-month, a solid result on the back of a 0.5% gain in January. Both service sector output and industrial production rose. That said, part of the early 2019 growth reflects stockpiling of inventories. Especially in the context of a long Brexit extension and the ongoing uncertainty, the pace of U.K. economic growth is likely to slow going forward.
European Central Bank
In April, the European Central Bank (ECB) held its policy interest rates steady and made no changes to its forward guidance, stating that interest rates would remain at their present low levels at least through the end of 2019. The ECB also provided no extra details – for now – surrounding its new round of targeted long-term loans, and said that the risks around the eurozone growth outlook have remained tilted towards the downside. In recent weeks, there have been some tentative signs of growth stability. The eurozone services PMI rose in March, although the manufacturing PMI remained in contraction territory. That said, even though eurozone industrial production fell 0.2% month-over-month in February, industrial activity for the first two months of the year was up 0.8% compared to its Q4 level.
China’s economic growth held to a 6.4% rate in the first three months of 2019 as factory production picked up significantly amid signs authorities worked forcefully to stabilize business following months of weakness. The growth rate was boosted by a powerful rebound in some key drivers, such as, industrial production, retail sales and property investment.
While China’s economy has been on a slow downtrend this past decade – weighed down by debt and excess capacity - a sharper-than-expected slowdown hit last year, exacerbated by severe trade tensions with the U.S. The government has appeared to step up work to arrest the slide. Beijing took tentative steps in recent months to address cash crunches among many businesses with new and targeted stimulus including tax cuts and red-tape curbs. It has also given a nod to local governments to spend on infrastructure, a partial unwinding of the central government’s credit squeeze that began two years ago in an effort to arrest the buildup of debt. Money supply also picked up visibly in March, a sign of credit easing.
Also boosting sentiment has been an easing of trade tensions between the U.S. and China that put off some investors last year. Bets that a deal is within reach have helped lift business confidence and underpinned markets in China.
Many past drivers of the economy still have not been firing. A number of headwinds have remained, including a drop in auto sales and slow growth in investment in factories, infrastructure and other fixed assets, an indication of trouble for both manufacturers and consumers. And while the data showed increases in property investment, real-estate downside risks have remained a concern.
Consumer prices have also risen due to a virus that is spreading through the nation’s pig population. The upward price pressure and risk of higher inflation would mean Beijing might avoid spending too much on projects that would support growth. Despite the stimulus and other support measures, the growth rate of China’s economy has been expected to drop to levels not seen in nearly 30 years.
The outlook for the U.S. economy is positive. GDP growth is on track, unemployment remains low, and there are no signs of inflationary pressures building. The economy should be poised to support solid consumer spending in the coming months, as the tight labor market induces faster wage growth and higher consumer confidence. The associated income growth and backing for consumer sentiment should generate healthy gains in household spending. Supportive fundamentals lead observers to expect growth in 2019 to come in close to 2.0-2.5%.
Though it does appear there has been progress on a U.S.-China trade deal, the full details and a final agreement remain elusive. In addition, continued policy uncertainty with Brexit comes at an inopportune time, as the global economy in general and manufacturing output in particular have decelerated. Central banks have responded in-kind: the European Central Bank seems unlikely to tighten in 2019, Chinese policymakers are easing both monetary and fiscal policy, the Bank of England is on hold until after Brexit and even the Reserve Bank of India has cut rates despite some of the fastest GDP growth in the world.
Does that mean a global recession is imminent? The consensus is that it does not. Just because global growth appears to be slowing from last year’s strong pace does not mean that an outright economic contraction is right around the corner. More dovish central banks and Chinese fiscal stimulus should help cushion the slowdown, as would a resolution to the U.S.-China trade and Brexit knots. Global growth is expected to stabilize rather than deteriorate in the quarters ahead.
Two headwinds facing the world may affect the above scenario. First, global central banks and others have dialed back stimulus. Second, Britain’s flailing effort to exit from the European Union has adversely affected business investment, and a financial backlash over budget-busting populism has sent Italy into recession. Meanwhile, the Trump administration’s protectionist moves, especially against China and the European Union, have wreaked havoc with world trade and global industrial activity. The second set of risks has persisted, but the first is receding.
Sources: Department of Labor, Department of Commerce, Institute for Supply Management, Bloomberg, Morningstar, Peoples Bank of China, European Central Bank, Office for National Statistics
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