Economic outlook for 2018 shows growth accelerating
Growth above long-term trend for first time since Great Recession
INSIGHT ARTICLE |
Economic data point to an acceleration of growth in 2018 driven by solid consumer spending and improvement in outlays on capital expenditures. There is now some wind behind the sails of the U.S. economy, and solid growth should result in greater resource utilization in an economy operating above its long-term trend.
Our view, based on our recession probability model, is there is only about a 15 percent chance of a recession during the next 12 months. Meanwhile, we expect wage growth should move above 4 percent with core inflation finally moving toward the Federal Reserve’s 2 percent target by the end
Base case economic scenario
Our base economic case forecasts growth of 2.5 percent next year with the unemployment rate falling to 3.7 percent as the pace of labor market tightening increases. Inflation will start to move higher but remain within the Fed’s target. A global synchronous expansion among the G-7 economies, India and emerging markets will support rising demand for U.S. finished goods and materials used at earlier stages of production.
The labor market will continue to tighten in 2018 with the economy generating about 150,000 jobs per month as firms find it increasingly more difficult to obtain qualified individuals to fill open positions. We expect overall wage gains will be at or near 4 percent by the end of the year. This should translate into compressed profit margins, which is what one would typically expect later in the business cycle. Even so, we expect corporate profits to increase by about 3 percent next year, with upside risks around the possible implementation of tax cuts.
Middle Market Insight: According to the third quarter RSM US Middle Market Business Index survey, 71 percent of middle market businesses said they were struggling, to some extent or to a great extent, to fill skilled labor positions. Meanwhile, 64 percent said they were increasing compensation levels to combat a tight labor market. Read the full
Better quality of U.S. growth ahead
Meanwhile, the strong labor market will underscore another solid year of household consumption. Through the end of the third quarter of 2017, spending has averaged 2.5 percent and we anticipate that will improve this year. This should translate into another strong year of industrial production and manufacturing, as well as the best year for agricultural products in the current cyclical expansion that began after the Great Recession.
Under new Fed Chairman Jerome Powell, the central bank will respond to these strong fundamentals by upgrading their forecast from four rate increases of 25 basis points each to five between now and the end of the next year.
In our estimation, the term structure for interest rates will flatten with the short end of the curve rising at a slightly faster pace than the long end. We are not as concerned about the flattening yield curve as some fixed income analysts. Because of the size of the Federal Reserve’s balance sheet on ongoing central bank bond purchase operations around the world, suppression of the long end of the curve will continue, thus reducing the information from the forward-looking components of the yield curve that, under other policy regimes, might point to growing risks of recession.
A decade ago, then Fed Chairman Ben Bernanke shifted the central bank communications strategy toward one of forward guidance, a move that was subsequently copied by global central banks. A combination of that new communications strategy, as well as structural changes in the U.S. economy organized around technology and life sciences, has reduced the efficacy of information from the yield curve.
However, we do expect the 10-year Treasury yield to finish the year between 2.75 and 3 percent, mostly due to a quicker pace of growth, with the U.S. dollar largely maintaining its trading range against the euro near 1.20. There is risk of further depreciation linked to political risk in the United States and greater risks around the Trump administration tearing down the North American Free Trade Agreement (NAFTA) and perhaps attempting to dismantle the World Trade Organization.
Alternative economic scenario
The alternative to the base case is that U.S. growth accelerates above 3 percent for the year if the massive tax cut proposal currently being considered by Congress is passed. If the large unfunded tax cuts are passed, we believe growth would accelerate considerably linked to spending by the upper quintile of income earners and the ensuing increase in the wealth effect acting to stimulate spending by the upper middle class.
Middle Market Insight: If tax cuts are aimed at the real economy, including pass-through entities and Subchapter
C corporations, we expect that the middle market will lead the way in 2018 by increasing outlays on capital expenditures.
If the tax cuts take place, we expect that both the trade and current accounts will widen noticeably, which will cause the U.S. dollar to appreciate against the major trading currencies and a trade-weighted basket of currencies, with yields on long-term U.S. Treasuries putting upside risk on our base case end-of-the-year trading range 2.75 to 3 percent on the 10-year Treasury.
Risks to the outlook
The major risk around the domestic U.S. outlook is the possibility that the Trump administration will disrupt U.S. trade agreements. There is a significant risk of disruption to the North American supply chain linked to NAFTA if the administration withdraws from the treaty. We expect trade frictions to increase in 2019 as risks to the NAFTA value chain increase due to more rigorous enforcement of trade rules and possible price disruptions along those value chains. Tensions around the U.S.-Korean Free Trade association and the World Trade Organization also figure into the risk matrix for 2018.
The possible secession of Catalonia, and the outcome of Italian elections should be on the radar along with the ongoing investigations into the Trump White House and the president’s business empire are the major political risks to the economic outlook.