2016 Outlook: Households, residential investment to drive growth
THE REAL ECONOMY |
U.S. growth in 2016 will likely remain well above the long-term trend of 1.5 percent. We anticipate the economy will grow near 2.6 percent next year with the household sector and residential investment being the two primary drivers. The recent Washington D.C. policymaker agreement, which resulted in a lifting of the debt ceiling, should add 0.2 percentage points to overall economic activity in 2016.
Our forecast is based on an estimation that household spending should grow by 3 percent this year, which will be fueled by job growth and wage gains. Meanwhile, we expect residential housing starts to accelerate to 1.375 million at an annualized pace, which would be a cyclical high.
Private fixed investment has lagged the overall expansion since the Great Recession, and 2015 has also been a disappointing year. This was due largely to the sharp pullback in investment in mining, utilities and energy associated with the decline in commodity and oil prices. However, we believe 2016 should see a modest bounce in private fixed investment.
MIDDLE MARKET INSIGHT: Middle market firms should see a solid year of growth driven by expansion in consumer products and real estate.
The manufacturing and tradeable sectors may continue to act as major drags on growth. Although the U.S. dollar’s rise will slow in 2016, firms that have large exposure to the global economy, or obtain more than half their revenues from the external sector, will face a very challenging year. Further erosion in competitiveness cannot be discounted.
Global growth should slow to or below 2.9 percent next year, which should result in an expanding trade deficit for the U.S. economy. The three major U.S. trading partners—Canada, Mexico and China—are all facing difficult periods of transition in their domestic growth models; oil in the case of the North American Free Trade (NAFTA) countries, and the move to domestic consumption in the case of China. This will likely continue to restrain growth and demand for U.S. goods. The consensus forecast is that the Canadian economy will expand by 1.9 percent, the Mexican economy by 2.8 percent and China near 6.9 percent, with risk to the downside for all three countries.
The three alternatives to our base case of 2.6 percent U.S. growth (which we give a 65 percent probability) is that the economy will slow toward the long-term trend of 1.5 percent (a 20 percent probability), the economy outperforms and grows above 3 percent (a 10 percent probability) or geopolitical tensions and security concerns result in a global recession, which includes the United States (a 5 percent probability).
Long-term growth trend
Our new estimate of the long-term growth trend in the United States is based on the slowing in productivity to about 1 percent and the secular slowdown in labor market growth to 0.5 percent per year. Under such conditions, growth above 2 percent implies a further narrowing of overall economic slack, tightening labor markets and rising wages, all of which provide a modest upside risk to inflation in 2016 and throughout the remainder of the business cycle. While this estimate is below the Federal Reserve’s long-term growth forecast of 2 percent, we believe that our estimate reflects both the longer-term dynamics in productivity and increasing demographic headwinds that will be the major part of the growth narrative during the next decade.
RSM Growth forecast
Central bank policy
The Federal Reserve will likely increase the federal funds rate by 25 basis points in December and then by 50 to 75 basis points in 2016, which is modestly below the Fed’s central tendency forecast that implies 100 basis points of rate increases during the year. We expect two increases prior to the U.S. presidential election and then another at the end of the year. The Fed’s own central tendency forecast implies that the policy rate will not get to 4 percent until the end of 2018, which we believe may be overly optimistic.
MIDDLE MARKET INSIGHT: Rising wages amid a tightening labor market and a rebound in prices will create margin pressures for middle market firms.
Labor market outlook
The U.S. economy will continue to generate about 175,000 to 200,000 jobs per month, reflecting moderation in overall hiring after the release of pent-up demand during the past few years. The composition of hiring should remain slightly tilted toward higher-paying jobs.
Meanwhile, the labor market is tightening with only about 1.43 unemployed persons available for each job opening. This indicates firms are facing challenges finding skilled and semi-skilled workers. It also implies wages and salaries will likely accelerate above 3 percent in the near term.
We expect a decline in the unemployment rate to 4.7 percent by the end of 2016 with risk of a lower unemployment rate as the economy moves past full employment. This poses a risk of escalating wage demands next year.
In 2016, the major inflation narrative will likely be modest increases in global oil and commodity along with rising costs for services and rents. This suggests upside risk to our forecast of a 2.3 percent increase in the consumer price index and a 1.9 percent rise in the core personal consumption expenditures (PCE) index, which is the Federal Reserve’s preferred inflation metric when formulating policy. If economic growth arrives near our forecast of 2.6 percent, which is well above the 1.5 percent long-term trend, this implies narrowing slack in the economy and rising wage demands, thus creating the conditions for a higher overall level of prices.
During the past 12 months, falling oil prices depressed top-line estimates of inflation. That will change in the near term. If the recent trend in inflation remains in place, the year-ago estimates will jump above 2 percent in the consumer price index and then, with a lag, in the personal consumption expenditures index. With the Fed meeting the employment portion of its mandate, core inflation will be the most important determinant in the central bank’s decision on the path of interest rate increases during the next two or three years.
U.S. financial conditions and interest rates
Overall financial conditions should tighten next year but remain supportive of growth. Given the direction of hiring and wages, we anticipate that households will continue to increase leverage and that demand for credit will improve, with private credit creation accelerating above 7 percent. That is highly correlated with growth in nominal gross domestic product.
Last year, we made an out-of-consensus call on long-term rates, making the case that the yield on the 10-year Treasury would average between 2 and 2.25 percent. This year the yield on the 10-year Treasury has averaged 2.11 percent. In 2016, we expect an average between 2.5 to 2.75 percent. The risk to this forecast is likely to be on the downside due to the chance of a greater slowdown than anticipated in the global economy and ongoing challenges in Europe.
We expect the U.S. dollar to continue to appreciate against a trade-weighted basket of currencies, albeit at a slower pace compared to the past two years. We have consistently made the case that the United States is engaged in a long term secular bull cycle and we see no reason to alter that stance. Given the growing probability of a strong increase in the European Central Bank’s asset purchase program, and deflationary risk associated with austerity policies in Europe, a move to parity against the euro cannot be discounted in 2016.
Consistent with our employment and wage outlook, the household sector should continue to have a fairly strong tailwind that will support spending at or above 3 percent. We continue to expect solid retail spending amid a structural shift toward online purchases and purchases of goods that are not aligned with traditional mall anchors and big-box stores. Because of this shift, estimating household outlays remains difficult, and we are skeptical that the monthly retail sales reports accurately capture the shift in spending preferences and behavior among the emerging majority of U.S. households.
Manufacturing conditions in the U.S. economy will remain a tale of two cities. The auto and aircraft industries will see strong growth and sales. We expect sales of autos to remain close to 18 million at an annualized pace as automakers use invoice-based pricing to attract buyers into showrooms. Inventory in the industry remains well managed and is consistent with solid production in the near term. Backlogs for narrow-body and wide-body aircraft at Boeing range from five to seven years.
Outside of the auto and aircraft industries, however, overall manufacturing conditions have weakened materially during the past 18 months due to the U.S. dollar’s appreciation and slowing external demand. Competitiveness challenges for firms with large exposure to the external sector will persist and require those firms to control costs and, in some cases, target domestic avenues of growth to offset slower growth or contraction elsewhere.
We expect housing starts will accelerate to 1.375 million at the peak of the homebuilding season in 2016, driven by modest improvement in household formation and sustained job growth. The composition of starts will remain tilted toward multifamily dwellings, reflecting the preference to rent among the key 25 to 34-year old cohort. Even so, basic demographics favor a stronger pace of housing starts in the near term. Equilibrium in residential starts implies an annualized pace of 1.6 million. That isn’t likely to occur until the next business cycle. While our base case on long-term rates is that they will range between 2.5 to 2.75 percent, if they move above 3 percent for a sustained period that will pose a test for housing sales in 2016.