United States

Jobs, interest rates, trade relations: Views from our chief economist

Joe Brusuelas reacts to key indicators in the second quarter

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RSM US Chief Economist Joe Brusuelas sat down earlier in May with the firm’s thought leadership director, Deborah Cohen, to discuss economic trends in the second quarter. He offered his outlook for jobs, interest rates, U.S. trade relations with China and more. The following is a condensed excerpt from that conversion.

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Deborah Cohen: The unemployment rate fell to 3.9 percent in April, hitting the lowest level since December 2000. What's your take, and what are the implications for the middle market?

Joe Brusuelas: That's a real milestone. We haven't seen that since the late Clinton era. We really only need to add about 80,000 jobs a month to stabilize the unemployment rate. If we continue on this very solid if not strong pace of jobs growth, we're going to be sitting probably somewhere near my forecast of 3.7 percent by the end of the year quite quickly. And it wouldn't surprise me if we get below 3.5 percent next year, especially given the idea that we have a late-cycle fiscal boost that is in train.

We frontloaded a $1.5 trillion-dollar tax cut and there's an additional $320 billion dollars in spending coming from the federal government linked to the two-year budget agreement. Boy, that's going to boost demand in the second half of this year, all the way into 2019. So you should expect to see that unemployment rate decline.

The jobs report overall? Very strong. You saw very strong goods-producing jobs, manufacturing and construction jobs, along with finance, information and business services, which all pay well above the median wage. This is what you’d expect late in the business cycle.

DC:   So are there any downsides?

JB:    We aren't seeing these high wages draw people off the sidelines to come back into the labor market. The prime-aged working male, aged 25 to 54—22 million of them aren't in the labor force. Half of them take pain medication every day. And probably a good number of them more are stuck in the ether of various social problems here in the United States. They're not coming back. So what does this all mean for the middle market? This historically tight labor market represents the single-greatest managerial challenge for this generation of middle market firm managers. It's likely to accelerate the time table in which the arrival of artificial intelligence and machine learning, along with big data, decisively impact middle market firms.

I would've thought we would be looking at seven to 10 years before we see it materially impact. You're going to see it much quicker. So in some administrative positions for things that are very routine such as processing email—you're likely to see some disruption within the next 24 to 36 months. Firms are simply going to have to substitute technology for labor, where labor is not available. You’re talking about through the entire industrial ecosystem. It’s likely we’re headed to an unemployment rate of early 1968, 1969 levels, of around 3.4 percent; this was during the Vietnam draft.

DC:   Do you think we are we going to see a revival of apprenticeship programs in the United States?

JB:    So with the skilled jobs, you're going to see different responses by management with respect to the mix of labor and technology. In non-core urban areas, think suburban ex-urban areas, where you have manufacturing present, you can identify the zip codes where your labor is going to come from. You can partner with high schools and community colleges and basically capture that labor before it disappears into the ether of American social problems. But that's likely to work only in those silos. In core urban areas, it's going to be much more difficult to do that because it's very clear that millennials have figured out that they've got to get the right combination of experience and education. And in some cases, due to behavioral choice, they just don't want to do those jobs. So it's highly idiosyncratic, depending on which region of the country you're in, and your proximity to an urban market.

DC:   Given the tight labor market, what’s your outlook for Federal Reserve rate hikes?

JB:    The Federal Reserve's going to be in a real quandary pretty quick. The natural rate of unemployment is clearly lower than what they expect, probably somewhere around 3.5 percent. There's a big debate in the market over whether they'll throw another additional rate hike this year. Instead of having three, which is their forecast, they may have four. Here's the challenge: Because we've got an economy that fundamentally changed after the structural break in 2007, and we've got broad demographic changes, which are decisively impacting the U.S. labor market, the Fed is going to have to make an assessment on where the policy rate can go and how high it can go before it becomes restrictive. Even as they have a $4.5 trillion-dollar balance sheet, which they're also beginning to draw down.

Traditionally the Federal Reserve needs 400 basis points of fire power to combat an economic downturn. And that's usually coupled with a fiscal stimulus. Well you look out a couple of years—we just did $1.5 trillion and another $320 billion. Let's just round up, call it $1.6 billion. So $6 trillion in overall spending. That means we're not likely to see a major fiscal stimulus when we have the economic downturn. So the Fed’s got to be very careful about its pace of the rate hikes, to ensure that a) they don't slow down the economy, and b) they don't cause the yield curve to become inverted. Once that yield curve inverts, you're on the clock 12 to 18 months for a recession—every single time since World War II.

DC:   That sounds quite serious.

JB:    Which is why, if you follow our work in The Real Economy, or that we put on the Insights portion of the (RSM) home page, on my Tumblr page or social media, we are making direct reference and visuals – showing data visualizations of what the yield curve looks like. And we're putting it up so you can clearly identify where the recessions were and how long after the yield curve crossed zero before we went into recession. So even though middle market firms don't really have to worry about a tick up in euro to dollar, or a tick down in the 10-year (treasury note), they do need to begin to pay attention to the shape of the yield curve, the direction of the federal funds rate, which is the policy rate, and the impact of overall policy at the long end of the curve. We are at that point in the business cycle.

Though middle market firms don't really have to worry about a tick up in euro to dollar, or a tick down in the 10-year (treasury note), they do need to begin to pay attention to the shape of the yield curve.

DC:   Well let's move on to trade. You've written extensively in recent weeks about U.S.-China trade friction. And we have seen a lot of back and forth over the tariffs on both sides that threaten to curtail global trade. Where do things stand at this point?

JB:    The notion that trade friction is the natural state of affairs in the international economy has really been illustrated well here. We moved from trade friction to a trade spat that could escalate into a trade war if we're not careful. So the administration just wrapped up a two-day visit to Beijing that clearly did not go well. It did not yield the intended results that the administration would have wanted. I now expect several rounds of tit for tat with tariff retaliation. That will likely spill over into other areas of the economy that the administration intended to protect. It's going to likely spill over into consumer retail space. Clearly we're already seeing a nasty decline in orders for agricultural goods. The orders simply aren't being fulfilled and ships aren't leaving the port. The data's already there. And then the dislocation in the aluminum market's been very illuminating for everyone involved. And every week I take calls from clients saying we talk about this and it's happening.

We moved from trade friction to a trade spat that could escalate into a trade war if we're not careful. 

DC:   How is this trade friction impacting supply chain for midsize companies, or hasn’t it yet?

JB:    It affects manufacturing in a much broader way than is commonly understood because over the past 25 years U.S. companies have gotten embedded in the Asian supply chain, in addition to our own North American supply chains.

There are ways to (negotiate) in terms of using an already-established network of international institutions and treating them in kind that will result in a much broader, deeper sense of change. One of the most important things that I've learned in dealing with the Chinese over the years—and it was reinforced when we were there recently—if you come at them alone you're not likely to get a good response. But if you present to them as a network of allies that's going to provide a global framework for rules of the road, it's much easier for concessions to be obtained. This isn't a schoolyard fight.

DC:   Right now though we've essentially got a stand-off, so what's your prediction for the near term?

JB:    We're going to see an increase in the trade spat. You should expect more tit for tat retaliation, more tariffs, more industries effected, yeah. We're going to start hearing from our clients very quickly once that's imposed. I don't expect either side to back down at this point. And it's going to go on for a while.

DC:   Are we seeing more hedging of commodities on the part of clients?

JB:    Yeah. Well I've gotten questions about alternative supply chains, different countries, and what the foreign markets are saying. Yesterday we spent a good deal time looking at the aluminum market, what foreign markets were telling us; we got into an in-depth discussion with a client who's been disproportionately impacted in a negative way.

The price of aluminum has suffered a pretty large shock. And there's nothing that indicates that's going to abate any time soon. We would need to see the NAFTA agreement modernized and rhetoric out of both Canada, Mexico and the United States that they intend to ratify the treaty. Then we will likely see prices recede. That's been the most illuminating thing, I think, for our clients. There was this thought that, well, you'd have to wait until the tariffs are actually implemented before they impact us negatively. No, that's not been the case, at all. It's been the exact opposite.

There’s uncertainty in the market. It's very clear to me that we had a slowdown in the first quarter of the year in terms of fixed business investment, and that's linked to the trade tensions. That (slowdown) will be more pronounced in the second and third quarters, which will just shave some points off growth that otherwise didn't need to be there.

DC:   Let’s talk about capital expenditures: One of the things you’re looking at in the RSM US Middle Market Business Index is what midsize companies with more cash on their balance sheets due to lower tax rates are going to do with that cash. What is your take?

JB:    We've been tracking cap-ex now for a couple years. While the numbers have never been great, they have picked up of late. We saw our first reading above 50 percent in terms of cap-ex and cap-ex intentions in the fourth quarter of last year and in the first quarter of this year. Middle market firms have become a bit complacent about the necessity of making capital investments in software equipment, intellectual property. When we had a pretty good idea that there was going to be a large tax cut, and we had formulated a set of questions and really some thoughts about what (middle market companies) are going to do with their tax windfall. And let's be blunt. Because of the reduction in taxes for Subchapter-C corporations, for many middle market firms this is likely to be the lowest statutory rate in their entire lifetime.

So for the second quarter Middle Market Business Index, we commissioned a set of special questions to find out exactly what they intend to do. And this is going to provide a really interesting narrative for the middle market, in terms of this is the first real report card on the efficacy of the Tax Cut and Jobs Act passed in the waning days of 2017. Thus far, our large friends are not re-investing the cash. At this point Apple, arguably one of the top five most important companies in the country, has committed about three quarters of a trillion dollars in cash, simply to buy-backs alone.

DC:   Where goes Apple, so goes the rest of the market?

JB:    That’s one of our concerns here. It may be that middle market firms are going to use (surplus cash) to retire debt. It may be that given the lack of access to large pools of capital, these firms will do exactly what the policy intended them to do – that they will take it and re-invest it. We will have to see what the data tells us. My sense is you're probably going to have a healthy split between the two, but I haven't had a chance to see the data, so when we get the results back I'm going to be just as interested as everybody else is.

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