The economic cycle continues to mature in the boom phase.
Jul. 5, 2018 Commentary

45-Degrees North

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What do the cities of Minneapolis (US), Halifax (Canada), Turin (Italy), and Krasnodar (Russia) have in common? All are close to the 45-degrees north latitude location, which marks half the distance between the equator and the North Pole. Half of 2018 has now come to pass. From an economic perspective, the first half of 2018 has been marked by both positive and negative surprises. What might the remainder of 2018 have in store for the United States and the global economies?

Quick Update – Rounding Third

Our major economic theme this year, Rounding Third and Heading Home, is playing out. Our theme remains that the U.S. economic cycle has entered its boom phase which, based on historical standard, tends to precede an eventual economic recession.

In the United States, we thought the gross domestic product (GDP) growth would accelerate to the politically-desired level of 3 percent. While the official data has yet to be produced for Q2, the Atlanta Federal Reserve estimates the U.S. economy grew by 4.7 percent (annualized) during that time. If we combine that potential result with the Q1 GDP growth of 2.2 percent (per the Commerce Department) it gives us an average annualized GDP growth rate of 3.4 percent for the first half of 2018. The last time the U.S. economy grew by this level was in 2005 when the overall GDP growth rate was 3.3 percent. We stand by our earlier view that U.S. economic growth will be in the 3 percent range for the year.

At the beginning of the year we also suggested inflationary pressure would start to build throughout 2018. This has been occurring. For the 12 months ending in May 2018, consumer prices increased 2.2 percent, up from an annual rate of 1.8 percent at the end of 2017. Various points of evidence suggest the acceleration to our inflation target of 2.5 percent should occur in the second half of this year. As an example, witness the New York Federal Reserve’s underlying inflation gauge data (UIG) depicted in the accompanying chart. As can be seen, the UIG (blue line) tends to coincide with the black line (consumer prices) over time. As can also be seen, the UIG is currently suggesting underlying inflation pressures are now slightly above 3 percent on an annual basis. This data suggests continued upside inflationary pressure going forward.

CPI Inflation

New York Federal Reserve 

Combining GDP growth and inflation gives us the trailing nominal GDP growth rate of 5.4 percent, among the highest growth level the economy has witnessed in more than 10 years.

Consequently, looking in the rear-view mirror confirms our Rounding Third and Heading Home theme is playing out well. However, before we take a victory lap, we need to sharpen our focus going forward.  Are events currently playing out which may disrupt our growth/inflation acceleration theme?

Second Half of 2018 and into 2019 – Heading Home 

In our annual outlook piece from the first of the year, we highlighted a short list of potential disruptors – factors which, if they came to fruition, could alter our positively-biased view on the national and global economic outlook. These disruptors include two factors currently weighing on investor’s minds.

  • Washington: We suggested political events could unfold and disrupt economic and eventual capital market trends. This is happening as the Trump administration’s trade policies are weighing heavily on people’s minds. Multiple trade tariffs have been announced/threatened by Washington for a variety of reasons. The potential economic risks of a full-blown trade war could be:
    • Upward pressure on inflation trends (as tariffs are imposed costs/prices tend to rise).
    • Central Bank (Federal Reserve) policies may be altered to adjust for the added building inflationary pressure, resulting in more aggressive action (rising interest rates) by the Fed.
    • Negative impact on consumer and business economic sentiment. The uncertainty which rising tariff rates can generate have the potential of lowering overall economic activity and growth.
    • The bottom line on tariffs, or threatened tariffs is not good – this disruptor has the capacity to lower overall economic growth and raising inflationary pressures.
    • We currently hope the uncertainty these actions are casting upon the global economic environment is part of the Trump process of negotiation. We believe the current economic uncertainty is due to the “smoke these policies are fostering. We need to ask, “Are current policies fostering “smoke” that will clear, or are we witnessing the “fog” of war?” Time will tell.
  • Federal Reserve: We have consistently been of the view that the Fed would raise rates four times this year. The consensus view has, until recently, held that no more than three interest rate increases would occur this year. Now, consensus has joined our view that the Fed will raise rates four times in 2018. This higher level of interest rate assumption is weighing on certain segments of the economy.
    • We continue to hold the view that the Fed will raise rates twice by the end of this year, followed by three rate increases in 2019. If enacted, these moves will take the Fed Funds rate above 3 percent by the end of 2019.
    • Additionally, the Fed has continued to shrink the size of their balance sheet. At the planned rate, the Fed will have reduced their balance sheet by about $1 trillion by the end of 2019. That action impacts monetary liquidity levels and interest rates.
    • Asset price volatility is affected by liquidity and its ability to absorb headline risks. Tightening liquidity in combination with trade issues and a late cycle rise in inflation may, at times, push asset price volatility upwards during the second half of 2018.
    • The Feds actions are starting to be viewed as a building disruptor. 

Disruptors are appearing and will probably continue to have some degree of negative effect on economic growth, inflationary pressure and interest rates during the second half of 2018. 

Last Word 

Even with all the above, we remain positively inclined towards the U.S. and global economic growth prospects. On balance, foreign economic growth is still positive, but some are taking a wait and see attitude towards the trade and monetary policy issues mentioned above. When the “smoke” of uncertainty is present, people tend to delay purchases and transactions. We sense this is currently happening in Europe and China.

On the other hand, if trade uncertainties diminish, we suggest overall economic growth in the United States should eclipse the 3 percent level, and global growth should chug along at a 4 percent overall growth rate for 2018.

We maintain our view that global economic growth will remain positive in 2018 and into 2019. The real question is…how positive and with what risks?

The economic cycle continues to mature.

 

The views expressed in this article are for commentary purposes only and do not take into account any individual personal, financial, or tax considerations. It is not intended to be personal legal or investment advice or as a solicitation to buy or sell any security or engage in a particular investment strategy. Please consult a financial services professional.

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