Recap
The partial government shutdown in December and January has imparted a near-term hit to the U.S. economy in two ways. First has been the direct impact, as the shutdown looks to have further sapped the economy’s recent momentum. The second has been the indirect impact, as the delay of releasing economic data has reduced visibility and added uncertainty to the near-term outlook.
Fewer hours worked by federal employees has pointed to weaker production of government services in Q1. Yet as activity has resumed to normal levels, growth is expected to pick up more in the second quarter than it would have otherwise, helping boost Q2 GDP growth.
The temporary hit to government spending was not the only soft spot in the outlook, however. The housing market continued to struggle, with builders offering larger discounts on new homes, existing home sales down for a third consecutive quarter and pending home sales not likely to rebound swiftly. All told, a large drag was expected from residential investment in Q1.
Nonresidential construction also weakened in late 2018 and pointed to commercial structures investment having contracted in Q4. That said the outlook for business investment going forward, however, is little changed. That has partly reflected the dearth of new data on investment spending, but also a calmer trade dialogue the past month as talks between the United States and China have occurred. A deal between the U.S. and China is expected in the near future.
The latest ISM reading has suggested that momentum in the manufacturing sector is not slowing. Yet there have still been signs of strain stemming from slower growth abroad, with the export orders index slipping to a two-year low. That portends poorly for exports, and suggests trade will be a drag on growth again in the first quarter.
That has kept the onus of growth on consumer spending. The shutdown has not been expected to have significant spillover effects on household outlays in Q1. One risk regarding this expectation for fairly strong consumer spending would be a sustained drop in consumer confidence. However, confidence will likely regain some ground in the next few months following the stock market rebound and the end to the shutdown. Moreover, income growth has looked strong with a significant number of new jobs added in January and February and with wages continuing to move up.
From the Federal Reserve’s view, however, the damage may already have been done. With both global and U.S. growth slowing, the risk of inflation breaking meaningfully above its 2% target has appeared low. At its January meeting, the FOMC adopted a notably more dovish stance, removing references to further rate hikes and vowing to be patient with future moves. Unlike financial markets, the FOMC’s next move will likely be to increase rates, but that time has been pushed back to least Q3-2019.
Meanwhile, across most other major economies, performance has shifted into a lower gear. China’s economy has weakened as its manufacturing activity has contracted. That impact has been felt acutely by China’s major trading partners and American companies with significant exposure to the region. The export-oriented Euro Area economy also ended 2018 on a weaker footing, growing at the slowest pace in four years.
Clearly, the toll on global growth from the U.S.-China trade dispute has risen, and the time to reach a deal before possible further escalation has run out.
Labor Market
The U.S. labor market notched its 101st straight month of increased employment in February while sustaining robust wage growth, and passing tests posed by a federal-government shutdown, market volatility and uncertainty about global economies.
Gains in nonfarm payrolls was well above last year’s average monthly job growth and showed that most private-sector businesses shrugged off the shutdown and kept on hiring. Wages rose at least 3% from a year earlier for the sixth straight month extending the best pay improvements since the recession ended in 2009.
Small Business
After a banner year, many small businesses have become more cautious about their investment and hiring plans. Some have responded to early signs of slowing sales, while others fear that tariffs, unstable financial markets, the aftereffects of the government shutdown and other headwinds could dampen economic growth in 2019.
Although the small business optimism index has remained high relative to historical averages, for the first time since the 2016 presidential election, small firms have become more pessimistic about their own financial prospects, compared to a year earlier, including plans for hiring and investing. More firms have reported difficulty finding labor, which continues to signal a tight labor market. Firms have become somewhat less upbeat about the future and have expressed more guarded optimism surrounding the prospects for 2019.
Housing
Sales of previously owned homes New Home Sales Existing Home Sales fell in January, although a decline in home prices and mortgage rates could bode well for a pickup this spring. January marked the third consecutive month of declining sales, and January’s home sales were the lowest since November 2015. Buyers pulled back in the latter half of 2018 as a combination of factors including rising mortgage rates, high home prices, a volatile stock market, concerns that prices would start declining and anxiety about the national political situation all caused a number of buyers to hit pause. The Trump administration’s 2017 tax law also reduced some incentives for homeownership—especially in costlier, high-density markets and high-tax areas—by reducing the cap for the deductibility of mortgage interest and limiting the amount of state and local taxes that can be deducted.
Still, there is some cause for optimism heading into the spring selling season. Higher mortgage rates and rising prices hurt affordability last year, especially for first-time home buyers. While affordability issues have remained, home prices have continued to moderate and mortgage rates have dropped. Moreover, the labor market has remained resilient, and wage growth has continued to track higher. Taken together, these factors point to a modest improvement in existing home sales in 2019.
Federal Reserve
The Federal Reserve has rightfully pressed the pause button on future rate hikes until the data confirms greater economic momentum. This has left a higher burden of proof on the data, suggesting specific pre-conditions will need to be met before the central bank steps back in with another upward policy rate adjustment. These have included relatively stable financial conditions, bounce back in global growth, and stronger evidence of intensifying domestic inflationary pressures.
It will take time for these factors to materialize, causing the timing for a rate hike to move into late 2019. Indeed, the FOMC could afford to be patient because PCE inflation (the Fed’s preferred measure of consumer price inflation) has run at its target of 2%.
China
China’s slowing economy has sent shock waves through its trading partners around the world. Beijing’s struggle with domestic weaknesses, including a huge debt buildup, overinvestment and constraints on private businesses, has combined with trade tensions to drag down growth.
The drop in factory production and consumption has taken a toll on how much China buys from companies elsewhere in Asia, the U.S. and Europe. And the slowdown has rippled far beyond stock indexes, retarding economic growth far from China’s shores.
The slowdown has hit Asia especially hard. For Europe, China’s slowdown has hit amid political troubles including Britain’s looming exit from the European Union and protests in France over economic grievances.
Eurozone
Eurozone economic growth will slow significantly this year as the currency union faces a perfect storm of weakening global trade and the increasing prospect of the U.K. exiting the EU without a deal. The U.S.-China trade dispute roiling international markets, coupled with a sharper than expected slowdown in the Chinese economy, is also sapping Eurozone growth. Growth will also be hampered from the fallout of the yellow vest protests in France, Italy’s ballooning national debt and the weakening manufacturing and export outlook in Germany.
The Eurozone’s waning fortunes have reflected a drastic turn from just two years ago when the currency area grew by 2.4% in 2017—the fastest pace in a decade. But the derailment of the so-called “euro boom” has resurrected old structural problems for the Eurozone, from debt sustainability to political resistance to economic reforms. GDP in the 19-member Eurozone will likely grow by 1.3% in 2019.
Brexit
The U.K. is scheduled to leave the EU on March 29, but it is still unclear whether it will have a transition period that maintains the status quo while a new trade agreement is negotiated, or will immediately shift to a new regime of tariffs dictated by World Trade Organization rules.
British Prime Minister Theresa May has sought to renegotiate the U.K’s divorce deal with Brussels to reach an agreement that would avoid a hard border on the island of Ireland, but allow the whole of Britain to exit the customs union with EU. European leaders have said the withdrawal agreement is not up for negotiation. Theresa May has set a new deadline of March 12 to win approval of a plan that suffered a shattering Commons defeat earlier. If a deal has not been ratified by March 29, the U.K. faces the economic upheaval of leaving the trading bloc without a transition arrangement in place for its exit. Even if there is a transition period, uncertainty about the future relationship is likely to persist as trade talks progress, potentially holding back growth into 2020. Brexit uncertainty has continued to be at the heart of the malaise as consumers have been deeply reluctant to spend under the continuing cloud of hesitation, indecision and ambiguity.
Japan
The Japanese economy rebounded in the final quarter of 2018, thanks to solid spending by households and companies, but worries about China and weaker spending might limit growth this year.
Japan expanded at an annualized pace of 1.4% in the October-December period following a 2.6% contraction in the previous quarter. Exports, an engine of the Japanese economy, have subtracted 0.3 percentage point from growth in the October-December quarter, showing the impact of the U.S.-China trade conflict and the overall slowdown in the Chinese economy. Risk is likely still tilted toward the downside with further economic slowdown in China and around the globe and deterioration in sentiment due to trade friction as the main downside risk factors. The Bank of Japan is likely to stick to its zero target for the 10-year Japanese government bond yield until 2021, given the uncertain economic outlook.
Emerging Markets
Global markets have had a strong start to the year, with equities gaining around the world, credit spreads falling on corporate debt, and emerging- market currencies strengthening as expectations fade for further increases in official U.S. interest rates. And while U.S.-China trade tensions haunted markets last year, news in the past month has been more positive. A weaker dollar, a less hawkish Federal Reserve and a lull in trade tensions have been a “perfect combination” for emerging-markets assets.
Outlook
The government shutdown, U.S.-China trade tensions, and cooling international economies all will dent U.S. output growth early this year. But the US is largely a domestic-driven economy, and the jobs data reaffirm that the U.S. economy is on solid footing despite clouds on the horizon. Forecasters have lowered projections for global growth in 2019 and encouraged the Federal Reserve to pause interest-rate increases.
The U.S. economy is expected to expand 2.3% in 2019. This would mark a slowdown from last year’s pace, but run slightly ahead of the average rate of growth for most of current expansion. Some areas of concern have remained. Consumer confidence in January dipped to the lowest level since October 2016, reflecting Americans’ worries about the shutdown. The housing market cooled last year in the face of rising mortgage rates. And the manufacturing sector has been uneven – stung by a strong dollar and retaliatory tariffs, but propped up by solid domestic demand.
The Fed has been prudent in waiting to evaluate domestic and global economic conditions before raising interest rates again. In addition to muted inflation pressures, a number of pressing event risks on tap for the first quarter of this year have yet to be resolved, including the partial government shutdown, a potential escalation in trade tensions with China, and the UK’s Brexit. Moreover, concerns about slowing global economic activity, particularly in China, have weighed on global sentiment indexes and rattled financial markets in recent months. Given this elevated level of uncertainty globally, it may take until June before the Fed receives enough clarity on the evolution of economic and event risks in order to make an adequate assessment on whether it’s the appropriate time to raise rates again.
Abroad, the threats have loomed larger. China’s manufacturing sector has contracted for the second straight month in January. The Eurozone economy grew at the weakest pace in four years in 2018 as Italy’s economy contracted for the second straight quarter. The Canadian economy has also slowed.
The U.K.’s slowdown has added to the headwinds facing the global economy and in keeping with developments elsewhere in Europe. The German and French economies also slowed in 2018, each growing by just 1.5%. A no-transition departure by the U.K. in March could further slow growth in the economies it leaves behind.
Sustained expansion of economic activity is expected, but strong concerns about slowing growth in major foreign economies, particularly China and Europe, the elevated uncertainty due to Brexit, ongoing trade negotiations and the effects from the government shutdown suggest the risk of a less-favorable outlook.
Sources: Department of Labor, Department of Commerce, National Association of Independent Business, Institute for Supply Management, the Conference Board, Morningstar, Bloomberg
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