The U.S. economy headed into 2020 on solid footing, with growth settling back to the roughly 2% pace that had prevailed during the decade-old economic expansion. U.S. real GDP grew 2.3% last year, after rising at an annual rate of 2.1% in the fourth quarter. The economy’s expansion last quarter reflected a boost from trade as exports increased and imports dropped. The pace of consumer spending slowed, and business investment dropped for the third quarter in a row, while residential investment picked up.
The economy was buffeted last year by the U.S.-China trade dispute and a slowing global economy but was buoyed by a strong domestic labor market that fueled consumer spending and optimism. The Federal Reserve left its benchmark interest rate unchanged, maintaining its make-no-move posture after cutting rates three times in the second half of 2019.
When it comes to fundamentals, the global economy has continued to sputter along, neither accelerating into a rebound nor decelerating into a recession. Economic growth in China and the Eurozone appeared to have held steady in Q4-2019, neither slowing further nor picking up. Data out of the United Kingdom have been a bit weaker over the past month, indicating economic growth may have been close to zero in the final quarter of 2019.
The New Year began on an encouragingly quiet note for geopolitics. The United States and China had achieved a tenuous pause in a trade war that had damaged both sides. The specter of open hostilities between the United States and Iran had reverted to a stalemate. Though Europe remained stagnant, Germany – the Continent’s largest economy – had escaped the threat of recession.
Now, the world has become worried again.
The coronavirus outbreak originating in China and reaching beyond its borders has summoned fresh fears, sending markets into a wealth-destroying tailspin. It has provoked alarm that the world economy may be in for another shock, offsetting the benefits of the trade truce and the geopolitical easing, and providing a new reason for businesses and households to hunker down.
How is the global economy going to respond to the outbreak? That will depend on the severity, spread, and duration of the outbreak which is unknown at this time. The economic impact, however, is expected to be short-term, limited and concentrated in East Asia.
U.S. Manufacturing Index
The U.S. factory activity contracted for the fifth consecutive month in December as trade tensions continued to pressure manufacturers. Manufacturing output showed little hope for a quick recovery as persistently weak new orders and employment have not bode well for a broad rebound in production in the coming months. Global trade policy uncertainty has remained the greatest concern across industries, but there have been signs that several industries should improve as a result of the phase-one trade agreement between the U.S. and China.
In addition to the trade tensions, other factors likely to continue to impede domestic manufacturing output would include weak foreign demand, a strong dollar, and less robust domestic demand.
U.S. Non-manufacturing Index
Diverging from its manufacturing counterpart, the ISM’s non-manufacturing index improved in December, ending the year on a good note. Helped by healthy consumer fundamentals and less exposure to trade tensions, the non-manufacturing index remained in expansionary territory throughout 2019, unlike manufacturing, where activity was contracting.
With the labor market continuing to churn out solid job gains, interest rates remaining low, and wages rising at an above-inflation pace, the fundamentals for consumption should be healthy heading into 2020. As a result, American consumers will help to ensure the continued growth of the services sector.
Housing appears poised to be a bright spot in the GDP growth in 2020, with nearly every key driver of home sales and new construction remaining solidly positive. Job and income growth should continue to be solid, with consumer confidence high. Interest rates remain low and credit is readily available.
The demographics are also more favorable, with a rising tide of Millennials reaching their late thirties and growing numbers of Baby Boomers relocating to states considered retirement havens. While affordability remains challenging for many first-time buyers, builders are increasingly looking to develop more products for this growing segment, and public policy is turning toward easing development burdens.
The improved housing outlook has been a byproduct of lower mortgage rates and diminished near-term recession worries. The apparent trade deal with China created the potential for an upside surprise, while heightened tensions in the Middle East will likely keep long-term interest rates, and mortgage rates, a little lower than they would otherwise be.
The labor market has remained strong across most measures, though there have been signs of deceleration, such as a slower pace of hiring in 2020. Layoffs rose in December, though they remained low and consistent with a tight labor market. Job openings, however, have rolled over and small business hiring plans have remained below last year’s level. Resilience in hiring has been evident in most private sector industries, except manufacturing and natural resources and mining.
Looking ahead, job gains are expected to slow markedly in 2020, though hiring for the 2020 Census will likely disrupt the quarterly estimates.
The tight labor market has led to stronger wages, though the pace of wage growth has slowed over the past year given that the unemployment rate has been at a 50-year low. This could point to a job market that is less hot than the unemployment rate would suggest. With firms continuing to cite difficulty finding qualified workers, employment costs are expected to grow around their current pace this year.
U.S.-China Trade Deal
On January 15th, the U.S. and China signed phase one of a trade deal. The deal removes the threat of additional U.S. tariffs and cuts the existing tariff rate on over $110 billion in Chinese goods by half. Perhaps the most striking element is the commitment from China to raise imports of U.S. goods and services by $200 billion over the next two years.
The deal has many provisions that would improve on prior commitments, including strengthening U.S. intellectual property protection, prohibiting forced technology transfer, increasing access to the Chinese financial service industry, abolishing competitive currency devaluation, and increasing market access and reducing non-tariff barriers to U.S. agricultural products. The deal contains an enforcement mechanism and a dispute resolution process.
Overall, the trade deal is likely to be positive for U.S. growth, returning support to American producers of agricultural, manufacturing, and energy goods. At the same time, its implications for the rest of the world could be more uncertain and possibly even have negative repercussions, since increased Chinese imports from the U.S. could come at the expense of other countries. This would be especially true for goods like agriculture and energy, where China has less capacity to substitute imports for its domestic production.
A second challenge to hit the ambitious targets laid out in the agreement would be capacity constraints and whether the deal could give American firms the confidence to make long term investments to meet these ambitious targets. If U.S. exports to China simply offset exports to other countries, there could be little benefit to overall U.S. growth.
Impact of Coronavirus on the Chinese Economy
Over the past few weeks, a new coronavirus – originating from the city of Wuhan, China – has spread across Asia and into the United States and other countries. In addition to its health effects, the coronavirus has rattled investors and financial markets in China and financial hubs across Asia. Global businesses operating in China have closed stores, scaling back operations and restricting travel as the Chinese government has raced to control the coronavirus.
The onshore Chinese renminbi currency has also moved lower as a result. Other emerging Asian currencies have also weakened as investor sentiment toward the region has soured, with the currencies of countries closely linked to China under the most pressure. Oil prices and most commodity prices have come down significantly, dragging commodity-linked currencies lower as well.
It is too early to make any specific determination on the effects of the virus on the Chinese economy. Given the travel restrictions in and out of China and general fear of contagion, there is likely to be a slowdown in economic activity to start the year, which would likely affect the overall growth prospects.
Chinese economic growth should slow to about 5.8% in 2020. However, the renminbi is likely to eventually strengthen over the medium-term. Other emerging Asian currencies would begin to strengthen as well, while the U.S. dollar would gradually weaken as demand for the safe-haven qualities of the greenback dissipates. Also, the euro is expected to modestly strengthen from current levels.
The economic growth rate in the U.S. will decline in the first quarter of 2020 before rebounding in the second quarter and eventually settling into a range of 2-2.5% throughout 2020.
Inventories are likely to be a drag on Q1 growth due in large part to the production stoppage of the 737 MAX at Boeing. As a result, industrial production is expected to decline at least at a 3.5% annualized rate in Q1-2020, after a scant 0.6% drop in the fourth quarter. In the second quarter, even if the stoppage continues, inventories will likely boost growth.
Other than that, fundamentals suggest slow but steady growth ahead, with consumer spending growing at about a two percent pace throughout 2020 and equipment spending gradually climbing out of its present slump before resuming a 3-4% pace of growth.
Employers in the U.S. will likely continue to add new jobs throughout 2020, despite some Census-induced volatility in the quarterly hiring estimates. Still, the pace of hiring is simply not sufficient to match the expected growth of the labor force so the jobless rate is expected to tick modestly higher towards the end of 2020. Real disposable income growth should remain positive but moderate slightly, reflecting slightly slower growth in the jobs market and somewhat higher inflation compared to 2019. Headline inflation is expected to rise near the Fed’s 2.0% target in the coming quarters after increasing just 1.4% last year.
The two elements to watch this year will be business investment and consumer spending. Investment was the weakest spot for the economy in 2019, beset by trade uncertainty and struggling global growth. With some positive development on the trade front, this should see modest improvement in the coming months. At the same time, consumer spending is likely to slow modestly this year. The fundamentals have remained solid, but neither interest rates nor household wealth is likely to be as supportive of spending as they were last year.
Potential negatives for the economy remain on the horizon. Boeing Co. halted production of its troubled 737 Max aircraft in January, a blow to U.S. manufacturing. Slowing growth in China and a coronavirus outbreak that originated there could also pose a risk to the global economic pickup this year. So long as there is not another flare-up, the recent U.S.-Iran tensions are not expected to have any material impact on the U.S. economy. The case for an upside surprise to growth in 2020 relies heavily on renewed business investment in the wake of the Phase One trade deal.
In Europe, there have been signs that stability in the manufacturing sector has taken hold. The Eurozone manufacturing PMI has stabilized around 46-47 over the past few months, and hard data on industrial output and factory orders in Germany suggest that the pace of contraction has eased. Furthermore, the service sector has remained resilient. In the absence of a stronger PMIs and/or a better-than-expected real GDP number, ECB will likely cut rates one more time 10 bps at its March meeting.
In the United Kingdom, the Bank of England is expected to keep its main policy rate on hold for the foreseeable future. Although some certainty seems to be on the horizon in regards to Brexit, the U.K. economy appears to be stalling.
Sources: Department of Labor, Department of Commerce, Morningstar, Bloomberg, Eurostat, Institute for Supply Management
This article was produced for Middleburg Financial by Capital Market Consultants, Inc.
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