U.S. Review
Cooler Weather and Cooler Data
- Industrial production jumped 0.9 percent in December, although about half the gain can be attributed to a surge in utilities output. Manufacturing production rose 0.1 percent after increasing 0.3 percent in November.
- Housing data released this week showed some moderation in activity. Housing starts fell 8.2 percent in December after unseasonably mild weather in November, while homebuilder confidence fell 2 points on lower homebuyer traffic.
Manufacturing Cooling from a Breakneck Pace
The industrial side of the economy has put up an impressive performance in recent months, and that trend continued in December. Industrial production rose 0.9 percent last month, which was stronger than expected. Part of the beat stemmed from a 5.6 percent jump in utilities output, as cooler weather blanketed much of the country. Utilities output accounts for a little over 10 percent of industrial production.
Mining activity also posted a solid gain, increasing 1.6 percent. The sector has benefitted from the rebound in oil prices over the past year, which has helped fuel new drilling and production. Output is up 11.5 percent since last December when oil prices were more than 10 percent lower.
Growth in the manufacturing sector, which accounts for about three-quarters of industrial output, was more restrained. Production rose just 0.1 percent in December. That followed an upwardly revised gain in November and sharp upturn in October (following the unwind of hurricane distortions), leaving manufacturing output rising at a 7.8 percent annualized pace over the past three months.
Despite December’s scant increase, we believe manufacturing growth will remain strong in the near term. After a tough few years, the sector is now benefiting from much higher levels of business confidence, stronger global growth and a weaker dollar. Yet December’s modest increase along with the first of the January purchasing managers’ indices (PMIs), suggests activity may be cooling from the exceptionally strong levels implied by the latest ISM readings. Both the Philadelphia and New York Feds’ regional PMIs came in lower in January, although both remained solidly in expansion territory.
Housing Starts Fall, But Poised for Improvement
New residential construction also appeared to cool a bit in December. Housing starts fell 8.2 percent in the final month of the year after rising 12 percent over the prior two months. December’s drop largely reflected a return to more typical winter weather. With relatively little new construction occurring late in the year, seasonal adjustment can exaggerate month-to-month changes, and this December followed an unusually mild November. In December, permits were 9.2 percent higher than starts and suggest new construction will trend higher over the next few months. Builder confidence also remains at an exceptionally high level even after edging back two points in January.
Recent tax changes will provide some hurdles to the housing market, but the market will benefit from the broader economy strengthening. Lowering the mortgage interest deduction, capping state and local tax deductions and doubling the standard deduction will likely push back the timing and size of homes purchased for some households. Lower tax rates for homebuilders, on the other hand, should help profitability and support construction of more entry-level and mid-tier homes. For a more detailed discussion of the effects the tax bill is likely to have on the housing sector, see our report "Tax Reform and Housing" (January 17, 2018).
U.S. Outlook
Existing Home Sales • Wednesday
Existing home sales jumped 5.6 percent in November to a 5.81 million-unit pace. Wednesday’s release for December is expected to show a slight slowing, but still-solid performance for existing home sales. Sales continue to be the strongest in the South, which accounts for roughly 40 percent of existing home sales. The recent increase in buyers is consistent with the stronger run of growth the economy has seen in recent months.
November’s surge in existing home sales came despite the continued drop in the inventory of homes available for sale. Year over year, inventories are down 9.7 percent. With inventories tight and demand increasing, home prices are being bid higher. The median price of an existing home continues to rise, and is up 5.8 percent over the past year. We may see a surge in closings of higher-priced homes in December, which would enable buyers to be grandfathered in with the current more favorable mortgage-interest deduction.
Previous: 5.81M Wells Fargo: 5.78M Consensus: 5.70M
New Home Sales • Thursday
December new home sales are slated to be released this coming Thursday. New home sales will be coming off a red-hot November in which sales surged 17.5 percent (733K unit pace). Much like existing home sales, stronger economic growth and unseasonably mild winter weather has propelled new home sales to cycle highs. Development activity has also ramped up, giving builders a little more inventory to sell.
The recent strength in sales is not surprising given that homebuilder confidence has surged, as buyer traffic and sales have also ramped up. The South and West accounted for the bulk of November’s increase, a trend we believe will continue in the December data. A lack of inventory will continue to be a limitation on home sales. We look for new home sales to increase at a 699K unit pace, a modest reprieve from November’s breakneck pace.
Previous: 733K Wells Fargo: 699K Consensus: 675K
GDP • Friday
This coming Friday we will see the first look at Q4 GDP as well as data for 2017 as a whole. On an annualized basis, we expect growth to be 2.9 percent – continuing the recent string of strong quarterly readings. For 2017, we expect 2.3 percent year-over-year growth, a marked improvement from the 1.5 percent growth rate notched in 2016. We project personal consumption and business fixed investment to improve on the quarter based on encouraging monthly data, which continue to point to high levels of confidence in each sector. Residential construction should also provide a boost to topline GDP following consecutive quarters of dragging the headline figure lower. Net exports are likely to exert a drag on GDP growth in Q4 after adding positively to the headline throughout 2017.
Incorporating the newly passed tax reform package, the U.S. economy appears to be on the upswing as 2018 kicks off. The balance of risks looks to be to the upside.
Previous: 3.2% Wells Fargo: 2.9% Consensus: 3.0% (Annualized Quarter-over-Quarter)
Global Review
Manufacturing Cooling from a Breakneck Pace
- The Brazilian economic activity index increased 0.5 percent sequentially, slightly above the 0.4 percent analysts were expecting. On a year-over-year basis the economy improved at a 2.8 percent rate.
- The Bank of Canada increased its benchmark interest rate 25 basis points, from 1.00 percent to 1.25 percent, following a very strong employment number in December.
- The Chinese economy grew 6.8 percent on a year-earlier basis in Q4, while it printed a rate of growth of 1.6 percent sequentially and not annualized.
Brazilian Economic Growth Continued in November
The Brazilian economy continued its march toward recovery in November according to the economic activity index, a monthly proxy for the behavior of gross domestic product. The index increased 0.5 percent sequentially, slightly above the 0.4 percent analysts were expecting. On a year-over-year basis the economy improved at a 2.8 percent rate, slightly below the upwardly revised 3.1 percent year-over-year rate reported for October.
Still, it is important to note that comparisons are being made against very low base numbers as the economy experienced the longest period of recession in recorded history. Nevertheless, it is clear that domestic consumption as well as foreign consumption, i.e., exports, have been trending up, which means that the economy seems to be, finally, hitting in all cylinders. And this is good news for the immediate future, even though uncertainties remain high as the country prepares to go to the polls later in the year and ex- President Lula da Silva, who continues to lead in the polls, is still facing serious legal troubles in several corruption cases.
Canada’s Central Bank Pulls the Trigger Again
Once again, the Central Bank of Canada increased its benchmark interest rates by 25 basis points, from 1.00 percent to 1.25 percent, following a very strong employment number in December and the lowest unemployment rate, at 5.7 percent, in 40 years. As we explain in our recent report "The Bank of Canada Hikes Rates" (January 17, 2018), we still expect the Bank of Canada to increase interest rates just once more in 2018 to close the year at 1.50 percent, although we acknowledge upside risk to this forecast.
China’s Economy Steady as it Goes
The Chinese economy grew 6.8 percent on a year-earlier basis in Q4 compared to expectations of a 6.7 percent growth rate, while it printed a rate of growth of 1.6 percent sequentially and not annualized. The sequential rate was a bit lower than what markets were expecting, 1.7 percent, but the reason for the lower-thanexpected sequential rate was that the rate for Q3 was upwardly revised from 1.7 percent to 1.8 percent. The fourth quarter GDP growth rate meant that the Chinese economy grew 6.9 percent during the whole of 2017, which was marginally better than what the consensus forecast was expecting, up 6.8 percent. The result for 2017 shows that economic growth in China has stabilized and the economy continues to grow at a relatively strong rate (for more on Q4 results see "Chinese Economic Outlook: Further Slowing in Store?" (January 18, 2018).
However, December numbers for retail sales and industrial production were mixed. Retail sales increased only 9.4 percent year over year in December after a 10.2 percent growth rate in the previous month and markets expectations of a similar 10.2 percent rate in December. Still, while December retail sales were weak, the index managed to grow 10.2 percent for the year as a whole. Meanwhile, industrial production was up a higher-thanexpected 6.2 percent in December, year over year, a bit higher than markets expectations of a 6.1 percent rate. For the year as a whole, industrial production increased as expected, up 6.6 percent.
Global Outlook
Eurozone PMIs • Wednesday
Business confidence in the Eurozone, as measured by the purchasing managers’ indices, is flying high right now. The manufacturing PMI rose to 60.6 in December, which is just shy of a record high. Although not as stratospheric, the service sector PMI stands at a very respectable level of 56.6. PMI data for January are slated for release on Wednesday. Separately, the Ifo index of German business sentiment is on the docket on Thursday. France releases its comparable business confidence index on Friday.
The European Central Bank will hold a regularly scheduled policy meeting on Thursday. Although nobody looks for a change of policy at the meeting—the Governing Council has stated that it will keep its QE program in place through at least September—market participants will scrutinize the statement for hints about potential policy changes later this year.
Manufacturing PMI: 60.6 Consensus: 60.3 Services PMI: 56.6 Consensus: 56.4
U.K. GDP • Friday
The U.K. economy has decelerated in recent quarters due, at least in part, to slower growth in consumer spending. The sharp depreciation of sterling in the immediate aftermath of the Brexit referendum caused inflation to shoot up. Higher inflation eroded growth in real income, which has weighed on growth in consumer spending. Investment spending has also taken a hit due, at least in part, to uncertainty related to Brexit. Preliminary data for Q4-2017 will be released on Friday.
Earlier in the week, the labor market report will print. The unemployment rate in the United Kingdom currently stands at 4.3 percent, the lowest rate in 42 years. Much like the United States, however, a low unemployment rate has not yet translated into significant wage acceleration. Average weekly earnings (excluding bonuses) were up only 2.3 percent in the August-October period on a year-ago basis.
Previous: 0.4% Wells Fargo: 0.4% Consensus: 0.4% (Not Annualized)
Canada CPI • Friday
The Bank of Canada (BoC) conducts monetary policy in order to maintain the CPI inflation rate in a range of 1 percent to 3 percent. At 2.1 percent, inflation is essentially at the midpoint of the range at present. However, citing stronger-than-expected economic growth in the context of an economy that is already operating close to potential, the BoC decided to hike rates 25 bps at the policy meeting on January 17. The BoC has hiked rates three times since last summer. We look for CPI inflation to rise to 2.5 percent in December which, if realized, would be the highest rate in nearly six years. The CPI data will be released on Friday.
Consumer spending has generally been strong in Canada recently. Indeed, the value of retail spending shot up 1.5 percent in October, which pulled the year-over-year growth rate up to 6.7 percent. Retail sales data for November are slated to print on Thursday.
Previous: 2.1% (Year-over-Year) Wells Fargo: 2.5%
Point of View
Interest Rate Watch
Three Observations
In recent weeks, several hypotheses have been advanced about the fundamentals behind any move in rates for the year ahead. In this note, we focus on the evidence for retail demand, bank perceptions of credit demand and the case for higher inflation.
Retail Demand? Unlikely
One concern in the market has been the focus on the Fed’s shrinking balance sheet and the rise in Treasury debt issuance. There has been an argument that retail investors will pick up the slack. We find that unlikely. First, investors will review their positions and see that equities have delivered excellent performance while interest rates are expected to continue to rise in the year ahead. Second, as illustrated in the top graph, the percentage of families aged 65-74 that own bonds has declined steadily over the past 17 years. This pattern is also repeated for 55-64 year olds and 45-54 year olds. Given these two factors, we believe it unlikely that households will pick up the ball and, therefore, there is an upward bias to our interest rate outlook.
Loan Demand: Will Tax Cuts Boost Demand?
In the latest Fed Senior Loan Officer survey, the net percent of banks reporting stronger demand in Q3-2017 was uniformly down over the four quarters up to that third quarter (middle graph). This indicates a delicate balance in the demand for shortterm credit. If the tax cuts boost current and expected profits for businesses, then the demand for bank loans should rise. However, we also know the Fed is on a path to raise rates and thereby increase the cost to borrow. We will watch how carefully this balance plays out in the year ahead.
Above FOMC inflation Outlook
Our PCE inflation outlook for 2018 is above that for the FOMC. We expect 2.1 percent compared to 1.7-1.9 percent for the FOMC. As illustrated in the bottom graph, the trend is definitely upward relative to the meandering pattern of recent years. Why? The pickup is driven by the unwinding of what we believe were largely one-offs in 2017—declines on wireless phone services and physician services. In addition, higher labor costs as the job market tightens and capacity utilization rates rise should put upward pressure on wages. Finally, the weaker dollar will bias import prices up.
Credit Market Insights
Change in Consumer Expectations
The New York Fed’s Survey of Consumer Expectations showed inflation expectations were gaining ground in December, though consumers were also more uncertain about that call. Notably, inflation expectations at the end of 2017 were even with where they were at the end of 2016. The uptick in actual inflation in recent months combined with higher prices at the gas pump may be convincing consumers that inflation will finally pick up.
The survey also provides insight into views about income and credit availability over the next year. Views on income and spending growth softened in December. Income growth expectations were the same as they were last year. That marks a recovery from a large dip in September that may have resulted from extreme weather events.
Expected spending growth was much lower in December 2017 relative to this time last year. Expected credit availability may have played a role. A year ago, a larger share of respondents expected easier access to credit than they did in December 2017. Nearly half of the respondents experienced no change in credit access last year, and now half expect the same to happen this year. Consumers may have found the goldilocks level of credit access. The share expecting they will default on a debt payment is also lower. It also appears they plan to spend closer to their income-provided means this year. That fits with the larger share of Americans expecting interest rates to rise.
Topic of the Week
The Case for Stronger Cap-Ex
"What can we do to boost capital spending?" That has been a top-of-mind question for our political leaders, as well as for fiscal and monetary policymakers in this expansion. Any informed discussion about below-trend economic growth focuses on chronically weak productivity. Since capital spending can boost productivity, it is often considered one of the most important missing links that could lift GDP growth.
Yet, aside from the initial post-recession recovery and a lot of energy-related investment in the middle part of the current expansion, businesses have been more interested in alternative uses for capital such as share buybacks, increased dividend payouts or mergers and acquisitions, than they have in ratcheting up capital expenditures.
A number of headwinds earlier in this cycle like the value of the dollar, global growth and energy prices have simultaneously switched in a direction more favorable to cap-ex more recently. That has occurred alongside a surge in business confidence that has been missing since roughly 2004. Our analysis finds that with all those improving dynamics already in the mix, the new tax cuts and associated capital spending incentives it contains will help lift the trend rate of cap-ex. On balance, our upward revisions to the equipment spending outlook could add a tenth of a percentage point to GDP growth in 2018 and 2019, all else equal.
That said, in these days of sky-high confidence and record-breaking highs in the stock market, it is easy to get carried away. We would be remiss not to acknowledge that we are late in the economic cycle and that a number of downside risks could still derail the expected pick-up. Stronger business spending also suggests a faster rate of growth in imports which means an offset in GDP when taking trade into consideration. Bigger trade deficits also mean increased current account deficits. Taking all these factors into account, our base case is for full-year equipment spending growth of roughly 8 percent next year, up from 6.2 percent in our prior forecast.
