U.S. Review
A Strong Start to the New Year
- Nonfarm employment blew past expectations, with payrolls adding 200,000 jobs in January and data for the past year were revised higher to show an average gain of 181,000 jobs per month, or 10,000 more than previously thought.
- The unemployment rate was unchanged in January at 4.1 percent, but average hourly earnings shot up to 2.9 percent year to year, which suggests the tightening job market may finally be pulling wages higher.
- The ISM manufacturing survey showed surprising strength, indicating that business fixed investment will likely be much stronger in 2018, adding some upside risks to GDP growth.
Happy Days Are Here Again
The past week marked a particularly tumultuous period for the U.S. economy. Most key economic data came in well ahead of expectations, causing many forecasters to reassess their expectations about how tax reform will impact U.S. economic growth and whether they should upgrade their forecasts. The yield on the 10-year Treasury spiked, as concerns about rising inflation and larger budget deficits pushed yields past key benchmarks. More forecasters have also raised their expectations for Federal Reserve rate hikes, adding a fourth hike in December 2018.
The strong start to 2018 appears to be fairly broad based. Manufacturing is clearly leading the way. The ISM manufacturing survey ticked down 0.2 points to 59.1, but new orders remained exceptionally strong and the backlog of unfilled orders increased. While the index declined slightly, it does not signal a slowing in manufacturing activity or the economy. The ISM survey is a diffusion index and measures the breadth of strength in the factor sector, not the magnitude of that strength. The current reading is consistent with solid growth in manufacturing and real GDP growth in the 4 percent range. Along those lines, the closelywatched Atlanta Fed GDPNow forecast for first quarter GDP growth jumped from 4.2 percent to a whopping 5.4 percent.
Other data released earlier this week also show the economy had strong momentum at the end of 2017 that was carrying over into the new year. Consumer confidence rose 2.3 points in January, with all of the gain coming from the expectations series. The rise in expectations likely reflects the surge in the stock market earlier in the month as well as growing optimism about tax reform. The present situation index fell slightly but remains near historic highs.
Rising consumer confidence helps explain the persistent drop in the saving rate. Consumers have become much more optimistic about their employment prospects and are willing to spend a larger proportion of their take-home pay. Attitudes are also likely being bolstered by the run-up in the stock market and rising home prices. S&P CoreLogic Case-Shiller home prices rose slightly more than expected and were up 6.2 percent year over year in November.
The Federal Reserve’s January FOMC meeting ended with little fanfare. The Fed kept the federal funds rate unchanged and made few meaningful changes to their policy statement. The financial markets are looking for the Fed’s new leadership to take a slightly more hawkish tone and will get the first good look into the Fed’s mindset when the Fed’s new chair, Jerome Powell, delivers his Semi-Annual Testimony to Congress later this month.
The January employment report came in well ahead of expectations. Nonfarm employment rose by 200,000 in January. Hiring rose solidly in construction and manufacturing. The factory sector appears to be benefitting from stronger global economic growth and the weaker dollar. The unemployment rate was unchanged at 4.1 percent, but average hourly earnings jumped up to a 2.9 percent year-to-year gain. The increase adds to concerns the economy might grow too fast for its own good in 2018, which sent bond yields higher immediately after the report was released.
U.S. Outlook
ISM Non-Manufacturing • Monday
The ISM non-manufacturing index slowed to 56.0 in December after hitting its highest level in more than a decade in the prior month. Hurricane-related distortions may have played a role. Employment rose in December, further suggesting that the slowdown seen in the December payrolls report was not particularly worrisome.
The new orders index slowed over the month to 54.5, its lowest level in more than a year. Coming off of its impressively high average of 61.2 over the past three months, this slowdown is worth noting. Input price pressures were revised down slightly and continue to remain below the elevated levels seen at manufacturers.
On Monday, we receive data for January. We expect the ISM nonmanufacturing index to pick up marginally to 56.4, based on continued growth and increased demand within the services sector.
Previous: 56.0 Wells Fargo: 56.4 Consensus: 56.5
Trade Balance • Tuesday
The U.S. trade deficit widened to $50.5 billion in November, registering the first time that the deficit has exceeded $50 billion since March 2012. There was broad-based strength on both the export and import side of the ledger. With the value of exports up 6.0 percent in the September-November period year over year, overall exports clearly have rebounded in 2017 after experiencing weakness in 2016. Similarly, import growth has strengthened over the course of 2017, in-line with higher commodity prices, but more importantly due to an up-tick in domestic demand.
As we noted at the time of the November release, the strong levels of exports and imports were likely to cause real net exports to be a drag, on Q4 GDP growth. The advance GDP report, published last week, disclosed net exports produced about a 1 percentage point drag on overall GDP growth in the fourth quarter. We expect a modest drag from trade to continue for the next few quarters.
Previous: -$50.5B Wells Fargo: -$52.2B Consensus: -$52.0B
JOLTS • Tuesday
After registering a sharp run-up over the first three quarters of 2017, job openings fell for the second consecutive month in November. Although total job openings are still up 4.4 percent over the past year, this rate marks a slowdown from earlier in the year and, if sustained, suggests a more moderate pace of hiring ahead.
Gross hiring fell in November, coming off of storm-related increases in October. However, the hiring rate, currently sitting at 3.7 percent, remains low relative to the previous cycle. This perhaps points to the less dynamic labor market that exists today.
The quits rate remains high, which perhaps explains the better than expected growth in average hourly earnings in this week’s jobs report. The strength of the January jobs report signals that overall demand for labor is holding up.
Previous: 5,879
Global Review
Mexican Growth Improves in Q4; Europe and Japan
- According to the "flash" release for the performance of economy in Q4-2017, the Mexican economy improved a bit in the last quarter of the year, up 1.0 percent, sequentially and not annualized. On a year-earlier basis, the economy grew 1.8 percent non-seasonally adjusted.
- Eurozone GDP grew 2.7 percent versus a year earlier in the fourth quarter, according to the advance release, while inflation continues to remain benign.
- Japanese industrial production increased a larger-thanexpected 2.7 percent month on month and 4.2 percent year over year in December.
Mexican Economy Improves in Q4
According to the "flash" release for the performance of the economy in Q4 2017, the Mexican economy improved a bit in the last quarter of the year, up 1.0 percent, sequentially and not annualized. On a year-earlier basis, the economy grew 1.8 percent non-seasonally adjusted. This means that the Mexican economy grew 2.08 percent for the whole of 2017. Our forecast for the Mexican economy in 2017 was 2.0 percent after reversing our original call for a slight recession due to the increased risks of the United States abandoning the NAFTA agreement between Canada, the United States and Mexico.
However, the details of the release were relatively weak with the economy being driven by the service sector, up 1.2 percent sequentially and not annualized and by 2.6 percent on a yearearlier basis. For the year as a whole, the service sector increased a strong 3.1 percent. That is, economic growth continues to be driven, fundamentally, by domestic consumption. The allimportant industrial sector was very weak at the end of the year, driven by a very weak mining sector. As this is a flash release, we do not have the details on the supply side or information on the demand side, but we are able to infer where the weakness resided during the year, something that we believe did not change as the year came to a close. The industrial sector managed to increase 0.1 percent sequentially and not annualized in the last quarter of the year but was down 0.7 percent on a year-earlier basis, not seasonally adjusted. The industrial sector however, declined 0.6 percent for the year as a whole. Meanwhile, the primary sector, which is a highly volatile sector and includes agriculture, cattle and fisheries, saved the day for the fourth quarter GDP release as it increased 3.1 percent on a sequential basis and not annualized and by 4.2 percent on a year-earlier basis, not seasonally adjusted. For the year as a whole, the sector increased a strong 2.8 percent.
Thus, even if the Mexican economy improved in the last quarter of the year it remains weak and we are not expecting much change regarding the Mexican economy’s performance this year as it continues to navigate a still risky NAFTA negotiating process and a contentious presidential election slated for July.
European and Japanese Expansion Continues
Meanwhile, Eurozone GDP grew 2.7 percent versus a year earlier in the fourth quarter, according to the advance release, while inflation continues to remain benign. In light of this, there is renewed talk of the ECB starting to tighten monetary policy in the near future. For more on this see "Eurozone Economic Outlook: Does Monetary Tightening Lie Ahead?," which is available on our website. In the U.K., the Markit manufacturing PMI was a bit lower than expected in January, at 55.3, compared to a slightly downwardly revised 56.2 print for December but well above the 50 demarcation point between expansion and contraction, while in Japan industrial production increased a larger-than-expected and strong 2.7 percent month over month and 4.2 percent year over year in December. All these data point to a relatively strong growth contribution from the developed side of the global economy.
Global Outlook
China FX Reserves • Tuesday
Last month, rumors that Chinese officials were considering slowing or halting purchases of U.S. Treasuries briefly roiled the bond market, sending Treasury yields higher. Although this attentiongrabbing headline quickly faded, hard data on Chinese FX reserves can partially help corroborate any change in China’s policy regarding Treasuries, were it to occur.
Foreign central banks have many instruments through which they can hold FX reserves, but they typically hold them via liquid, interest-earning assets such as U.S. Treasury securities. Chinese FX reserves declined rapidly for about a two-year stretch from 2014 to 2016 as the Chinese renminbi encountered significant selling pressure, and Chinese Treasury holdings declined accordingly. Since then, Chinese FX reserves have stabilized and even grown slightly as capital flows out of the country have slowed. The Bloomberg consensus looks for another month of little change in January.
Previous: $3.14 Trillion Consensus: $3.17 Trillion
Bank of England Meeting • Thursday
Economic growth in the United Kingdom has generally been sluggish, rising a modest 1.5 percent year over year in Q4. The sharp depreciation of sterling after Brexit led to a rise in inflation that subsequently eroded income growth and led to a drag on consumer spending. Growth in investment spending also slowed over the past year as Brexit uncertainties likely inhibited more expansionary business decisions. Amid above-target inflation and fading recession fears, the Monetary Policy Committee (MPC) of the Bank of England hiked rates 25 bps in October 2017.
In our view, growth will remain slow enough over the next few quarters to keep the MPC on hold for now. By the end of the year, however, real GDP growth should be showing signs of strengthening anew as inflation recedes. We forecast that the MPC will tighten by 25 bps in Q4-2018, and we look for two more 25 bps rate hikes over the course of 2019.
Previous: 0.50% Wells Fargo: 0.50% Consensus: 0.50% (Bank Rate)
Canadian Employment • Friday
Canadian employment surged to end 2017, posting the second strongest cumulative two-month gain on record. These job gains helped drive the unemployment rate a stunning 0.6 percentage points lower over the course of just two months. A rapidly tightening labor market and economic growth of 3 percent year over year gave the Bank of Canada (BoC) the confidence to lift its main policy rate 25 bps to 1.25 percent at its first meeting of 2018.
The BoC has been willing to move quickly based on economic data, with its September and January rate hikes following unexpectedly strong GDP and employment growth, respectively. That said, we believe high household debt levels and uncertainty over the future of the North American Free Trade Agreement will give the BoC pause about ratcheting up the pace of tightening further. Next Friday’s jobs report will give policymakers a look at whether the recent trend in job growth will come back to Earth or keep heading to the moon.
Previous: 78,600 Consensus: -2,000
Point of View
Interest Rate Watch
Loan Growth: Where We’re Going
As recorded economic growth and expectations for growth in 2018 increase, the expectations are that bank lending will increase as well. With more growth comes more opportunities to lend by banks and a greater willingness by their customers to borrow. How can we monitor the change—if it comes?
The Incentive to Lend: Expectations
For banks, the profitability on lending has diminished in recent years (top graph). Banks continue to face competitive pressures from non-banks and capital markets in general. Bank loans to nonfinancial corporations represented 25 percent of credit in the 1980s, and are down to a representation of 11 percent today. In addition, the decline of interest rates since the early 1980s has also lowered the spread in lending credit to non-financial institutions.
Expectations matter here. If lending institutions, both banks and non-banks, anticipate better economic growth going forward, then in an environment of modestly rising interest rates, lending spreads would widen and offer better returns to all creditors.
Demand Side for Credit
Credit demand at banks typically is very pro-cyclical. In the early years of the recoveries of 1990, 2002 and 2010 (middle graph), there was a distinct upswing in the reported demand for credit at banks. This upswing reflects the improved optimism of business on future growth and therefore the willingness to borrow.
Currently, it remains to be seen if the optimism reported in surveys will translate to an upswing in demand.
CRE: A Less Cyclical Issue
While the tax program aims at stimulating business investment with immediate expensing, it is less obvious if the tax program, or the pick-up in economic growth, will stimulate commercial real estate (CRE) investment. As illustrated in the bottom graph, the demand for CRE loans at banks has been declining for several years. This may reflect a less cyclical pattern for real estate credit and thereby less of a lift due to the current fiscal package going forward.
Credit Market Insights
Loan Growth: Where We’ve Been
Commercial and industrial (C&I) loans at commercial banks grew 1.1 percent in December on a year-ago basis. This rate is up slightly from November’s 0.9 percent pace, but still near a six-year low.
C&I loan growth has slowed broadly across institution types. However, small domestic banks have fared better than their foreign and large domestic counterparts, with loans up 4.4 percent on the year in December. At foreign-related institutions, C&I loans declined 3.8 percent for a ninth straight month of negative growth.
Companies may be turning to other sources of funds, explaining lower loan demand growth. Rising corporate profits likely mean less need for financing. In addition, corporate bonds are making up a larger share of total liabilities for nonfinancial corporations as capital markets open up. Since small domestic banks tend to have customers with less access to capital markets, this factor could help explain their smaller drop-off in loan growth.
Loan demand has been tepid despite relatively easy financial conditions. According to the Senior Loan Officer Opinion Survey, banks on net are still loosening or maintaining standards for C&I loans. Short term rates ticked up with the fed funds rate in 2017, but long term rates stayed about put. This led to a flattening in the yield curve to around a decade low. However, long-term rates have marched higher since the start of the year, which may constrain loan demand further.
Topic of the Week
When Supply Doesn’t Meet Demand
U.S. Treasury yields have jumped to start the year, with the benchmark 10-year Treasury yield rising nearly 40 bps since January 1. A key driver has been concerns surrounding supply and demand in the Treasury market.
On the supply side, net issuance is set to accelerate in 2018 for a variety of reasons, including less tax revenue due to recently enacted legislation, steady spending growth and technical reasons related to the debt ceiling. We forecast a federal budget deficit of $750 billion in FY 2018 and $950 billion in FY 2019, up from a deficit of $666 billion in FY 2017. This jump in issuance is set to occur right as the Fed’s balance sheet reduction program begins to meaningfully ramp up in the coming months. The result is a significant increase in the supply of Treasuries the market must absorb, a topic we have covered at length (top chart).
Rising supply has raised questions about who will buy all this new debt, and at what price. In a report published last fall, we found that price-sensitive buyers, such as U.S. households and foreign-private purchasers, are the most likely candidates to become the marginal buyers. We noted that "if demand for Treasury securities falls short of supply at current prices, then yields will need to rise to clear the market." This appears to be playing out now as the market adjusts to less demand from central banks amid an expected onslaught of new supply.
First, however, Congress must increase the debt ceiling, or the legal upper-bound on the nation’s borrowing limit. Since December, the Treasury has been utilizing extraordinary measures to remain solvent. In a report published Tuesday, our analysis indicated that the extraordinary measures will last until the first week of March, at which point the Treasury will likely become dangerously low on cash. The combination of another potential budget impasse, in conjunction with a debt ceiling countdown, could rattle consumer confidence and financial markets in the weeks ahead (bottom chart).
