U.S. Review
‘Tis the Season to be Jolly
- Consumer confidence surged to a 17-year high in November, according to the Conference Board, which is good news at the start of the holiday shopping season.
- The personal income and spending report for October showed healthy income growth as spending receded from September’s storm-induced surge to a still-respectable pace. Consumers also increased their saving rate from a cycle low in October. The ISM manufacturing index showed factory conditions continue to strengthen.
Data Continue to Provide Reasons for Cheer
The consumer was in good spirits heading into the last quarter of the year, according to most of the new economic data this week.
Shoppers in the new housing market may be one exception, however, as October’s new home sales report suggests that the market was very competitive and there is little relief ahead. The pace of new sales accelerated to the fastest of the current cycle, as product was snapped up even before construction. Some of the uptick may be traced to seasonal factors. The largest gains were in the Northeast and Midwest, which are smaller and susceptible to large seasonal swings. Still, not seasonally adjusted gains were also strong in all four regions. Attesting to the strong demand, homes where construction had not yet started accounted for the entire rise in new homes sold and almost all of the increase in forsale inventory on the market. At October’s pace of new home sales, there were just 4.9-months of inventory, down from 5.2 in September. The inventory of completed homes was unchanged. Such fundamentals should keep developers in good spirits this winter.
The Conference Board provided the most recent evidence that consumer confidence remains high, with its headline index registering a 17-year high in October. Confidence stemmed from a combination of the strong labor market and financial gains improving consumers’ assessment of the present situation, as well as rising expectations about the future. There has been a marked uptick in the expectations index in recent months. Apparently any partisan bickering has not deterred consumers’ optimistic outlook for tax cuts. The rising stock market and home values are also likely boosting their outlooks. Consumers’ buying plans for major appliances increased to 52 from 48.8, which should give retailers reasons for cheer this holiday shopping season.
October’s report on personal income and spending suggested consumers should have the means to act on surging confidence. Disposable personal income increased another 0.5 percentage points in October, building on September’s 0.4 percent increase. Inflation trimmed some of October’s rise, but the 0.3 percent increase in real disposable income was a welcome lift from essentially flat growth since May. The consumption expenditures side of the report was more a come-down story from September’s 0.9 percent hurricane-induced lift. Spending in October increased a more modest 0.3 percent or 0.1 percent in real terms. The saving rate increased a bit in October to 3.2 percent from a cyclelow of 3 percent.
All told, the personal income and spending story in October gave reason for cautious optimism for spending in the last quarter of the year. The fundamentals are aligned to support a strong showing for holiday sales, from the improving labor market and consumers’ assessment of current financial conditions to their high expectations. October’s solid bump in disposable income was a welcome change as income growth has been somewhat of a Scrooge in recent months. The spending picture looks bright going into the holiday sales season.
U.S. Outlook
International Trade • Tuesday
The trade deficit rose slightly in September to $43.5 billion. Exports for the month grew 1.1 percent while imports rose 1.2 percent. Exports were boosted, in part, by stronger industrial supplies while the stronger import growth was supported by an improvement in capital goods and industrial supplies. For the last three quarters net exports have marginally added to headline GDP growth. We expect that trend to reverse course in the fourth quarter as strong domestic demand lifts the growth rate of imports above than the more modest pace of export growth. We expect the trade deficit to widen further in October to $47.4 billion. For the fourth quarter as a whole, we expect net exports to subtract 0.2 percentage points from headline GDP growth. This trend is expected to continue into next year as the pace of domestic demand is expected to lead to a faster pace of imports than exports.
Previous: -$43.5 Billion Wells Fargo: -$47.4 Billion Consensus: -$47.0 Billion
ISM Non-Manufacturing Index • Tuesday
ISM’s non-manufacturing index climbed higher in October to 60.1 from September’s reading of 59.8. The index was lifted by better current activity and employment. Several respondents reported greater activity related to hurricane recovery efforts. The more forward-looking new orders component pointed toward continued solid growth, at 62.8, only slightly below the 63.0 reading in September.
Looking ahead to November’s reading, we expect the index to pull back slightly to 59.7 as some of the hurricane effects begin to subside. We continue to expect the service sector to lead growth in employment as the year progresses. The continued strength in the service sector will also continue to be a key driver of economic activity going forward and supports our forecast for 2.1 percent GDP growth in the fourth quarter of this year.
Previous: 60.1 Wells Fargo: 59.7 Consensus: 59.0
Employment • Friday
Nonfarm employment bounced back in October following a disappointing reading in September related to post-hurricane effects. Nonfarm payrolls rose 261,000 in October following a gain of just 18,000 in September. The unemployment rate continued to fall, reaching a cycle low of 4.1 percent. A bit more disappointing was the flat average hourly earnings reading following a 0.5 percent rise in September. We expect nonfarm payrolls to rise by 220,000 in November, which should keep the unemployment rate steady at 4.1 percent. Overall, job growth should average 197,000 in the fourth quarter, and we expect the unemployment rate to end the year at the current 4.1 percent rate. We continue to expect the pace of job growth to gradually decelerate next year as slack in the labor market continues to diminish. By the end of 2018 we see the unemployment rate at 3.9 percent.
Previous: 261,000 Wells Fargo: 220,000 Consensus: 200,000
Global Review
Mixed Global Data; Brazil Back from the Brink
- In Germany, real retail sales fell 1.2 percent sequentially in October after a relatively strong print in September, up 0.5 percent.
- Better news came from the important Chinese economy with a slight improvement in the official manufacturing PMI index to 51.8 from 51.6 in October.
- Although the Brazilian economy grew less than what markets were expecting in Q3, up only 0.1 percent sequentially versus consensus expectations of 0.3 percent, growth in Q2 was revised up from an original 0.2 percent to a 0.7 percent improvement. For the year as a whole this will make a big difference.
Mixed Economic Signals Across the Global Economy
This week we saw some mixed signals from the global economy. In Germany, real retail sales fell 1.2 percent sequentially in October after a relatively strong print in September, up 0.5 percent. This was the weakest month-on-month performance since November 2016 when real retail sales declined 1.7 percent. The decline in October brought the year-over-year rate into negative territory, down 1.4 percent after printing a strong increase of 4.1 percent in September. However, the behavior of both the month-on-month as well as year-over-year rates is not atypical for this German series so it should not dim the prospects for a continuation of economic growth in the largest economy of the Eurozone.
Better news came from the all-important Chinese economy with a slight improvement, to 51.8 from 51.6 in October, of the official manufacturing PMI index. The difference with the previous month is negligible, but the fact that consensus was expecting a slight decline was enough to improve the view regarding this important sector in China. The Caixin manufacturing PMI, which includes small and medium-sized manufacturing firms typically not included in the official PMI, was slightly lower in November, to 50.8 versus 51.0 in October but still above the 50 demarcation point.
The Brazilian Economy: Back from the Brink
In Brazil the data were better than expected. We have been at the top of the consensus expectations for the whole year on Brazilian GDP but are probably going to fall short when all is said and done. After the release of Q3 results markets will likely considerably re-price growth in GDP higher for this year and next. Although the Brazilian economy grew less than what markets were expecting in Q3, up only 0.1 percent sequentially versus consensus expectations of 0.3 percent, growth in Q2 was revised up from an original 0.2 percent to a 0.7 percent improvement which, for the year as a whole, will make a big difference. The economy has already grown 0.6 percent year to date and that is our current forecast for this year, which would mean that economic growth in Q4 will make for a stronger performance for the year as a whole.
The details were even more encouraging as economic growth was kept relatively low by a strong increase in real imports of goods and services, which increased 5.7 percent versus a year earlier and 6.6 percent sequentially, not annualized. Recall that imports enter the GDP calculation with a negative sign so imports are a subtraction from economic growth. At the same time, real exports of goods and services were very strong, up 7.6 percent versus a year earlier and 4.1 percent sequentially. Real personal consumption expenditures were up 2.2 percent year over year while they were up 1.2 percent sequentially and not annualized. Meanwhile, although real gross fixed investment was still negative on a year-earlier basis, down 0.5 percent, it surged 1.6 percent sequentially, which means that investment is on track to start contributing to GDP growth in Q4. All these data points show an economy that is, finally, back from the brink.
Global Outlook
Brazil Industrial Production • Tuesday
Brazilian industrial production has continued its steady grind higher, returning to positive year-over-year growth back in May and trending up over the past couple months. Industrial output was up 0.8 percent sequentially in Q3 and 0.4 percent year over year, with annual gains across all three sectors of mining, manufacturing and construction.
The Brazilian economy was decimated by the commodity price collapse, the slowdown in global growth that occurred over the 2015-2016 period plus a severe political crisis. As we highlighted in this week’s international review, export growth was strong in Q3, likely aided by healthy growth in external demand among the world’s economies, and fixed investment spending surged in the quarter. These trends bode well for continued momentum in Brazilian industrial production headed into the fourth quarter.
Previous: 0.2% Consensus: 0.1% (Month-over-Month)
Bank of Canada Meeting • Wednesday
The Bank of Canada (BoC) surprised some back in September when it chose to increase its overnight lending rate 25 basis points, bringing the policy rate to 1.0 percent. Real economic growth was especially robust in Canada in the first half of the year, averaging a more than 4 percent annualized rate.
Data released this morning showed Canadian real GDP decelerating from the breakneck pace seen through the first half of the year. Economic growth coming back down to earth should reassure monetary policymakers in Canada that a gradual path of monetary policy tightening is warranted. As the BoC’s last policy statement from October highlighted, wage and other data indicate there is still some slack in the labor market, and household spending is likely more sensitive to interest rates than in the past due to high debt levels. We do not expect a rate hike at the December meeting and look for the BoC to roughly keep pace with the Fed next year.
Previous: 1.00% Wells Fargo: 1.00% Consensus: 1.00% (Overnight Lending Rate)
U.K. Industrial Production • Friday
The factory sector in the United Kingdom strengthened in the third quarter, with manufacturing output rising 0.4 percent or better in each month of the July-September period. Capital goods production in particular has been strong, up nearly 7 percent year over year through September, an encouraging sign given the concerns surrounding investment spending in the wake of Brexit.
The depreciation of the pound that has spurred above-target inflation in the United Kingdom this year has likely provided a boost to U.K. manufacturers looking to export their products abroad. The improving global growth environment, particularly across the English Channel in Europe, has also helped spur stronger factory sector output. Looking ahead, the depreciation effect on both inflation and manufacturing will likely begin to fade, which should produce a more balanced composition of economic growth as slower inflation improves purchasing power for consumers.
Previous: 0.7% Consensus: 0.0% (Month-over-Month)
Point of View
Interest Rate Watch
Yield Curve and Recessions
With all the commentary on the yield curve and recessions recently, we shall review some points we made in our empirical study released several months ago – Is the Yield Curve Enough to Predict Recessions?
Inverted Yield Curve Not a Leader
An inverted yield curve did not lead every recession—top graph. The yield curve inversion is neither a necessary nor sufficient condition for a recession. Moreover, the yield curve is neither causa remota nor causa proxima. For example, the long lead times for the recession of 1990, 2001 and 2007 intimate that the yield curve had little to do with any factor(s) that promoted the recession as causa proxima. In addition, the variable lead times throughout the table would imply that there is no reliable remote link that leads directly to a recession. The inverted yield curve appears as one factor, and just one factor, within a host of other factors that alters the economic/financial landscape. On a fundamental level, the yield curve reflects the underlying shift in both policy and private sector attitudes about the willingness to take on risk over time.
Recession–Lags are Long and Variable
As evidenced in the table at the right, the lag times between the appearance of the inverted yield curve and the recession are long and variable. Moreover, the lengths of an economic expansion also vary quite a bit so the length of time for an expansion or the lead time for the yield curve, or any set of indicators to signal recession, is likely to be highly variable simply given the complexity of the modern economy.
Our Probit model predicts the probability of a U.S. recession during the next six months. The model utilizes the LEI, S&P 500 index and Chicago-PMI employment index as predictors. Using the most recent data (October 2017), our model suggests a low chance of a U.S. recession during the next six months (0.20 percent probability, bottom chart). Therefore no recession clouds are looming over the next six months.
Credit Market Insights
Confident on Credit
Consumer confidence, as measured by the Conference Board, reached its highest level in 17 years in November. While the headline figure is encouraging, parsing through the individual questions can shed light on more specific confidence measures.
For example, the percent of consumers who plan to buy an automobile within six months continues to trend upward. Such sentiment is not unfounded, especially when the fed funds rate is just 1.25 percent and consumers are looking to lock in low rates before future rate hikes. In fact, consumers are increasingly turning to credit markets for auto purchases, and financers appear willing to provide credit, even as the average auto loan stretched to 67 months in Q2.
Likewise, the percent of consumers who plan to buy a home within six months climbed to 6.9 percent in November, the highest measure since the Great Recession. However, unlike the period leading up to the Great Recession, loan delinquencies continue to trend downward. In Q3 only 1.4 percent of mortgage loans were categorized as delinquent – the lowest rate for all household debt categories.
While lofty consumer confidence measures are often attributed to animal spirits and viewed as non-analogous to the underlying hard data, credit conditions in the consumer space appear to be healthy. We will keep a close eye on the net charge-off rates on consumer products as the Federal Reserve continues guiding rates higher.
Topic of the Week
Understanding the Tax Bill’s Dynamic Score
Yesterday the Joint Committee on Taxation (JCT), Congress’s official revenue-scorekeeper, released its "dynamic" score of the Senate GOP tax plan. In short, a dynamic score differs from a "static" score in that it attempts to account for changes to aggregate economic variables such as GDP and interest rates when estimating the revenue impact of a tax bill. The score from JCT showed the Senate plan increasing the deficit by roughly $1 trillion over the next 10 years amid GDP growth that is about 0.08 percentage points faster per year, on average (top chart).
A host of factors can influence the output of a dynamic score, but one of the most important factors that explain different outcomes is a phenomenon known as "crowding out." Crowding out occurs when an increase in the federal budget deficit leads more national savings to be used to buy Treasury securities rather than to fund private investment. The Congressional Budget Office, a cousin to the Joint Committee on Taxation, estimates that when the deficit goes up by one dollar, private savings rise by 43 cents and foreign capital inflows rise by 24 cents (as higher interest rates increase the incentive to save and attract foreign capital flows), leaving a net decline of 33 cents in savings available for private investment.
Some independent think tanks have also produced dynamic scores, with somewhat similar results. The Tax Policy Center and the Penn Wharton Budget Model produced estimates suggesting that the House-passed bill would lift growth by less than 0.1 percentage point per year. The Tax Foundation, a leading conservative think tank whose model assumes a much smaller crowding out effect, estimated the House bill would lift growth by about 0.3 percentage points per year over the long-run.
As we wrote in a piece earlier this year, with real potential GDP growth roughly 2 percent at present, the hurdles to sustained economic growth of 3 percent or more are high, even with optimistic assumptions about the possible growth effects from tax reform (bottom chart).
