Paul Single
Managing Director
Paul.Single@cnr.com
(415) 576-2531

Steven Denike
Portfolio Strategy Analyst
Steven.Denike@cnr.com
(212) 702-3500

While a downturn in stock prices can be a leading indicator of economic activity, it is not a foolproof signal. As Nobel Laureate economist, Paul Samuelson famously observed many years ago, the stock market has predicted nine of the last five recessions. That is one reason why the recent correction in the stock market has been so frustrating to investors. Other measures of the economy simply do not seem to be reflecting the same degree of negativity. On the contrary, after a disappointing end to 2015, early indications are showing that first-quarter GDP growth is rebounding at a solid rate. 

Much of the recent economic worries in the U.S. have largely been centered on concerns that weakness in the manufacturing sector may spill over into the rest of the domestic economy. Yet, the factory sector continues to hold up relatively well, especially considering the impact of the stronger dollar and the more downbeat signals from the survey measures. Over the past year, output increased by 1.2% (which is admittedly not much) but it is much better than the “collapse” it is often characterized to be.

In any case, the fortunes of the U.S. economy ultimately remain tied to the consumer, and right now there are few signs that their spending is rolling over. After ending 2015 with relatively modest performance, consumer spending (driven by continued strong real income gains) surged in January and is back on track to post a 3.0% annualized pace in the first quarter. Household fundamentals remain strong, the labor market remains healthy, and sentiment indicators continue to show that Americans feel generally good about their economic prospects. Solid consumer spending should continue to drive growth this year, and as long as it does, the expansion should be on solid footing. 

There are legitimate concerns about the effects that tightening financial conditions could have on growth and the banking industry. Financial conditions have indeed tightened over the last several months, as the dollar has continued to trend higher, corporate credit spreads have widened, and stock markets have suffered a correction. Often, such deterioration can serve as a warning sign for the economy, but here too, market fears appear to have overtaken reality. Financial conditions, while not as accommodative as they were, are far from restrictive (Figure 1).

Banks, for instance, have recently become more reluctant to lend to certain businesses, primarily in the oil and gas sector, but for other types of borrowers (particularly households), financial conditions have not tightened. Mortgage rates are near record lows, and the majority of banks continue to loosen lending standards on credit card and auto loans for households. Indeed, the latest release from the Federal Reserve showed that bank lending is at its strongest level since the financial crisis.

Further analysis by the Fed also indicates that overall risk in the U.S. financial system remains modest today, especially in contrast to the vulnerability that had built up in years prior to the financial crisis. In particular, market concerns over the ability of energy sector exposure to impair the banking system (similar to what was experienced with the mortgage crisis) seem unjustified. U.S. commercial bank exposure to energy is currently estimated at 2.0% of outstanding loans, or 10.0% of equity. This stands in sharp contrast to banks’ mortgage exposure in 2007, which represented 42.0% of outstanding loans and 245.0% of bank equity.

Ultimately, recessions are typically preceded by GDP surpassing its potential growth rate and overinvestment in cyclical sectors. Yet, after almost seven years, the current expansion still has not produced significant overall debt growth, business investments remains below earlier peaks relative to GDP, home sales continue to lag population growth, and there remains plenty of spare capacity in the economy. Of course, despite this, there is a chance that pessimism in financial markets becomes self-fulfilling if it causes consumers to stop spending and if businesses further curtail investment. For now, however, the gloom that has taken hold of investors since the start of the year seems misplaced, and we continue to see the probability of a recession in the near-term as low. 

THE FED

The outlook for economic growth and inflation has not been materially affected by the volatility in the global markets. Various Fed policymakers have stated that they plan to continue with an increase in the federal funds rate this year, albeit maybe not as aggressively as previously stated. In December, the Fed projected a 100 basis point increase in the federal funds rate in 2016; however, the Fed will update this projection in mid-March. Federal Reserve chair, Janet Yellen, has stated that the Fed is “closely monitoring global economic and financial developments” to assess the impact that it may have on the U.S. economy.

The rate of economic growth slowed in the fourth quarter of last year (1.0%), well below the post-recession average of 2.0% to 2.5%, due to transient factors that caused the slowdown (a strong dollar reduced exports and low oil prices reduced investments). The Fed is looking past those factors toward the upside potential of lower oil prices, which should serve to boost consumption. This, in the long term, will overshadow the financial conditions, which have recently become less supportive of growth.

LABOR

Employment growth continued to roll along in January. Total nonfarm payroll employment increased by 151,000, marking the 63rd consecutive month of increases (Figure 2). This increase is not as strong as some of the recent gains (the fourth-quarter of 2014 had an average gain of 279,000 per month). However, this might be a result of a pullback following the blockbuster growth that benefited from unseasonably warmer weather at the end of last year. Also, around year-end, there is a huge amount of seasonal distortions (for example, there is a large number of retail workers who are laid off following the Christmas holiday) that can skew the monthly reading. The important issue is that payroll gains can be volatile on a monthly basis, but the trend for growth has been remarkably steady. The three, six, and twelve-month average payroll gains are around 220,000.

The unemployment rate dipped to 4.9%, marking the first time it has been below 5.0% in the past eight years (Figure 3). It is now solidly in the range of what economists call full employment. This is when it becomes more difficult for companies to find qualified employees, resulting in companies having to pay more to attract qualified workers. Full employment, in turn, helps push up the average hourly earnings wage, which has been firming in the past few months and is now at 2.5%. This is also causing job seekers to enter into the job market in an attempt to find employment. The labor force participation rate has nudged up to 62.7% after falling to the lowest level in a generation of 62.4% back in September 2015.

INFLATION

Despite persistent declines in the price of energy (which has fallen for the past three consecutive months), the yearly change in inflation (Consumer Price Index [CPI]) has been trending upward and now stands at 1.4% (it spent most of 2015 near 0%) (Figure 4). Core CPI (equal to CPI minus food and energy prices), used by central banks to assess the true underlying trend in inflation, is at 2.2% year-over-year (the largest increase since June 2012). The Fed’s preferred inflation rate, Core Personal Consumption Expenditures Price Index (Core PCE), currently stands at 1.7%.

Most important is breadth of price gains. In the past year or so, most of the inflationary gains came from just two of the eight major sectors: the housing and medical sectors. Now gains are seen in five of the eight sectors. Also, many of the steep declines in commodity prices are now falling off of the year-over-year calculations.

This is all good news for the Fed as inflation is approaching its goal of 2.0% – a number that has eluded the Fed for almost four years. The fear of disinflation (a falling inflation rate) or deflation (negative inflation) seems to be positioned securely in the rear-view mirror.

GDP

Domestic economic growth lost some momentum in the second half of last year. The quarterly data hit a peak in the second quarter at 3.9%, but third-quarter growth was just 2.0%, and fourth-quarter growth was a mere 1.0% (Figure 5). Since the quarterly data can be volatile, looking at the yearly data tells a story that is less bleak. For the past year, economic growth increased 1.9%, which is more in line with the post-recession average of 2.1%.

The most important part of GDP is the outlook, where growth is expected to pick up. First-quarter growth for 2016 is forecasted to be up 2.2%, with the following quarters expecting to grow at a pace above 2.0%. Much of the anticipated growth will come from positive consumer spending, which is benefiting from continued improvements in labor gains and stronger purchasing power due to the rapid depreciation of gasoline prices. Combine that with lower mortgage rates and greater access to credit, and it sets the stage for continued expansion.

 

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Index Definitions

The St. Louis Fed Financial Stress Index measures the degree of financial stress in U.S. markets. The index combines 18 financial market variables into a single index that is compiled on a weekly basis.

The Kansas City Fed Financial Stress Index is a monthly measure of financial stress in the U.S. economy based on 11 financial market variables (seven money/bond market yield spreads and four measures of asset price behavior), each of which captures one or more key features of financial stress).

The Chicago Fed National Financial Conditions Index provides a comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets, and the traditional and “shadow” banking systems.

The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living.

The Core Personal Consumption Expenditures Price Index (Core PCE) measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices to reveal underlying inflation trends.

Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

Bonds and bond funds are subject to interest rate risks and will decline in value as interest rates rise.

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