economic perspectives

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

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

Amid another bout of global turbulence, economic indicators show that the U.S. economy continues to move in the right direction. While concerns over growth in China and falling oil prices have dominated headlines and roiled financial markets recently, the stream of economic data reveals growing evidence that the U.S. economy continues to hold a favorable position relative to its global peers. Indeed, the response from investors looks to be out of proportion with underlying fundamentals, particularly in the U.S.

The latest upward revision to second-quarter U.S. GDP growth to 3.7% shows that the U.S. economy regained a substantial amount of momentum after the slow start to the year (Figure 1). Activity and employment data over the past month suggest that momentum has continued into the third quarter. Although the manufacturing sector has struggled to cope with a strengthening dollar and sluggish demand from overseas, other domestic-oriented sectors appear to be doing quite well. The Institute for Supply Management Non-Manufacturing Index surged to a near-record high of 60.3 in July, and the housing recovery continues to gain traction.

In particular, the household sector appears to be on solid footing and is well positioned to drive growth going forward. Although there is widespread concern that China’s devaluation and economic slowdown will negatively affect the U.S., we would argue that these concerns are net positives for U.S. domestic growth, particularly consumer spending. A stronger dollar will further lower U.S. import prices, and China’s slowdown is likely to contribute to lower oil prices (and gas prices), which would help to further boost U.S. consumer confidence and real purchasing power. 

Looking overseas, the prospect of a harder landing than anticipated for the Chinese economy, and its potential to trigger problems far beyond its borders, has played a large role in the massive volatility seen recently across global stock markets. However, in our analysis, investors are overreacting to economic risks in China. The collapse of the Chinese equity bubble, which was not fundamentally driven, tells us very little about the state of the world’s second-largest economy. 

Undoubtedly, China is facing major challenges, and the headwinds on its manufacturing sector, most notably due to weak foreign demand, are not likely going away anytime soon. Still, underlying data have been more positive than headlines might suggest, with large parts of the Chinese economy, such as the consumer sector, still looking strong. Policymakers in China also have the luxury of still being able to loosen policy if necessary.

It is worth remembering that China’s growth rates have already slowed sharply, from a peak of around 14.0% in 2007 to roughly half that now, as its economy continues to transition away from pumping money into infrastructure investment and the property market and toward services, consumer spending, and technology. The much larger size of China’s economy, as a result of the previous years of rapid expansion, means that its contribution to global demand has been pretty stable over this period.

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A shift to slower, but more sustainable growth in China – particularly if it is less dependent on commodity-intensive investment and on exports – could leave the rest of the world better off. Certainly, the adjustment phase would be bad news for commodity producers. While there will be some big losers, an extended period of lower commodity prices would still be a net positive for plenty of developing countries, such as China and India. More generally, as the engine of global growth continues to shift away from the emerging market economies, data from other major economies, including the Eurozone and Japan, have generally been positive, and we believe there is very little to support fears of a major global downturn.  

The latest market panic, along with disinflationary pressure from a stronger dollar and lower commodity prices, has led investors to conclude that the Fed will be less inclined to tighten monetary policy in the near future. Surely, the Fed is not going to ignore what is happening in financial markets. However, unless the current turmoil is sustained (which we doubt), better-than-projected economic growth and cumulative progress in labor market conditions suggest that the Fed is ready to begin normalizing policy rates. That being said, it is not the lift-off date that matters so much as the pace of future rate hikes – and the Fed has made it clear that the pace will be low and slow.

THE FED

The next policy meeting will be a two-day meeting ending on September 17. At that meeting the Fed will decide if it will initiate the raising of short-term interest rates. If the Fed decides to raise the federal funds rate, it will be the first time in almost a decade. For the Fed to commit to raising interest rates from the near-zero level, it must be confident that it has come close to meeting its objectives. The Fed has two statutory objectives: maximum employment (which we are close to, with only a 5.3% unemployment rate) and stable prices (this has been more elusive – the Fed has targeted 2.0%, but inflation has been averaging just 1.5% for about three years).  

There is much speculation about the Fed’s intentions. A Wall Street Journal survey of economists in July places an 83% chance of the Fed raising the federal funds rate. However, as of August 31, the federal fund futures market places a 38% chance that the Fed will not initiate an increase. It is important to keep in mind that this proxy is very volatile (Figure 2). 

The timing of when the Fed initiates the first rate increase is far more important to Wall Street than it is to Main Street. The most important issue is the trajectory of future interest rate increases. Chairwoman Yellen has stated that she wants to raise the rate slowly over the next few years, gradually reducing the Fed’s long-running stimulus.

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LABOR

The job market continues at a solid clip, with monthly payroll gains averaging a strong 213,000 for the past six months (Figure 3). The unemployment rate is at 5.3%, a seven-year low. It has been at that level for the past two months and, more importantly, it is close to the Fed’s view of full employment (an unemployment rate in the range of 5.0% to 5.2%).

Another important proxy for determining the health of the labor market is “claims for unemployment insurance,” which has been hovering near low levels not seen in four decades. This report from the department of labor tallies the number of workers applying for unemployment benefits for the first time. Since it is a weekly number, the report is timely. Presently, the data appear to be telling us two important facts: 1) that companies are not laying off employees because the need for their work is great and 2) that it is difficult to replace workers.

INFLATION

There has been a persistent weakness in price increases for the past three years (Figure 4). The Federal Reserve Bank would like inflation to be around 2.0%, yet inflation consistently has been below that level. The energy supply shock that is still unfolding has been the main culprit to keeping price pressures low. In addition, the drop in the prices of other commodities and the strengthening dollar are bringing down the cost of many imported goods and services. At the other end of the inflation spectrum, the cost of shelter is up 3.1% in the past year and is at its highest rate since the beginning of 2008. 

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It is important to note that all of the subcomponents have seen relatively strong price increases. The cost of a home has increased as of late, mainly due to the lack of supply in the market. As a result of the housing crash, the cost of renting a home has increased as millennials have started to move out, generating a strong demand for rentals in urban areas. As rental supply decreases, rental prices continue to increase. There has even been a surge in hotel/motel lodging, which has been supported by a strong travel and tourism season.

The recent sell-off in the global commodities market, triggered by China’s slower rate of growth and currency devaluation, along with the currency devaluations that have occurred in Europe and Japan, will probably work their way throughout the U.S. broader economy and keep inflationary prices low in the near term. Yet the Fed is concerned with inflation over the medium term. At this stage, many senior policymakers have stated that they are “reasonably confident” that inflation will “raise gradually toward 2.0% over the medium term.”

COMMODITIES

The variable prices of commodities are reaching multi-decade lows (Figure 5) as the fundamental demand for them increasingly weakens. Like most things in life, the drop in commodity prices is a double-edged sword. It tends to be a good thing for the American economy, as the drop in the price of raw materials can increase the potential of greater profits. For American consumers, the lower cost of goods (most notably gasoline) provides extra money for discretionary spending, which further supports the strengthening of the economy. However, for countries that export commodities (e.g., emerging markets), reduced demand lowers their revenue stream and their currency tends to fall in value, thus increasing the risk of inflation. Further complicating matters, their central bank may come in and raise interest rates to manage inflationary expectations, which may serve to slow their economy even more.

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