IN THIS ISSUE

  • The Fed will likely wait until December for next rate hike.
  • Employers have recently picked up the rate of hiring.
  • Consumer prices have remained stubbornly low for the past three months.
  • The manufacturing sector has been on an upward trajectory since 2015.

After nearly a decade of uneven and divergent growth, the global economy appears to have turned a corner. World trade is on the rise again, climbing to a seven-year high, and for the first time since 2010, no G20 economy is expected to post a decline in output. Indeed, with signs of renewed momentum coming from all corners of the world, the global economy looks set for a period of its strongest and broadest growth since the immediate aftermath of the last recession.

Across the Atlantic, Europe’s economy has reached a comfortable, if slow, cruising speed, with sentiment running at its highest level since 2011 and unemployment declining to its lowest point since the global expansion got underway in 2009. Japan likewise is in the midst of its longest stretch of growth in more than a decade.  Meanwhile, in the developing world, China continues to defy fears of a hard landing as authorities manage the difficult transition to a lower-growth but more advanced economy. Even Brazil and Russia, whose economies have been mired in commodity-driven recessions for some time, appear poised to grow again this year.

Back at home, the U.S. economy is also proving its resilience as the current expansion enters its ninth year. Indeed, given the general lack of excess in the economy, we would not be surprised to see it continue for some time longer. The 2.6% rise in second-quarter GDP confirms that the slowdown at the start of 2017 was temporary, and expectations are for growth to remain at a modestly above-trend pace over the next year. That’s not bad considering the mature phase of the business cycle, the absence of spare capacity, and an aging population that is beginning to weigh on job growth.

With most of the world’s economies appearing at last to be growing in lockstep, the difficult question is whether a more fundamental shift is occurring. Are world economies enjoying a structural improvement, or simply benefiting from favorable but transitory trends? To be more confident that post-financial crisis sluggishness is ending, one thing we will need to see is a sustained expansion in investment to improve productivity and raise potential economic growth.

Figure 1

synchronized-global-upturn

Investment is a key indicator of economic strength because it shows how confident firms are in committing resources to increasing future output. The good news is that the investment outlook has begun to turn more supportive, with corporate profitability picking up globally and reducing demand uncertainty. In fact, for the first time in many years, investment growth in advanced economies is now forecast to overtake consumption growth, while more stable commodity prices should boost capital formation in commodity-exporting countries.

Of course, the sustainability of this global cyclical upswing is not assured. Political uncertainties may ultimately discourage a recovery in investment, and progress on much-needed structural reform in many developed economies remains slow. Significant challenges also may arise when central banks begin to reverse years of ultra-accommodative monetary policies, raising the possibility of policy mistakes and unintended consequences that could damage the global economy and financial markets. Still, a growing number of indicators appear to be finally pointing in the right direction, and fears of a renewed global slump are now being replaced by hopes of a broader and more enduring upturn. These are still early signs, but they’re good ones.

The Fed

The Fed raised the federal funds rate back in December, and then again in March, and then again in June. We believe the Fed will take a break from this sequence of quarterly rate hikes in September and wait until December before deciding on the next rate hike. A key factor for this pause in the reduction of Fed stimulus is the recent softening in the inflation rate. As it stands currently, there is a 42% chance of a rate hike this December (see Figure 2).

Figure 2

implied-probability-25-bps-hike

It is widely expected that the Fed will announce plans for reducing the amount of assets on its balance sheet—a process called “balance sheet normalization”—at its meeting in September. These are the securities the Fed purchased during its various stages of quantitative easing (QE). The economy is strong enough to handle this reduction in stimulus. Furthermore, the Fed wants to get this process underway in case there is a change in leadership next year. Yellen’s position as Chair of the Board of Governors expires early next February, and it is uncertain whether the president will reappoint her.

Labor

Recently, employers have picked up the pace of hiring, as exhibited by the 222,000 increase in nonfarm payrolls shown in the June labor report. While this report can be volatile on a monthly basis, the recent trend is improving. Overall, the second quarter average month’s gain was 194,000, which is well above the first quarter average month’s gain of 166,000 and slightly better than the 2016 average of 187,000. Economists, who often look at longer-term trends, are pleased that the news has been stable and strong. To put this in perspective, in the past year, more than 2.4 million jobs have been created, while over the past five years, the economy has averaged about 2.5 million new jobs on an annual basis (see Figure 3).

Figure 3

non-farm-payroll-data

Presently, the unemployment rate is at 4.4%, which is near the lowest level of the cycle. For the past several months, it has been below the Fed’s estimate for NAIRU (Non-Accelerating Inflation Rate of Unemployment). Essentially, this means that the economy is at full employment, which should help to put upward pressure on inflation.

Inflation

Consumer prices have remained stubbornly low for the past three months. The annualized rate for this period has been just 0.1%. Recent weakness has forced the annual rate to decline from a peak of 2.7% back in February down to the current level of 1.6% (see Figure 4).

Figure 4

consumer-price-index-august-2017

Over the past few months, the Fed has described this inflation slowdown as “transitory.” Much of it has been due to decreases in particular sectors, such as cell phone service plans and prescription drugs. However, this “transitory” period is beginning to get a little long in the tooth. Market consensus is beginning to shift, and it is widely believed that the Fed will need to see inflation trend back up toward the 2.0% level before it makes the next increase in the federal funds rate. This recent drop in inflation has helped push down the probability of a September rate hike, but December is still a possibility. This should not affect the Fed’s planned reduction in its balance sheet, which is expected be announced in September and may happen as early as this October.

Manufacturing

The manufacturing sector has been on an upward trajectory since the end of 2015. The ISM manufacturing index, a survey of 400 purchasing managers, has surged recently to its highest level in nearly three years (see Figure 5). This surge marks the tenth consecutive month in which the index has been above 50 (this is a diffusion index; when it is reported above 50, it is showing expansion).

Figure 5

ISM-manufacturing-diffusion-index

Forward-looking components of this survey are strong, indicating that manufacturing production should continue to improve in the coming months. New orders, which have increased from the lows of 2015, are being helped by the weaker dollar (down 9.0% from the recent highs in December), thus making U.S. exports more competitive in the international market. The backlog of orders has also been increasing, further showing that the pipeline is strong. Additional good news comes from the prices paid component, as manufacturers who are paying less for their raw materials are enjoying the flexible benefits of some pricing power for their finished products.

Index Definitions

The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services,  including 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 ISM manufacturing index is based on surveys of 400 purchasing managers nationwide regarding manufacturing in 20 industries. The ISM manufacturing survey is a diffusion index, calculated as the percent of responses that are positive plus one-half of those describing conditions as “same.”

Indices are unmanaged, and one cannot invest directly in an index.  Index returns do not reflect a deduction for fees or expenses.

Important Disclosures

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