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

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

It has been seven long years now since the Great Recession ended, and all things considered, the U.S. economic expansion is looking pretty good for its age. At a point where all but two prior expansions had already succumbed to recessionary downturns, U.S. economic fundamentals remain relatively solid, and none of the normal warning signals for recession risk are flashing. Nevertheless, the slow and choppy pace of growth continues to be a source of real frustration.

Considering the deep hole dug in the aftermath of the financial crisis, by many measures the economy has come a long way since the recovery began in June 2009. More Americans are working today than ever before, household balance sheets are healthy again, housing continues to steadily improve, and asset prices have appreciated to record highs. Still, despite all of this progress, the economy has been unable to break out of its 2% or so trend rate.

The incongruity between the rates of job growth and economic growth this business cycle has been especially glaring. Since employment has improved so much, shouldn’t the economy be doing better? Well, not necessarily. An economy’s growth is a product of not only gains in its workforce, but increases in productivity as well. Unfortunately, labor productivity has barely increased over the last five years, falling to just a 0.5% annual rate, the lowest level since the early 1980s (Figure 1).  However, why productivity growth is stalling is a source of much debate.

Part of the slowdown is likely due to the fading impacts of the IT revolution, as output per worker has been trending lower since it peaked at more than 3% in the early 2000s. Demographics could also be playing a role, with an increasing reliance on older workers who may no longer be as productive. More recently though, the makeup of job gains has been skewed toward lower-productivity industries and away from the high-productivity ones in which technological advances have the most impact. Firms in industries such as finance, information, and mining have hired fewer people, while sectors such as education, leisure and hospitality, and healthcare services have hired more.

The U.S. economy may see resurgence in productivity growth at some point in the future, but it is very hard to know exactly when that might be or what will spark it. In the meantime, the problem can become self-reinforcing. More workers plus static output, drives labor costs up and profits down, limiting the ability of businesses to invest in the capital equipment needed to enhance workers efficiency and allow the economy to grow faster.

As has been the case over the past couple of years, we expect economic activity to pick up in the second quarter. Although the disappointing start to the year has added to the sense of unease over the strength of the current expansion, early indications from retail sales, home building, industrial production data and a turnaround in forward-looking business activity indices, all suggest domestic demand is regaining traction.

Most reassuring, it appears that the demise of the American consumer has once again been greatly exaggerated. Strong job gains and signs of wage growth, along with accumulated savings at the pump, are giving households both the confidence and means to spend. In fact, recent data shows that consumer spending over the second quarter is back on track to grow at a 3% annual rate, enough to lift GDP growth back above the 2% mark.

Indeed, as long as jobs expand at a decent pace, the expansion should remain on a stable footing. The bad news is that even at 2% GDP growth, until productivity begins to recover, the economy is likely operating close to its potential and prospects for a meaningful acceleration remain low. The good news is that slower growth, while frustrating, continues to help prevent the building up of excesses that typically sow the seeds of the next downturn. For the optimists among us, this means that with any luck, odds are good the current economic expansion will be celebrating another anniversary a year from now.

THE FED

The next FOMC (Federal Open Market Committee) meeting will take place on June 14 and 15. There is a growing probability that the FOMC may decide to raise the federal funds rate by 0.25% to the range of 0.625% to 0.75% (Figure 2). This would be the first of their two planned increases for the year.

At the meeting, the FOMC will probably determine that the domestic economy is strong enough for another rate increase. The only rate increase to occur in this business cycle was this past December. Several issues point to the increase: First, the labor market is uniformly strong with an unemployment rate of 5.0% (near full employment); second, monthly payroll gains are averaging more than 200,000; third, the inflation rate (which has been trending upward) is just a few tenths of a percent away from the Fed’s target rate of 2.0%; and fourth, international financial markets (albeit volatile at the beginning of the year and a concern to the Fed) have since calmed down in recent months.

One fly in the ointment is the Brexit vote that will take place approximately a week after the FOMC meeting. If the polls indicate a close vote or a probability of Great Britain deciding to leave the E.U., the FOMC may delay the rate hike until their July meeting to avoid adding more volatility to the markets.

LABOR

The labor market continues to make positive strides by racking up 67 months of continued gains in nonfarm payrolls (the longest continuous string of gains on record), all while the unemployment rate holds steady at near-full employment level.

Oftentimes there are some ebbs and flows in the subsectors of the monthly data, and April was definitely one of those ebbs. Nonfarm payrolls increased just 160,000 and the two previous months were revised downward – it was the fewest number of jobs in seven months. This monthly gain was below the twelve-month average gain, which is a more robust 224,000 (Figure 3). Although some in the market became fearful it was a start to another weak quarter, we do not agree. Just like the old saying of “one swallow does not make a Spring,” one weaker-than-expected employment report is not a harbinger of weaker economic data. Furthermore, the underbelly of the report was good. The unemployment rate remained at 5.0%, and average hourly earnings have increased 2.5% in the past year.

INFLATION

Price pressures are trending upward, and this is a good thing. Inflation has been below the Fed’s target rate of 2.0% for about three and a half years. In a world of economic uncertainty, a trend away from negative inflation is welcomed news because it shows how the U.S. economy is breaking from the economic malaise of Western Europe, Latin America, and much of the remaining emerging economies.

The April Consumer Price Index (CPI) jumped 0.4%, the biggest gain in more than two years. This has helped push up the yearly change inflation of both CPI and Core PCE (Personal Consumption Expenditures Price Index), the two most common inflation benchmarks (Figure 4). While price increases occurred in most of the categories, it was a 3.4% increase in energy prices that gave it the biggest boost (this is the second consecutive increase of this category following three consecutive months of price declines). Motor fuel prices were the main cause; they jumped 8.1%, following a 2.2% increase in March and a 12.9% decline in February. They are down 13.8% from twelve months ago.

The hawkish members of the Fed will probably view this recent report as supportive data for a rate increase at their upcoming meeting.

BREXIT

This is the common name for the United Kingdom’s European Union membership referendum. On June 23, the U.K. will vote to decide whether they will remain or leave the E.U. Britain is one of 28 members of the European Union, a political-economic union that, among other things, allows for the free flow of people, goods, services, and capital. The E.U. has a GDP of about $18.5 trillion, which is about one trillion larger than the United States. This is not to be confused with the subset, the Eurozone, which is made up of 19 countries that all share the euro as the common currency. Britain is one of nine countries in the E.U. that uses its own currency.

Britain is looking into the abyss on this issue since there is no historical precedent for a country like Britain (GDP of about $3 trillion) leaving such a large trading union. As a result, fears are high – the pound recently fell to a seven-year low (Figure 5). The largest fear being that London’s status as the financial capital of Europe could be in jeopardy.

Many of Britain’s trading partners, like the U.S. and the IMF, don’t want Britain to leave the E.U. because it will cause a major disruption to the U.K. and all of its trading partners at a time when the world economy is not very strong.

 

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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, 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.

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