U.S. Economic Metrics Continue to Impress, Reinforcing Higher Interest Rates
U.S. economic metrics continue to be impressive. The economy added 250,000 net new payroll jobs in October, putting the average monthly gain for 2018 through October at 212,500. It will be increasingly difficult to maintain that strong pace of job growth going forward because the pool of available labor is getting smaller. Increased competition for labor is pushing wages up. Average hourly earnings for private sector workers were up by 3.1 percent in October, over the previous 12 month period. This is the strongest year-over-year gain in wages since April 2009. The Federal Reserve Bank of Atlanta’s wage growth tracker is stronger at 3.5 percent wage growth.
U.S. businesses are enjoying strong demand growth. Real GDP expanded at a 3.5 percent annualized rate in the third quarter, after growing at a 4.2 percent annual rate in Q2. Industrial capacity utilization appears to be closing in on a cyclical high. The cyclical high points in overall capacity utilization have been trending down since the late 1960s, so 78 percent capacity utilization in September 2018 may be on par with 88 percent capacity utilization from early 1967.
With labor markets tight, and industrial capacity utilization high, there is relatively little slack in this economy. In a low slack economy the potential for demand-pull inflation is higher. We believe that the Federal Reserve will respond to the increased potential for demand-pull inflation with more interest rate hikes over 2019. We expect the Fed to leave interest rates unchanged at the Federal Open Market Committee this week over November 7/8. We look for the next fed funds rate hike to come at the conclusion of the December 18/19 FOMC meeting. We have three more 25 basis point fed funds rate hikes on our interest rate forecast for 2019, beginning on March 20, 2019. The implied odds of a December 19 rate hike have fallen in recent weeks due to the sell-off in U.S. and global stock markets. According to the CME, they are down to about 73 percent. We expect the implied odds to increase quickly after the stock market stabilizes and the dust settles after the mid-term election.
With wages going up, interest rates going up and import prices going up, it is fair to say that corporate profits are facing some headwinds. Fortunately, corporate tax reform came at an auspicious time and helped to boost corporate profits when they otherwise would have been squeezed. As of 2018Q2, after-tax corporate profits were up by 16 percent over the previous year. However, the support to corporate profits from tax reform will fade in 2019. Meanwhile, the pressure from wages and interest rates will increase. Import price pressure from tariffs could go either way depending on trade negotiations between the U.S. and China.
Global economic growth is slowing. The European Union posted weak Q3 GDP of just 0.2 percent over the previous quarter. Some of that can be blamed on a hiccup in German auto production due to new emissions tests. Italian GDP was unchanged in Q3 over Q2. China’s manufacturing sector is barely expanding. The Caixin China Manufacturing Purchasing Managers Index inched up from a flat 50 in September, to a faintly positive 50.1 in October. China’s service sector is also showing reduced growth. The trend in China’s economy looks ominous with likely spillover effects on other Asian economies. Japanese industrial production fell by 1.1 percent in September. South Korea posted a 2.5 percent decline in industrial production in September.
So even with current strong U.S. economic metrics, we believe that downside risk factors for the U.S. economy are increasing. Cooler U.S. and global economic growth in 2019, combined with higher interest rate and higher labor costs could start to put pressure on corporate profits and increase stress on corporate debt markets.
For a PDF version of this report, please click here: November 2018 U.S. Economic Outlook
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