Two Stories, One Economy
There are two believable but contrasting stories for the U.S. economy as we turn the page into 2019. One story focuses on the majority of economic data, which indicate very positive current conditions. Labor-related data in particular is stellar. December payrolls were much stronger than expected, expanding by 312,000 jobs. October and November payrolls were revised up significantly. Wages were up 3.2 percent in December over the previous year. Job openings exceed the number of unemployed. Unemployment insurance claims remain extremely low. The unemployment rate ticked up inconsequentially in December, to just 3.9 percent. We expect it to tick back down in the months ahead. Also, inflation is benign and corporate profits have been strong.
The other story is forward looking, focusing on increasing downside risks for the U.S. economy in 2019 and beyond. The list of downside risk factors for the U.S. economy has grown appreciably in recent months. Equity markets sold off in October and again in December. Bond yields have dropped as investors shift toward quality. The middle part of the Treasury yield curve has flattened, raising concerns about yield curve inversion. U.S. housing data is underperforming. Housing affordability remains a critical issue for many new buyers. Support from the rest of the world is faltering. Economic growth in China and in Europe eased in the second half of 2018 and looks set to ease further in 2019. The quality of corporate debt markets is a growing concern.
Trade policy is another major source of uncertainty for 2019. Increased tariffs on imports from China and restrictions on U.S. exports to China would add further strains to supply chains and corporate balance sheets. Higher input prices would be passed through and ultimately add to inflationary pressure. More inflation could require the Federal Reserve to raise interest rates more than expected. Conversely, a resolution to the trade war and a roll back in trade friction could be significant positives for both the U.S. and China in 2019.
In this uncertain environment, the Federal Reserve executed its fourth 25 basis point rate hike in 2018 on December 19, pushing the fed funds rate range to 2.25-2.50 percent, 100 basis points above where it was a year ago. The Fed believes that the fed funds rate is getting closer to “neutral” where it is neither stimulative nor restrictive for the overall economy. The problem is that a “neutral” fed funds rate is a theoretical concept that is very difficult to determine in advance. It may be the case that “neutral” is found only by going farther than neutral.
The combination of higher interest rates and high wage rates could start to squeeze corporate profits later this year. Weaker corporate profits are often the trip wire for corporate restructuring and layoffs. General Motors and Tata Motors have recently announced restructuring plans which highlight the uncertainty in the global auto industry. Verizon’s recent layoff announcement shows stress in the telecom sector.
Lower oil prices and reduced business confidence could impede business fixed investment in late 2018 and into 2019. After a strong first half of 2018, growth in business fixed investment cooled to just 2.5 percent (annualized) in the third quarter. The fourth quarter GDP data will tell us if the cooler Q3 numbers were just in response to faster growth earlier, or if the Q3 cool down in investment spending growth was a true inflection point for the economy.
Finally, the U.S. political climate is likely to be contentious in 2019, raising the possibility of lurching fiscal policy by late 2019. The now two-week-long partial federal government shutdown suggests that federal budget negotiations later this year will be difficult.
For a PDF version of this report, click here: January 2019 U.S. Economic Outlook
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