Strategy: A checklist for the US economy

A checklist for the US economy With Brexit behind us and no imminent risk factors on the horizon, attention is increasingly on the scope for the next Fed hike. The Fed will need US growth to be on a firm footing and global risks to be balanced to pull the trigger. Below, we provide a short checklist on the status of the US economy.

• GDP. The Federal Reserve Bank of Atlanta's GDP ‘nowcast' for Q3 stands at 3.4% q/q AR rebounding from 1.2% q/q AR in Q2. This would leave the average for the two quarters at 2.3%. This is above US trend growth and enough for slack in the labour market to diminish further.

• Financial conditions. Equity markets are higher, credit spreads much tighter, bond yields lower and the USD broadly sideways. This leaves financial conditions much more supportive of growth (see Chart 1)

• Labour market. Employment has been back on track in recent months with average monthly job growth of 190,000 over the past three months. This is above the interval that Fed Vice Chairman Stanley Fischer mentioned as the level needed to outpace the rise in the labour force, which he put at 75,000-150,000 in his speech this week. We look for some downside risk to the August payrolls following two strong months but the 3M average should stay close to 200,000. The unemployment rate at 4.9% is close to the level seen as the long-term unemployment rate (NAIRU).

• Wage growth. Wage increases have increased gradually to around 2.5% as slack is diminishing (see Chart 2).

• Manufacturing. ISM manufacturing and industrial production both rebounded in H1, suggesting that the worst is over for US manufacturing. Signals for August are mixed with regional indices mixed and PMI manufacturing also being less upbeat. This leaves some uncertainty about the state of manufacturing.

• Investments. Following a long decline in durable goods orders in 2015, the report for July this week pointed to a further bottom in investment growth. It suggests that one of the main drags for the US economy is starting to ease. A rebound in the oil price and easer financial conditions provide support for investments in coming quarters.

• Private consumption. Retail sales rebounded strongly in Q2, showing the strongest growth in two years. It is probably too strong and July retail sales were on the soft side. However, looking through the noise, consumers seem to be on a firm footing.

• Housing. New home sales jumped higher in July and rose to the highest level since 2007. It points to rising activity in the construction sector in H2 and shows that lower yields are feeding through to economic activity.

• Global risks. With a robust performance in emerging markets, calm on the China front and the effects of Brexit apparently more muted than feared, the risk picture is looking more balanced currently.

• Core inflation. The Fed's preferred measure of inflation is the core PCE deflator. It has hovered around 1.6% y/y in 2016 up from 1.3% y/y in mid-2015. It is thus closing in on the Fed's inflation target of 2% but so far not there yet. Core CPI inflation has been above 2% for nine months.

Overall, the picture for the US economy has improved over the past quarter, which explains why Fed members have started to put a potential rate hike back on the agenda.

Fed vice chairman Stanley Fischer last week said: ‘So we are close to our targets. Not only that, the behaviour of employment has been remarkably resilient... The unemployment rate is currently close to most estimates of the natural rate... Core PCE inflation at 1.6% is within hailing distance of 2%'. Other prominent members have also highlighted that a rate hike is drawing closer.

The communication around the next hike has been a bit blurred by a separate discussion within the Fed on the long-term neutral rate. Most members agree that this level has come down – partly due to lower productivity growth. However, even if the neutral rate is lower, say 3%, it does not mean that the Fed will not raise the rate from the current level of 25-50bp, which is still far below the lower neutral level.

The question is just how close the Fed is to pulling the trigger. The Fed is likely to need further evidence that the labour market is in good shape, growth is on track and global risks balanced. However, the probability of a rate hike this year has clearly gone up. We will review our own forecast of a hike in June 2017 after the next employment report on Friday next week.

 

Euro area holding up following Brexit – we revise up GDP growth

This week's data on Flash Euro PMI for August held up well once again further highlighting that the spill-over from Brexit to continental Europe is likely to be limited. We have thus revised higher our euro area GDP forecast as growth in H2 looks likely to be higher than expected than before (see Flash Comment: Euro area – resilient PMIs – the recovery should continue, 23 August 2016). The German ifo index fell back a bit in August but it still points to robust growth in Germany. We have also changed our view on the ECB to remain on hold at the meeting in September. We believe that in the ECB's view, the incoming information since July does not warrant further easing. We still firmly believe the ECB will eventually extend QE purchases beyond March 2017 due to the lack of a sustainable path in inflation. However, for now, we expect it to keep its powder dry.

 

Stocks underpinned by low yields, EUR/USD range bound

Volatility in global stock markets has come down significantly, with daily swings very small compared with earlier this year. We still see stocks underpinned by record-low bond yields – and in the case of Germany and Japan, even negative 10-year yields. Global risks have come down and investor money is increasingly finding its way to the stock market in search of yield – even if global growth is sluggish. We look for more of this in the short term. Even if the Fed does hike this year, it will signal a very gradual hiking cycle which should not lead to a sustained decline in risk markets. In the medium to long term, we expect the stock markets to be restrained by weak profit growth and high valuations. The business cycle is also likely to lose some momentum in 2017, again driven partly by weaker Chinese macro momentum.

We expect government bond yields to stay low for a long time as negative rates will keep pushing investors out on the yield curve to find returns. Further easing from the Bank of Japan and an extension of the ECB's QE at some point will also underline that monetary policy should stay accommodative for a very long time. US short yields will push a bit higher if the Fed decides to move rates this year but the money market curve is likely to stay very flat and put a lid on the move.

In the FX market, we expect EUR/USD to stay in the 1.10-1.14 range bound in coming months before the cross moves higher as structural flows are supportive of the EUR and it is fundamentally undervalued on our medium-term models.

 

Download The Full Strategy