The U.S. economy started 2019 on much stronger footing than forecasters and market participants had anticipated. This can be easily seen if we look back at the sharp deterioration of consensus growth estimates for the first quarter. Between the end of 2018 and the release date of first quarter figures for U.S. gross-domestic-product (GDP) expectations declined from 3.1% to 2.8%. That partly reflected fears concerning the negative effects from the longest government shutdown in history (35 days). Another factor making economic forecasts difficult during this period was the incomplete data as a direct result of the shutdown. And of course, uncertainty over trade negotiations and fears of global growth softening further clouded many economist's crystal ball. In retrospect the reported 3.2% quarter-over-quarter annualized GDP growth rate for the first quarter was more than comforting. When looking at the details of the GDP figures, some mixed feelings remain however. For economists the composition, or the growth mix, is as essential as the headline numbers, if not more.
Private consumption remained a strong driver of economic growth during the first quarter. This is not surprising, given the continuing strength in U.S. labor markets. The not so good news is, private consumption slowed from the last quarter in 2018. Here the government shutdown played a role. Government and especially government contract workers, not sure when they would receive their next paycheck, naturally held back on purchases. In this episode, households spent less than usual on more expensive merchandise (durable goods, like cars, for example). Looking ahead, the soft patch in consumption is likely to be temporary. Indicators of consumer sentiment, such as the one published by the University of Michigan, also suggest somewhat higher consumption going forward. Another surprise: net trade contributed by far the most to growth in the first quarter. That reflected a combination of stagnant imports (due to lower spending on durable goods) and a surge in U.S. exports. A look into recent trade statistics suggests plenty of stockpiling by European and Asian importers of U.S. goods, perhaps in anticipation of escalating trade tensions. The most interesting item was a jump in U.S. business inventories, the second highest contributor to growth during the first quarter. Our take on this: U.S. domestic businesses prepared for a trade war escalation as well. It probably also reflects producers expectations for higher domestic demand later on in 2019. Recent surveys support this view[1]. While e.g. the ISM manufacturing Purchasing Manager Index (PMI) followed a clear downward trend through the first four months, the new order component remained resilient until March. So, looking beyond the headline GDP figure for the first quarter, the underlying trend of growth remains moderate but reasonable. One good way to extract a reasonable indication of the prevailing momentum in the U.S. economy is to take a look at final sales to private domestic purchasers. They are currently quoted at around 2% quarter-on-quarter annualized – a number which is roughly in line with our growth expectations. Looking ahead, inventories must be wound down at some point in time. Moreover, the favorable support from net trade is unlikely to repeat itself in the short term. So we expect at least some negative payback in the following quarters.
There are also some encouraging trends, though. Strong labor-market data for April underpins our picture of a well-behaved moderation. Besides a strong increase of non-farm payrolls and the new cyclical-low unemployment, we were delighted to note an upward trend in labor productivity growth. And labor markets could improve further. As aptly put by one U.S. Federal Reserve (Fed) official, advances in technology may have pushed the natural rate of unemployment lower as job matching may have become more efficient. Also, if sustained, higher productivity may offer some scope for further wage growth. This would support consumption and protect household's balance sheets. Based on this we maintain our scenario of moderating, but above potential, growth through 2019 and 2020. We still expect deceleration not to be excessive nor do we expect a recession in the next twelve months. Furthermore we welcome the fact that such an environment also reduces the long-term risks to the current expansion, such as high inflation and, excessive private leverage.
However, risks to this outlook remain. The recent escalation of trade negotiations with China and the lingering dispute with Iran would be the most prominent ones. Until recently, we and most observers had hoped for a fairly quick resolution to the trade dispute between the United States and China. The unexpected increase of U.S. tariffs from 10% to 25% on 200 billion U.S. dollars (USD) of imports from China has dashed those hopes. In the usual tit-for-tat manner, China retaliated by introducing various tariffs between 10% – 25% on 60 billion USD of U.S. exports. The latest move, an executive order by President Trump to essentially ban trade with Chinese technology companies, increased the uncertainty even further. Our assessment of this complex situation remains an optimistic one, at least for the time being. We expect some verbal moderation in the course of 2019, most likely followed by a retraction of some of the measures. The recent announcement of delaying the decision on European auto tariffs by the United States and the offer of President Trump to meet with China's Xi Jinping support this view. One key date to watch will be the G20 summit in Japan at end of June which both leaders are planning to attend.
Besides our rather optimistic view on the politics of the trade war, we have to consider at least some economic implications. As we know from the first round of tariffs, the initial fallout will be visible in higher U.S. import prices for the affected goods, which in turn impacts producer prices and eventually consumer prices. Our calculations suggest that the impact on consumer prices in the current situation is moderate and somewhat transitory. This is the good news. Of course this assessment changes if the situation escalates further. Introducing 25% tariffs on the remaining ~300 billion USD of imports would hit the consumer directly. The reason is, that current tariffs mainly target intermediate goods while the next round would hit mainly consumer goods. While it is relatively easy for economists to estimate the direct consequence of higher tariffs, a complete trade ban for a sector is a much tougher assessment. Complex supply chains are not observable from the outside and so it is not straight forward to model the impact of disrupting them. It remains to be seen what net-effects will show up.
Transitory seems to be the word of the hour, not least among Fed officials in recent comments. They mostly used it in the context of weak inflation figures, including the disappointing March ones for the core Personal Consumption Expenditure Price Index (PCE) – the Fed's preferred measure of inflation. Prices increased only very modestly at 1.6% year-on-year in March, relatively far below the Fed's 2% target. So a rather dovish statement following May's Federal Open Market Committee (FOMC) meeting was widely expected. And, at least from the statement, markets got what they had been looking for. In the press conference however, Chair Powell was more upbeat than expected. His wording was in the neutral camp and he seemed convinced that observed weakness in inflation would be transitory. Further he stated that the Fed remains committed to the symmetric 2% inflation target and that "insurance" rate cuts because of low inflation would not be on the cards. In general, the FOMC also judged labor markets as strong and financial conditions as favorable. In light of their economic assessment, the overall policy stance was, again, seen as appropriate and the "wait-and-see" approach was reiterated. So nothing new here.
What has changed since the last FOMC meeting is, of course, the recent escalation in trade negotiations. Back at the time of the meeting, Powell mentioned reports of progress in trade talks. We now expect the Fed to alter their assessment towards a more cautious tone. And they are already preparing. Summing up recent Fed talk, current tariff measures would only have a minor effect on growth while boosting inflation only a few tenths in the coming months. A prolonged episode or even an escalation could have significant effects, though. Besides this, Fed talk was concentrated on the review of the monetary-policy framework. Here Richard H. Clarida, Vice Chair of the Board of Governors of the Fed, caught our attention, stressing the role of inflation expectations for optimal policy setting. Up until now, the various measures of inflation expectations remain well anchored and imply, if used to derive an estimate of optimal policy, a fairly neutral to slightly accommodative current policy stance.
We expect the Fed, despite the increased political risks and the economic implications of those risks, to maintain a neutral stance in the next quarters. Indeed, weakness in core PCE seems to be transitory. The latest readings of the consumer price index (CPI) and producer prices suggest as much. Furthermore, we believe the effect from tariffs, in the absence of further escalation, should bring back inflation towards target a bit quicker than had previously been anticipated. Also recall the symmetric nature of the Fed inflation target. If you read between the lines on the discussion on the policy framework, the Fed appears most likely to tolerate a modest overshoot of their 2% target – just as they have previously tolerated below target inflation.
All said, we believe there is no reason for euphoria nor for being overly concerned, at least from an economic point of view. The economy remains on a fairly balanced, but moderating, path. Looking ahead, it's all about politics and how markets react on the news flow. So an escalation of the trade war would directly impact financial conditions, followed by a more severe fall-out for the U.S. economy. As of now financial conditions remain favorable, but that can change quickly. Just recall what happened during the last quarter of 2018, when markets tumbled and fears of an immediate recession increased. Based on the current economic data, we do not expect a repeat, for the time being.
