Outlook for the US - solid fundamentals amongst a lot of noise

Introduction

The US economy is experiencing a strong and durable growth recovery after a slowdown in 2016 that was largely due to a large decline in energy production and poor global growth. Changes in the US economic environment are an important driver for global developments, with the US economy accounting for around 25% of total world GDP and ~60% of economies anchoring their currencies to the US dollar. How much longer can the good US growth backdrop continue? We explore the issues around the US economic outlook in this Econosights.

The US expansion – can it continue?

We are currently in the eighth year of the US economic expansion and GDP growth around 2.5-3% looks achievable in the near-term. While this type of outcome is below the historical long-run average (of ~3%), it is above the US economy’s current assessed “potential” level (of 2% or so). Potential growth is a theoretical concept about the rate that an economy can expand at if all resources are fully utilised (labour and capital), with unemployment at its optimal rate, and without any upward pressure on inflation. Productivity growth and labour force participation are key components of potential GDP growth.

Potential growth has slowed in the US (and in other advanced economies) over recent years because of softer population growth (which affects labour force growth), an aging population and a decline in productivity growth. Normally, when an economy is growing consistently above its potential level, inflationary pressures start to lift (see chart below where the arrows indicate prior times in history when actual GDP ran above potential and had a positive impact on inflation).

Slow and manageable inflation and a central bank that is slow to raise interest rates is positive for the growth backdrop at this stage of the recovery. As well, there are few signs of excesses or overinvestment across industries, that would normally be a cause for a downturn or lead to a central bank policy mistake.

Consumer outlook still positive

The outlook for the consumer remains positive. Retail sales growth is lifting and broader trends of consumer spending in non-retail areas are strong. Consumer sentiment across surveys has also maintained its upward momentum (see chart below).

Some of the improvement in confidence probably reflects the expectation of a lessening in the tax burden as well as positive labour market developments that are assisting household incomes. The labour market remains in a very good position with the unemployment rate (at 4.2%) - its lowest level since 2001, and likely to decline even further, based on low jobless claims. While wages growth has been stubbornly slow to rise (considering this stage of the cycle), there are early signs that this trend is reversing, with a pick up in wage indicators like median weekly wage and average hourly earnings (see chart below). There are also some early signs of labour shortages in specific industries (e.g. in construction, particularly housing)

One positive of low inflation has been that real wages growth (nominal wages less inflation) has remained positive.

One factor that could make a significant difference for household incomes in the near-term is any change to personal taxes. The main changes that are proposed by the Trump administration are: lower and fewer individual income tax brackets, an increase in the tax-free threshold (positive for lower income households), a higher Child Tax Credit, an end to the Alternative Minimum Tax and the repeal of most itemised deductions including State and Local taxes which would have a negative impact on high income taxing states like California, Oregon and New York. Overall, the proposed policies would lead to a lower tax burden for households but some tax analysts have suggested that the biggest positive impact from the proposed changes will be for households at the top end of the income spectrum. Tax reform currently has around a 60% chance of getting through Congress.

Slow recovery in housing construction to continue

The housing sector recovery after the Global Financial Crisis (GFC) has been slow, with new supply of housing gradually coming online, following an oversupply of dwellings before the GFC. Prior excesses in the housing stock appear to have now been worked through, with builders indicating that inventory of dwellings is low (see chart below).

Vacancy rates in the rental market have ticked up a little, but are still well below levels ten years ago. Homeowner vacancy rates continue to decline and are around multi-decade lows which normally tends to be a signal of upside risks to rental price growth. Tighter conditions in the housing market should lift new housing construction, particularly as demand for housing is rising because of better population growth and an improvement in the labour market (which is normally a good sign of labour demand).

Lending standards for households have become a little easier which is usually a good sign for housing demand and price growth. Housing prices are running around ~6% on most metrics. Given tight new housing supply and continued positive demand for housing, home price growth should lift from current levels, to around 7% for the near-term.

Business investment – waiting for tax reform

Business investment growth has recovered after the energy-driven slump in 2016, so mining investment is increasing strongly. But, investment growth across the other industries is still tepid. It is the right time in the cycle for business investment to lift, particularly in an effort to increase productivity growth. Business surveys remain very positive across the board and indicate positive sentiment for the outlook ahead, as well as solid current business conditions.

The Trump administration’s efforts to roll back regulation in some sectors have been received well, particularly for manufacturing firms. But, the business surveys still have an expectation that proposed corporate tax reform may unlock some spending demand and investment.

The key components of the Trump’s administration’s proposed corporate tax reform are: cutting the top corporate tax rate from 35% to 20%, lower the small business tax rate, repatriation of overseas profits, expensing of new capital investments, limiting interest deductibility by some corporates and elimination of some business credits.

The chance of taxation reform passing through Congress is completely dependent on the approval of a 2018 Budget through the “reconciliation” process. Reconciliation means that a legislation can pass with less votes in the Senate (51 rather than 60 out of 100). The downside of passing legislation through reconciliation is less flexibility in the proposed components. In the case of tax reform, this means the condition that any reform should be revenue neutral (tax cuts should be offset by “saving” measures) with no impact on the budget deficit. The Republicans will propose two accounting measures to create revenue that will partly offset the tax cuts for households and corporates - “dynamic scoring” which is based on the theory that lower tax rates will boost growth and hence tax revenue and a “sunset clause” which assumes that any tax cuts in law today would expire sometime in the future.

The chance of passing a Budget look positive for now, with the House of Representatives approving a 2018 Budget and the Senate Budget Committee approving a draft Budget. The next step will be: the full Senate approving a Budget and the House and Senate resolving any differences in the components of the Budget. So, the chances of tax reform occurring look mildly favourable at around 60%. But, the timing around this occurring may be longer than expected because of the complexities around achieving genuine reform. The risk is that tax cuts are the only component of the package that is passed. This would be disappointing as the purpose of the debate around tax is about trying to create genuine changes and reform in the system through decreasing distortions and creating the right incentives to work and invest.

The impact of tax reform on the economy is difficult to estimate and depends on the details of the package and how it is funded (i.e. does it increase the budget deficit and by how much?). While the overall effect to the economy from tax reform would be positive, the impact to the economy will be slower compared to current expectations and projections as firms and households slowly adjust to the changes. Congress could also decide to phase in the changes over time, which would make the process even more drawn out. On our estimates, the increase in GDP growth from tax reform would be around 0.2-0.3 percentage points on an annual basis for the near-term and 0.1-0.2 percentage points higher for inflation. The boost to corporate earnings could be around 5-10%, with improvements for companies with high tax rates. The impact on the budget deficit is uncertain because the details on the legislation is still unclear.

Another fiscal change to watch for is infrastructure spending. Infrastructure spending tends to have a faster impact on growth and inflation than changes to the tax system.

Inflation – there are more upside than downside risks

Despite some disappointment in inflation readings over recent months, we are still confident that inflation will edge higher as GDP growth continues to improve and we see the key measure of inflation (core personal consumption expenditure index) at around 1.8-2.0% in a year (the Fed targets 2% inflation) from 1.4% now. Above-potential GDP growth, a tighter labour market (and higher wages growth) and pockets of inflation breakouts (e.g. housing construction input costs) will lead to higher price growth. The business surveys “prices paid” component is also indicating stronger price growth.

The Fed – changing Board, interest rate hikes and balance sheet issues

Expectations of better inflation readings looking ahead means that the Federal Reserve (Fed) will likely persevere with another 0.25% rate hike in the December meeting and continue to lift interest rates in 2018 given its view that while recent inflation misses should be considered, the fundamental outlook for inflation remains positive and consistent with reaching an inflation target of 2% over the medium-term.

One of the important changes that is going to occur soon at the Fed is the change in Board members. In 2018, there will be four to five new appointments onto the Board of Governors (including the new Fed Chair) that President Trump will appoint. Despite the frenzied speculation around who will be the next Fed Chair and on the Board of Governors, the Fed is unlikely to stray from its current plan of gradual rate hikes towards a neutral interest rate of 3%. The Fed has been very good at communication around its policy (probably because it would want to avoid a 2013 taper tantrum scenario) and this forward looking guidance is very much likely to continue, even with the new Fed Board makeup.

The Fed has also begun to unwind its balance sheet assets (in October) through allowing its maturing investments of Treasury securities, agency debt and mortgage-backed securities .to roll-off the balance sheet (rather than reinvesting the proceeds). The Fed’s balance sheet roll-off has been well explained but the actual impact on the market has been minimal to date. It will take years of asset roll-off (likely to be four to five years) to achieve a more “normal” size of the balance sheet and this will lead to higher bond yields – probably by around 10 basis points per year.

Implications for investors

The strong momentum in the US economy has been and will continue to be positive for US and global equities, particularly if taxation reform is approved over. However, our valuation indications have been suggesting that US equities are overvalued on some measures. Eurozone and Japanese equities look more compelling from a valuation perspective and would still benefit from better US growth and still have central banks that are running very easy monetary policy. Our expectations of US tax reform being passed, higher inflation and Fed rate hikes mean we expect bond yields and the US dollar to gradually move higher.