Third Quarter 2017: I’m All Right … Don’t Nobody Worry About Me
The reports of the coming economic demise continue to prove premature. For much of the past few years, we have filled these pages with our data-driven retort to the constant noise about the next impending economic and market downturn. One year ago, after United States gross domestic product (GDP) fell to 1.2% year-over-year from a recovery high of 3.8% in early 2015, we titled our commentary, “To Every Season Turn, Turn, Turn.” We expressed our belief that the conditions for rising future U.S. and global economic growth were in place. After a weak first-quarter 2017 U.S. growth report caused many to doubt the accuracy of our prior forecast, we reiterated our position in a commentary titled, “It’s More Than a Feeling.” Why? Because we noted that even with the weak first-quarter GDP report, the forward-looking economic leading indicators – notably business and consumer confidence – pointed to stronger growth ahead.
Consider it done. Indeed, second-quarter U.S. economic growth recently clicked in at a robust 3.1% quarter-over-quarter rate, which pushed the year-over-year number to 2.2%. And we note during the third quarter that these same leading economic indicators leading us to forecast rising economic growth in the second quarter kept expanding. Indeed, both the Institute for Supply Management’s Manufacturing and Non-Manufacturing Index reports on business continue to post extremely strong readings in the third quarter, with the leading indicator of new orders at expansion highs and at levels that have historically led to strong future economic growth.
On a more granular basis, consumer confidence during the quarter remained near levels last witnessed during the strong expansion in the late 1990s. The same can be said of business owners who are finally expressing their belief that it is a good time to expand their companies. Regardless of whether the proposed tax reform becomes law, we believe that business owners must invest to improve the productivity of the millions of workers they have already hired, substitute for the workers they can’t currently find and replace aged plant property and equipment. The confluence of these factors plus a global economy that is accelerating continues to shape our forecast that the U.S. economy is all right and primed for the above-trend growth in the coming quarters.
Does Economic Expansion Have Ample Time To Run?
With the economy having turned the corner, the chorus of naysayers has shifted the conversation to a question of how much longer this aging expansion can last. My answer to this is the same as it was to my children for most of our long summer vacation, when they continually asked “Are we there yet?” from the backseat: Be patient; the journey is not yet over.
The conditions that have historically marked the end of an economic cycle are an out-of-slack U.S. economy with rising inflation and a Federal Reserve rushing to tighten interest rates to snuff it out. During the third quarter, inflation remained at moderate levels. While we believe that it will begin to rise in the future, all indications remain that the Fed will not be in any hurry to stomp on the brakes this time. Our current analysis remains that both the U.S. and global economy have further room to expand; and as history has shown, this means the economy will drag the U.S. and global equity markets higher.
The Fed is an entity that wants to be overly sure everyone is all right. They can’t just let it be. The last sentence of the prior paragraph is exactly opposite of recent history. Quite the contrary: Over the last 10 years, the Fed has prodded the financial markets higher first with a goal of dragging the economy into expansion. Their prescription was to 1.) Lower short-term interest rates. 2.) Buy large amounts of intermediate- to longer-term Treasuries to push their prices up and yields lower. 3.) Make promises (forward guidance) to solidify their actions and reassure investors to take risks in equities and the economy.
The big event of the third quarter was the Fed’s announcement of the commencement of the second step in the process of unwinding the application of their above prescription. While they have previously begun raising short-term rates, at their September 2017 meeting, they announced they will begin shrinking the $4.5 trillion balance sheet of U.S. Treasury bonds and mortgage-backed securities they have accumulated to push long rates lower. The adjective they used to describe their planned process was “gradual.” You may ask, why? Because, as Fed Chairwoman Janet Yellen mentioned during her last press conference, the Fed’s latest research estimates that its actions have lowered bond yields by around 1%. Yellen added this color to the importance of “gradual” when she said, “By limiting the amount of securities that private investors have to absorb as we reduce our balance sheet, the caps will guard against outsized moves in interest rates and other potential market strains.” In my opinion, this translates into layman’s terms that the Fed wants to keep financial markets elevated because it fears any market volatility (stocks or bonds) could cause a financial market shock, which could spill over into the real economy and cause a recession. The Fed remains supportive of financial markets in the nearer term.