Economic Growth Remains Quite Solid
The latest GDP report and its historical data revisions show that economic growth enjoys plenty of momentum, even if the pace is only moderate. Actually, that pejorative is unfair, since the pace is actually quite solid. On its current trajectory, unemployment is likely to hit 4.0% by the end of this year and plumb historic lows by next year, with obvious unfavorable consequences for inflation. Fed officials seem to have a much better grasp of these circumstances than investors, so the Fed is likely to continue its policy of gradually hiking rates over time.
The economy has managed to sustain a healthy pace of economic growth despite a retrenchment in drilling for oil and gas that weakened activity in the second half of 2015. From Q4 2014 through Q2 2017, GDP has grown at a 1.9% annual rate. Excluding the second half of 2015, when the oil sector retrenched sharply, GDP has averaged a 2.3% pace, despite the tendency for all Q1 quarters to be reported as quite weak. With the rebound in energy drilling underway, GDP growth should continue to grow between 2% and 2.5% (2017 Q2 of 2.6% merely makes up for the usual overly weak Q1).
The economy’s growth rate is still somewhat disappointing compared to previous economic expansions. But with retiring baby boomers depressing labor force growth and productivity having slowed, U.S. growth potential has clearly slowed. We may want faster growth, but it doesn’t appear feasible without some inexplicable and probably unrealistic acceleration in productivity. Moreover, the more moderate expansion compared with the past has been more than sufficient to drive the unemployment rate down to low levels. The labor market is already tight and getting tighter. We expect another solid employment report on Friday.
Corporate profits continue to shine. After a stellar Q1 (despite weak GDP) when profits surged close to 15%, we are on track for another double digit gain in Q2. With more than half of all S&P companies having reported so far, upside surprises of 204 exceed 61 earnings misses by more than 3 times. Sales are coming in better than projected and exceed misses by 2.9 times. And many companies are also revising up their profit projections for the balance of the year. This strong performance of corporate profits, reinforced by a weaker dollar, easily justifies the rally in the equity market even without tax reform. If and when tax reform comes, it will add another burst to corporate fundamentals.
The only fly in the GDP ointment appearing in the data was the notable decline in the household savings rate, which fell to 3.8% in Q2. On its face, this suggests that consumers are running out of firepower to sustain spending. However, the history of the savings rate estimate is that it is routinely badly understated at first and revised higher in subsequent revisions. As long as job growth remains close to 200,000 per month and wages continue a gradual ascent, consumers should retain the ability to increase spending. The bean counters will catch up eventually.
All in all, the economy’s performance remains solid with plenty of momentum, even if it is not robust. As long as the unemployment rate trends down however, growth remains above potential and somewhat greater than can be sustained. The Fed clearly recognizes this, which is why it continues to repeat publicly that it intends to maintain its gradual tightening of monetary policy. As long as inflation remains under target, the Fed need have no sense of urgency to normalize rates, even though unemployment is clearly below target and headed lower. A gradual, methodical pace of change in policy is quite adequate right now. It will become manifestly inappropriate only if inflation moves above the 2% target. So we expect the Fed to implement the gradual decrease in its balance sheet at the September meeting and to hike the funds rate for the third time this year in December. By then, the growing scarcity of labor is likely to increase wage rates faster, making the need for rate hikes in 2018 clearer.
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