U.S. Quarterly Economic Forecast

U.S. Outlook - High Water Mark in the Past

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• The U.S. economy grew at a 3.5% annualized pace in the third quarter, fueled by a confident consumer. This was close to our published September QEF update of 3.3%.
• Momentum has since decelerated quite a bit heading into the fourth quarter, but is holding at a respectable 2.3% pace. The slowdown was a long-standing feature of our prior narrative, but momentum is tracking below our September expectation of 2.9%. The trend drives home the view that the high water mark is in the past, fueled by the initial impulse from fiscal stimulus. 
• For the year as a whole, 2019 should average about 2.5%, but the quarterly pattern reflects a steady slowdown. Fiscal impacts will continue to fade through the year, while higher interest rates lean against demand (Chart 1). Growth in 2020 is expected to notch down even further as the economy synchs back up to its fundamental drivers. Real GDP is forecast to average 1.9%, but this too masks a quarterly pace tapering through the year to around 1.8%.

Job market holds its ground

• Hiring has averaged 170k jobs over the past three months (to November), despite disruptions from major hurricanes. The unemployment rate has fallen to 3.7%, a level not seen since 1969. Broader measures of unemployment (Chart 2) are in line with the height of the tech boom in 2000. 
• There appears to be room for the job market to draw in more marginalized workers. The labor force participation rate of core-aged (25-54 years) workers has shown steady improvement. Even so, it is below its pre-recession peak, and will well off its historic high. Interestingly, some of the largest strides of late have been made among younger women (aged 25 to 34) entering the workplace.
• The tight labor market is also (finally) showing up in higher wages, both in average hourly earnings and the employment cost index, which captures wages and benefits. Notably, average hourly earnings finally broke through the 3% growth ceiling that has stood for nearly a decade. 
• Paralleling the job market strength, consumer confidence has reached new heights. This optimism has helped propel consumer spending growth to an average of 3.9% (annualized) over the second and third quarter of this year. The recent tax cuts are a big part of this story, adding about half a percentage point to disposable income growth. This boost will fade in 2019, setting the stage for a more staid consumer performance at around the 2-2.5% mark in real terms.

Investment spending slowed in Q3

• After setting a blistering 10% annualized pace over the first half of 2018, business investment disappointed in the third quarter (+2.5% annualized). The softness was led by a decline (-1.7%) in non-residential structures investment. Spending on equipment and intellectual property both moderated, but grew at 3.5% and 4.3% respectively. 
• One concern around the slowdown in investment growth is that businesses, particularly in the manufacturing sector, are revisiting their investment plans in light of tariff activity. This bears close watching, as there has been an increasing chorus of voices around the impact flowing through from higher input costs and reduced global growth prospects. We believe 2018 will prove the peak for business spending growth. 
• Lower oil prices in the past quarter are also likely to crimp spending in the oil and gas sector. Directly, the sector only accounts for about five percent of business investment, but the pullback in investment during the last oil price downturn hit capital spending more than was expected.
• However, this takes a backseat to the persistent weakness occurring in residential investment. The third quarter marked an unfortunate hatrick – three straight quarters of contraction. Housing starts and activity in the resale market both suffered in the quarter. 

• Some commentators have noted that the decline in housing is reminiscent of the pre-2008 experience. We think this is a little misguided. Household leverage is night-and-day to that period, as is the quality of mortgages. We have previously noted supply-side factors constraining the inventory of resale homes and thus sales, which is also in stark contrast to the prior expansion cycle.  
• One area that offers us some comfort is that the weakness in residential investment stands in contrast to a recent surge in residential construction employment, which has expanded by 7% over the past 12 months. Hiring at this pace wouldn’t be occurring in the absence of a pick-up in construction and renovation activity, offering some cautious optimism for 2019. Certainly, the fundamentals are supportive of that outcome, defined by solid household finances, pent-up demand evident by low homeownership rates, and ongoing population growth. 
• Putting all the pieces together, our forecast neither incorporates a strong rebound in housing activity nor a large contribution to economic growth. The numerous supply-side constraints will ultimately act as a counterweight to the fundamental dynamics, particularly as the construction mix shifts to more affordable units and inventory within the resale market receives little relief (Chart 3).

Fiscal risks to come to the fore in 2019

• The two-year budget deal that raised the caps on defense and non-defense spending through the 2019 fiscal year comes to an end in the fourth quarter of 2019. Our current forecast assumes that Congress extends the caps at 2019 levels to prevent a “sequestration” in 2020, as would otherwise be required under the 2011 Budget Control Act. However, if these automatic spending cuts (of roughly $100 billion) do occur in fiscal 2020, they would subtract an estimated 0.5 percentage point from our current GDP growth forecast (Chart 4). 
• The other fiscal risk that bears watching is the potential for a partial government shutdown, stemming from ongoing continuing resolutions for parts of government spending. This threat was recently elevated in a confrontation between the President and
• Democratic Senate and House leaders, Chuck Schumer and Nancy Pelosi.
  Should it occur, past experiences have demonstrated limited economic impact, as they typically prove to be short-lived. However, financial markets are already on edge, and political brinkmanship this time around can prove more damaging to confidence.

Lack of inflation momentum adds downside risk to Fed hike path

• The Federal Reserve is likely to hike rates on December 19th, bringing the fed funds target to 2.50%. Thereafter, how much higher the policy rate will go is up for debate. In recent months, the Fed’s preferred inflation measure, core PCE, has lost significant momentum (Chart 5). After hitting 2% on a year-on-year basis earlier this year, it dropped to 1.8% in October. More meaningfully, the three-month annualized pace has averaged just 1.2%, suggesting the trend is not our friend. This offers the Federal Reserve lots of breathing room to take a more gradual approach to interest rates in 2019, particularly as it enters the homestretch.
• We have penciled in only two more rate hikes from the Federal Reserve in 2019. This will bring the rate to 3.00% and also mark the peak in the rate-cycle within our forecast.

• Alongside the uncertainty surrounding the market’s fed funds expectations, Treasury yields have been on a roller coaster ride over the past three months. The UST 10-year initially rose to a high of 3.26% in October, before falling below 2.85% in December as market jitters kicked up (Chart 6). We still believe a 10-year yield of 3.25% is attainable over 2019, based on a combination of higher policy rates, inflation and the term premium.
• The broad U.S. trade-weighted dollar is up 2% over the last couple months and close to 8% on the year. The majority of this move comes against emerging market currencies, where weakness have been exposed within this global economic slowdown. As long as event-risks like trade tariff threats persist, so too will the flight to safety bid on the greenback. Given the high degree of event risks occurring in Q1 2019, we suspect the U.S. dollar will hold its dominance, with the balance of risks thereafter shifting to some portfolio rebalancing to other currencies.