U.S. Quarterly Economic Forecast

Tariffs Impart a Chill Wind on Green Shoots

Date Published: June 17, 2019

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Summary

Global economy: At a crossroads

  • The global economy has been unfolding largely as we had anticipated in March. Following last year’s steep deceleration, high-frequency indicators suggest that global growth has stabilized, albeit at a below-trend rate of just above 3%.  
  • Next year, however, the growth outlook has been downgraded by 0.2 percentage points to 3.3%, in part reflecting the recent escalation in trade tensions. 
  • Signs of bottoming in growth have reflected a mix of factors. Recent trade-induced gyrations aside, global financial conditions have eased broadly, driven in part by expectations of lower policy rates. This and other stimulus measures – notably in China – have supported a firming in economic activity. Green shoots have appeared across emerging Asia as well as a number of advanced economies, including core Europe and Canada. 
  • The overall picture masks a continued divergence between manufacturing and service sectors. Global manufacturing activity remains in the doldrums, largely related to trade uncertainty and the knock-on effects of declining auto production in Europe. In contrast, service industries have remained comparatively resilient, particularly in advanced economies. 
  • Trade tensions represent a clear and present danger to the global economy. Our outlook embeds tariffs that have already been implemented, but the threat of further actions – and the potential for an unexpected severe bout of risk aversion – remain key downside risks to the forecast.

Other Forecasts

U.S. economy: Outperformance, but risks loom

  • U.S. economic growth outperformed expectations early in 2019. Real GDP advanced at a 3.1% (annualized) pace in the first quarter, boosted by temporary factors including a significant inventory build. With some reversal, growth is expected to slow in Q2. Still, the first half of the year is tracking 2.5%, roughly a half a percentage point above our prior expectation.
  • This places the 2019 annual average at 2.6% (previously 2.4%).  Economic growth is expected to slow to 1.8% in 2020, as capacity constraints bind.
  • The White House has raised its tariff rate from 10% to 25% on the second tranche of Chinese imports subject to tariffs. Taken by itself, the impact is likely to be relatively small (we estimate a drag if a little over 0.1 percentage points), but much will depend on how spending and investment react to the continued ratcheting up of trade conflicts. Manufacturing sentiment has already begun to converge to lower levels seen abroad. This raises the prospect that another round of tariff action could have a larger impact on economic growth and sentiment relative to last year when both were at higher starting points. 
  • Markets have recently priced as many as four rate cuts  between now and the end of 2020. This aggressive positioning reflects worries of further tariff escalation alongside low inflation and slowing economic growth (both globally and domestic).
  • We believe the market has over-priced the extent of accommodation the Fed will ultimately need or be willing to provide absent a significant deterioration in the economic data. However, the persistent elevated risk environment opens the door for the central bank to take a risk management approach and provide a modest accommodation (50 basis points in cuts) later this year as “insurance”.
  • We expect some semblance of a deal with China to occur this year. Critical to this outcome will be developments that occur from discussions between President Trump and President Xi at the G-20 meeting at the end of June. However, even in the event of a trade deal, it’s unclear at this stage whether the weight on the economy and market sentiment would fully lift. Importantly for the former, a deal would need to unwind the 25% tariffs placed on China in May. In addition, global trade concerns may quickly return to the spotlight with Trump having already signaled a desire to quickly pivot to Europe (a larger export market for the U.S.). 

U.S. Outlook

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    Chart 1: Domestic demand has slowed beneath quarterly GDP volatility
  • The U.S. economy had a stronger start to the year than expected, with real GDP increasing by 3.1% (annualized) in the first quarter. That healthy pace was due in large part to temporary factors including a sizeable buildup in inventories. This is expected to be reversed in the second quarter, holding headline growth to a softer 1.9%.
  • The better start to the year raises the 2019 outlook for the annual average to 2.6% (from 2.4% in March). Growth is expected to be held to a rate of less than 2% in the coming quarters, as capacity constraints begin to bind and as tariffs restrain business investment (Chart 6).
  • In contrast, inflation has run below expectations. Some of the softness earlier in 2019 has proved transitory, but the otherwise strong economy is generating less inflationary pressure than anticipated (Chart 7).
  • Notably, tariff threats have returned to the fore. In May, the White House raised the tariff rate on the second tranche of Chinese imports from 10% to 25%. This could subtract roughly 0.1 percentage points from U.S. growth over the next 12 months assuming the tariffs remain in place. Although, the administration threatened escalating tariffs on Mexico, only to pull the threat at the eleventh hour, the threat on Europe remains very much alive. 
  • The persistent elevated risk environment alongside a very modest inflation backdrop allows the Fed to err on the side of caution and cut the funds rate in two 25 basis point steps in the second half of this year as “insurance” (see our report for more details). 

Solid consumer fundamentals

Chart 2: Looking beyond transitory factors, inflation is close to 2% target
  • Consumer spending had a weak first quarter, up only 1.3% (annualized). However, activity is on track to rebound to 3.0% in the second quarter, before likely settling in at a pace of around 2% over the remainder of the year. 
  • The fundamentals supporting consumer spending are solid. Job gains, while slowing, have averaged 150k per month over the past three months, in line with our expectations. At 3.6%, the unemployment rate is at its lowest in nearly 50 years.
  • Despite market and media commentary on slow nominal wage growth, soft inflation means real wage gains have strengthened, offering a strong foundation for domestic demand. 

Housing struggling to gain traction

  • Housing is another interest-rate-sensitive sector that has struggled of late. Housing starts and resale activity were little changed in the early months of 2019. Residential investment contracted for the fifth consecutive quarter in Q1, and is on track to underperform our expectations for the first half of the year.
  • On the supply side, the number of homes for sale is low relative to history and housing construction is running well below trend household growth. As a result, vacancy rates for both rental and homeowner housing are at several decade lows. This is unlikely to prove lasting and construction activity should pick up in the months ahead.
  • On the demand side, lower mortgage rates should entice buyers. When combined with slower house price growth and decent wage gains, improved affordability is expected to give support to housing demand into 2020.

Tariffs top list of downside risks to investment

  • Despite solid real GDP growth, business capital spending has also been weaker than we had expected, advancing by just 2.3% (annualized) in the first quarter. Spending in industries reliant on federal government contracts was likely held back by the government shutdown, but it is difficult to tease out the precise impact. 
  • Recent high-frequency data suggest that momentum has softened further, with overall business spending likely to contract in the second quarter. Some of the weakness reflects production cuts for Boeing’s 737 MAX, which is estimated to subtract about 0.2 percentage points from real GDP growth in Q2. If production returns to normal, growth would receive a boost in the second half of the year. But, more ominously, unrelated business spending on structures and a variety of equipment is also declining.
  • This is perhaps not surprising given the deterioration in business sentiment in recent months, more so in the manufacturing sector (Chart 8). Uncertainty has been ratcheted up once again with the escalation in the U.S.-China tariff battle. In addition, the administration looks to open another front with Europe, which could further dent confidence. 
  • Our forecast builds in tariffs that have already been implemented, but assumes no additional tariffs are implemented. Clearly, any positive developments would help to lift business confidence and investment, particularly in 2020 and beyond.  In the meantime, the risks to our business investment forecast are to the downside. 

Fed is likely to cut rates in late 2019, but not as much as markets (currently) expect

Chart 3: Confidence and spending intentions have softened
  • Despite the tariffs enacted to-date, inflation has remained contained. The Fed’s preferred inflation metric picked up to 1.6% in April (from 1.5% in March), but is well below the Fed’s 2.0% target, a place it has been for the majority of the decade-long economic expansion.  
  • Chair Powell has framed some of the recent bout of weaker-than-expected inflation as transitory. Indeed, other inflation metrics, such as the trimmed-mean PCE inflation rate have hit 2.0%. Even so, Powell and other Fed officials have emphasized that the inflation target is symmetric, and will look for proof that it is turning convincingly higher. Further tariffs are likely to raise consumer prices, but unless this results in an upward shift in inflation expectations, the Fed is likely to look through it and focus on the detrimental impact on economic growth.
  • The fed funds futures curve is pricing in several cuts to the target rate over the next 24 months, which is also weighing on longer-term yields. Assuming no further escalation of tariffs, we expect some of this to be unwound in the coming months. Still, benign inflation increasingly suggests the U.S. economy has more room to run and can afford the Federal Reserve taking a risk management approach by providing a modest accommodation (two 25 basis point cuts) later this year as “insurance”.
  • Escalating tariffs have put upward pressure on the U.S. dollar, especially relative to emerging market economies. Assuming tensions ease, much of the upward movement appears to be in the rear-view mirror. As U.S. growth converges a little closer with its trading partners, it is likely to lead to a modest weakening in the dollar over the second half of the year. 

Forecast Tables & Research

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Contributing Authors

  • Beata Caranci, Chief Economist | 416-982-8067

  • Derek Burleton, Deputy Chief Economist | 416-982-2514

  • James Marple, Senior Economist | 416-982-2557

  • Fotios Raptis, Senior Economist | 416-982-2556

  • Brian DePratto, Senior Economist | 416-944-5069

  • Leslie Preston, Senior Economist | 416-983-7053

  • James Orlando, Senior Economist | 416-413-3180

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