Quarterly key points
- U.S. GDP growth fell back to a more modest +2.1% rate in Q4 from the faster pace we saw in Q3 (+3.5%).
- The labor market remained strong and most measures of inflation rose during the quarter.
- Consumer confidence rose to a 16-year high during the quarter, supported by the healthy job market and solid gains in equity markets and housing prices.
- The Fed raised its policy rate by 25 basis points (0.25%) at the March February Federal Open Market Committee (FOMC) meeting, to a target range of 0.75% to 1.00%.
- Despite the setback on healthcare reform, we continue to expect significant fiscal stimulus over the next 6-12 months, which should help GDP growth
to accelerate anywhere from 2.5% to 3.0% this year.
- The Fed has signaled it expects to hike two more times in 2017. Policy makers may feel pressure to quicken the pace of rate hikes if fiscal stimulus
causes growth to accelerate.
- Markets appear somewhat complacent despite what we view as rising “tail risks” from U.S. policy uncertainty and its potential impact on the global
economy and financial markets.
Fourth quarter GDP growth slows despite strong “soft data”
U.S. GDP rebounded to a solid +3.5% pace in Q3, a significant improvement over the anemic 1.1% growth rate of the first half of 2016. Growth in Q3 was bolstered by a rebound in inventory building and a spike in agricultural exports. Personal consumption grew at a strong 3.0% pace during the quarter. Incoming survey data suggests Q4 growth remained solid, giving the economy significant momentum heading into 2017. The Institute for Supply Management’s (ISM) monthly survey of business activity showed gains in both manufacturing and service sectors during Q4.
In the current quarter, survey levels – the so-called soft data – including the ISM and regional Fed surveys, consumer confidence, and homebuilder sentiment remain consistent with above-trend growth. Unfortunately, stronger soft data readings in recent quarters have not consistently translated into robust results in the hard data of spending and investment activity, and ultimately, above-trend quarterly GDP growth. Early indications of both personal and business spending and investment for Q1 suggest a sluggish start to 2017.
The labor market remained on-track during the quarter. Although March’s non-farm payroll numbers (released in April) were weaker than expected, employers still added an average of 178,000 jobs per month over the quarter. The unemployment rate fell to 4.5% in March, while average hourly earnings rose at a 2.7% annual pace for the trailing 12 month. Consumer confidence in March jumped to a 16-year high reading of 125.6. Inflation measures continued to trend higher as well, with most measures at or near the Fed’s 2% target range by the end of 2016. As of the February data release, headline CPI rose at a 2.7% year-over-year pace while core inflation, excluding food and energy, rose 2.3%. The Personal Consumption Expenditures (PCE) price deflator – the Fed’s preferred inflation measure – rose 2.1% over the 12 months ended February at the headline level, while Core PCE, excluding food and energy, rose 1.8%.
Figure 1 | GDP Growth and Weighted ISM Index1
“Trump rally” challenged by Healthcare reform failure
For most of the first quarter the “Trump rally” continued, as post-election optimism for tax cuts, a more friendly business environment, and the potential for faster growth lifted U.S. stocks and credit-sensitive fixed income sectors. The S&P 500 Index continued to set new highs during the quarter and credit spreads (both high yield and IG) reached a 2-year low.
The administration’s policy agenda suffered a very public defeat with the failed attempt to pass healthcare reform. A cornerstone issue for Republicans on the campaign trail since the passage of Obamacare in 2010, the administration’s failure to get a workable bill through the Republican-controlled Congress damaged investor confidence in President Trump’s ability to implement his broader policy agenda. U.S. stocks initially sold off following the healthcare bill failure and ended the quarter 1-2% below record-high levels.
Despite the setback on healthcare reform, we continue to expect the administration to advance significant fiscal stimulus over the next 6-12 months. Both tax reforms and infrastructure spending appear to have broad support among Republicans and, if well-positioned, could appeal to at least some Democrats.
Figure 2 | CPI and PCE Inflation – Headline and Core2
Fed signals two additional hikes over 2017, reduction to balance sheet also in Fed’s sights
The Federal Reserve used the positive market sentiment to its policy advantage during the quarter. After passing on a hike at the early February FOMC meeting, Fed officials took to the press in coordinated fashion with a broadly consistent message that a March hike was likely. The preparation worked: when the Fed did raise its policy rate by 25 basis points (0.25%) at the March meeting and signaled two more hikes in 2017, the market had fully priced-in the move. Policy makers have also begun openly discussing the need to begin reducing the size of the Fed’s $4.3 trillion portfolio of U.S. Treasury and agency mortgage-backed securities (MBS). The minutes from the March FOMC meeting confirm that Fed officials discussed tapering reinvestment of principal and interest payments on the portfolio later this year.
Interest rates were little changed on balance over the first quarter. Yields at the very front end of the yield curve (one-month to one-year) rose
nearly lock-step with the Fed’s policy rate increase, while the rest of the yield curve was largely unchanged. Global equity markets rallied strongly
in both local and U.S. dollar terms as the dollar weakened ~2% on the quarter versus other major currencies. Oil prices fell sharply during the
quarter on a perceived setback in OPEC’s plan to reduce global oversupply and the continued rebound in U.S. domestic oil production from the lows
Overall, we note that markets appear somewhat complacent despite what we see as rising “tail risks” from U.S. policy uncertainty and its potential impact on the global economy and financial markets. As a result, increased caution is warranted.
Figure 3 | U.S. Federal Reserve Balance Sheet3
1. Source: U.S. Bureau of Economic Analysis, Bloomberg, The Institute for Supply Management
2. Source: Bloomberg, U.S. Bureau of Economic Analysis, U.S. Bureau of Labor Statistics
3. Source: Federal Reserve, Bloomberg
The information contained herein reflects the views of Galliard Capital Management, Inc. and sources believed to be reliable by Galliard as of the date of publication. No representation or warranty is made concerning the accuracy of any data and there is no guarantee that any projection, opinion, or forecast herein will be realized. The views expressed may change at any time subsequent to the date of publication. This publication is for information purposes only; it is not investment advice or a recommendation for a particular security strategy or investment product. Graphs and tables are for illustrative purposes only. FOR INSTITUTIONAL INVESTOR USE ONLY. © Copyright Galliard Capital Management, Inc.