Our Insights

December 31, 2017 — Market Insights
Economic Update
 




Quarterly key points

  • ∙The U.S. economy shrugged off the impact from Hurricanes Harvey and Irma during the third quarter, posting a second consecutive quarter of GDP growth above the 3% level.
  • ∙Republicans passed into law a major tax cut package, including a significant cut in the corporate tax rate and more modest cuts at the individual level.
  • ∙The Fed raised its policy rate by 25bps at its December meeting and signaled three more hikes in 2018.

Our view

  • ∙Economic fundamentals remain positive across Europe, developed Asia, and the United States, and the recent solid pace of global growth looks set to continue into 2018.
  • ∙Tax cuts seem likely to add modestly to the already strong pace of growth in the U.S. On the negative side, the Fed’s gradual removal of policy stimulus (rates and balance sheet unwind) should temper growth optimism over the intermediate-term.
  • ∙With the U.S. economy at full employment, inflation readings will likely be more important than the pace of hiring or the level of GDP growth for the Fed’s rate hike decisions this year.

U.S. Economy Shrugs off Hurricane Disruption to Post Strong Growth in Q3

The U.S. economy posted strong GDP growth in the third quarter, increasing +3.2% over the prior quarter on an annualized basis. With a 3.1% pace of growth in the second quarter, the last two quarters experienced the fastest back-to-back quarters of growth since 2014. Growth in Q3 was driven by solid personal consumption (+2.2% Q/Q ann.), business investment (+4.7%), and exports (+2.1%).

The job market remained strong over the quarter, although job creation has slowed over the last 12 months as the economy approaches full employment. On average, employers added 172,000 jobs per month over 2017 versus nearly 187,000 in 2016 and 2015’s average of 226,000 jobs per month. The unemployment rate stood at 4.1% in December, down 0.1% since the end of the third quarter and 0.6% from the start of 2017.

The sustained recovery in business investment this year, particularly in equipment, is a welcome development in terms of the balance of GDP growth between consumption and investment. Whether encouraged by the relatively scarce supply of workers, recently passed cuts to the corporate tax rate, or provisions for immediate expensing of capex – or all of the above – companies have clearly begun to invest more into their businesses than in recent years. Such investment, if sustained, bodes well for continued economic expansion.

Figure 1 | U.S. GDP Growth by Quarter (Annualized Rate)1

FOMC Median Year-End Fed Funds Rate Projections

Tax Reform, Global Growth Outlook Boosts U.S. Equities, Corporate Bonds

Over the quarter, global growth indicators pointed to a continuation of above-trend growth in the U.S., Europe, and developed Asia. JPMorgan/Markit’s global composite of purchasing manager indices (Global Composite PMI) rose to 54.4 in December. In October, the International Monetary Fund (“IMF”) boosted its estimate of global GDP for 2018 by +0.1% to 3.7%.

In the U.S., passage of the Republican tax cut bill, which features a significant cut to the corporate tax rate and provisions for immediate expensing of capital expenditures, boosted investors’ outlook for corporate earnings and improved credit fundamentals.

U.S. and global equities both rallied strongly during the quarter, with the S&P 500 gaining 6.6% and the MSCI EAFE index of non-U.S. developed markets posting a +3.7% gain in local currency terms. In the U.S., credit risk spreads declined, boosting the relative performance of corporate bonds versus U.S. Treasuries during the quarter. Most other fixed income spread sectors followed suit in outperforming Treasuries, which experienced muted returns in response to pressure from the Fed’s December hike and faster than expected economic growth.

Figure 2 | Capital Goods Shipments and Business Development2

GDP Growth For Selected Developed Economies

Steady-On Fed Raises Policy Rate as Expected in December

As expected, the Fed raised its policy rate by 25bps at the final FOMC meeting of the year in December. Emboldened by recent strong GDP growth, continued labor market gains, ebullient equity markets, and the prospect for fiscal stimulus from tax cuts on the immediate horizon, the rate hike decision faced little controversy overall. Market reaction to the rate hike was muted. Over the quarter, front-end interest rates rose to price-in the Fed hike, while yields on intermediate maturities were less affected. At the long-end (30-year maturity), yields actually declined.
As a result, the yield curve flattened during the quarter, continuing a year-long trend.

Consistent with prior releases, FOMC members’ December forecast for the forward path of the policy rate calls for three hikes in 2018, putting the policy rate at 2.125% by end-December 2018. The market, meanwhile, looking at Fed Funds futures, is priced for two hikes and roughly a 40% probability of a third hike.

With the U.S. economy at full employment, we believe that upcoming inflation readings are likely to be more important than the pace of incremental job gains or GDP growth rate in terms of the Fed’s rate hike decisions this year. If inflation measures show signs of building price pressures, the Fed could easily feel emboldened to hike more aggressively than the market currently expects.

Figure 3 | Fed Funds Futures - December 2018 (%)3

Federal Reserve Balance Sheet

Looking Ahead

 

Measures of consumer spending and business sentiment point to another strong growth quarter in Q4, possibly as strong as 3.0-3.25%. Tax cuts seem likely to add modestly to the already strong pace of growth in the U.S.

 

With the U.S. economy at full employment, inflation readings will likely be more important than the pace of hiring or the level of GDP growth for the Fed’s rate hike decisions this year. Recent inflation data suggests that disinflationary pressures from one-off factors may be moderating, revealing a stronger underlying core inflation trend.
On the cautionary side, the Fed’s gradual removal of policy stimulus (rates and balance sheet unwind) should temper growth optimism over the intermediate-term. By removing the shock absorber of excess liquidity, tighter monetary policy also creates the potential for higher market volatility going forward.

1. Source: Bloomberg, Bureau of Economic Analysis
2. Source: Federal Reserve
3. Source: 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. 2018 All rights reserved. ECON01082018