US Economic Update - Modest gains ahead, middle market continues to outperform

U.S. economic growth remains on track to expand by our forecast of 1.9 percent in 2017. The economy in the first quarter expanded at a 1.4 percent rate while growth in the second quarter is on track to increase by a more robust 2.5 percent. We anticipate solid, if unspectacular growth in the second half fueled by solid consumer spending, which is on track to increase by 3 percent in the second quarter and just under that throughout the remainder of the year.

A mild housing recovery appears to have stalled on the back of tightening lending standards and supply constraints, with housing starts increasing at a 1.25 million unit pace on an annualized basis. The manufacturing sector continues its modest rebound, with risks being the slowing demand for autos and the impact of the U.S. dollar appreciation on exports. These two areas of the economy represent the major domestic risk to the outlook. Given that this is the ninth year of the cyclical expansion, these two sectors demand close monitoring heading into 2018.

On a more encouraging note, the labor market continues to thrive and the probability of a recession is quite low at around 15 percent. The unemployment rate declined to 4.3 percent in June with job growth averaging 162,000 new jobs per month after averaging 181,000 per month during the past 12 months. Given the underlying labor dynamics, it wouldn’t be surprising to see a slower pace of monthly job growth even as the unemployment rate declines toward 4 percent by the end of this year.

Meanwhile, wholesale and retail gasoline prices have fallen to 2017 lows just as the summer driving season gets underway. Lower retail gasoline prices indicate the potential for a strong domestic vacation season supporting sales for restaurants, hotels and entertainment establishments, which will in turn bolster overall consumption and economic growth in the current quarter.

We remain cautiously optimistic on the tentative rebound in fixed business investment, which expanded 3.7 percent on a year-ago basis and which should increase 5.5 percent through the middle of the year.
RSM’s Middle Market Business Index jumped to a cyclical high of 132.9 in the second quarter with expectations on gross revenues, net earnings, hiring and compensation posting fresh highs.

The policy outlook: Pulling back on great expectations
Thus far there have been few substantive policy reforms other than the rollback of regulation impacting the energy distribution infrastructure. At this point, it’s highly unlikely any substantive policy reforms—health care, tax and infrastructure—will be accomplished this year. While an improved earnings outlook has bolstered the real economy and equity valuations, if no meaningful tax reform is implemented this year it wouldn’t be surprising to see a retracement of recent gains in business optimism and equity prices. If, however, the Trump administration and GOP are able to get past the Affordable Care Act replacement and push on for meaningful tax cuts and reform, middle market businesses should anticipate demand to pull forward from 2018 on expected increases in after-tax income moving forward.

Financial conditions: Supportive of improved growth
Financial conditions in the United States, including technology and housing, stand at 1.84 standard deviations above neutral, which is a function of rising stock market and housing prices and is supportive of growth. Foreign capital flows into fixed income markets have driven the U.S. 10-year Treasury yield 2.1 percent from 2.4 percent despite two rate increases by the Federal Reserve during the first six months of the year. We expect the Fed will begin to draw down its $4.5 trillion-dollar balance sheet at the September meeting and hike another 25 basis points at the December meeting. The U.S. dollar measured against a trade weighted basket has declined 3.4 percent this year, mostly due to a nascent global economic recovery.

Given that fiscal stimulus doesn’t appear to be on the horizon, the Fed has an enormous amount of room to respond to any exogenous shocks to the economy by slowing the pace of policy normalization.

Published in: RSM's The Real Ecomony - July 2017