- U.S. first quarter real GDP was revised upward to 1.1% and the second quarter is projected to be at or around 2.5%. This means the economy was growing at an annualized rate of 1.8% for the first half year. Depending on how the second half performs, the economy is probably on track for around 2% this year. This assumes no significant policy changes in Washington, such as infrastructure spending and tax reform.
- Good news remains in the labor economy with U3 down to 4.4% and U6 dropped to 8.6%. Even at the 62.8% participation rate, it is hard to argue that there is much labor slack remaining. Although wage growth has not been obvious, the Employment Cost Index (wage and benefit cost) is now growing at 2.9% while the average weekly earnings is at 2.5%. Both are now above the inflation rate.
- The Federal Reserve has definitively moved from a dovish bias to a normalization bias. The FOMC is expected to raise rates three times this year, and the market expects the next hike to be in December. The FOMC is positive about the U.S. and global economy, positive about the labor economy, confident with the core inflation returning to 2%, confident with the strong banking system, and more able to act under a supportive financial condition environment in the market, but the pace is expected to remain accommodating in supporting its dual mandates.
- The FOMC is expected to embark soon on its efforts to normalize the Fed’s balance sheet by not reinvesting all the principal payments from agency debt and MBS and not rolling over maturing Treasury securities at auction. The June FOMC meeting provided an updated guidance and framework of how the FOMC will use an escalating cap system to shrink its balance sheet over time. This process would be gradual and over an extended period. The market expects the normalization to begin this September.
- CPI and Core CPI have taken a surprising turn downward and away from the 2% inflation target, but the FOMC expects the causation to be transitory. The FOMC’s long-term outlook for inflation remains higher than the market expectation as evidenced by the 5- year, 5-year forward inflation expectation value, as well as the 10-year forward inflation estimate comparing the 10-year treasury yield with 10-year TIPS. Historically, the market has proven to be correct about a lower interest rate with a lower inflation rate, and the FOMC had to repeatedly revise its projection towards the market expectation. This remains a risk if this scenario changes.
- After almost a decade of unconventional and extraordinary monetary accommodation globally, investors and markets have gotten complacent with and reliant on the central bank’s safety net. The normalization phase would likely be tricky and sooner or later will witness financial conditions tighten, adding stress to the system. This would be that much more exaggerated if ECB and other central banks also begin to normalize. Regardless of the gradual pace of balance sheet and rate normalization, the market is always looking out to the destination and is less concerned about the path.
- The world has dodged a bullet in Europe after the Brexit Referendum with the outcome of a string of Europe elections not favoring the breakup of the eurozone and the euro under populism. This has helped to reduce political risk and uncertainty in the eurozone and added support to a cyclical economic rebound.
- In our last quarterly commentary, we compared the forward looking soft data against the backward looking hard data. It was clear at the time that consumer and business sentiments were buoyant with high expectations of new initiatives from Washington that would lift the economy for years and such excitement was not reflected in the hard data. At the time, we were skeptical that the sentiment would be translated into hard data in the next few quarters. Since then, the soft data has turned down and the IMF has just revised down U.S. growth for 2017 from 2.3% to 2.1%, and in early June, OECD also revised down U.S. growth to 2.1%.
- In the U.S., the Trump reform agenda is not likely to be realized this year. This is further complicated by the looming debt ceiling and the 2018 budget negotiations which exaggerate the differences in ideology among Republicans and Democrats. To further incite the bipartisan roadblock is Trump’s style and the never ending Russian investigations. Risk may be rising from here forward for markets and the economy.
To read the complete 2nd quarter commentary, please click here.