Closing Brief: Bailard’s View on the Economy and Market Performance

Art Micheletti, CFA, Economic Consultant*

June 30, 2019

U.S. Economy

U.S. economic activity appears to have deteriorated in the second quarter of 2019: the Bloomberg Consensus forecast is currently projecting 1.8% annualized growth and the Atlanta Fed GDP Now Model improved to 2.1%. Both projections are well below the first quarter pace of 3.1%, where real growth was boosted by a sharp drop in the GDP deflator from 1.9% to 0.5%. With energy prices rising again the headline inflation indicators are likely to rise and slow future real growth.

Since the 2016 presidential election, growth has been steady around 2.5%, supported by the 2018 tax cuts. This is about 0.5% more than the 2% growth rate during President Obama’s eight years. As the benefits of tax cuts fade, we expect to see growth moderate again. As of May, 2019, real consumer income was growing at a 2.2% annual pace. Employment growth held steady at 1.5% year-over-year and real average hourly earnings were up 1.1%, but the work week has declined 0.3%. Real personal consumption has continued to rise faster than income, as the consumer dips into savings and takes on more debt.

Corporations used the 2018 tax cuts to boost dividends, buybacks and mergers. Beyond that, corporations went further into debt; in fact, the Federal Reserve’s Financial Stability Report (May 2019) noted that corporate debt is historically high relative to GDP. Further,

the riskier firms—those with signs of deteriorating credit—have been experiencing the greater increases in the corporate debt-to-GDP ratio. Capital expenditures have dropped year to date through April, which is concerning as increasing capital expenditures indicate

investment in future growth.

The manufacturing sector has been trending weaker as auto sales remained soft and the aircraft sector is feeling the impact of Boeing’s distress. Weakness can also be seen in the purchasing managers survey, as reported by the IHS Markit US Manufacturing Purchasing

Managers Index (PMI). The Index fell to 50.1 in June, a crucial inflection point. A PMI of 50.0 or greater signals growth, while a PMI of less than 50.0 indicates contraction. Residential construction has been down for four straight quarters and the sharp drop in mortgage rates

has yet to provide much of a boost to home sales. New home sales were down 3.7% year-over-year in May, while existing home sales were down slightly less at -1.1%. As mortgage rates decline, this could be one sector that helps upcoming growth.

Inventories have been building for three quarters, which has helped boost GDP growth by an additional 0.5% over the last year. With growth slowing faster than inventories, this accumulation appears to be involuntary and will likely weaken growth going forward

as those inventories are worked off.

Net exports are likely to be a drag in the second quarter, after they had added 1.0% to growth in the prior quarter. As trade tensions escalated earlier in the year, China and the U.S. both increased trade to beat the tariff deadline. Going forward, if the trade war with China

is not resolved, it is likely to negatively impact growth.

With growth slowing, the Federal Reserve has moved toward a more dovish view. Most economists predict two to three more interest rate cuts in 2019. The big question is how effective Fed policy will be when started from such a low level. The Fed has much further

to go to catch up with negative short rates in Europe and Japan, both of which have continued to struggle economically suggesting ineffective monetary policy.

For now, we see continued slow growth and would like to see it bolstered by broad stability in the near-term.

International Economies

China

China’s GDP growth continued to slow through early 2019 and into the second quarter. GDP slowed to 5.6% annualized growth in the first quarter and the year-over-year pace decelerated to 6.4%. The Li Keqiang Economic Index (named after Premier Li Keqiang) is considered a more accurate measure of GDP because inputs are less easily manipulated. The Index measures electricity usage, rail freight volume and credit growth. As of May, the Index continued to trend lower and the current reading is consistent with 6% growth, well below the 9% average growth rate China has enjoyed since 2005.

Coincident indicators such as retail sales, industrial production and capital spending have all been trending lower. Leading indicators such as the Markit Manufacturing Purchasing Managers Index (PMI) point to continued weakness as the impact of the trade war takes hold. The PMI fell to 49.4 in May, below 50 and into negative territory.[EMR1]

Recent weakness is partially due to the trade war but also due to the mid-2016 monetary policy shift from stimulus to austerity in response to a rapid buildup in debt along with concerns about speculation and financial risks. Monetary policy has recently shifted back to providing more liquidity. The question going forward, like everywhere else, is: will monetary policy be less effective with interest rates so low? So far, China’s stimulus has underwhelmed the financial markets as the focus remains on trade.

Japan

Japan’s economy unexpectedly grew at an annualized 2.2% pace in the first quarter, pulling the year-over-year growth rate up to 0.9%. Unfortunately, the gains were for the wrong reasons. Both imports and exports fell, with imports falling faster than exports, which

created a positive shift in the trade balance. But falling exports reflect weaker global growth and falling imports indicate weaker domestic demand. Domestic the demand continued to cast a shadow over the economy, with private domestic demand increasing only 0.4% and consumer spending decreasing 0.4% (both quarter-over-quarter, annualized). While generating a short-term positive impact on GDP, trade is likely to be a drag in coming quarters as global tensions have escalated.

Capital spending and public investment ahead of the 2020 Summer Olympics in Tokyo also provided a temporary boost to GDP. While inventories have continued to grow (and are over three times higher than one year ago), the coming inventory reductions should be a drag on growth going forward. With that, the consensus forecast predicts flat growth through the rest of 2019.

Capital spending and public investment ahead of the 2020 Summer Olympics in Tokyo also provided a temporary boost to GDP.

Europe

European growth improved in the first quarter, to 1.6% following two quarters of less-than-1% growth. Yearover-year growth remained stable at 1.2%, and appears to be locked on a slow growth path.

Leading indicators—such as the Markit Manufacturing Purchasing Managers Index—have fallen into contraction territory and coincident indicators are showing signs of weaker growth in the second quarter. Real retail sales growth slowed to a 1.5% pace year-over-year in April, as sales declined for the second month in a row. Real industrial production also declined for three months in a row, pulling the year-over-year rate of growth down to -0.4%, as of April, 2019. The European Union trade surplus with non-European countries continued

to trend lower, further contributing to slower growth.

The consensus outlook for 2019 has been steadily declining for the Eurozone, with expectations of 1.2% growth for the full year. After a strong first quarter, this pace would indicate lower growth expectations for the remainder of the year.

The start of the third quarter brings plenty of uncertainties for the region. Besides tensions between the U.S. and China, there are a number of uncertainties that lie ahead, including: if the U.S. settles with China, will trade focus go back to Europe? And, a new European Central Bank (ECB) president will replace current president Mario Draghi with limited firepower remaining. Tensions with the ECB surrounding Italy’s budget, and political instability surrounding Italy’s coalition government are not going away. The UK will appoint a new Prime Minister after leadership races in July, with Boris Johnson being the favorite to be appointed; this suggests rising risks leading up to the current Brexit deadline of October 31st.

*Editor’s Note: As of June 30, 2019, Arthur A. Micheletti, CFA retired from Bailard, and now serves as an economic consultant among Bailard’s deep bench of research professionals.