After an historic U.S. government shutdown, we are pouring through backlogged data. Many reports have missed consensus estimates, stoking fears that Wall Street may be overlooking a slowdown in the U.S. economy.
Since consumer spending accounts for about 70% of gross domestic product (GDP), the best gauge of output is the U.S. consumer. While a healthy job market and solid wage gains are more conducive to consumer activity than at any other point in this economic cycle, a wave of negative headlines has hampered spending as of late. December’s retail sales unexpectedly fell 1.2% year over year, the worst drop since September 2009 and far below consensus estimates for 0.2% growth.
Some economists have questioned the report’s accuracy, but consumer confidence has dropped sharply over the past few months, so lower spending is somewhat warranted. Trends in retail sales have historically been tightly correlated with longer-term GDP growth. Year-over-year retail sales growth has slipped noticeably since July 2018. Since the latest retail sales report was released, consensus expectations for fourth quarter GDP have dropped to 1.5–2.5%. If GDP growth comes in at the lower end of that range, it would be the slowest quarter of growth in three years. Slowing growth is expected this late in the cycle. Quarterly GDP growth this year will be less than the 3% growth we saw last year. However, the odds of a recession remain low. With fiscal stimulus still in play, the government shutdown drama resolved, the Federal Reserve (Fed) on hold, and a strong rebound in equity markets, consumer spending is likely to improve. We’ll be monitoring this week’s GDP report for more clues on the factors driving output growth.
U.S. companies are wrapping up another earnings season of double-digit profit growth. Business’s top- and bottom-line health appears solid, but the corporate outlook is dimming. Gauges of business optimism have declined, first-quarter profit expectations have dropped at an above-average rate, and companies have put expansion plans on hold as they wait for a resolution to global headwinds. We’ve been especially discouraged by recent data showing tepid growth in capital expenditures, as stronger growth in business investment is crucial this late in the expansion. Higher capital investment boosts productivity, which effectively caps labor costs and helps support profit margins. The latest durable goods report showed growth in new orders of nondefense capital goods (ex-aircraft), the best proxy for capital expenditures, unexpectedly fell 0.7% month over month. Part of the recent drop could be from waning overseas demand, which has weighed on global manufacturing, but declines in other corporate-focused reports show domestic corporate appetite has taken a hit, too. We expect business spending to pick up somewhat once corporations get more clarity on trade and helped by aspects of the Tax Cuts and Jobs Act designed to encourage business investment. However, we likely have seen peak earnings growth this cycle, and a lower GDP for 2019 is partially due to muted capital expenditures in the second half of 2018.
Inflation data have been under a microscope recently as investors have tried to reconcile evidence of a slowing global economy with cycle highs in pricing and wage growth. Financial markets’ inflation expectations have fluctuated this year after investors interpreted the Fed’s patient policy approach as a sign policy makers do not want to stifle growth by raising rates at the pace seen in 2017 and 2018. While the Fed has likely paused, we think any future rate hikes will be primarily in response to upside inflationary risks. Data released this month showed the core Consumer Price Index (CPI) rose 2.2% year over year in January, while the core Producer Price Index (PPI) climbed 2.8%. To us, current core inflation, which strips out the impact from food and energy prices, is manageable enough that it will not force the Fed’s hand into additional policy tightening in the near term. We expect slightly higher (but manageable) inflation in 2019 amid a tight U.S. labor market, a flexible Fed, and prospects for moderate output growth, especially if near-term headwinds subside. Core CPI has hovered around 2% for the bulk of this tightening cycle as quarterly GDP growth has averaged slightly above 2%, which aligns with the Fed’s 2% growth target for core personal consumption expenditures inflation.
Investors have been understandably skittish about the economic environment these days. Even if we do not slip into a recession, slowing economic growth is usually a headwind
for equities.
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- Data provided by LPL Financial.
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