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Is the U.S. at its peak?

Picture Of United States Flag

Ten years after the global financial crisis, it is safe to say that the U.S. has come out in a far stronger position than most other major economies. Output is up 23% from the 2009 gutter, while there are over 20 million more people in the workforce. Inflation is in line with the Federal Reserve’s mandate, interest rates have increased, the central bank’s balance sheet is being decreased and the dollar is in its ascendancy. 2018 has been a rather good year, with the U.S. economy likely growing at the fastest rate for 13 years and the unemployment rate falling to a 49-year low. Realistically, how long can this continue?

In the near-term, the story remains very positive. There is broad-based momentum in the economy with huge tax cuts providing additional thrust. Given this situation, the Federal Reserve chose to raise its policy rate in each of the first three quarters of the year with another rate rise looking highly probable in December. After all, the economy is booming, inflation is at or above the 2% target on all the key measures and the jobs market is finally generating wage pressures.

However, the U.S. economy will face increasing headwinds in 2019 as the lagged effects of higher interest rates and a stronger dollar act as a brake on activity. The support from the fiscal stimulus will also gradually fade, with the split Congress mid-term election results limiting the chances of additional significant tax cuts or spending increases. Then there is the weaker global growth outlook, with Europe and Asia seeing clear signs of slowdown. Intensifying trade protectionism could exacerbate the softening trend.

Some positive signs

Furthermore, corporation tax cuts do not appear to have yielded the results in terms of domestic investment that President Trump had been hoping for. Instead, a significant amount of those tax cuts appear to have been used to fund share buybacks and special dividends. Additionally, the recent spell of equity market weakness isn’t going to be helpful for business sentiment with regards to investment programmes.

That being said, it is important to point out that there are positives. Wage growth has broken above 3% year-on-year and we think there is more upside ahead given the tightness of the labour market. Indeed, the National Federation of Independent Business (NFIB) survey suggests that companies are finding it increasingly difficult to find labour and are consequently increasing compensation. Also, the Federal Reserve has noted greater competition on benefit packages including healthcare, vacation days and signing bonuses. Should wages continue rising, consumption will be supported while adding to medium-term inflation pressures.

Outlook for Fed policy

The latest comments from Powell suggest the central bank is closing in on neutral policy whereas back in September he mentioned that their policy is accommodative. The criticisms of the Federal Reserve policy stance by President Trump, combined with what appears to be a toning down in Powell’s comments regarding the monetary policy stance, mean that markets are only pricing in two rate hikes by the end of 2019.

It is estimated that growth will slow to around 2.4% in 2019, but inflation will likely persevere above target for much of the year thanks to those wage increases and the prospect of higher imported costs. As such, it is expected that interest rate rises will continue in 2019.

As for the risks for 2019, they seem skewed to the downside. Trade tensions persist given that China seems to be digging in with a three-pronged strategy of fiscal stimulus, looser monetary policy and a weaker yuan. This doesn’t suggest China is about to come to the negotiating table and offer the allowances President Trump desires on trade access and intellectual property rights. Indeed, tariffs on Chinese imports are likely to be raised and broadened in 2019 even though they have a 90 day break.

Moreover, should relations worsen markedly, China could use the U.S.’s deteriorating fiscal position and the fact the Federal Reserve is running down its balance sheet as a way of fighting back against the U.S. administration. China holds 20% of U.S. Treasuries, and while it won’t sell those holdings, it could well choose not to turn up at future Treasury auctions. Given China is typically such a huge buyer, this could mean a failed auction. The result could be a spike in yields, which would have ramifications for U.S. equities and furthermore, the U.S. economy. Domestically, tensions could remain high. The Democrats having obtained the majority of the House of Representatives means that President Trump’s legislative agenda is likely shortened and there is risk of government shutdowns as legislators battle over the budget and potentially, the debt ceiling. Forging a bargain seems unlikely at the moment but it is not beyond the realm of possibility as he seeks re-election in 2020. An outcome like that would be a positive surprise and should lead to growth and employment.

The Calamatta Cuschieri Traders Blog is available daily on CC WebTrader. Other market coverage including coverage of the International Bond Markets is also available.

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