Economic Outlook – 28 October 2018

US

• US real GDP topped consensus expectations and grew a solid 3.5% in Q3. The outturn represents a modest downshift from the 4.2% registered in Q2; however, the US economy continues to grow at a strong rate that is likely above the long-run potential rate. However, the recent solid pace of expansion will likely lead the Federal Reserve to continue raising rates at a gradual pace given the still-strong labor market and inflation steadily trending higher.
• US consumer and government spending remained strong in Q3, while fixed investment and net exports were a drag. Real personal consumption expenditures rose 4.0%, driven in part by the boost to disposable income that was delivered by reductions in personal income tax rates earlier this year. The effects of fiscal stimulus showed up in a 3.3% jump in government spending, the strongest sequential rate of growth in more than two years. An added boost was provided by a rebuild of inventories amounting to $USD76 billion, which added 2.1% to the overall GDP growth rate.
• Not everything in the report was positive. Fixed investment spending declined 0.3% on a dip in both nonresidential structures and residential fixed investment, which fell 7.9% and 4.0%, respectively. Deteriorating affordability and higher building costs may by exerting some drag on the housing market. Business spending was stronger elsewhere, as real spending on intellectual property grew 7.9% and spending on equipment edged up 0.4%. Net exports were also another area of weakness in Q3, shaving off 1.8% from the top-line GDP growth rate.
• The weakness in the US housing sector continued in September as new home sales declined 5.5% to a 553,000-unit pace. New home sales have fallen for five out of the past six months. The West registered a 12.0% drop, while the South posted a smaller 1.5% decline. Inventories rose for the sixth consecutive months to a 7.1 months’ supply, the highest since 2011. New home prices also dropped as the median price fell 3.5% year-over-year.
• US durable goods orders came in stronger than expected and rose 0.8% in September. Much of the gain occurred from a nearly 120% surge in defence orders. Aside from defence, orders were more modest. Transportation orders rose just 1.9%, while civilian aircraft orders dropped 17.5%. Orders for non-defence capital goods excluding aircraft fell 0.1%, the second consecutive monthly decline. Shipments of core capital goods orders have also stalled recently and have been flat in each of the past two months.
• US earnings reports for the third quarter have been solid, but top-line growth has slowed to 7.4% from last quarter’s 10% year-over-year growth rate. The revenue slowdown, combined with an increasing number of reports from companies that they are facing challenges from US and Chinese tariffs, rising wage and transportation costs, and headwinds from a rising dollar, investors are increasingly nervous that companies’ earnings have peaked for this cycle. The selloff in recent weeks has derated valuations, reflecting lowered expectations ahead. While slightly slower than last quarter’s pace, Q3 earnings are still running around 22.5% above year-ago levels.
• On Friday, the US Commerce Department reported its initial estimate that gross domestic product expanded at an annualised rate of 3.5% in the third quarter, slightly above consensus estimates and well above the 2.0% to 2.5% trend in recent years. The underlying data seemed to show consumer spending increasing at a healthy pace but due, in part, to a decline in the savings rate. Increased government spending also contributed. A dark spot in the report was a sharp slowdown in the growth in business capital expenditures, and more current data offer little evidence of a snapback. Improved business investment was a central goal of last year’s tax bill and will be key to improving productivity and accelerating US economic growth over the longer term.
• The US is refusing to resume trade talks with China until Beijing comes up with a formal proposal to address Washington’s concerns about forced technology transfer, intellectual property theft and other economic issues, The Wall Street Journal reported on Thursday. US president Donald Trump and China’s Xi Jinping are set to meet on the sidelines of the G20 Summit in Buenos Aires in late November but are unlikely to have a detailed trade discussion, the paper reported.
• US stocks endured another week of sharp declines. The S&P 500 and Nasdaq Composite Indexes joined the small-cap benchmarks in correction territory (down more than 10% from their recent peaks) last Friday morning. The narrowly focused Dow Jones Industrial Average avoided a correction and held up best for the week, but the Nasdaq was the sole major benchmark to end Friday still ahead for the year to date. Within the S&P 500 Index, the defensive consumer staples, utilities, and real estate sectors performed best, while energy shares suffered the largest declines. Trading volumes were elevated for much of the week, and the Cboe Volatility Index (VIX) reached a new multi-month high.
• US investment-grade corporate bond spreads drifted wider as equity volatility contributed to softer sentiment. The firm’s fixed income traders observed that many investors sold into strength after recent strong performance and that buying by overseas investors was mainly focused on longer-term securities. New issuance was well short of expectations, a trend that is expected to continue in the near term if market weakness persists.In the US this week, the most important release is the job reports for October, which is due out on Friday. Non-farm payroll is expected to rise by 190,000 (in line with the current trend). It seems the tighter labour market is beginning to put upward pressure on wage growth.
• On Thursday, ISM Manufacturing data is due out. The index has been too high compared to reality for the past couple of years and, therefore, PMI seems to be a better indicator for manufacturing.

UK

• The Monetary Policy Committee (MPC) of the Bank of England (BoE) will meet on Thursday, November 1, with its decision due to be released at 13:00 CET. The last Inflation Report of 2018, with updated forecasts and a new assessment by the MPC, will also be published on that day alongside minutes from the monetary policy meeting. At its August meeting, the MPC decided unanimously to raise the policy rate to 0.75% from 0.5%. At its September meeting, the MPC reiterated the message from August; that and ongoing tightening of monetary policy over the forecast horizon would be appropriate provided that the economy developed broadly in line with the BoE’s projections. In August, the conditioning path indicated two more policy hikes by the end of 2020. However, regarding Brexit, the MPC noted in September that there had been indications of greater uncertainty about future developments in the Brexit withdrawal process. The MPC underlined that its outlook for the UK economy and expectations for further monetary policy tightening, hinged upon the assumption that the Brexit adjustment process would be smooth and orderly. Since the September meeting, the Brexit outcome has certainly not become any clearer.
• With negotiators from the United Kingdom and European Union unable to agree on the Irish border, there appears to be a growing likelihood that the UK will seek an extension to beyond 2020 of the transition period in which the UK remains in the EU customs union. In fact, a leaked document from May’s cabinet suggests the transition period may last through the end of this Parliament in 2022, if not indefinitely.
• British households enjoyed faster wage growth in the year to April but, when adjusted for inflation, earnings are still below their levels before the financial crisis a decade ago, an annual survey showed on Thursday. Median full-time weekly earnings increased 3.5% in the year to April 2018, the strongest growth in nominal terms for 10 years, the Office for National Statistics said in its Annual Survey of Hours and Earnings.
• In the UK, the most important event this week is probably the UK budget on Monday. PM Theresa May’s supporting party the DUP has previously threatened to vote down the budget (which is against the vote and supply deal after the election) if the UK government is set to make any kind of border control deal between Northern Ireland and Great Britain as part of a future withdrawal agreement with the EU.
• No policy changes are expected from the Bank of England (BoE) on Thursday. Attention is on the accompanying Inflation Report, the minutes and Governor Mark Carney’s press conference. It is unlikely the BoE will find it necessary to send a more hawkish signal to the markets at this point although it remains a possibility given wages are growing at the fastest pace in this cycle (3.1% year-on-year). Inflation and unemployment are in line with projections while GDP growth has been revised lower.

EU

• As highly expected, the ECB’s policy meeting contained little news compared with the September meeting. Hence, the overall message of the banks’ normalisation intentions was unchanged, with the prospects of QE purchases ending at year-end and unchanged key ECB rates until at least through the summer of 2019. The December policy meeting will likely be a bit more interesting, as updated ECB forecasts on growth and inflation will be shared.
• The October flash composite PMI index disappointed as it decreased to 52.7 from 54.1 in September. This was much weaker than expected and brought the index to a 25-month low. Hence the index suggests that Q4 activity started out on a weaker footing after a period of stable readings for the past five months.
• Rewrite your budget or face heavy fines next year, European Union officials have told the Italian government. The rejection of the draft budget was a first for the EU, which called the spending blueprint too risky given it’s 2.4% of GDP deficit coupled with a 130% debt-to-GDP ratio. Italy has three weeks to rewrite the plan, but leaders of the populist coalition ruling the country show no signs of backing down, though they did reject any talk of Italy leaving the euro.
• On Tuesday, the euro area preliminary Q3 GDP numbers will be released. Quarterly growth rates slowed down to 0.4% quarter-on-quarter in H1 2018 and a similar pace of expansion is expected in Q3 18. A component breakdown will not be released, but growth in Q3 is expected to have been mainly driven by domestic demand.

China

• China’s main stock market indexes posted a weekly gain, but the yuan flirted with a 10-year low against the US dollar on Friday, as trade tensions stoked bearish bets against the currency. The Shanghai Composite Index added 1.9% for the week, while the CSI 300 Index (a gauge of large-cap stocks) ended up 1.2%. The latest gains came one week after the Shanghai Composite Index and CSI 300 sank to their lowest levels in four years and two years, respectively, amid signs of slowing domestic growth and the trade impasse with the US.On Friday, the yuan nearly touched a 10-year low in onshore market trading (which is regulated by Beijing) before ending roughly flat. After the recent months’ declines, the exchange rate is now on the brink of hitting 7 yuan per US dollar, a psychologically key threshold not seen since the global financial crisis. China keeps a close eye on the yuan-dollar exchange rate, partly because a sliding currency could lead to domestic businesses and individuals rushing to send money out of the country.
• In China this week, focus turns to industrial profits (Saturday) and manufacturing PMI (Wednesday/Thursday). The PMI manufacturing from Caixin will be followed closely as it dropped to 50 in September and a further decline will take it below the 50-level. This would in theory indicate contraction and could grab some headlines. However, when PMI fell below the 50 line in 2017, industrial production was still growing around 6.0% year-on-year. Industrial profit growth fell to 9.2% year-on-year in August and they are expected to stay within the 5.0% to 10.0% range in coming months. It is close to the average of the past six years.

Sources: Wells Fargo, T. Rowe Price, Reuters, Danske Bank, MFS Investment Management.