Economic Outlook – 7 October 2018

US

• Fed Chairman Jerome Powell has used a variety of superlatives to express his pleasure with the current state of the US economy. Powell believes the economy is in a good place, with exceptionally low unemployment and inflation close to target. With inflation expectations in check, the Fed continues to believe it can gradually nudge interest rates higher. A growing chorus of Fed officials is also beginning to question what full employment actually is, suggesting policy will likely remain on its current track even if the unemployment rate falls below the Fed’s expectations.
• The ISM manufacturing survey fell 1.5 points to 59.8 in September but has been hanging around the 60 level in recent months and remains slightly above average for the year. Any reading above 50 means that more manufacturers see business conditions improving than see them worsening. At the current level, the ISM index would be consistent with GDP growth in the 5% range and strong industrial production growth.
• The ISM non-manufacturing index climbed 3.1 points to 61.6 in September. Business activity rose 4.5 points to 65.2 and the closely watched employment index jumped 5.7 points to 62.4. The surge in the employment series raised expectations for the September jobs report, particularly since it was accompanied by more good news from the ADP employment survey, which reported a gain of 230,000 jobs in September, and weekly unemployment claims, which fell back to the lowest levels since the late 1960s.
• The actual number of jobs created for September came in short of expectations, with payrolls adding just 134,000 jobs. Employment growth for the prior two months was revised higher by 87,000 jobs, which brought the three-month average up to 190,000 jobs. The shortfall in non-farm jobs appears to be partly due to estimates of how Hurricane Florence impacted employment. Employment at restaurants tumbled by 18,200 jobs, and 20,000 jobs were lost in retailing.
• US, Mexico and Canada have reached a last-minute deal for a successor to the tri-country NAFTA pact. The US-Mexico-Canada Agreement (USMCA) marks a new era for trade among the three countries. It also means the US will no longer be fighting a trade war on multiple fronts. The trade brawl is now primarily between the US and China, with no clear end in sight. The White House is determined to rewrite trade flows, and has not been shy in using tariffs to this end. While their deficit with Canada has been declining, their deficit with Mexico is nearing historic highs, and that with China has worsened despite tariff measures. It remains to be seen if the latest tranche of tariffs imposed on China are up to the task of “correcting” this perceived imbalance and how it will impact growth. There are still vital steps ahead for USMCA implementation, but the agreement in principle allows auto manufacturers in all three countries to breathe a sigh of relief. The deal, however, may raise US vehicle prices in the future given new provisions on wages for auto-workers.
• The unemployment rate, however, continues to impress, falling to a near half-century low of 3.7%. In response, 10-year Treasury yields breeched 7-year highs (above 3.2%) – cementing increases posted earlier in the week on similarly strong ADP employment data. All in all, the US economy remains a force to be reckoned with and poised for above 3% growth in Q3.
• Last Wednesday, the US Senate voted on a measure to reauthorise the Federal Aviation Administration for five years in an attempt to counter China’s growing influence on major infrastructure and development projects. The new agency would have broad authority to offer countries financing options for such projects, which would put the US in competition with China. The measure came about in response to concerns over the scale of China’s goals around restructuring global trade routes.
• The major benchmarks ended lower, with the large-cap indexes holding up substantially better than the technology-heavy Nasdaq Composite Index and the smaller-cap benchmarks. Trading volumes were elevated, especially later in the week, and the Cboe Volatility Index (VIX) jumped to its highest level since April. Within the S&P 500 Index, energy shares were among the best performers, boosted by a rise in oil prices as traders braced for the implementation of new sanctions on Iran in early November. Financials shares also outperformed, helped by a surge in longer-term interest rates, which bodes well for bank lending margins. Utilities stocks, which typically perform poorly as rates rise, were among the week’s best gainers as they seemed to benefit from a general migration to more defensive stocks. The strong relative performance of the three sectors helped slower-growing value shares easily outperform higher-valuation growth stocks.
• Investment-grade corporate bond issuance was in line with expectations. A highly anticipated new deal from Comcast to fund its acquisition of Sky received strong interest. Credit spreads – the additional yield offered over Treasuries with similar maturities – ended the week little changed after a mixed week in terms of spread movements.
• On Thursday, CPI data for September is due for release and the core index is expected to continue to rise around 0.2% month-on-month.

EU

• European stocks followed US equities lower amid a rise in global bond yields and continued worries about the Italian government’s spending plans. For the week, both the pan European STOXX Europe 600 Index and the FTSE MIB Index dropped 1.8%. Italian banking stocks traded near their lowest levels of the year amid worries that Italy’s sovereign debt would be downgraded. Fresh concerns about Greek banks also pressured European banking shares, with the EURO STOXX Banks Index down 1.4% for the week. Investors grew increasingly concerned throughout the week that Greek banks might need fresh capital injections to handle their mountains of bad loans. Greece left its eight-year long bailout program in late August and recently submitted ambitious new plans to reduce bad loans to the banking supervision unit of the European Central Bank (ECB).
• Italy set budget-deficit targets for 2020 and 2021 at 2.1% and 1.8% of GDP, respectively, lower than the previously anticipated 2.4% deficit targets for both years. The government still plans to move ahead with the 2.4% deficit for 2019, pending the approval of European authorities. The lower target levels for 2020 and 2021 suggest that Italy is taking a more practical position after investors began to sell off Italian assets upon news of the government’s initial budget plan. Currently, Italy’s debt stands at around 130% of GDP, the second-highest level in the eurozone, following Greece.
• On Thursday, the ECB minutes from the September meeting will be released. Since the meeting, central bank communication has been less dovish, so the assessment of the underlying inflation dynamics and in particular wage growth are of particular importance. Wage growth played a central part in the meeting in September.

UK

• The UK Manufacturing PMI increased to 53.8 in September from 53.0 in August (revised from 52.8). The outcome was quite a bit stronger than the consensus expectation of 52.5. Sentiment was pulled higher by improving growth in both output and new orders. The increase in new orders came as export orders, which saw a huge drop in August, regained some of the lost ground. Growth in domestic orders also saw some improvement. According to the survey, output growth improved due to an increased inflow of business, rebuilding of inventories and efforts to clear backlog of work. That said, the backlog of work fell for a ninth successive month. Employment growth increased somewhat compared with August, but remained rather subdued, as job growth at SMEs offset cuts at large-scale producers. The September survey also signalled a pickup in both input and output price growth, indicating that cost pressure remains elevated. Firms noted that the exchange rate, supply shortages and global inflationary pressure have led to cost increases. Business optimism improved from August to September, but remained below the historical average. Some companies noted that Brexit and exchange rate movements made forecasts less certain.
• British workers’ productivity grew at the fastest pace since late 2016 in the three months to June and labour cost growth slowed, suggesting the home-grown inflation pressures that the Bank of England is watching closely remain muted. Output per hour rose by 1.4% compared with a year earlier, the biggest increase since the three months to December 2016, albeit a fraction below an initial estimate of 1.5%.
• Brexit continues to be a hot topic, in particular now that the Conservative Party Conference is over and PM Theresa May probably has more room to manoeuvre. The next EU summit takes place on 18-19 October and the EU27 leaders are meeting the day before for a working dinner with (among other things) Brexit on the agenda. The UK and the EU will negotiate heavily next week ahead of the EU summit. The Irish backstop remains the biggest obstacle for the withdrawal agreement at this point. The consensus opinion is the UK and the EU will reach an agreement eventually – the most difficult part is for PM Theresa May to get it through the House of Commons.

China

• In China, it is a quiet week, but the trade data may attract more attention than usual. The numbers will give further clues as to how much the exports are being hit by the trade war. Judging from PMI data, export orders have weakened quite a bit. It is partly due to slowing growth in other EM countries and Europe though. The numbers are expected to show weakness in both exports and imports. Speaking of trade, there is still uncertainty on whether Trump will enter what he has called ‘phase three’ and put tariffs on all of Chinese imports. There is a high risk he will do it but the timing is uncertain.

Sources: Wells Fargo, T. Rowe Price, Reuters, Handelsbanken Capital Markets, TD Economics.