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United States / Analyst Insights
Q2 2018 Macroeconomic Update

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by Anna Amir, Rachel Hyland, Mario Ismailanji, Viraj D’Costa
Sep 07 2018

Inflation-adjusted Gross Domestic Product (GDP) grew at an annualized rate of 4.2% during the second quarter, up from 2.2% in the previous quarter, according to the Bureau of Economic Analysis (BEA). This significant growth is primarily the result of positive trends in personal consumption expenditure; net exports of goods and services; and increases in government consumption expenditures and gross investment. However, poor growth in gross private domestic investment, particularly from residential markets, has limited overall growth. Overall, real GDP increased 2.2% in 2017 compared with 1.6% in 2016. As growth has accelerated, consumer spending has continued to exert inflationary pressure, which is likely to support interest rate increases in 2018.

Consumer spending and labor

The US economy added a total of 157,000 nonfarm jobs in July, according to the Bureau of Labor Statistics (BLS). However, this increase is slightly below the projected average monthly gain of 203,000 new nonfarm jobs. This job growth coincided with a small decrease in the unemployment rate to total 3.9%. The labor force participation rate remained at 62.9% in July, which, in combination with the other jobs data, signals that there is still room for employment growth. Growth in the professional and business services sectors of the economy were particularly robust, but employment in commodity- and export-based sectors, such as mining and manufacturing, has begun to exhibit slow growth as prices improve. In July, professional and business services jobs grew 51,000 and manufacturing gained 37,000. The slight decrease in the unemployment rate and stable labor force participation indicate less slack in labor markets.  This was seen as average wages grew $0.07 in July compared with $0.04 in June. However, real wages decreased 0.2% in July, as real average wages remained unchanged coupled with a 0.3% decrease in the average workweek. Amid rising nominal incomes, personal consumer expenditure, which accounts for more than two-thirds of all economic activity, grew 0.4% in July. Despite real average wages remaining unchanged, overall consumer spending is increasing and supporting sectors of the economy that supply discretionary goods and services. The Personal Consumption Expenditure Price Inflation Index (PCEPI), the Federal Reserve’s favored measure of inflation, increased 0.1% in July and 0.2% when excluding food and energy prices. When considering the latest July data, the PCEPI exhibited a trailing 12-month 2.3% increase, slightly above the Federal Reserve’s target. However, when removing food and energy prices, the PCEPI increased 2.0% over the past year. As inflation continues to rise, the Federal Reserve is likely to continue to gradually increase interest rates in 2018.

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Fixed capital investment and construction trends

Fixed capital investment (CAPEX) also exhibited signs of growth, albeit slow in relation to previous levels. According to data from the Federal Reserve Bank of St. Louis, total private nonresidential fixed investment increased 2.6% to $2,789.9 billion in Q2 (latest data available). While this is slower than the previous quarter’s growth of 2.9%, the level of investment is up 8.3% from the same period last year. This significant increase in investment activity can be attributed in part to changes to the federal tax code passed in 2017 and enacted at the start of 2018.  The Tax Cuts and Jobs Act is a sweeping tax reform reducing the potential tax liability for businesses enabling them to increase capital expenditure and other capital-intensive projects.

Construction spending is another method of analyzing nonresidential investment. Businesses often spend on building projects when they believe the revenue generated from new locations will remain profitable, indicating long-term trends for nonresidential markets. In June 2018, nonresidential construction declined 1.6%, which is the biggest decline since June 2017. This decline is most likely due to the implementation of steel and aluminum tariffs that have caused input prices for construction projects to increase significantly. Contractors and business may have decided to delay projects due to these increased costs. Over the second quarter of 2018, the largest decline in nonresidential construction was in the communications sector, which decreased over 10.0%. Conversely, conservation and development construction increased over 10.0% during Q2 of 2018.

Residential construction and housing activity has experienced similar trends to nonresidential construction. Housing starts fell sharply in the latter half of the quarter, falling 12.3% in June alone. Additionally, this represents a 4.2% decline from June 2017. Housing permits also fell in June, but by a much milder 2.2%. This caused housing permits to reach their lowest level since September 2017. However, when a six-month moving average is applied, the trend for housing permits is flattening rather than declining, indicating there is opportunity for a trend reversal. Similar to nonresidential construction, increased input prices, such as steel and wood, resulting from tariffs have been the primary reason for these declines. The increasing interest rate environment has also contributed to this decline as it places downward pressure on residential investment as mortgages become increasingly expensive.

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Financial markets and interest rates

Financial markets continued to perform well over the second quarter of 2018 as business investment activity continued to expand. However, the quarter was subject to increased volatility in the financial markets primarily due to macroeconomic developments in the domestic economy, as well as shifting geopolitics on the international stage. This includes changes to many trade policies, such as tariff implementation and retaliation. The instability of a pending trade war has many business and investors worried about future performance if the proposed tariffs are put into place. Additionally, some of the top performing stocks in the information technology sector experienced heavy scrutiny over data usage and protection of consumers. The market has continued growing despite these increased concerns, reaching a new all-time high in August 2018. This represents the longest bull market in history, running for more than 3,453 days.

Additionally, corporate earnings continued to grow on the back of the corporate tax reform that was put in place during the previous quarter. This helped to increase the number of Initial Public Offerings (IPO), an indicator of merger and acquisition (M&A) activity, which increased significantly during the early half of 2018. As of the end of Q2, IPO filing were up 42.9% compared with 2017, making this quarter the most active IPO market in more than three years. This growth is in both the value and the number of deals hitting the market as over 60 companies went public during the second quarter alone. This indicates that as the unemployment rate stays below the natural rate of unemployment and the US economy continues to grow, businesses may start to become less skeptical about prospects for growth.  

Interest rates continued to increase during the second quarter of 2018, as the Federal Reserve raised the federal funds rate in June and indicated that it might raise rates an additional two times in 2018. This signaled to many investors that the Federal Reserve felt confident about the economic outlook. Additionally, inflation hit the Federal Reserve’s 2.0% target during the second quarter of 2018, incentivizing further rate increases. This increase in the federal funds rate increased the yields on many of the US treasuries and corporate bonds. The yield on the five-year Treasury note rose 17 basis points to 2.73% while the 10-year Treasury note rose only 11 basis points to 2.98%. This concerned many investors in the fixed-income market as it indicates that the yield curve is flattening, which is typically the precursor to a market correction. Additionally, the tight labor market and rising inflation have many equity investors concerned that the Federal Reserve will continue to increase rates at a more aggressive level.

Sector Impacts: Construction, Finance and Insurance