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US Economic Outlook For 2018-2019

Despite buoyant short-term (2018-2019) outlook, fiscal stimulus is unlikely to spur growth to 3%

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The ongoing economic expansion should last for another two years - 2018 and 2019 (i.e. in the short run) - after the US economy grew by 2.3% in 2017 and ended that year on a solid note. Two factors are likely to underpin economic expansion in these two years and significantly spur US real GDP growth - solid economic fundamentals and a colossal pro-cyclical fiscal stimulus (comprising of US$1.5 trillion tax cuts (corporate and income tax) and marked increase in discre-tionary spending of US$300 billion over two years - 2018 and 2019). A long-term infrastructure plan might be forthcoming at the end of this year, which will add to the stimulus.

The vaunted goal of this stimulus is that the US economy should grow by 3% a year on a sus-tained basis. This seems an exercise in delusion, considering that the US economy is already run-ning near potential and productivity and labor force growth are likely to be insufficient to propel US GDP growth to 3% or above on a sustained basis. As a result, such a stimulus is likely to lead to large and chronic budget deficits (which is already at an elevated level - 3.5% of GDP in 2017 - and could rise above 5% of GDP in 2019 and in the following years) and higher inflation than expected - possibly prompting more aggressive monetary tightening by the Fed that could well tip the US economy into a recession in the medium term (3-5 years).

This is something that investors should be truly worrying about. I expect the yield curve to invert somewhere around early 2020 - which is usually indicative of a looming recession. Further, I ex-pect the stronger US spending spurred by the fiscal stimulus to fade away rapidly, which in turn is likely to result in growth slowing down substantially in the medium-term (possibly starting from around 2020) - along with a swelling budget deficit that will drain substantial amount of domestic savings. The US economy is projected to grow by only 1.8% in 2020 - according to CBO's latest ('The Budget and Economic Outlook: 2018 to 2028') projections. Further, the US yield curve is currently the flattest in a decade, which is indicative of subdued long-term eco-nomic growth prospects.

Returning to the short-term economic outlook, according to IMF's World Economic Outlook (April 2018), the US economy is projected to grow by 2.9% in 2018 and 2.7% in 2019. Further, CBO's latest annual growth projections for the US economy are 3.3% for 2018 (my own growth projection for 2018 is 2.8% - reasons are stated later in this article) and 2.4% for 2019 - which is significantly above potential (estimated at 2%). In terms of the short-term impact of the com-bined fiscal stimulus on growth, OECD (Interim Economic Outlook, March 2018) estimates this stimulus to increase US GDP growth by between 1?2-3?4% in both 2018 and 2019.

Having stated the above, my own economic analysis seems to suggest that the US economy is likely to grow by less than 3% in 2018 and growth while strong, will moderate to around CBO's latest projected growth rate (2.4%) for 2019. Though, I have detailed why I think so later in this article, briefly, this massive pro-cyclical fiscal stimulus (in fact fiscal profligacy) is being given to an economy which is already at an advanced stage of the business cycle - with historically low unemployment (4.1%, a 17-year low), elevated budget deficit (3.5% of GDP in 2017), public debt-to-GDP ratio (76.5% in 2017) and current account deficit (which rose to 2.6% of GDP in 2017Q4, compared to 2.1% in the previous quarter - according to BEA data) - and there is an on-going process of normalization of monetary policy by the Fed to ward of potential inflation.

As a result, the fiscal 'multiplier' is likely to be small and stoking of demand via a fiscal stimulus at this stage of the business cycle will boost inflation more than output. Consequently, not only is growth likely to be less than 3% in 2018, but there is a strong probability of growth moderating in 2019, relative to 2018.

Other factors, such as simmering trade disputes with China and other trading partners, widening budget and current account deficits (i.e. rising twin deficits) etc. - detailed later in the article - are likely to offset some of the positive impact of a fiscal stimulus on growth over the next two years. Consequently, I don't think there will be a surge in capital investments or consumer ex-penditure to the extent envisaged - which in turn should restrict growth in both these years.

With reference to solid economic fundamentals, briefly, the key positives for the US economy are: underlying strength of consumer spending (which grew at its fastest pace in three years in 2017Q4 - though growth in the same softened markedly in 2018Q1) and business investment (which registered double-digit growth in the second half of 2017 - though growth in the same was a bit subdued in early 2018, as reflected in February and March data on core capital goods order growth - a proxy for business investment), robust labour market, pick up in housing starts, brisk and broad expansion of the services sector (which accounts for over 70% of US na-tional output), solid industrial production and a buoyant manufacturing sector (which accounts for around 12% of the US economy) - new orders for manufactured goods continue to rise at a rapid rate, which in turn should boost industrial production and jobs in this sector in the coming quarters. Essentially, the US economic backdrop seems rather encouraging.  

US Short-Term Economic Outlook (2018-2019)

Unless trade related frictions between China and the US escalate significantly in the near future or the world witnesses unexpected geo-political shocks (such as a serious middle-east crisis or escalation of US and Russia standoff over Syria etc.), I expect global economic expansion and the strong global trade momentum to continue at least until the end of 2019 (with investment spending being a key driver of global economic growth) - with growth in the US expected to ac-celerate in the coming quarters of 2018, after a soft start to the first quarter (the US economy expanded at an annual rate of only 2.3% in 2018Q1 - according to official data).

Factors that are likely to accelerate growth in the following quarters of 2018

Growth is likely to be strongly supported by the fiscal stimulus, consumer spending, which is ex-pected to pick up strongly from second quarter onwards (supported by a strong labour market, gradual pick up in wage growth that will bolster household incomes, low interest rates, rising house prices and stock market valuations (which enhance household wealth), healthier household balance sheets as a consequence of substantial deleveraging by households (as indicated by a much lower household debt-to-income ratio) and elevated consumer confidence - which recently was at a 14-year high in March - but moderated slightly in April), and business investment, that is poised to grow significantly in the coming months as a result of corporate tax cut from 35% to 21%, weaker dollar, firming oil prices, elevated levels of business confidence - as reflect-ed in recent  sentiment surveys - rising demand due to continuing strength of consumer demand, low interest rates, accommodative financial conditions and expectations of US exports remaining buoyant (its top five export markets are Canada, Mexico, China, Japan and UK) - unless there is a trade war -as a result of continued global economic expansion.

US economy unlikely to grow by 3% in 2018

My expectations of growth have been scaled back to around 2.8% for 2018. There are several factors that are likely to restrain growth in the following quarters of 2018 and offset some of the positive impact of fiscal stimulus on growth. These factors have been stated below:

On-going trade related frictions between US and China (for example, if the US actually imposes tariffs of up to USD 150 billion or less on Chinese exports, then China would probably take re-ciprocal action), heightened uncertainty regarding future trade relationships, unpredictability of US trade policy, more protectionism, recent decline in technology stocks, size of budget deficit and its continued rise, uptick in bond yields (the 10-year treasury yield rose to 3% in late April) and possibility of trade deficit (which rose for six consecutive months and reached a nine-year high in February) zooming to a record high in the following quarters (due to higher imports - as a result of rising consumer demand and more imports of raw materials, intermediate inputs and industrial machinery by firms in view of higher household demand for goods - and lower ex-ports due to a strengthening dollar).

Other factors are: political uncertainty, rising concerns about geo-political risks, build up of in-flationary pressures in recent months as indicated by various inflation indicators (such as the PPI or for example, core CPI, which rose to a one-year high of 2.1% year-on-year in March af-ter rising by 1.8% in February (according to official data) and is expected to increase steadily over the next few years. Further, core PCE inflation (Fed's preferred inflation measure) rose to 1.9% in March 2018, from 1.6% in February), likelihood of more upward pressure on infla-tion over the coming months from the massive fiscal stimulus at a late stage of the business cycle, higher energy prices, higher wage growth and possible new tarrifs in the coming months - which might prompt three more rate hikes by the Fed this year ( and take the Fed Funds rate to 2.25 - 2.50% by end-2018, from 1.50 - 1.75% currently) - and rise in inflation expectations (which wor-ryingly has risen to a more than 3-year high).

The aforesaid factors are likely to intensify stock market, bond market and currency volatil-ity in the coming months, which in turn will probably make the business climate muddier and cause business confidence to wane a bit in the coming months - resulting in some firms either de-laying, restricting or not undertaking investment. Further, the elevated consumer confidence lev-els may moderate too in the following months. Consequently, the upside impact of fiscal stimulus on growth would naturally be lower. Another factor that could bear on business confidence and investment in the coming months is the ongoing process of  unwinding of quantitative easing - the Federal Reserve is in the process of shrinking its US$ 4.5 trillion in bond holdings  - which should put upward pressure on long term rates.

US economy likely to grow strongly in 2019, yet at a slower pace than 2018

A coalition of factors are likely to lead to a moderation of growth in 2019, relative to 2018: lagged downside effect of earlier tightening of monetary policy on overall economic activity, moderating business investment and consumer spending growth (relative to 2018) - as a result of rising interest rates, further tightening of financial conditions and lower business and consumer confidence (relative to 2018) - due to higher inflation, further widening of twin deficits (leading to more government borrowing via the US treasury market - which will require higher foreign demand for treasuries, that in turn may push up market rates and 'crowd out' some private in-vestment), strength of US dollar, elevated energy prices, possibility of enhanced stock market gyrations, less optimistic medium and long-term economic outlook of the US economy and strong possibility of greater trade related frictions (particularly with China) - given the mercurial Trump administration - which might possibly cause supply chain disruptions, undermine the buoyant manufacturing sector and business confidence.

Other factors are: wider trade deficit being a bigger drag on growth (due to fiscal stimulus, weaker private savings, stronger US dollar and possibility of slight cooling of Canadian, UK, Eurozone and emerging market growth in 2019 (Chinese growth will probably slow down further to a more sustainable level in 2019, which in turn might affect growth in Japan, Singapore, Hong Kong, Malaysia, Vietnam, Taiwan, Germany and France - who export substantially to China and consequently their growth tends to be significantly correlated with China's growth rate) - leading to lower demand for US exports by these economies in 2019, relative to 2018.  

Prior to the fiscal stimulus, my growth forecast for the US economy for 2019 was 2.2%. Howev-er, now with the fiscal stimulus and possibly more stimulus in the form of infrastructure spend-ing, the US economy will probably grow more rapidly. As mentioned earlier, CBO's latest pro-jection for US growth for 2019 is 2.4% - which I find very realistic, considering the considerable headwinds to growth. Next, I expect the 10-year US treasury bill rate to be in the range of 3.2 - 3.3% by 2018Q4 (which is likely to hurt equities) and will rise further in 2019.

Three important factors are likely to push US 10-year treasury yield higher in 2018 and be-yond; higher inflation, ongoing unwinding of Fed's quantitative easing program and likelihood of rising budget and current account deficits (i.e. twin deficits). Further, as a consequence, long-term interest rates will be driven up (such as fixed rate mortgages and corporate bonds) - which in turn will increasingly weigh on business investment and consumer spending in 2019.

Finally, given that core inflation and wage growth are going to rise steadily over the next couple of years, along with fiscal stimulus, rise in twin deficits, labour shortages, weaker dollar and pos-sible tariffs giving additional impetus to inflation, I expect the Federal Reserve to hike rates by 25 basis points twice in 2019 (taking the Federal Funds rate to 2.75 - 3% by end of 2019).

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.


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Sher Mehta

The author is Director of Macroeconomic Research and Econometrics, Virtuoso Economics

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