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Source: Euromonitor International Macro Model
The US economy slowed down in the first quarter of 2017, repeating the seasonal pattern of other recent years. However, economic activity rebounded in the second quarter, leaving year-on-year growth at 2% for the first half. We have maintained US GDP growth forecasts at 2% annually in 2017-2019, reflecting a mix of lower expected costs of protectionist and anti-immigrant polices, combined with growing scepticism about any major fiscal stimulus.
In our baseline forecast, the US economy continues on a path barely above its long-term trend of 1.8% annual output growth and 2% annual inflation, despite the initial optimism in some quarters that a Republican administration would revive a mediocre economy, and the pessimism of other analysts that a Trump presidency would cause much slower growth.
At the end of July, the Republican controlled congress abandoned attempts to repeal and replace ex-President Obama’s healthcare reforms (the Affordable Care Act- ACA). The failure to replace the ACA highlights the strength of the divisions inside the Republican Party between economic moderates and conservatives. It has also contributed to a worsening relation between President Trump and Republican Congress leaders such as senate majority leader Mitch McConnell. This puts into question the ability of the Republicans to execute other major legislative objectives, such as large tax cuts.
The level of uncertainty surrounding the US forecast has remained similar to that in May 2017. However, we have moderately reduced the probability assigned to our upside fiscal stimulus scenario. In our most likely downside scenario, growing disappointment with policy changes under the Republican administration and concerns about overvalued stock prices lead to declining private sector confidence and a moderate stock market correction. These factors reduce GDP growth to 1.1% in 2018. We assign this scenario a 15-20% probability over a 1-year horizon. On the upside, the Republicans could pass bigger tax cuts than expected in our baseline outlook, stimulating business confidence and investment. GDP growth would rise to 3% in 2018. We assign this scenario a 10-20% probability over a 1-year horizon.
The risk of a Federal government shutdown looms at the end of a September, if congress cannot agree on raising the current debt limit on US government debt. A shutdown would cause a drop in government spending while it lasts, in addition to potentially causing a default on some government bonds and raising turbulence in financial markets. For now, a shutdown remains unlikely, and even if it were to occur, its overall economic impact is likely to be modest, based on the experience with the 2013 shutdown. However, in the highly unlikely event that a more prolonged government shutdown occurs, the economic impact could be similar to our most likely downside scenario, with GDP growth dropping to 1% in 2018.
The main downside risk in the medium-term remains much lower than expected long-term productivity growth, combined with worsening trade and immigration restrictions, leading to stagnation in the US and other advanced economies. These factors could reduce US annual GDP growth by 1.3% over 2017-2021. We assign this scenario a 10-15% probability over a 1-year horizon.
Consumer spending remains the most important driver of the US economy, increasing by 2.7% year-on-year in the first half of 2017. Spending slowed down in the first quarter, but rebounded in the second quarter. Consumer confidence has declined since the end of 2016, although it is still relatively high. Labour markets have continued improving, with the unemployment rate likely to stay at 4.3-4.4% in 2017-2018. However, real wage growth has been sluggish at barely 0.5-1% year-on-year. As a result, real disposable income is still just 1.2% above its level a year earlier. This mainly reflects low labour productivity growth of around 1.2% in recent quarters.
US households are in relatively good financial shape, with the debt service to disposable income ratio of 10% at the lowest level since the early 1980s. Household net worth has also continued rising due to ongoing house price and stock market price increases. This leaves the net worth to disposable income of households above its pre-recession peak. The combination of continuing high confidence levels and improving household balance sheets, countered by sluggish income growth, is expected to support consumption growth of 2.4% in 2017 and 2.3% in 2018.
Private sector confidence levels have declined in the first half of 2017, in line with growing doubts about the ability of the Republican congress and the Trump administration to implement any significant fiscal stimulus. However they remain significantly above the long-term historical average.
Businesses investment surged upwards in the first half of 2017, leaving it 2.7% above its level a year earlier. There was a strong rebound in the oil, gas and mining sector. But investment spending increased significantly in other sectors as well, especially on new equipment. The recent political turmoil has lowered expectations of major corporate tax cuts in 2017-2018, however pre-tax corporate profits are still expected to rise by 3-4% annually in 2017-2018, after declining in 2015-2016.
Business financing costs remain low by historical standards, and businesses have accumulated a large amount of cash (around 30% of total assets for S&P500 firms) that could be invested more profitably. In the most recent Business Roundtable CEO survey, capital spending expectations over the next six months continued to increase. US business investment is now expected to increase by 4% in 2017, and by 3.5% in 2018 (after contracting by 0.5% in 2016). However, both earnings and business investment are much more sensitive than other GDP components to macroeconomic shocks, and current investment plans may still be based on excessive optimism regarding tax cuts. In our most likely pessimistic scenario, business investment growth in 2017-2018 would decline to 0-1% annually.
US stock market prices have continued to rise during the spring and summer of 2017, and stock price volatility (as measured by the VIX index) was close to historical lows in early August. The recent rise in political tensions between the US and North Korea caused the S&P500 (the main stock market index) to drop by 1.5% in a single day, with stock market volatility rising by 45% to the highest level since early November. However, volatility is still low, and given the highly negative consequence, the current tensions are unlikely to lead to a conflict.
The ongoing bull market in US stocks has been a key element in the recovery of households’ net worth, as well as reducing the effective cost of financing for business. A key question is whether the stock-market is overvalued, especially in light of the declining likelihood of big corporate tax cuts. Looking at the price to earnings ratio (P/E) for the S&P500 gives conflicting signals depending on the definition of earnings. As of late August, the forward P/E ratio based on 1-year ahead earnings forecasts was 17.7, compared to a 25-year average P/E of 16. Earnings forecasts from corporations and Wall Street analysts could turn out to be excessively optimistic. The more conservative trailing 12-months P/E is at 24.4, suggesting significant over-valuation relative to the historical average.
However, historical averages are likely to be a misleading measure of long-term valuation due to the major changes in the structure of the global economy in recent decades. In particular global long-term real (inflation adjusted) interest rates have shifted down by around 3-4 percentage points since the 1980’s. To form a more forward looking estimate of a sustainable stock market P/E ratio, we use the following relation based on the standard Gordon model for long-term valuation:
P/E = 1/(long-term real return on equity – long-term real earnings per share growth)
Using this formula, we estimate a sustainable long-term P/E of around 22, suggesting that the US stock market is either moderately over-valued (using the trailing 12-months P/e) or undervalued (using the forward P/E). Our estimate is based on a long-term real (inflation adjusted) return on equity of 5% and long-term real earnings growth of 0.5%. Incorporating the faster expected short-term earnings growth and lower interest rates in 2017-2019 would imply a higher fundamentals based valuation for stocks, making current prices seem less overvalued.
The 5% long-term return on equity can be decomposed into a 1% real risk-free interest rate (based on the current yield on 30-year US inflation indexed Treasury bonds) and a 4% equity risk premium (a common consensus estimate). The earnings growth projection is based on a long-term GDP growth forecast of 1.5-2%. Overall business earnings should grow at the same rate as GDP in the long-term. However, part of those earnings reflects new businesses entering the stock market, diluting the earnings of existing shareholders. As result, S&P500 earnings per share have historically grown by around 1.2 percentage points more slowly than GDP growth. Taking this into account leads to our long-term real earnings growth forecast of 0.5%.
Overall, we do not see a significant stock market correction as the baseline outlook for 2017-2018. However, this forecast is sensitive to macroeconomic shocks that could raise required equity risk premia or reduce long-term earnings forecasts. In negative scenarios such as an advanced economies stagnation, more adverse Trump policies on immigration and trade, or more permanent increases in global political instability, stock prices could decline by 20-40%.
US inflation has again declined below 2% during the second quarter of 2017, after reaching 2.8% year-on-year in February. Five-year ahead inflation expectations of financial markets have also declined to 1.6%. Falling oil prices since early 2017, together with transitory price shocks in specific sectors such as telecommunications provide a partial explanation for this downward shift. However, falling inflation expectations may also reflect more persistent factors. In particular, they could reflect a lower probability of a major fiscal stimulus and of trade wars or major immigration restrictions (which tend to be inflationary). While financial market based inflation expectations may have a slightly pessimistic bias, we have reduced our inflation forecasts to 2% annually in 2017-2018 (compared to 2.4-2.5% in our May forecasts).
The Federal Reserve increased the federal funds rate (its main policy interest rate) by another 0.25 percentage points in June to 1-1.25%, despite falling inflation and barely above-average economic growth. It has maintained the same forecasts regarding the pace of monetary policy normalisation, with short-term interest rates projected to reach almost 3% by the end of 2019. In contrast, financial market based expectations are for short-term interest rates to stay below 2% even in 2020. Our current forecasts are between the Fed’s more aggressive projected monetary policy normalisation path and the more gradual path forecast by financial market measures. We expect the federal funds rate to reach 2.4-2.6% by the end of 2019 and converge to around 3% by the end of 2021.
US long-term interest rates have declined in the first half of 2017, reversing some of the increases from the end of 2016. Despite the Fed’s projected short-term interest rate increases in 2017-2019, long-term interest rates are still below their level in early 2014. This is mainly a reflection of a downward revision in the equilibrium long-term interest rate, caused by factors such as slower long-term growth, higher savings for retirement due to population ageing and growing inequality (increasing the importance of households with high saving rates in the economy).
Credit market conditions have improved significantly since the first half of 2016, with the corporate-government bond spread declining by almost 1.5 percentage points since its 2016 peak. Corporate credit market stress is low, with default rates and credit spreads between high and low grade corporate bonds below long-term averages. However, like stock prices, credit conditions are vulnerable to downside risks such as a stagnation in productivity growth, or worsening political instability.
In our latest report extract, we provide you with an update on our latest macroeconomic forecasts for key economies and what these mean for our predictions for the global economy. Download Global Economic Forecasts: Q3 2017 to stay ahead of risks and opportunities as they emerge on a macroeconomic basis.