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shipping ships out at sea

A number of economic signs have recently pointed to a strengthening economy and solid prospects for the future, but the U.S. and global economies may not be out of the woods yet. There are a handful of challenges both here and abroad that could stall the recovery.

Among the bright spots, gross domestic product (GDP) grew at 3.0% in the 3rd Quarter, consumer spending and employment have been climbing consistently for the past several years, as has the stock market. Inflation has remained in check and the housing and construction market have recovered nicely in many parts of the country.

More recently, corporate earnings have been strong, and the oil industry – which had been a drag on the economy for the past few years – has been steadily clawing its way out of the mire.

But economic conditions are still far from normal. Federal Reserve Board (Fed) policy mistakes and tax reform failure are the biggest risks domestically. Bond yields and consumer interest rates are still near historic lows in the U.S. – and yields are even lower abroad. Slow wage growth both here and abroad could also be an impediment to stronger growth.

Headwinds

Here are some of the key challenges the economy and the markets face in the months ahead:

Fed balance sheet reduction. In October, the Fed began a gradual, long-term effort to reduce its $4.5 trillion balance sheet. It plans to accomplish that by ending its policy of purchasing Treasury bonds and mortgage-backed securities. As the older bonds reach maturity, the Fed will not replace them with new debt holdings, essentially allowing its inventory of debt securities to decline over time.

While this strategy of “unwinding the balance sheet,” is considered necessary for the long-term good of the economy, it could create some short-term strains as money comes out of the economy and liquidity diminishes. It could push up interest rates and cause stock and bond prices to drop. It could also lead to less consumer spending and business development, as well as dampening home purchases and commercial and residential construction. However, we believe that these pitfalls can be avoided if the Fed is flexible in managing its balance sheet reduction strategy. (See: How Fed Monetary Tightening Could Affect the Economy)

Low yields and government debt abroad. Government bond yields remain at very low levels – including negative rates in much of Europe and Japan. Those governments must ultimately begin normalizing their monetary policy, which could negatively affect their economic recovery. China is also facing some economic challenges. Repercussions from its mounting debt could ultimately affect the global economy.

Slow wage growth. Although employment growth has been strong the past few years, wages are still relatively low and moving up slowly – only about 2.9% year-over-year.

Uneven retail sales. Although retail sales were up last month, according to the U.S. Department of Commerce, much of that gain was attributed to the hurricane recovery. In prior months, retail sales have been fairly erratic. While auto sales surged last month in the wake of the hurricanes, the modest demand for cars and the sluggish housing markets in certain parts of the country could be signs of trouble for the consumer. Department store sales have also been hurt by the rapid growth of online sales.

Stock valuations. Stocks continue to climb, pushing the S&P 500 index1 to a 12-month forward price earnings (P/E) level of nearly 182, which is about 3 points higher than the historic average. (The forward P/E measures the stock price to earnings ratio of the S&P 500 index based on corporate earnings forecasts for the upcoming 12-month period.)

Political discord. Political discord in Washington, D.C. has hurt the country’s ability to pass meaningful legislation. Disjointed negotiations abroad have raised the specter of war in Asia.

Tailwinds

GDP growth has been at or above 3% for the past two quarters, indicating that the economy is growing at a healthy pace.

Several economic indicators have strengthened over the recent months. Personal consumption expenditures have increased for 31 consecutive months beginning February 2015.3

Oil continued to rebound over the past month, moving to well over $50 per barrel (West Texas Intermediate). Rising oil prices should be a boon to U.S. producers, and could lead to improving profits and an increase in well-paying jobs in the industry.

If Congress is successful in enacting a tax plan that reduces corporate taxes, that could be an added boost to the economy and the stock market. If not, that could be a setback for both the market and the economy.

The unemployment rate has dipped to just 4.2% -- the lowest rate in 16 years, stocks are on the second longest bull run in modern market history,4 personal income is up about 7% since 2015.5

Bank savings and CD rates are finally moving up toward the 1% range.6 Mortgage rates remain low, and the housing and construction market has been solid this year, while the building supplies sector has been among the strongest segments of the retail sales market.

Corporate earnings grew double-digits in the first half of 2017, and we expect them to grow by at least 10% for the year, and manufacturing activity appears to be on the upswing.

The dollar has declined versus most major currencies throughout 2017, including the Yen and the Euro, aiding the earnings of U.S. multinationals and exporters, as well as making U.S. companies more competitive abroad.

In Europe, the economic recovery continues despite historically low interest rates and slow wage growth. Our economic survey data suggests that consumer confidence and other economic indicators in Europe are at historic highs.

Expectations

The economy seems to be gaining strength, although the Fed’s new policy could have a dampening effect. But continuing problems in Washington, D.C., and international concerns could have an effect on the markets.

We believe the employment market will continue to add jobs this year, although perhaps at a slower rate. As the job market improves, wage growth could accelerate which should be good for the economy—even if it contributes to a rise in inflation.

The consensus view for inflation has been 2.4% for 2017 and 2.3% for 2018,7 which is somewhat higher than our projections. Inflation has been growing at less than 2% so far this year.

The Fed board has indicated that it may approve one more rate hike by the end of 2017, which could help drive up interest rates. (See: Fed Hikes Rates for Second Time this Year)

Outside the U.S., over the next 12 months, we expect European growth to continue its gradual improvement. We believe that China will continue to have GDP growth of around 7%, but still faces some persistent fundamental risks due to past excessive credit growth. We also expect the emerging market economies to continue to improve.

Despite several impediments to continued economic growth, we believe the risk of recession has continued to diminish.

The economic recovery should continue if consumer spending continues to improve, wages and corporate earnings rise, oil prices remain stable, and consumer interest rates continue to move up.

The economy strengthened again in October. Get the latest details in the October Market Recap: Economy Flexes Its Muscles.

 

 

All information and representations herein are as of 11/1/17, unless otherwise noted.

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management associates. Actual investment decisions made by Thrivent Asset Management will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product.

Past performance is not a guarantee of future results. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.


1 The S&P 500® Index is a market-cap weighted index that represents the average performance of a group of 500 large-capitalization stocks.

Factset, October 31, 2017

Federal Reserve Bank of St. Louis Personal Consumer Expenditures as of Aug. 31, 2017

S&P 500 and Dow Jones Industrial Average

Bureau of Economic Statistics. Personal saving as a percentage of disposable personal income (DPI), frequently referred to as “the personal saving rate,” is calculated as the ratio of personal saving to DPI. Personal saving is equal to personal income less personal outlays and personal taxes; it may generally be viewed as the portion of personal income that is used either to provide funds to capital markets or to invest in real assets such as residences.

Bankrate, October 2017

Organization for Economic Cooperation and Development

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