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CNB Economic Comments: 2016 Review and 2017 Preview

December 27, 2016
To: Everyone
From: Gregory S. MacKay, Economist

The U.S. Economy: 2016 Review and 2017 Preview

There were a few surprises in 2016: “Brexit” – the break of the United Kingdom from the European Union, the Chicago Cubs winning the World Series for the first time in 108 years, Army beating Navy in football for the first time in 15 years, and 99% of the pollsters getting the U.S. Presidential race wrong. It was not surprising that the U.S. economy continued to roll along at a moderate pace, quietly rebuilding the corporate and individual wealth lost during the “Great Recession.” The economy did come under a somewhat larger spotlight in 2016 as both major presidential candidates pledged to “fix a bad economy” in their own way. While the pace of the expansion may bear comment by some, it’s hard to find major fault with the length of the current recovery, which in March 2017 will become the second longest economic expansion in the United States since record keeping began in 1854.

I had hoped to see GDP growth of 1.9% to 2.2% for all of 2016, slightly better than 2015 growth (+1.9%) but below 2014 growth (+2.4%), acknowledging the carryover into 2016 of the headwinds created by the strong dollar, the energy glut, and weak global demand. For the first six months of 2016, GDP grew at an abysmal rate of about 1%, as business spending turned badly negative, offsetting reasonable consumer spending. The second half of 2016 saw these economic headwinds begin to diminish. Business spending turned positive, and consumer spending remained moderate. It appears that full year GDP will be reported at just over 2%, within my predicted range.

Employment gains in 2016 averaged about 180,000 jobs per month, down from a 225,000 per month pace in 2015. Job gains continued to be good in the service industry, particularly the business and professional categories, while goods producing jobs remained somewhat stagnant due to the various economic headwinds. The pace of earnings growth continued to expand moderately, up about 2.5% to an average hourly rate of $25.89 at the end of November. The unemployment rate at month end November was 4.6%, within the predicted range, and down from 5.0% a year ago. This “headline” unemployment rate was nearing a level considered to be full employment, and had fallen by more 50% from its peak of 10% in 2007. The often mentioned “U-6” rate of which includes unemployment, underemployment, and discouraged people has fallen from 18% in 2010 to 9%today. The labor participation rate has been mentioned as too slack, and an aging work force may influence that ratio. So employment/unemployment data seemed reasonable.

Retail sales levels in 2016 also indicated moderate strength. Though there were some fluctuations in monthly spending patterns during the year, year-over-year and eleven month comparisons showed consumers with fairly healthy spending patterns. November 2016 total retail sales were up 3.8% from November 2015, but were up only .1% from October 2016 levels. In the first eleven months of 2016 retail spending was 3.1% higher than for the same time in 2015. Of interest was the fact that the “gas dividend” had begun to subside, perhaps slowing some retail category gains. Gasoline sales for the first eleven months of the year were down 7.3% (in dollars) compared to 2015, but were 3.7% higher when comparing September thru November 2016 to June through August 2016. Yet some categories of retail spending continued to improve. Year-over-year results from November 2016 showed strong increases in internet and miscellaneous store sales (although at the expense of department stores), restaurants, health and personal care stores, building materials, and furniture. Auto sales remained a bit sluggish toward year end, but were up 3.8% year-over-year November. Add in generally stronger consumer confidence funded by improving home and stock values, and consumers seem able to carry economic growth onward.

Total home sales for 2016 will be close to the six million unit level I had predicted. A lack of inventory in existing homes and early year shortages in land, labor, and materials slowed new home sales. At month end November, total home sales were running at an annualized rate of 6.2 million, up a solid 7.6% from 2015 levels. Existing home sales had a median price of $234,900, up 6.8% from median 2015 levels, and the median new home price nationally was $305,400, up 3.0% from 2015.

Business spending in 2016 was best described as soft. Total business spending didn’t add to GDP until the third quarter of 2016, and then only marginally. Fixed investment spending remained weak, with inventory buildups creating the small positive contribution to GDP. Industrial production levels in November were .6% below November 2015 results, as both mining and utilities reported negative year-over-year results, while manufacturing had a tiny .1% increase. Similar results for durable and non-durable goods orders were reported for the first ten months of 2016, as both were below 2015 levels. However, indications toward year end suggested autos, computers, machinery, and non-defense capital goods were experiencing smaller headwinds. The Institute for Supply Management’s Manufacturing and Non-Manufacturing Indices had both improved well over early 2016 levels, as did the Federal Reserve Bank’s Beige Book of economic activity throughout the country.

Government spending was mildly positive to GDP growth for three of the last four quarters, with spending remaining a $3+ trillion rate and an expected deficit of about $500 billion. There was no good news from the export/import data for the past year. While there were fluctuations, the trade deficit continued to average about $40 billion per month.

Most inflation indicators in 2016 remained below the Federal Open Market Committee’s (FOMC) target. My prediction of Personal Consumption Expenditures (PCE) inflation of 1.2% to 1.4% was right on target, and the Consumer Price Index at 1.7% for the past twelve months also hit its mark. The “core” (subtracting food and energy cost) for PCE was 1.7% and for CPI was 2.1%, both continuing to reflect the energy glut and the sharp increase in service prices during 2016.

The FOMC raised the federal funds rate on December 14 to .50% - .75%, giving the economy a two year run of “one and done.” The Committee cited moderate economic activity, a strengthening labor market, good job gains, moderate household spending, and increasing inflation for the decision. While their predictions for inflation, economic growth, and unemployment in 2017 were little changed from September levels, the Committee hinted that there could be up to three rate hikes in 2017 - data dependent, of course.

Stock prices had a “Trump Bump” rally after the election, as market mavens judged the incoming President and his proposed polices to be very pro-business. Add in the federal funds rate increase that was taken as a sign of an improving economy, and U.S. stock prices rose 5%-8% after the election, doubling the advances for the first ten months of the year and far surpassing my expectations of 4%-6% gains for the whole year.

Interest rates began to move upward late in the year as funds began to move from bonds to stocks in anticipation of stronger business returns. Three year certificates of deposit have reached the low side of my predicted range of 1% to 1.25%.

While 2016 was a year of moderate growth, improving unemployment, and modest inflation, 2017 appears to have a new set of challenges. The election of Donald Trump as President has uncovered a social, political, and economic divergence of opinion that has polarized the country and could affect economic growth next year. Mr. Trump’s pro-business, America first platform of tax cuts, increased spending on national security, the military and veterans, reformation of Obamacare, better trade agreements and job creation will test the mettle of the Republican controlled Congress as it attempts to govern the nation in an arena where one-half of the voters are unhappy. Picking a careful path of some fiscal and some monetary stimuli will eventually beget stronger economic growth, but the next year is fraught with challenges. Two political road bumps exist. First, Mr. Trump wants to jump start the economy with a blast of fiscal stimulus, while the FOMC has gently suggested that the economy is doing well enough that the amount of fiscal stimulus should be limited. Secondly, the Federal Reserve strongly believes in its independence and the need of separation from massive congressional oversight, while some in Congress seek more control over the Fed.

Beyond the political challenges, there are other headwinds to face. Most inflation indicators remained benign until late 2016. As oil began to rise from its over pumped lower levels, other commodity prices also began to rise. Add in some creeping wage inflation that seems to be developing and it appear that some inflationary concerns will be on the front burner in 2017. As energy and commodity prices rise, the separation between “core” and headline” inflation diminishes, creating a bit more spending pressure on consumers. It does seem that the Fed’s goal of 2% PCE inflation is reachable in 2017. I’m thinking that two federal funds rate hikes seem likely by year end.

The slower than normal recovery of GDP growth since the “Great Recession” is traced directly to the issue of productivity. After averaging close to 3% annual gains since the early 1960’s, this post-recession period has experienced U.S. productivity gains in the 1% area. U.S. output per hour remains hampered by cheap global labor, ineffective use of technology and education, regulatory issues and both global and domestic demand issues. Without increased production, falling unemployment and rising wages may create higher inflation.

Of course, as the Fed raises interest rates to fight inflation, the amount of federal spending on interest costs to fund the burgeoning debt will increase, either drawing resources away from other spending, or forcing the country to increase borrowing and/or taxation. Winston Churchill said it best: “I contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself by the handle.”

Both business and consumer spending should expand in 2017. The pro-business climate on the horizon should increase confidence levels for business to add more inventory, as well as renew spending on everything from structures to equipment. Consumers will prosper from appreciation in home and stock values, as well as promised tax cuts. Moderate job gains in the 160,000 to 180,000 range per month will aide both business and consumer spending levels. Housing should improve. As millennials and others gravitate away from higher rents toward ownership, total home sales continue to rise. Only an unexpected, rapid rise in interest rates would threaten the ongoing improvement.

The contribution to GDP growth of government spending and exports will be determined by the pace of promised legislative changes in Washington. Remembering that fiscal programs often take 3-5 years to demonstrate success, I don’t see much net contribution from the combination of these two categories.

So for the record, here’s how I see 2017:

Real GDP growth: 2.1% to 2.3%
Unemployment: 4.5% to 4.7%
PCE Inflation: 1.9% to 2.1%
CPI Inflation: 2.1% to 2.4%
Federal Funds Rate (12/17): 1.00% to 1.25%
3 year C.D.: 1.75% to 2.25%

As for the financial markets, I don’t know when the “Trump Bump” to stock prices will rest, but some correction from the over exuberance of the last couple of months is due in the short term. For the year, I expect moderate stock price appreciation will foretell moderate economic growth. Look for another year of 4-6% stock price growth and slowly increasing bond yields.

Merry Christmas and my best wishes to all of you for a happy, healthy, and prosperous New Year!