Economic Outlook: More of the Same Anemic Growth
Despite high hopes, we believe 1.9% GDP growth will prove closer to the mark in 2017.
Hope always seems to be high at the end of the year, with optimism that the last year's low GDP growth rate was anomalous and that things will certainly be better next year.
Last year at this time, according to a Wall Street Journal poll, economists expected GDP growth of 2.6% on a full year-over-year basis for 2016. Instead, it now appears that 2016 growth will be in the neighborhood of 1.6%. The year before, everyone thought the economy had reached the lift-off point and growth would likely exceed 3% by a comfortable margin in 2015 (consensus forecasts were around 3.3%). Those forecasts turned out slightly closer to the mark but were still well above the actual growth rate of 2.6%.
This year expectations look high again, with a consensus forecast for 2017 of 2.4%. We believe 1.9% GDP growth will prove closer to the mark.
On a positive note for forecasters, their end-of-year expectations are no longer wildly high, as they realize that the demographics of lower population growth and an aging population will keep a lid on growth for some time.
Consumption Dominates GDP Calculation
The table above shows the key components of GDP growth, their past contribution to growth (not the overall growth rate), as well as our outlook for 2017. We sum the boldfaced major categories in the table to get our full-year GDP forecast. A quick glance at the underlined categories shows that consumer spending has totally dominated the GDP calculation since 2014.
Consumption growth had a nice pop in 2014 and 2015 as wages moved up quite a bit faster than inflation. However, that gap began to close in 2016 as energy prices stopped falling, causing consumption growth to take a breather. Real wages and disposable income could take another hit in 2017 as inflation moves higher and Social Security payment increases fall even further behind inflation.
Although we continue to believe labor shortages will push nominal wages up faster than in the past, inflation will likely increase more than currently anticipated, gobbling up a lot of the wage increase. Lower inflation-adjusted wage and income growth will likely suppress consumption growth in 2017, an event that is not widely anticipated.
Businesses Didn't Open Their Wallets Except for Software in 2016, Slightly Better Results Possible in 2017
Prior to 2014, a sharp rebound from recession-depressed levels kept business investment spending in the game. Afterward, however, investment slowed for a variety of reasons, including slower total growth and problems in the oil patch that decimated the structures category (the oil wells themselves) and the equipment category (drilling equipment).
The need for fewer retail outlets didn't help, either. Investment in software (in the intellectual property category) continues to grow ahead of GDP growth and at a relatively consistent pace as firms invest in the cloud and big data. Continued software spending and less pain in the oil patch could push business investment growth into the black in 2017. If our GDP forecast is too low for 2017, we suspect that our relatively conservative business investment spending forecast will likely be the reason.
Apartments and Existing Home Sales Hold Back the Housing Market
It was an odd year for the residential market. Low levels of new apartment building and poor sales of existing homes resulting from low inventories were the primary culprits for the unusual slowing. We suspect that stabilization in the apartment market and more new home sales will push the residential market back to its more normal 0.3% GDP contribution.
Inventory Purge Hurt 2016 Results, Not Expected to Recur in 2017
High inventory levels were part of the problem in 2016, too. Except during a recession, inventories are generally a small boost to GDP, but hover very close to zero over a 12-month period. If it weren't for inventories, GDP growth would have been a more acceptable 2.0% in 2016.
For next year, we are assuming that inventories return to more normal levels and have no impact on 2017 GDP results, a huge positive swing from 2016. This swing has been widely anticipated by most economists, including us. However, we caution this change is not a sure thing. Auto inventories, especially of conventional sedans, are still too high and will likely need to be reduced further. If we are wrong about our forecasted economy-wide inventory improvement, the auto industry and its suppliers would be the most likely culprits.
Despite the Endless Worries About Trade, Low Trade Volumes Didn't Hurt 2016
Export growth has done little for GDP growth the last two or three years as one might expect with a stronger dollar. However, imports hardly grew at all in 2016, either. So, slow imports offset slow exports, making trade a nonevent.
With dollar strength continuing, we doubt that this run of good luck can continue in 2017. We suspect that the swing in trade could take as much as 0.5% from the 2017 GDP calculation, as exports remain lethargic and imports resume their more normal pattern of growth.
What About Trump?
We are assuming no Trump changes in our base case. We believe that implementing many of his proposals may take more time than expected. Although many forecasters are beginning to include positive assumptions relative to taxes, regulation reform, and stimulus in their forecasts, they often omit the potential negative effects. These might include sharply lower exports, lower immigration (and labor force growth), cuts in healthcare subsidies, higher inflation (from stimulating an economy already close to full employment), and higher interest rates (from higher budget deficits and inflation).
Our forecast reflects the underlying trends in the economy that have been building for some time. The impact of new proposals (often provided by the Congressional Budget Office) should be added to our base case, which is free of Trump assumptions.
Job Growth Likely to Decelerate Slowly, Inflation Increase and Interest Rates to Move Higher
The table below fills out our outlook for 2017. We are expecting higher inflation and interest rates despite a relatively lackluster economy.
Continued labor shortages are likely to push wages and core inflation higher in 2017 from 2.3% to 2.5% (and limit job growth). Energy prices, which are currently moving higher, could push headline inflation to over 3% by the end of 2017 from about 1.9% at the end of 2016. With inflation moving that high, we don't think the Fed can continue to successfully suppress interest rates to below inflation levels. It may be able to prevent the normal premium over inflation from emerging, but holding rates below inflation levels will prove nearly impossible.
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