Outlook and Market Review - Fourth Quarter 2018

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The Bureau of Economic Analysis revised fourth quarter GDP growth from 2.6% to 2.2% in the most recent announcement. For all of 2018 the economy grew 2.9%. The labor market remains tight with an unemployment rate of 3.8% and a steady 63.2% labor force participation rate. Wages and salaries are growing at a 3.5% rate with labor unit costs increasing at a modest 2%. Many economists now believe that the “non-accelerating inflation rate of unemployment” is consistent with unemployment rates below 3.8%. The recent announcement that the Fed is likely to suspend fed fund rate hikes in 2019 seems to confirm this view.

Inflation remains calm even with strong economic performance and an uptick in wage pressures. The headline personal consumption expenditure (PCE) measure of inflation increased 1.7% on a year-ago basis in the fourth quarter and the core PCE increased 1.9%. The headline consumer price index (CPI) grew 1.5% and the core CPI increased 2.1%. Sentiment surveys show that inflation expectations have not changed. The strong value of the dollar limits price increases in imported goods and competition from abroad helps keep domestic producer prices from accelerating.

Consumer disposable income grew 4.3% on a year over year basis in 2018 following a 5% rate in 2017. Lower taxes, wage gains, and high employment provide favorable conditions for consumers in 2019. The savings rate grew to 7.6% in December from 6.1% in November, providing a buffer for consumer spending in the first months of 2019. Both the Conference Board’s Consumer Confidence Index and the University of Michigan Confidence Index suggest favorable consumer sentiment in the first quarter of 2019.

The yield curve remains very flat as low inflation expectations, the strong value of the dollar, and relatively lower interest rates abroad all work toward keeping long terms rates low in the U.S. The Fed has transitioned to placing a relatively higher priority on sustaining economic growth rather than a proactive attempt to stall inflation. Even so, the spread between long term and short-term rates should remain flat throughout 2019.

International trade remains a drag on U.S. GDP growth. The biggest factor has been slower economic growth for U.S. trade partners and the strong value of the dollar. Trade talks are ongoing with China but a return to a trade war seems unlikely. Brexit talks are also ongoing and the ultimate consequences of the withdrawal of the U. K. from the E.U. will take time to unfold.

Growth in the first quarter of 2019 is likely to be around 1.5% with the long-term Treasury yield moving back up to about 2.6%. With the Fed Fund rate of 2.5% and the 10-year Treasury of only 2.4% the maturity spread is currently negative. Oil prices are moving higher and food prices may be higher due to flooding in the Midwest, but there is little reason to expect significant inflation pressure in the first half of 2019. Job gains should continue to average about 150,000 per month and the unemployment rate could tick slightly lower.