Outlook and Market Review - Third Quarter 2018

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The U. S. economy grew at a 3.5% rate in the third quarter of 2018 following a 4.2% growth rate in the prior quarter, according to the revision by the Bureau of Economic Analysis. Consumer spending was the key driver of growth followed by inventory investment. Tax cuts and “under withholding” by the IRS are working to stimulate the economy but these effects are likely to wane in 2019. The “quality” of GDP growth was not as strong in the third quarter given the significant contributions from inventory accumulation rather than fixed investment. Final sales, which exclude the impact on GDP from inventories, rose only 1.2% after climbing 5.4% in the second quarter. The economy is on track to expand slightly above 3% on the year, which is the strongest annual growth rate in the last decade. Fourth quarter growth should be around 2.5% on a seasonally adjusted basis. If lower oil prices continue, the economy would grow at a slightly higher pace.

The economy is growing above trend with only 3.7% unemployment and payroll expansion remains healthy with an average over 200,000 new jobs per month. The labor-force participation rate is up slightly reaching 62.9%. Inflation pressures are low and headline measures remain close to the 2% Fed target. Even with sustained short-term interest rate increases engineered by the Fed, 10-year Treasury interest rates remain close to 3%, which is still about 200 basis points below the long run average. Wages are now on a steady growth trend but productivity is picking up, keeping unit labor costs down. Economic performance is as good as it gets but many economists believe that current conditions are not sustainable. Fiscal stimulus from tax cuts and slightly higher government spending will begin to wane by the end of 2019. Expectations for a slower economy and lower equity valuations will grow if optimism over a deal with China fades and pending trade agreements with Mexico, Europe, and Canada do not get final approval. The housing market is now cooling off and automakers are re-tooling to larger SUVs and trucks with expected plant shutdowns. The stock market reversal this fall destroyed a significant amount of expected wealth that may affect spending going into 2019 unless there is a sustained market rebound. Finally, there is a behavioral tendency to fear the worst since the last recession was nearly a decade ago, adding to volatility.

The Fed is likely to increase the Fed Fund rate target in December to 2.5%. The Fed’s adjustment to short-term interest rates combined with the strong value of the dollar continue to flatten the yield curve. Even so, Fed Chairman Powell recently offered a more dovish perspective on the Fed’s progress toward a neutral monetary policy position, making it likely that Fed Fund hikes in 2019 may be below the expected 100 basis point increase. Before Powell’s recent speech, analysts uniformly expected four rate hikes of 25 basis points each. Fed policy now tends to be data driven without the urgency to increase short-term rates back to a predetermined level. The Fed remains committed to preemptive moves to get sustainable growth rate without inflation but it now also wants to avoid Fed policy as the impetus for downward swings in growth or the equity markets. Equity markets have been volatile and returns are now negative for 2018. Interest rate fears, trade fears, and a behavioral sense that the economy has been too good for too long may tip the market downward if the Fed is overly aggressive with liquidity reduction moves.