Jan. 31, 2019
By Jeff Korzenik, Chief Investment Strategist, Fifth Third Private Bank
We started last year with the motto of, “Do Worry, Be Happy.” This reflected our expectation that we would have a “happy” year of above-trend economic growth, but that investors were in for a year with challenges: a Federal Reserve on an ambitious tightening path, trade policy uncertainty, and rising inflation and bond yields. In 2019, we expect that it will be investors who have more to celebrate, while business owners struggle to contend with a slower global growth environment, higher compensation costs and other margin challenges, and the distractions of restructuring supply chain and talent acquisition pipelines.
With that context, our outlook for the year incorporates four significant themes:
- The U.S. Economy will grow more slowly than last year, but still deliver above-trend growth.
- Manufacturing jobs are back and growing in the United States.
- The Federal Reserve’s full employment mandate has not been met.
- We are still in the 8th inning of our expansion, but closely watching for the start of the 9th.
U.S. Economic Growth
We witnessed an acceleration of the U.S. economy in 2018. While as of this writing, we do not yet have an official estimate of real growth for last year, industry estimates hover around the 3% growth mark. Barring any surprise, this would make last year’s pace the highest since 2005 and an atypically high rate to achieve this late in an economic expansion.
The discussion of growth for any given year has to start with the consideration of the long-term potential growth rate of the United States. This calculation revolves around labor force growth and productivity gains. The Congressional Budget Office estimates that U.S. potential GDP growth for the 2018-2028 decade is 1.9%, a far cry below the 3.2% average since 1950.
Such structural limitations will come into play in 2019, but we expect several factors will be supportive and keep growth above these constraints. First and foremost is real wage growth in the U.S. as tight labor market conditions continue. Pay hikes, while a challenge for corporate profitability, coupled with some of the consequences of individual tax reform, will support the large consumer sector. These tax reductions were not met with government spending restraint, so the net effect is a stimulus to the economy (one that of course comes with the long-term risks of federal debt expansion).
Less clear is the direction of capital investment. We have been disappointed in our expectations for solid capex growth in the wake of tax reform but have not yet abandoned this possibility. Regardless, we expect that productivity growth in the U.S. economy will probably surpass expectations as the result of enhanced investment from 2017. In the balance, this suggests U.S. growth in the neighborhood of 2.5%.
A greatly underappreciated trend in the U.S. economy is the growth and return of manufacturing employment. This trends flies in the face of a commonly held belief that U.S. manufacturing jobs are disappearing as a result of technological disruption. It is certainly true that technology is a job disruptor, and that historically, roles in manufacturing have been more vulnerable to technological disruption than those in the service sector. But that has always been the case.
The data supports our belief that technological innovation may be destroying specific job descriptions in manufacturing, but not the total number of jobs. Globally, the broad category of “industrial” jobs has grown steadily for decades. While it is true that the subsector, “manufacturing” jobs, retreated after the 2008-09 global recession, such jobs are increasing again. The increase is particularly visible in the United States where we have added over 1.3 million net manufacturing jobs since 2010, and the trend is accelerating. Not only is the U.S. increasing its global share of manufacturing employment, in 2018 we added 284,000 such positions, the largest increase since 1997.
This trend has meaningful implications for the U.S. economy and for U.S. economic policy. Manufacturing jobs typically pay more than service sector jobs, and have a higher “multiplier effect”—each such job is associated with the creation of at least three other jobs. Moreover, manufacturing jobs offer better career paths to those without traditional 4-year college degrees, lessen income inequality and broaden the geographic distribution of growth. The ability to capitalize fully and further this trend is highly reliant on informed decisions in many areas: trade, education, energy and even drug and criminal justice policies.
The Fed’s Unfulfilled Mandate
Most central banks around the world are charged primarily with price stability—managing monetary policy so that neither deflation nor hyperinflation develops. The U.S. Federal Reserve faces an even more complex challenge, having a “dual mandate,” that also tasks the institution with managing to “maximum employment.” With the unemployment rate hovering near multi-decade lows, and wages starting to rise, it is tempting to think that the Fed’s full employment objective has been met.
However, our multi-decade low level of unemployment should be understood in the context of a multi-decade low level of labor force participation, that percentage of the non-institutionalized adult population that is either employed or actively seeking employment. Historically, sidelined workers rejoin the labor force as expansions progress, both strengthening the economy and elongating the growth cycle.
At Fifth Third, we have been quick to note that the ability to draw individuals back to the labor is far more complex and difficult today than in past cycles. Three socials ills represent barriers that plague the working-age population: long term unemployment, the opioid epidemic and the incarceration/recidivism cycle. We were not surprised therefore, when broad labor force participation rate did not move, but remained mired in a 5-year range. However, noting that it is “difficult” to raise labor force participation is not the same as saying it is “impossible.” We believe that the business community, in search of desperately needed employees, is starting to bring its problem-solving abilities to these social problems. Coupled with supportive government policy, we believe the end result will be higher labor force participation, and longer and faster U.S. economic growth.
Watching for the Ninth Inning
Even with the most optimistic projections of improvements in our labor force, there is little doubt that we are late in the economic cycle. We have characterized our moment as the “eighth inning” of our long expansion. In terms of this baseball analogy, that’s when you start thinking about the end of the game, and every play can count (recent fears about a Federal Reserve rate overreach illustrate that latter point!).
What constitutes the ninth inning? In our view, the beginning of the end of the economic cycle is the point where inflationary pressures require the Federal Reserve to continue raising rates despite any negative impact on corporate profitability, the consumer and overall growth. Quite simply, with core inflation hovering around the Fed target of 2%, we are not yet to the point where the Fed lacks maneuvering room. Fed Chairman Jerome Powell has acknowledged this, advertising that the Fed will be patient and flexible. This does not mean that the Fed will completely stop increasing rates, but rather that the Fed does not need to continue on this path if the economy weakens further. Indeed, we believe that one or two additional rate hikes are likely this year, but only if the economy is strong enough to absorb these increases.
We continue to focus on signals that will tell us when we are moving deeper into the eighth inning or into the final inning of play. An inversion of the yield curve, a 6-8 month downtrend in purchasing manager surveys, a widening of credit spreads, and an outright decline in expected earnings are all important indicators that risks for investors and businesses are rising. Until then, “Play ball!”