Perspectives on The Real Economy

One of @huffpostbiz 26 Economists You Should Be Following. Jazz lover. Wine enthusiast. Cigar aficionado, USC Trojan. Perspectives on The Real Economy is the blog written by RSM US LLP Chief Economist Joe Brusuelas. The opinions here are his own.

[joebrusuelas]

Impact of U.S. Government Shutdown to Show Up in January Jobs Data

Twenty-five days into the latest U.S. government shutdown, it is appropriate to begin estimating the impact on the domestic labor market. Based on our research, we now expect the U.S. unemployment rate to increase by 0.3 percentage points in January, which would bring the metric to 4.1 percent in the month (currently 3.856 percent). We now anticipate the first estimate of the change in total employment for January 2019 will result in a net loss of jobs. That would represent the first monthly negative number since September 2010, or 99 consecutive months. At this time, we do not consider this move sufficient to cause longer-term damage to the labor market, but it is troubling. Moreover, the combination of what will almost certainly be a damping of consumer and business sentiment due to the government shutdown and elevated anxieties around the various trade conflicts is surely imposing a growing uncertainty tax that will influence outlays on critical capital expenditures and hiring in the near term.

Since the shutdown lasted through the Jan. 12 reference period, the 380,000 furloughed government workers—.23 percent of the total workforce—will be classified as unemployed in the Bureau of Labor Statistics household survey of employment used to conduct the unemployment rate estimate. The 420,000 individuals working without pay will be considered employed in the establishment survey. Hours worked and earnings data are compiled using private sector employees, so this portion of the BLS January payroll estimate will not be affected by the government shutdown.

While roughly 800,000 government workers are now going without paychecks due the shutdown, some 420,000 are currently working without pay and about 380,000 are furloughed; that cohort is permitted to apply for unemployment insurance. Forward-looking investors and firm managers should anticipate a modest increase in initial jobless claims associated with the government shutdown to be reported Thursday morning for the week ended Jan. 12, 2019, and over the next few weeks, should the shutdown be sustained. It is important to note that the number of furloughed workers that file will not show up in the weekly initial jobless claims, but rather, will be reported separately by the U.S. Department of Labor. For example, the DOL in 2013 reported an increase of 70,000 claims linked to furloughed workers. Now, due to variations in state laws, government workers filing unemployment insurance claims may be without benefits for up to three weeks following the application for first-time filers.   According to the National Employment Law Project, some furloughed workers may need to pay those claims back once they receive back pay, which will likely damp the number of first time claim filings based on individual expectations about how long the shutdown will endure. In any case, the Labor Department will provide an estimate of direct and indirect first-time filings caused by the shutdown in coming days.

In table 1, we show the number of first-time filings versus the thirteen-week moving average of claims around the number of government shutdowns since 1980. We did not notice a significant jump in claims in any of the shutdowns; thus, we do not anticipate a major increase this week or in coming weeks. However, the nature of this shutdown does appear different from past episodes, including the twenty-one-day shutdown in 1995 and 1996. Both sides are digging in and planning for a possible end of a shutdown at the end of February; it is critical to note that is when food stamps (SNAP) funding runs out and the shutdown would begin to impact the program’s roughly 40 million recipients; the stoppage of food stamps would foster conditions resulting in a shutdown with different outcome than shutdowns of the past.

However, the 1995-1996 shutdown did result in a monthly loss of 13,000 jobs in the January 1996 estimate. The current shutdown started on Dec. 21, marking 25 days at the time of this writing. It has crossed the Jan. 12 reference day that will be used in the monthly sample for the Bureau of Labor Statistics payroll estimate. Thus, it is highly likely that the monthly payroll estimate will deviate from the three-month rolling average of 254,000 and show a net loss of jobs on the month.

We have not altered our economic estimate of the shutdown: we expect economic losses of roughly $1 billion per week with an upside of $1.5 billion, should indirect effects turn out to be larger than currently estimated. Since funding for food stamps is currently secure through the end of February, we are standing by our estimate of a 0.53 percent hit to GDP if that funding is lost.

[joebrusuelas]

The economic costs of a U.S. government shutdown? About $1 billion per week

Political polarization in Washington D.C., illustrated by the ongoing partial government shutdown, will begin to exert an increasing economic price over the next few weeks that will look much different than previous shutdowns. Currently, the economic impact of the shutdown translates to about a $1 billion hit per week, rather modest in a better than $20 trillion U.S. economy. However, an extended shutdown will extract a much greater price through the imposition of an “uncertainty tax” on the economy, fading business and consumer confidence and the disruption of commerce indirectly linked to the basic functioning of government. If this happens, we will revise down our first quarter 2019 forecast to 1.7 percent from 2 percent.

The longest shutdown on record lasted for 27 days during the 1995-96 standoff. Given that this episode will impact 9 of the 15 government agencies, there is a growing probability that the current political standoff will exceed that record, which will create conditions that put downward pressure on fixed business investment. Policy makers and investors should then anticipate that a lack of government spending will shave roughly three tenths of a percentage point off GDP in the first quarter.

There will be no impact on the estimate of the December 2018 payrolls, nor will there be a material increase in jobless claims for the week ending December 29, 2018. However, investors should anticipate an impact on both during the month of January.

As the partial U.S. government shutdown approaches its third week amid an environment of elevated volatility across asset classes, global trade tensions, a decelerating international economy and growing policy uncertainty out of the White House, it is increasingly likely that a non-functioning U.S. government will begin to damp both business and consumer confidence. Given the economic backdrop, the shutdown could result in greater volatility and declines in equity prices. Even more likely would be a reduction in business investment which, in the final quarter of 2018, will likely come in flat. Business investment could show and outright decline in the first month or two of 2019, placing further downside risk to our growth forecast in the current quarter.

Our discussions with policy makers in Washington D.C. suggest that a deal could revolve around a tradeoff between increased outlays on border security and the status of children born in the U.S. to those who are without legal status, what is commonly referred to as DACA. Even so, because the standoff revolves around the politics of immigration, a deal to open the government isn’t likely to happen this week or next.

More importantly for investors, the present stalemate is a dress rehearsal for what will almost certainly be a debt ceiling standoff this year sometime between August and November. Financial markets largely tend to tune out government shutdowns, as opposed to the real economy, which tends to shoulder the burden of adjustment, however fixed income market participants take debt-ceiling showdowns quite seriously. Thus, the duration and intensity of the dispute over funding for border security/wall is a likely preview of coming attractions later this year.

[joebrusuelas]

Economic and Political Costs of Not Paying SNAP Benefits During the Government Shutdown

As the U.S. government shutdown enters its third week, it is becoming increasingly likely that outlays to sufficiently fund the Supplemental Nutrition Assistance Program, or SNAP, will run out this month, cutting off support for 20 million low-income households and 40 million individuals. The SNAP program serves all 50 states and the military. Currently 23,000 military households receive SNAP assistance.

Our economic analysis of the cessation of SNAP suggests that should the shutdown extend to one year it would result in a direct loss of $60.6 billion and an indirect loss of $48.5 billion. Depending on one’s estimate of the multiplier, the losses will vary from anywhere between .53 percent (1.8 multiplier) of GDP to 1.03 percent (3.5 multiplier).

Participation in the food stamp program has been declining since the depths of the Great Recession as the economic recovery has taken hold (see Figure 1) and as more households have been able to rejoin the labor force. However, a look at the data demonstrates that even amid a near decade-long economic expansion, the number of individuals on SNAP assistance has not declined to pre-recession levels. While there are roughly 40 million individuals on assistance, that number stands well above the 20-year average of 34 million, and just below the cyclical average of 43 million. The potential impact on roughly 14 percent of the population should make shutting down the government untenable.

As you would expect with less than 4 percent of the labor force currently unemployed – which is well below the 4.6 percent level that we consider to be the natural level of unemployment – participation in the SNAP program is falling at a yearly pace of 9 percent, according to the latest month’s data from the U.S. Department of Agriculture (see Figure 2).

Figure 1 – The Level of participation in SNAP has been declining during the recovery from the Great Recession 

Figure 2 – The rate of growth of SNAP participation coincides with trends in the unemployment rate 

While the states that have the highest proportion of the population dependent on food stamps (15 percent or more) are predominantly in the South (see Figure 3) , according to analysis by the Center on Budget and Policy Priorities (CBPP), the states with the most participants are those states with large populations (see Figure 4). This essentially points to serious economic pain across the GOP electoral heartland should an agreement to reopen the government not be reached soon.

Figure 3 [see CBPP https://www.fns.usda.gov/pd/supplemental-nutrition-assistance-program-snap]

 States with at least 15% of the population participating in SNAP

1.       New Mexico (21.7%),

2.       Louisiana (19.0%)

3.       Mississippi (17.7%)

4.       Washington, DC (17.6%)

5.       Oregon (16.5%)

6.       Alabama (16.2%)

7.       Tennessee (15.5%)

8.       West Virginia (15.4%)

9.       Oklahoma (15.1%)

10.   Florida (15.1%)

11.   Georgia (15.0%)

Figure 4 – States with largest number of SNAP participants 

Economic cost of not funding SNAP

The economic cost of not funding SNAP can be divided into direct and indirect losses. Assuming that households spend all of the SNAP benefits available to them and that they will be unable to find additional funds to pay for those food expenses, the loss of SNAP spending by households implies a direct yearly loss to GDP of $60.6 billion. For example, if one estimates that every dollar of SNAP spending generates $1.80 of further spending by the rest of the economy (according to estimates by the CBPP), there will be knock-on losses of an additional $42.4 billion for a total loss of about $103 billion, or 0.53 percent of GDP, over one year. Because the political authority is talking about the shutdown lasting months or even years, we think that this baseline estimate should begin to incorporate that into official growth and employment estimates going forward.

Figure 5 – Estimates of direct and indirect loss of SNAP spending

Source: RSM US

Furthermore, the loss of SNAP benefits is not likely to have a one-off impact on GDP growth. Like the effects of a lost day of work, a lost meal can never be recovered or made up for by two meals next month when benefits resume. And, like long-term unemployment, the indirect effects of hunger have far-reaching consequences that will lead to generational diminishment of the quality of the labor force.

[joebrusuelas]

Is it time for a U.S.-U.K. free trade agreement?

Increasing uncertainty about the policy direction of the United Kingdom as it approaches the March 29, 2019 deadline to negotiate an exit from the European Union hangs heavy over an economy rife with uncertainty impeding economic growth. Unresolved questions over whether the U.K. will remain within the E.U. orbit or move toward “Global Britain” contribute to a weak business investment and consumption environment. While it may seem counterintuitive given the lack of answers to those questions and the rising protectionism out of the Trump administration, now is the time to begin laying the groundwork for a move toward a U.S-U.K Free Trade Agreement.

Since the Brexit referendum, active trade associations inside Washington D.C. have quietly been preparing for the day when the U.K. and E.U. resolve the treatment of third parties. Inside the U.S. political authority, the construction of a U.S-U.K free trade caucus has been formed and the Trump administration has clearly signaled enthusiasm to negotiate a bilateral free trade agreement.

The relationship between the two economies and the common set of political and legal institutions make this a no brainer. U.S foreign direct investment in the U.K. until 2017 steadily improved, cresting at $682 billion in 2016 before falling to $337.9 billion in 2017, mostly due to uncertainty over the economic direction of the U.K following the 2016 Brexit referendum.

Despite the direct investment decline, the trade relationship between the two economies remains robust. U.S-U.K. trade in goods totaled $119.9 billion and services totaled $71.2 billion. Moreover, dense linkages between the two economies’ financial sectors and strong relationships between cities such as Chicago and Birmingham have fostered deep and enduring trade ties in heavy manufacturing tied to the defense industrial base in both countries; those ties illustrate that the countries are more than just allies in commerce.

To be sure, the negotiation of a U.S.-U.K. trade agreement will not happen overnight. Public discussion that a FTA could be agreed upon in a matter of hours or weeks is counterproductive and not tethered to any economic, financial or political reality. A reality check here is important.

The better parallel would likely be the U.S.-Australian FTA, which took 14 months from start of negations to agreement and 22 months from origination of talks to implementation. With respect to all bilateral trade agreements that the United States has negotiated, the average duration from start to agreement is 18 months, and start to implementation is 45 months. Thus, policymakers on both sides of the Atlantic should begin to put in place appropriate personnel and budgets for a period of negotiations that will at least stretch over a two-year period, with additional time included to account for the gap between the end of negotiations and implementation.

U.K.’s negotiating difficulties are an ‘open secret’

It’s an open secret on both sides of the Atlantic that the U.K. finds itself in a very difficult negotiating position. Should Britain exit the European economic orbit, it will need to strike a deal quicker than it otherwise would to support economic activity. So how can a mutually beneficial deal be reached?

First, both London and Washington, D.C. need to accelerate in advance of any final status agreement with the E.U. the cooperation between the U.S.-U.K. Regulatory Working Group. Discussions on harmonization of financial services regulation should be assigned priority and move forward over the next several months on the assumption that the U.K. will be exiting the European economic orbit. Given that financial services account for roughly 17 percent of U.K. exports to the United States and 21 percent of U.S. exports to the U.K., the natural industrial ecosystem requires the start of negotiations.

Second, it’s critical that trade associations on both sides of the Atlantic get to work on expressing preferences on potential trade alignment in the areas of agriculture, pharmaceuticals, technology and telecommunications.

Third, these negotiations will be tough and at times contentious. Not unlike the U.S.-Australian FTA, they will test the longstanding special relationship and both sides will likely exit bruised. Indeed there is a strong probability that negotiations could get bogged down around non-tariff and regulatory concerns surrounding the issues of digital, food safety, genetically modified organisms, access of U.S. health care firms and privacy protection.

However difficult the negotiations will be, the benefits for both are tremendous. Once an FTA can be agreed upon, there will be more agriculture coming from the United States than there are stars in the sky. Food prices will fall significantly inside the U.K and Scotland will find a deep and wealthy export market for its whiskey and Angus beef. The logical integration of the Anglo-American financial services sector can proceed and a deeper integration of the U.S.-U.K defense base obtained. And what of chlorinated chicken which has received so much outsized attention in the U.K.? Contrary to popular opinion in the U.K., the United States has a healthy supply of free-range and organic poultry that can clearly meet U.K. standards.

The benefits of such a U.S.-U.K. agreement over free trade are quite clear. Currently, the trade weighted tariff for all goods is 2.7 percent in the U.K. and 2.2 percent in the United States. In agriculture these tariffs are 8.5 and 3.8 percent, respectively. Bringing these tariffs to zero would boost economic activity and improve the living standards in both economies. Free trade is the solution and not the problem. That is something that both sides of the Atlantic would do well to remember so as to not miss a major economic opportunity that lies just over the horizon.

[joebrusuelas]

Momentous Fed Meeting Looms

Policymakers face narrowing margin for error

This week’s Federal Reserve Open Market Committee (FOMC) meeting is a major economic event that will set in motion a series of monetary policy decisions that will culminate in the central bank running up against the long run real neutral interest rate, which we estimate at or near 3 percent, within the next 12 months. With the spread between the U.S. 10-year Treasury yield and two-year Treasury note yield currently at about 45 basis points, the margin for error is narrowing with each policy decision. As a result, the Fed may eventually begin to face criticism from investors and fiscal policymakers that they are prematurely shortening the businesses cycle as the yield curve flattens further or reaches the point of inversion.

 Our forecast is for a 25 basis point hike in the federal funds rate at the June 13 meeting, which would increase the policy rate to a range between 1.75 and 2 percent. After the June rate hike, as the economy accelerates well above its long-term growth rate of 1.8 percent and the unemployment rate likely falls to 3.7 percent, our estimate of the Fed’s reaction function implies additional 25 basis point hikes at the September and December meetings, bringing the policy rate to a range between 2.5 and 2.75 percent.

The spread on the U.S. yield curve will then likely flatten to about 30 basis points at the end of the year, setting up a series of important decisions for the Fed next year.

Taylor Rule model for Fed Funds rate

By the end of the year, our estimate of the Fed’s optimal policy rate is 2.55 percent, which suggests that heading into 2019 the central bank risks pushing the policy rate well above the long term neutral rate as the yield curve likely flattens. While the remainder of 2018 will be defined by the late cycle fiscal boost and risks linked to US trade protectionism, the major policy decision by the Federal Reserve that will define the final innings of the business cycle will likely arrive in the March to June period of 2019.

This week we expect the FOMC statement at the June meeting to include an update to policy language around the federal funds rate being “accommodative,” and it would also not be surprising if the committee altered the phrase “the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.” If either changes to the statement occur, it will likely cause yields along the maturity spectrum to rise after the publication of the policy communique, especially if, as we expect, the “dot plot” inside the summary of expectations points to an additional rate hike of 25 basis points in December. This would be in contrast with current market expectations of a 26.5 percent probability of the Fed moving in that direction.

The Fed’s balance sheet normalization should remain on track to peak at $50 billion per month in October and total $1 trillion by end of 2019.

Inside the summary of economic projections, which will accompany the Fed policy statement, we expect an upgrade to the growth and employment forecasts to 2.9 percent and 3.7 percent, respectively. As well, the midpoint of FOMC participants’ assessments of appropriate monetary policy, or the “dot plot,” will likely include an additional rate hike relative to the 2018 forecast for the policy rate this year given the impact of the fiscal boost associated with the $1.5 trillion 2017 Tax Cuts and Jobs Act, as well as the additional boost of $320 billion in real spending included in the $1.3 trillion 2018 budget.

Meanwhile, economic risks are rising heading into the second half of this year. First, based on our visits with policymakers in Washington D.C., there is a rising risk of a government shutdown on Sept. 30 ahead of the midterm U.S. Congressional election. The shutdown will likely occur over the subject of immigration and funding of the Trump administration’s proposal to build a wall along the Southwestern border of the U.S. If political conditions move toward a more intense polarization around this issue, and a government shutdown looks likely when the Fed meets that month, it could cause the Fed to hold off on a rate hike.

Second, trade protectionist policies that may be put in place by the U.S. will likely exacerbate the slowdown in overall global growth, and place strains on the nearly 75-year old rules-based global trading system. The increased risk of U.S. protectionism, and the fact that oil prices that are up about 35 percent from a year ago, both imply downside risk to the global economy later this year. For the Fed, this will be the most difficult headwind to navigate. It will mostly likely want to steer clear of the political controversy surrounding the trade spat between the Trump administration and both its allies and adversaries. That said, the knowledge that an intensification of the trade spat will damp growth, cause an increase in prices, while disrupting supply and value chains that took a generation to build, will put the central bank in the most difficult of position of its forecast pointing to higher rates as the global trade systems spirals toward a possible trade war.

With respect to long-term interest rates, the combination of polarization in Washington and an intensification of trade disputes, could result in a loss of confidence among the global investors the U.S. relies upon to damp rates along the long end of the curve. The current deficit-to-GDP ratio is 3.7 percent and will rise to more than 5 percent in the near term. With a total debt-to-GDP ratio of 103 percent, it is not out of the question that global investors will charge a rising premium on debt issued by the U.S. Treasury. Our preferred estimate of the term premium charged by buyers of U.S. debt implies that the risk premium remains in negative terrain. If global financial instability returns due to international trade disputes or systemic risk associated with Italy, those risk premia could turn positive, sending rates much higher along the maturity spectrum regardless of what the central bank does.

Debt-to-GDP ratio

Term premium

Finally, there is increasing political risk in the Eurozone associated with a new government in Italy that is openly antagonistic toward monetary policy and the Brussels based regulatory regime. Given the fact that Italy is the largest bond market in the world with an estimated €2.3 trillion in outstanding debentures, owes €426.1 billion to the ECB and holds a debt to GDP ratio of 130 percent any attempt to increase spending along the lines of those suggested by the Five Star Movement-The League coalition government will create the conditions for a classic debt crisis inside the fourth largest European economy and call into question the viability of the euro.  

At a minimum this will almost certainly create periods of global financial volatility and tighter financial conditions along the lines of those that recently caused a 15 standard deviation move in the cost of Italian 2 year debt. Should the “Italian Question” become more problematic then the Fed will likely need to take another look at the balance of risks to the outlook and pull back on its rate hike forecast.

[joebrusuelas]

Labor market continues to sizzle

Unemployment rate matches 48-year low

The economy continued to add jobs at a sizzling pace in May as the unemployment rate declined to 3.8 percent, matching the 48-year low last reached in April 2000. The major policy implication from the report is that the Federal Reserve’s interest rate campaign will remain in place. We expect the Fed to boost the federal funds rate by 25 basis points at its June 13 FOMC meeting.

 The private sector boosted employment by 218,000 with 40 percent of the gains coming in the high-wage goods producing, construction and manufacturing sectors. Most importantly, average hourly earnings came in above the consensus forecast of 0.3 percent and are up 2.7 percent on a year-ago basis. When combined with the 0.2 percent gain in aggregate hours worked, which is up 2.5 percent on a three-month average annualized basis, this means the economy is likely to shift into another gear, bolstered by strong consumption and the late cycle fiscal stimulus which will likely soon begin to show up in the data in a meaningful fashion.

 While the minutes from the recent FOMC meeting tilted dovish, the impact of the late cycle fiscal boost to the economy and the hiring that follows it will certainly put modest upward pressure on wages and support at least two more rate increases this year, if not the three that is the foundation of our baseline outlook for financial conditions and rates this year.

 The household survey showed 213,000 workers exited the economy, which was the primary cause for the decline in the unemployment rate. This indicates that businesses will need to begin hiring non-traditional workers, many of who may lack some of the necessary skills that are in demand. This in turn means we should expect an increase in outlays on training and retraining.

The employment to population ratio of men aged 25-54 stands at 79.2 percent, and the unemployment rate of that cohort is 3.1 percent. Unless there is a meaningful migration of those aged 25-54 back into the labor force, monthly job gains will likely decline toward the 80,000 necessary to meet demographic demand going forward. Given that immigration policies are misaligned with the U.S. labor supply, businesses will likely continue to turn to substituting technology for labor, pulling forward the disruption that public policy has yet to address.

 The details of the report were strong across the board. Private service sector jobs increased by 171,000, with trade and transport advancing by 53,000, retail trade by 31,000, business services by 31,000 and education and health adding 39,000 on the month. The leisure and hospitality sector added 21,000 jobs and total government hiring increased by 5,000.

[joebrusuelas]

Fed takes step toward achieving dual mandate

The Federal Reserve’s Open Market Committee (FOMC) took one more step toward fulfilling its dual mandate of maintaining price stability while promoting maximum sustainable employment. While not a declaration of victory, the FOMC’s policy communique noted progress in achieving its 2 percent symmetrical target amid modest growth and a tightening labor market.

The committee chose to maintain a policy rate in a range between 1.5 and 1.75 percent. Our preferred estimate of the Federal Reserve’s reaction function implies a policy rate of 2.5 percent 12 months forward. The central bank appears determined to get the policy rate as close to 4 percent as possible prior to the end of the business cycle, which is consistent with the view that the Fed will need at least 400 basis points of firepower to address the next recession. Given the late cycle fiscal boost from the Trump administration, that goal is at once both necessary and compelling due to the probability that any fiscal boost that arrives in the wake of the next downturn will likely be less than robust.

One imagines that somewhere out there former Fed Chair Janet Yellen is smiling while her predecessor Ben Bernanke is lighting up a victory cigar. For current Fed Chair Jay Powell, however, he has the burden of moving forward the pace of the Fed’s rate hike campaign in an environment where the politicization of the Fed is a real risk, especially once the fiscal boost begins to noticeably fuel growth and inflation in the second half of the year.

Although markets have priced in a 39 percent probability of a fourth rate hike this year--which has been our base case for all of 2018--one gets the sense that the FOMC is determined not to fall behind the curve on the risks to the economy as reports of supply constraints and bottlenecks in production begin to pile up.

Other than the updated language on inflation, the Fed’s policy statement didn’t change much and the committee was careful not to front-run the boost to the economy from fiscal policy. The committee also refrained from addressing any risks to the economic outlook from accelerating trade tensions. We anticipate that the June FOMC meeting will include a more significant update to the overall outlook while pointing toward a possible fourth rate hike this year.

[joebrusuelas]

What Does a Trade War Look Like?

There has been quite a bit of talk about “trade wars” lately, and while such loose talk is often bandied about, the idea of what constitutes a serious trade war is not well understood. It has been nearly 90 years since the trade wars of the 1930’s upended the 1875-1914 period of globalization, so there is little memory of what a trade war looks like or even how to identify one has started.  One thing, however, is clear: If the Trump administration follows through on its threats to impose taxes on steel and aluminum imports we will move from the first stage of a trade spat to a full-blown trade war.

The goal of this policy, ostensibly, is to save jobs in the steel and aluminum industries. So let’s do the math. Let’s say the tariffs result in saving 10,000 jobs. The 25 percent tax on $29 billion of imported steel, and 10 percent tax on $17 billion of imported aluminum, will result in increased costs passed along to firms and consumers to the tune of $9.15 billion. Therefore, the implied cost of saving those jobs amounts to about $915,000 per worker. (Incidentally, this is line with the costs of the failed tariff policy pursed by the Obama administration between 2009-2012).

Since the middle of the 20th century the U.S. has largely refrained from engaging in trade spats and trading tariffs due to the inherent economic damage that is associated with them. Trade conflicts are often followed by higher prices, job losses, and economic distortions that cause more harm than good, and where the costs outweigh whatever benefits follow the imposition of targeted taxes on imports.

It is essential that policymakers, investors and business managers understand the differences between a trade spat and a full-blown trade war. The following framework is intended to bring a bit of reason to the discussion around what is quickly emerging as the major risk to the U.S. and global economic outlook in 2018.

Trade Spats

Friction between trading economies is the natural state of affairs for states in the global economy. Despite efforts to reduce frictions between states over the past 30 years through the World Trade Organization, such frictions from time to time result in trade spats. An example of a trade spat would be the 1980s era dispute between American and Japanese agricultural producers. That featured non-tariff barriers and was most famously illustrated by disputes around apple (the fruit, not the company) imports into Japan.

In an effort to protect its upscale apple market, where a single apple could cost more than $5 dollars, the Japanese government erected a series of non-tariff barriers in an attempt to prevent entry of cheaper American apples into the national market using the justification that it was attempting to prevent entry of fire blight bacterium into the domestic ecosystem via the import of apples. In 2002 the U.S., via the WTO, convened a panel where that trade spat could be mediated. Japan and the U.S. reached a mutual agreement ending the trade spat in September 2005.

Trading Tariffs

Trading Tariffs is best defined as the tit-for-tat or asymmetrical retaliation across industrial or tradable service products between two or more trade partners. Tariff wars are often short in duration and typically involve the party that instigated the trade conflict to withdraw tariffs after losing in the World Trade Organization courts, or due to domestic economic losses associated with the tradeoffs that typically involve job losses and higher prices.

Recent examples of tariff wars would be the actions taken by the George W. Bush and Barrack Obama administrations. The former imposed 20 percent tariffs on steel imports in 2001 that resulted in a retaliation via the WTO, which ruled such actions were illegal under existing treaty obligations. That was quickly followed by the imposition of $2.5 billion in retaliatory tariffs by the European Union. The Bush administration quietly withdrew the import taxes in 2002.

The Obama administration imposed taxes of 35 percent on the import of tires in an effort to “save jobs.” That resulted in a net increase of about 1,200 jobs at a cost of roughly $1.1 billion, or $900,000 per job, according to trade economists Gary Huffbauer and Sean Lowery. After a rigorous economic analysis by the Obama administration, it quietly backed away from the tariffs and they were withdrawn in late 2012.

The prospective tariff war that the Trump administration intends to start will likely look like the Obama experience. Policymakers, investors and businesses should anticipate asymmetrical and substantial targeting of industries outside of steel and aluminum, such as agricultural, advanced technologies and mobile system ecosystems. Google, Amazon, Facebook and large U.S. banks will also likely become potential targets.

For now we would not characterize the actions of the Trump administration as a trade war. For that we would need to see something more far reaching.

Trade War: Disruption and Devolution

A move into what we would refer to as “a trade war” would be when countries move beyond the WTO and engage in punitive trade and financial taxes. The first indictor that a trade war has begun would be the announced intention to withdraw from, or abrogate, current trade treaty arrangements. The best example of that would be the ongoing threats by the Trump administration to withdraw from the North American Free Trade Agreement. Under this framework we would not categorize a move into a trade war until the formal notification to withdraw from the trade pact is put forward.

Should the trade war spin out of control then one will likely see a period of disruption and devolution in global trade featuring the following: Dissolution of the global trade regime featuring the abrogation of multilateral trade treaties such as NAFTA and the WTO, the aggressive erection of non-tariff barriers, limits to capital flows and, in some cases, the risk of nationalizing and expropriating foreign-owned firms and property. At that point one could not rule out the return of the beggar-thy-neighbor currency devaluations that characterized the 1930s and intensified the Great Depression.

While the U.S. rests on the edge of a trade friction spilling over into a period of trading tariffs, it is not yet on the brink of a trade war. There will be plenty of opportunities for the U.S. Congress and business community to prevent such one from happening. Over the last 75 years the U.S. has helped provide the foundation and framework of the global trading system. The decision by the Trump administration to impose tariffs of 25 percent on all steel imports, and 10 percent on all aluminum imports, and sustained threats to pull out of the North American Free Trade Agreement, have stimulated fears that the U.S. is on the cusp of starting a trade war and bringing that era to an end.

[joebrusuelas]

Stock Market Decline Poses Little Risk to the Real Economy

The three-day slide in global equity markets doesn’t represent a significant risk to either the U.S. real economy or the middle market at this time. There has been an attention grabbing 1.2 standard deviation move downward in U.S. financial conditions, including housing and technology (see figure 1). Even so, policymakers tend to only take note when there is a greater than 2 standard deviation tightening in overall financial conditions. 

 Figure 1: Global Financial Conditions 

At this point the stock market decline appears to be a function of the following: 

An acceleration in global and U.S. growth has resulted in a quicker pace of monetary policy normalization by  the U.S. Federal Reserve, with the risk of inflation rising above the central bank’s 2 percent target in 2019 and 2020.

Rising political risk associated with difficulties in government funding, lifting the debt ceiling and the risk to global trade linked to the Trump administration’s policy. The markets are beginning to consider the implications of the U.S. Treasury issuing more debt, and the reality of what may be $1 trillion in annual operating deficits starting perhaps as early as 2018. 

Reassessment of risk appetites by global investors and the unwinding of a consensus trade linked to shorting volatility. It will likely take a number of days to completely unwind trades linked to that consensus strategy. While this is a highly technical and isolated problem that is creating noise across equity markets, it does not necessarily imply a premature end to the current business cycle or the longer-term bull market in equities.

The shift away from human trading to algorithmic trading strategies was in part responsible for the decline of nearly 1,000 points in a span of about 10 minutes on February 5. 

From an industry perspective this will likely have little impact beyond select financial institutions and the private equity space.

We anticipate that there will be more market disruptions along these lines going forward as global central banks unwind their unorthodox policies and reduce the size of their balance sheets to more manageable proportions. 

[joebrusuelas]

Retail Sales Point to Best Holiday Season in Decade

The U.S. consumer announced its presence with authority in November with retail sales data indicating that this is shaping up to be the best holiday shopping season in more than a decade. This data also suggests that the Federal Reserve had it right in its December summary of economic projects when it upgraded its growth and unemployment forecast. 

Given the likelihood of a large late-cycle tax cut, perhaps implemented as soon as Jan. 1, 2018, it is now likely that growth will be turbo-charged both next year and in 2019. This will surely alter the pace of policy normalization from the Fed with respect to the policy rate and the paring down of the balance sheet. The robust retail sales spending data affirms our above-consensus call for four rate increases in 2018.

It is important to note that retail sales comprise roughly 23 percent of all household spending, so this data does pose upside risk on the consensus forecast of a 2.4 percent increase in spending and GDP in the current quarter. Because of the outsized increases, spending may ease somewhat in December. Regardless, it is likely to remain quite robust. The spending is supported by strong job gains, falling unemployment and rising wages across much of the economy.

Topline spending on retail items increased at a 0.8 percent pace, with the core ex-autos metric up 1 percent. Ex-autos and gas increased 0.8 percent, ex-gas 0.6 percent, ex autos and building materials 1 percent. Ex-food services, ex-building materials, auto dealers and gasoline stations, and the control group that feeds into the calculation of GDP, were all up 0.8 percent. Ex-food and vehicles increased 1.1 percent.

Meanwhile, there were upward revisions to the September and October data.

Due to the noise int the month-to-month data, we prefer to look at a smoothed three-month average annualized pace, which provides a better indication of the underlying trend in retail outlays. The numbers here are staggering and the best in this business cycle. The topline was up 11.7 percent, the core 10.1 percent, ex-food service 13 percent and the control group was up 6.6 percent. Ex-gas increased 9.3 percent, ex-autos and building materials 9.4 percent, and ex-autos and gasoline sales 6.9 percent.

The detail of the data was quite impressive. The proxy for e-commerce increased 2.5 percent on the month and is up 10.5 percent on a year-ago basis. We have made the case for some time that the Commerce Department is underestimating the pace of overall internet driven retail sales, and we would not be surprised if this number is upwardly revised when we get the December data. With the exception of outlays on motor vehicles and parts, which declined 0.2 percent and general merchandise, which saw sales flat, spending was robust across the board. Outlays on furniture were up 1.2 percent, electronics 2.1 percent, building materials 1.2 percent, food and beverages 0.2 percent, while spending on health and beauty items increased 0.4 percent. Sales at gasoline stations increased 2.8 percent, clothing 0.7 percent, sporting goods 0.9 percent and eating and drinking establishments 0.7 percent.

[joebrusuelas]

More noise than signal in August jobs report

 The August employment report was more noise than signal. Ignore that topline slowing in total employment and focus on the longer-term trend growth near 175,000 per month (185,000 three-month average), and the strong gains in goods-producing and business service employment.

Despite the increase in the unemployment rate to 4.4 (4.442) percent, the labor market remains tight as a drum. The economy needs to add about 80,000 new jobs per month to keep the unemployment rate stable. Gains at or above twice that rate will continue to put downward pressure on the overall unemployment rate.

Given the traditional seasonal adjustment problems, policymakers at the Federal Reserve will look right through this jobs report and remain on track to begin paring operations next month with another 25 basis point interest rate hike likely to come in December 2017.

The detail of the report, as one would expect due to traditional seasonal issues, was somewhat soft. Beyond the gain of 70,000 in goods producing, 28,000 in construction and 40,000 in business services, gains were spotty. Trade and transport added only 8,000, the financial sector added 10,000, education and health contributed a below trend 25,000 and leisure and hospitality added 4,000. The government sector shed 9,000 and the IT sector contracted by 8,000. Average weekly hours remained unchanged at 34.4 and total aggregate hours worked increased 2.6 percent at a three-month average annualized pace.

Hurricane Harvey did not impact this report. That said, we do anticipate modest gains to continue over the next month or two, followed by an increase in the pace of hiring as rebuilding and reconstruction begins. We expect that the first sign of an adverse impact on the labor market will be seen in the weekly jobless claims data for the weeks ending Sept. 9 and Sept. 16. We anticipate that first time claims will likely rise by greater than 100,000 in the near term. The scope of the storm damage with respect to lost wages, homes, infrastructure and substructure will require a special supplemental out of the U.S. Congress. In our estimation that critical policy discussion will start at $75 billion.

[joebrusuelas]

Economic growth affirms Fed’s policy path

Policy response to storm will require substantial increases in federal outlays

U.S. growth in the second quarter rebounded strongly to 3 percent (2.2 percent on a year-ago basis) in contrast with the sluggish 1.2 percent posted during the first three months of the year. All told, the economy advanced at an above-trend rate of 2.1 percent during the first half of the year, which is impressive given the lack of policy reforms out of Washington D.C.

This reaffirms the low reading in our recession probability model, which points to a 15 percent probability of an economic downturn during the next six months. The economic rebound also affirms the Federal Reserve’s monetary policy path that points to a paring down of the balance sheet beginning in September, with another 25 basis point rate increase in December. Given the disaster unfolding right now on the Gulf Coast, the policy response will require a substantial increase in federal outlays and an increase in the annual operating deficit of the U.S. in 2017 and beyond.

Our view is that the second estimate of a $1.8 billion increase in inventories grossly understates what is happening in the real economy, thus there is a strong probability that there will be a further upward revision in the final estimate of second quarter GDP. That should translate into a noticeable boost to current quarter growth. Within the context of the disaster in the Gulf Coast region, that boost carries with it the power to completely offset the expected 0.2 percent net drag expected on GDP due to lost economic activity associated with the storm.

The composition of growth in the GDP report was impressive, driven by an upward revision on household consumption to 3.3 percent, from 3 percent previously. Gross private investment increased 3.6 percent on the quarter (2 percent previously), fixed investment 3.6 percent (2.2 percent previously), non-residential 6.9 percent (4.9 percent prior), 8.8 percent (8.2 prior), and intellectual property 4.9 percent (1.4 percent previously). Outlays on durables advanced 8.9 percent (6.3 percent prior) and non-durables increased 4.3 percent (3.8 percent prior). Spending on services increased 2.1 percent versus the 1.9 percent first estimate.

Exports advanced at a 3.7 percent rate while imports increased 1.6 percent. Government consumption declined 0.3 percent versus the first estimate of a 0.7 percent advance.

Alternative measures of growth indicated that real final sales improved at a 3 percent rate, gross domestic purchases 2.7 percent, and final sales to private domestic purchasers 3.4 percent with nominal GDP advancing 4 percent.

Importantly, corporate profits increased 1.3 percent on the topline and profits of non-financial corporations increased 5.4 percent versus a 0.3 percent advance during the first three months of the year, which indicates that the real economy rebounded significantly during the second quarter. Overall corporate profits are up 0.7 percent on a year-ago basis.

[joebrusuelas]

Harvey has taken 25 percent of oil and natural gas production offline

Likely to impact gas prices in Northeast  until capacity comes back online 

Texas will likely see an increase in retail gasoline prices of about 20-30 percent during the next 7-10 days if patterns compared with past hurricanes in the region hold. Forward-looking wholesale gasoline futures and retail gasoline prices indicate that retail gasoline prices are up 10 percent over the past week and should increase another 3.5 percent in coming days. This probably understates the likely path of prices given that Hurricane Harvey, now a tropical storm, and the flooding in its aftermath has knocked out 15.3 percent of oil refining capacity in the U.S. A full 25 percent of all oil and natural gasoline production has been taken offline.

Consumers should anticipate gasoline prices to continue to rise during the next two weeks, followed by an increase in supply once refining capacity starts to come back online. The median price of gasoline will likely then move back toward the trend in place before the storm, which was around $2.30 per gallon.

Because of the unique nature of the storm, which looks to be a landmark event in the history of U.S. natural disasters, a majority of refining capacity between Corpus Christi and Houston are offline. The Corpus Christi area is awaiting approval form the Army Corp of Engineers and Coast Guard to reopen in the next week, mitigating price increases in the region.

That said, the lack of cargo out of Houston, which is the second largest port in the US and handles 14 percent of container traffic in the U.S., will have a major impact as it’s a major source of gasoline supply for the U.S. Northeast in general and the New York-New Jersey area in particular. Thus, the most populous area of the U.S. should anticipate a noticeable increase in prices in heading into the U.S. Labor Day holiday. Again, those price increases will likely dissipate over the month of September, and local prices should revert to the mean by early October.

The Federal Emergency Management Agency indicated that, at the time of this report, about 30,000 people will need to be housed and approximately 450,000 will need some form of Federal Assistance during the next few years. Houston should see a sharp jump in initial jobless claims, which should show up in the data for the weeks ending Sept. 9 and 16. At this time, we don’t anticipate a sizeable slowing in hiring that would impact that Bureau of Labor Statistics estimate in September. However, if disruptions persist due to the unexpectedly large nature of the flooding, we will revisit that outlook for the October estimate.

We expect an impact on high frequency data because of the sizable drop in demand from utilities, which will show up in industrial production and consumption in the personal consumption expenditures report. Given that reports indicate demand for electricity declined by approximately one-third during the first 96 hours of the crisis, we expect a modest impact on the monthly data. While retail, housing and construction may see a modest negative impact in the September data collection, they will be the source of robust regional activity in coming months and probably a catalyst for faster growth to close out the year.

[joebrusuelas]

Hiring rebounded in April as economy added 211,000 jobs

Fed will likely see economy at full employment

The U.S. economy added 211,000 in April as hiring rebounded following a tepid 79,000-job gain in March. The April additions were enough to bring the unemployment rate down to 4.4 percent.

While the market will celebrate the topline gain, the most important development in this report was buried in the details, which showed that those facing involuntary part time employment for economic reasons declined to 5.27 million, below the long-term average of 5.4 million. This will not be lost on policymakers at the U.S. Federal Reserve who at this point are likely moving toward a judgment call that the U.S. economy is now at or below full employment.

Meanwhile, market participants will probably interpret this data as a reason to pass the tacos and tequila later today as they celebrate the Cinco de Mayo commercial holiday in the U.S. It would be wise not to over imbibe as the central bank may soon pull away the sangria. The April estimate of employment affirmed the Fed’s recent decision to look past the slowdown in first quarter growth, and the underlying detail in the jobs report, as well as the diffusion in hiring, all point toward a 25-basis point rate increase in June, with an additional 25 basis points later this year. We have made the case that if growth, like the April jobs data, rebounds or even accelerate, the central bank may even choose to add a third 25 basis point rate increase to the two it is already forecasting.

[joebrusuelas]

Economic growth off to a slow start on weaker consumption

Capex, a continued bright spot, may be ready to pick up the slack

Growth slowed noticeably during the first quarter due to a combination of residual seasonality, a sharp downturn in non-farm inventory building, warmer winter weather that damped utility demand and rising inflation. The result was a meager 0.7 percent increase in gross domestic product (GDP) and a weak 0.3 percent increase in overall consumption. Even so, the details of the report look a bit stronger than the headline increase, with growth on a year-ago basis up 1.9 percent. Meanwhile, real final sales increased 1.6 percent and final sales to private domestic purchasers climbed 2.2 percent.

The policy implications of the GDP report are twofold: first, the Federal Reserve will likely look right past this data, comfortable that the underlying details and bump in inflation is aligned with their forward-looking forecast for additional interest rate increases this year. Second, the Trump administration and Congress will likely view this as evidence that, absent comprehensive tax reform and infrastructure development, the economy will continue to chug along at a sub-2 percent pace for growth. While we forecasted a rebound to near 2.5 percent growth in the current quarter, there is a growing imbalance between investor and business expectations (the so-called soft data, which reflects sentiment) for growth, and hard data, which points to sluggish economic activity.

The bottom line is that if tax reform and clarity on infrastructure investment isn’t forthcoming this year, one should expect a reduction in risk appetites across the real economy and asset markets. That alone should get the attention of policymakers in D.C.  

Consumption details in the report were somewhat bleak. Demand for utilities waned, resulting in an abysmal 0.4 percent increase in outlays on services, well below the 2.5 percent average over the previous four quarters. While utilities account for about 5 percent of total service demand, seasonal shifts in demand can exert powerful swings from quarter to quarter inside the GDP estimate. And, slowing non-durable demand to 1.5 percent was definitely influenced by the 20 percent year-over-year increase in the price of retail gasoline. Regardless, the aforementioned declines should reverse in the current quarter back toward the long-term trend.

A bit more concerning is the decline of 2.5 percent in durable goods. This is undoubtedly a function of the auto sector seeing the impact of tightening credit conditions and damped consumer purchasing after a multi-year period of robust demand. That said, the sustained increases being seen in job creation and wages should support a return to form, which has resulted in a 3 percent increase in overall spending over the past three years.

During the first quarter, disposable personal income increased $121.0 billion, or 3.4 percent, compared with an increase of $141.6 billion, or 4.1 percent, in the fourth quarter of last year. Real disposable personal income increased 1.0 percent, compared with an increase of 2.0 percent during the previous quarter.

The silver lining in the data was the sustained improvement, albeit at a slower pace, of gross private investment to near 4.3 percent. Fixed investment climbed 10.4 percent, and residential investment expanded by 9.4 percent. Outlays on structures increased 22.1 percent, equipment 9.1 percent and intellectual property advanced 2 percent. Residential investment improved by 13.7 percent. We expect these gains in overall capital expenditures to be sustained in the current quarter, an improvement over the sluggish capex seen so far throughout this business cycle. Moreover, the most recent quarter’s RSM US Middle Market Business Index indicated that, at least among middle market businesses, there is continued scope for increasing capex six months ahead.  

Exports advanced 5.8 percent and imports were up 4.1 percent as net exports remained essentially unchanged from the previous quarter. The swing in non-farm inventories, which exerted close to a 1 percent drag on overall growth, will be reversed in the current quarter and support a much strong pace of economic expansion. Government spending dropped 0.3 percent due to declines in defense, state and local spending.

[joebrusuelas]

March Jobs Report More Noise Than Signal

The March nonfarm payrolls estimate of 98,000 new jobs created reflected both seasonal noise and a slowing of overall business activity during the month. Hiring averaged 190,000 during the first quarter of 2017, which is in line with the 187,000 average per month during 2016. So apart from payback for two strong months of hiring in goods producing industries and the seasonal noise in trade, transport and retail, the longer-term trend in hiring remains on track.

While the monthly estimate indicated hiring slowed, the unemployment rate declined to 4.5 percent on the back of an increase of 472,000 in the household survey. For the change to be statistically significant, it has to be +/- 500,000, so it is highly likely that this will not impress policymakers at the Federal Reservce enough to increase the pace of policy normalization. The bottom line for the March employment estimate is that it was more noise than signal.

Aggregate hours worked increased to 106.4 and are up 0.8 percent on a three-month average annualized pace. This bodes well for income gains to close out the quarter. Average hourly earnings increased 2.7 percent on a year-ago basis. The labor force participation rate held firm at 63 percent and the employment ratio improved to 60.1 percent.

Details in the report showed an improvement of 56,000 in business service hiring, 61,000 in private services sector hiring, a 28,000 increase in goods producing, 6,000 in construction and 11,000 in manufacturing. The gains in both construction and manufacturing, like the quarterly trend in overall hiring, are both sustainable following two months of above trend hiring. One important note on local policy: Starting in January about 20 major metro areas began the long, slow march toward a $15 dollar per hour minimum wage. In March the unemployment rate for those without a high school degree declined to 6.8 percent from 7.9 percent. In our estimation this is the first tangible sign that a shift in policy around the country is attracting the most disenfranchised among the population back into the labor force. Thus, it isn’t surprising that the U-6 or the estimate of those not employed, marginally attached to the work force or employed part time for economic reasons, declined to 8.9 percent, below its historical average of 9 percent.

[joebrusuelas]

FOMC Preview: Fed Shifting Into Second Gear to Keep Up With Improved Economy

The U.S. Federal Reserve will likely raise interest rates by 25 basis points this week in what is shaping up to be the most meaningful Federal Reserve Open Market Committee meeting since the December 2015 conclave that kicked off the Fed’s normalization project. The Fed is also likely to make an adjustment in its “dot plots” to suggest a fourth rate hike this year and raise both the growth and inflation forecasts in the summary of economic projections (SEP). 

In short, we e think the central bank is adjusting to an improvement in underlying economic fundamentals while tacitly acknowledging forthcoming expansionary fiscal policy.

 The Fed’s SEP will likely indicate that participants now anticipate four rate hikes this year, with an additional three in 2018. The goal is getting the central bank back to its estimated nominal neutral interest rate of about 3 percent by 2019. Upon the publication of the SEP we do expect noticeable increases in interest rates along the maturity spectrum, and appreciation of the U.S. dollar against the major trading currencies.

The upgraded dot plot forecast will require an improvement in the growth and inflation estimates. Forward-looking investors and firm managers should anticipate changes in the inflation outlook with the committee removing any references to inflation undershooting the 2 percent objective.

In addition, we expect the Fed to look past what is shaping up to be another first quarter of soft growth, mostly due to sustained problems in correcting for noise in the seasonal adjustments, a slower pace of tax refunds than is normally seen and a modest deceleration in inflation-adjusted spending. Given the improved outlook across industrial sectors and financial conditions (if one accounts for housing and technology financial conditions are well above one standard deviation above neutral) the economy will likely see a strong rebound in the second quarter and slightly stronger growth in the second half, which should provide the impetus for the Fed to effectively ignore the weak first quarter of growth. 

While the Fed will not publicly acknowledge the strong probability of the implementation of expansionary fiscal policy later this year, now is the time to begin revising up growth estimates for 2018 and 2019. Thus, we do expect the median growth forecast in the SEP to be revised upward. What will be just as interesting will be the changing expectations of participants in the probability of an increase in inflation during the next two years above the 2 percent target.

The statement will likely continue to characterize the labor market as solid and note the modest improvement in business fixed investment. The committee will almost certainly alter the language surrounding the risks to inflation to be balanced and we expect that there will be no changes to the final paragraph if the statement reflecting balance sheet policy.

The presser following the publication of the SEP and the policy communique should see Yellen outline her thoughts in such a way that it damps down financial market expectations and reiterates that the pace of normalization will remain gradual, following language in both documents that will likely be interpreted as hawkish by financial market participants.

There has been much talk among financial participants of possibly one or two dissents at the meeting but we expect that Brainard, Evans and Kashkari will hew to the consensus and hold back on any dissent until later in the year when policy discussions turn to a possible fourth hike amid changes in fiscal policy.