The Fed remains cautious to not push rate rise expectations in the US as other major economies keep interest rates lower for longer
The US economy is the backbone of the world economy in more ways than one. Firstly, it is the largest economy in the world, although the margin between the US and China is falling fast. More importantly, it is the most robust large economy in the world. It’s this latter point that holds the strongest relevance for long term investors, particularly those looking for stability in their portfolios.
In recent reports we have described the US economy as "good, but not great". That remains our view. We also stated that the balance of risks were to the upside until late 2015, while observing warning signs that the US economy might be dragged down by the malaise in other major economies such as Europe, China and Japan.
The start of 2016 has seen a turning point again, and now the balance of risks has shifted back to the positive. The US economy continues to show its robustness and ability to adapt to the slowing world economy; for example, US: GDP grew by just 0.8% pa in the first quarter of 2016, weighed down by falling exports. Comparatively, growth in the 2nd quarter is on track to produce a 2.8% pa growth rate, bringing the trajectory for 2016 back in line with a mediocre but robust 2% pa growth rate. There are also some statistical errors apparent in the US method of adjusting for seasonality, as five out of the last six years have seen very low first quarter figures with a rebound in 2Q.
Of particular note in the last two months:
- Housing starts and home sales. Like Australia and most mature economies, residential construction is an important source of economic activity. Housing starts in the US have averaged 1,441,000 per month since 1959, and because of its relatively slow population growth – compared to Australia – it has been very consistent around this level for the last fifty years onwards. However, in the depths of the GFC, housing starts fell to around half of their previous lowest levels. Since then, they have recovered gradually and are currently almost back at long term averages. This means that confidence has returned to the consumer sector and that there is still considerable upside to this housing cycle. Growth in residential construction spending was 17% in the past quarter.
- Exports and durable goods have bounced back. This news is more mixed, but at least the direction is positive. Falling exports were the source of the weakness experienced in the US in 2015, so while the contribution exports have made in 2016 is only slightly positive, a turnaround is still evident. Orders for durable goods such as cars and computers rose sharply in April but might be short lived, due to a huge jump in civilian aircraft orders that drove around 85% of the month's overall increase.
- Retail trade. 70% of the US economy is driven by consumer spending, so retail trade is an extremely important driver of the overall economy. Retail trade is also a lead indicator of business investment, as the more confident businesses are that consumers will keep spending, the more they will invest in inventory and new business. Wage growth has picked up and consumer confidence is holding at relatively high levels, meaning that the outlook for retail spending is strong.
- Impact on interest rates. All eyes are now on the US Federal Reserve to see if they will increase rates again this year. Our view remains that one more increase this year is very likely. Whether that is in June or later matters little for long term investors; the more pressing question is whether long term interest rates have priced in this year's increases and the likely trajectory beyond. While the US economy is robust, it falls short of its average economic growth rate and inflation targets. Economic momentum will allow the Fed to increase rates slowly to allow some flexibility in case the economy slows again, but they will not risk halting the economic recovery by increasing rates too quickly.
With all other major economies facing economic headwinds and keeping rates lower for longer, the Fed will be very cautious not to push expectations of rates higher and thereby cause the US dollar to jump. A higher US dollar hurts exports as seen in 2015; a fact that has been repeated by the Fed in several recent speeches. Headwinds exist for the global economy for the next 10 years at least, between the retirement of the baby boomers, fiscal pressures in almost all western economies, slowing emerging markets, and the unwinding of the QE stimulus that must eventually occur. Economic growth will be below average for some time to come.
While the US provides a brighter outlook than other markets, this does not mean that long term interest rates will rise to historic levels. We expect US rates to remain around their current levels, oscillating with market fear and greed cycles between 1.5% and 2.5%.