U.S. Economy Slowing as Expected


March 1, 2019— At long last, we have an estimate of economic growth for the fourth quarter of 2018. The report, which was delayed a month due to the government shutdown, surprised a bit to the upside, showing that Gross Domestic Product (GDP), adjusted for inflation, grew at an annualized rate of 2.6% in Q42018. There had been a few indications that growth might come in weaker, so it was a nice upside surprise. The inflation report released this week showed prices are still moving up only at a subdued rate. Taken together, the economic data this week supports our view that the U.S. economy is slowing relative to stronger growth in the middle of last year, but remains encouraging, while the tame inflation will keep the Fed from hiking rates in the first half of the year. This is supportive of our positive outlook and overweight position to U.S. equities.

GDP growth and capex

Growth of 2.6% in the fourth quarter caps off a strong year of overall growth, driven both by consumers and companies. For the full 2018 calendar year, growth measured 2.9%, matching the high-water mark set in 2015, making them the two strongest years of growth in this recovery (Figure 1). Consumers benefited from the continued strength in the labor market (2.7 million jobs added), accelerating wage growth, and of course, lower taxes. That said, consumer spending growth of 2.6% was just one-tenth of a percent higher than in 2017, and a tenth weaker than it had been in 2016. But by nearly any measure, consumers are still in a strong position.

Figure 1: U.S. economic growth (Y/Y%)


Source: Macrobond, Bureau of Economic Analysis. Data as of 4Q2018.

Companies investing in new capital showed renewed strength in 2018, growing 7% compared to 5.3% in 2017. Buoyed by strong sales and a positive outlook, firms also took advantage of lower tax rates and changes to expensing rules, both of which increased the incentive for capital investment. Of particular interest to us was the sharp acceleration in capex on intellectual property in 2018 (Figure 2). That category includes primarily investments in software as well as research and development (R&D) efforts. The sharp acceleration to a 16-year high in those types of spending reflect an ongoing “arms race” of companies investing in new technologies to gain a competitive edge in a dynamic economy with scarce available labor. We cover this dynamic and the investment implications in detail in our 2019 Capital Markets Forecast (CMF), in which we contend the economy is in the midst of a 4th Industrial Revolution.

Despite the strong year in 2018, we expect GDP growth to slow to roughly 2% in 2019. Consumers remain in a strong position, and firms do too. But we don’t expect firms will keep up the same kind of capex activity this year as they did in 2018.

Figure 2: Investment in intellectual property (Y/Y%)


Sources: Macrobond, Bureau of Economic Analysis. Data as of February 28, 2019.

Inflation remains in check

Another report this week gave an update on the Fed’s preferred measure of inflation, the Personal Consumption Expenditures (PCE) price index. (This is distinct from the Consumer Price Index (CPI), another measure of inflation that is informative, but the Fed prefers the PCE for a variety of reasons.) It was not a surprise that inflation remained quite low. The PCE was dragged down to 1.7% y/y. It had peaked at 2.4% y/y in July of 2018 but has since been pulled down, in large part due to the sharp drop in gasoline prices.

Due to the volatility in gas prices (and food prices), it is helpful to focus on Core PCE, which removes the impact of those items (Figure 3). That measure is much steadier, and came in at 1.9% y/y, just a tenth below the Fed’s target rate of 2.0%. Looking at the Core PCE in a higher frequency, the 3-month rate (also shown in Figure 3) reveals that after a sharp slowdown in mid- to late-2018, the gauge has bounced back to the 2% level. The previous weakness was one reason the Fed moved to a more dovish stance of late, and the recent bounce will help assuage any concerns of a more serious problem with too-low inflation. We do not expect inflation to run very high in 2019, in large part due to the 4th Industrial Revolution as discussed in our CMF.

Figure 3: Core PCE inflation

Figure 3.png

Sources: Macrobond, Bureau of Economic Analysis. Data as of February 28, 2019.

Core narrative

The report on GDP confirms our view that growth remains solid, but will not be as strong in 2019 as it was last year. We expect firms to continue investing in new technologies, but overall capex will slow a bit, unable to keep up the strong pace set in 2018 that was heavily dependent on the newly enacted tax law. We expect growth will be strong enough to boost U.S. equities, and inflation to remain subdued enough that the Fed will not even contemplate another rate hike until the back half of the year, which would also be supportive of risk assets.


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Luke Tilley


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