US Forecast Updates, Q1 2018
Euromonitor International Macro Model
Baseline Outlook: A modest boost from Republican tax cuts
The outlook has improved since November 2017, due to stronger than expected economic momentum at the end of 2017 and passage of the Republicans’ long awaited tax cuts. Our baseline forecast is for GDP growth of 2-2.6% in 2018 and 1.8-2.6% in 2019. Beyond that, the US economy is likely to settle towards a long-term annual GDP growth rate of 1.3-2.3%.
Labour markets have continued to tighten with an unemployment rate of 4.1% in recent months, and private sector optimism remains high. Stock markets kept rising in the fourth quarter of 2017 and in early January, and they remain at high levels despite declining in the first half of February.
At the end of December, Congress passed the final version of the Republican tax reform bill. Most of the tax cuts are for businesses. The corporate tax rate is cut from 35% to 21% in 2018.There is also a 20% of income deduction for non-incorporated business taxes, implying a tax rate cut for the typical non-incorporated business from 39.6% to 29.6%. The top income tax rate declines from 39.6% to 37%. The business tax cuts are permanent, while the income tax cuts will expire after 10 years. We estimate that the tax cuts will boost 2018 GDP growth by 0.2-0.4 percentage points and 2019 GDP growth by 0-0.3 percentage points. Over a ten years horizon, the tax cuts are estimated to raise GDP by 0.3-1.4%.
We assign a 20-30% probability to the US baseline forecast over a 1-year horizon.
In January the US imposed large tariffs on imported solar panels and washing machines. Most likely, this is part of a limited set of tariffs on specific industries that will be imposed in 2018, rather than a general trade war. But trade war risks are still present. Concerns are also rising that the US may withdraw from NAFTA negotiations in 2018. While this is still not our baseline forecast, a withdrawal from NAFTA could reduce US GDP by 0.1-1%.
In our most likely pessimistic scenario private sector confidence and the stock market decline significantly. The impact of the tax cuts on business investment is much lower than expected. GDP growth declines to 1.5-2.1% in 2018 and 1.3-2.1% in 2019. Estimated probability: 15-25% over a 1-year horizon.
The most likely optimistic scenario assumes that businesses respond to the tax cuts by investing more than expected, private sector rises again at the same pace as in 2017 and stock markets continue to boom. GDP growth reaches 2.5-3.1% in 2018 and 2.3-3.1% in 2019. Estimated probability: 15-25% over a 1-year horizon.
Aggregate Demand: Growth increases in the second half of 2017, business investment outlook has improved
US GDP increased by 2.4% year-on-year in the second half of 2017, compared to long-term trend growth of 1.8%. However, US output is still 5.5% below pre-crisis trend almost 10 years after the 2008 financial crisis.
Business investment has increased by 5.4% year-on-year in the second half of 2017 (compared to long-term trend growth of 2.8%). This fast growth still leaves a gap of more than 12% relative to pre-financial crisis projected investment levels. Business investment is expected to grow by 3.8-5.8% in 2018 and by 2.9-5.5% in 2019.
The recovery in consumption has been better than for other GDP components, with the gap relative to pre-financial crisis trends at 3%. Year-on-year consumption growth was 2.7% in the second half of 2017. High consumer confidence and improving labour markets are the main factors sustaining robust consumer spending growth, while weak wage increases continue to hold it back. Consumption is expected to increase by 2-2.6% in 2018 and 1.9-2.7% in 2019.
Private Sector Sentiment and Labour Markets: Private sector remains optimistic, with ongoing labour market strength
Consumer sentiment has declined moderately since October, according to University of Michigan survey. However, it remains at one of the highest levels in the last few years. As for business confidence, the US CEO outlook index rose in Q4 2017 to the highest level in the last six years. CEOs are forecasting 2018 GDP growth of 2.5%. There were modest increases in short-term capital expenditure expectations, while hiring expectations declined slightly. In parallel, the small business confidence index has increased to the highest level since 1983. Strong private sector confidence support strong aggregate demand growth. However, the current level of optimism is likely excessive given the moderate impact expected from the recent tax cuts.
The US unemployment rate has stayed at 4.1% since October 2017, and is expected to remain at 3.8-4.2% in 2018, indicating full employment. The employment rate of prime working age (25-54 year olds) people has recovered around 80% of its decline during the financial crisis, showing a less optimistic picture of US labour markets than the unemployment rate. However, this more robust statistic confirms the strength of employment growth in 2017. 2018 is likely to see a complete recovery of the employment rate to pre-crisis levels.
Wage growth has remained weak in recent quarters at just 0.5-1% in real terms. This is moderately above the 0.4% average annual real labour compensation growth over the last 10 years. The extremely low wage growth has puzzled many analysts of US labour markets. Slow labour productivity growth (on average 1.3% over the last 10 years) is one contributor to low wage growth, but cannot fully explain it. Alternative explanations include a secular shift to more capital intensive production processes, and a reduction in workers’ wage bargaining power. In particular, the financial crisis may have made workers more worried about unemployment risks and more cautious in demanding wage increases.
Financial Markets: Financing costs remain low despite recent market turbulence
The US stock market has continued its strong rally from the bottom of the GFC at the end of 2017 and throughout most of January, accompanied by historically low volatility. In late January and early February, US stock markets declined by 10%, officially entering a market correction. Prices rebounded in mid-February, for a month-on-month decline of 2-3% (depending on the index used). The decline in stock prices was accompanied by rising bond yields and a spike in volatility to the highest level since August 2015.
Financial investors seem concerned about interest rates rising faster than earlier expected due to better than expected macroeconomic conditions. However, real (inflation-adjusted) interest rate increases in early 2018 have been modest, at around 0.2 percentage points. Our baseline estimate for a long-term fair value price to earnings ratio (PE ratio) for the S&P500 index is 22, with a plausible range of 16-33. As of mid-February, the S&P500 PE ratio ranges from 17 to 25, depending on the measure of earnings per share used. This suggests any overvaluation relative to fundamentals is modest, limiting the scope for further stock price declines.
In its December meeting, the Federal Reserve raised the Fed funds rate target range by 0.25 percentage points to 1.25-1.5%, as expected. It maintained its current projection of three rate hikes in 2018. Our Fed funds rate forecast for the end of 2018 is 1.9-2.1%, followed by 2.4-2.6% at the end 2019 and 2.5-3.5% in the long-term. Interest rates remain low and will likely remain low by historical standards, despite the recent modest increases in government bond yields.
The US yield curve has flattened over the last year, with spreads between long-term and short term yields close to the lowest level in the last 10 years. Financial market analysts have expressed some concern, and even fears of short-term interest rates exceeding long-term rates (an inverted yield curve), which is a recession signal. However, most of this flattening is due to further monetary policy normalisation, which would naturally lead short-term rates to converge to long-term rates in 2018-2019.
In our latest report extract, we provide you with an update on our latest macroeconomic forecasts for key economies and what these mean for our predictions for the global economy. Download Global Economic Forecasts: Q1 2018 to stay ahead of risks and opportunities as they emerge on a macroeconomic basis.