Source: Euromonitor International
Baseline outlook: Above trend growth, mainly driven by business investment
We have upgraded the outlook for US economic growth by another 0.2 percentage points since February 2018, on the back of stronger than expected growth momentum at the end of 2017 and in early 2018. GDP growth is now forecast at 2.2-2.8% in 2018, and 2-2.8% in 2019, compared with a long-term trend growth of 1.3-2.3%. The positive impact of business tax cuts on investment remains the main driver of this above-average performance, with business investment expected to rise by 4.5-6.5% in 2018 and 3-6% in 2019. Consumption growth is also expected to remain above its long-term trend, though rising by a more modest 2-2.6% annually in 2018-2019.
Private sector sentiment remains high, though it is no longer rising and is vulnerable to uncertainty about rising import tariffs and the risks of a financial markets correction. External financing conditions remain loose, with interest rates remaining low despite recent increases. However, the expected normalisation of monetary policy over 2018-2019 raises the risks of financial market turbulence as the Fed gradually raises short-term interest rates towards 3%.
Estimated baseline forecast probability: 20-30% over a 1-year horizon.
Forecast risks
There is significant uncertainty about the impact of the business tax cuts on investment. On the upside, provisions such as the expensing of equipment investment can encourage investment more than ordinary corporate tax cuts. On the downside, investment adjustment costs and a corporate bias towards raising dividends and share repurchases could lead to an under-reaction of capital expenditures to the tax cuts.
Most likely pessimistic scenario: a lower response of investment to the tax cuts, declining stock market prices, rising corporate bond yields and greater uncertainty about trade wars reduce GDP growth to 1.9-2.5% in 2018 and 1.3-2.1% in 2019.
Source: Euromonitor International
Estimated scenario probability: 15-25% over a 1-year horizon.
Most likely optimistic scenario: a stronger than expected investment boost from the Republican tax cuts and further increases in stock markets and private sector optimism raise GDP growth to 2.5-3.1% in 2018, and 2.7-3.5% in 2019.
Source: Euromonitor International
Estimated scenario probability: 15-25% over a 1-year horizon.
Over March and April the US imposed 25% tariffs on USD50 billion USD of Chinese imports, in addition to earlier tariffs on steel and aluminium. China retaliated with its own 25% tariffs on USD50 billion in US imports. Further tariffs on up to USD100 billion in Chinese imports are possible in May or June.
NAFTA negotiations have also reached a critical junction, with crucial discussions ongoing during May and June. There are several signs of convergence on key issues, and the baseline forecast assumes minor or moderate modifications to the existing agreement.
In our baseline scenario, bilateral tariff increases remain limited and NAFTA survives, leading to declines in US GDP over 2018-2019 of 0-0.2%. However, trade war risks have still significantly increased in recent months. In our trade war scenario bilateral tariffs between the US and China increase by 15-25 percentage points. NAFTA is also dissolved, leading to the imposition of tariffs between the US, Canada and Mexico. In this scenario, US annual GDP growth declines by 0.2-0.5 percentage points in 2018-2020. We assign this trade war scenario a 10-20% probability over a 1-year horizon, and a 15-35% probability over a 2-year horizon.
More generally, greater fears about potential trade wars and more populist policies in the US and other advance economies could interact with fragile stock market and bond market valuations, leading to a major decline in financial asset prices and a sharp drop in private sector confidence. In our global downturn scenario, US GDP annual growth over 2018-2020 declines by 1-2 percentage points. We assign this scenario an 8-13% probability over a 1-year horizon, and a 15-25% probability over a 2-year horizon.
Private sector sentiment and stock markets: Still high, but no longer rising
Private sector confidence levels have remained much higher than long-term historical averages. However, they are no longer increasing significantly. The Michigan Index of Consumer Sentiment declined in April, though it was up by 1.9% relative to its level a year ago. The Small Business Optimism index increased slightly in April, but it remains below the average levels in Q4 2017 and Q1 2018.
US stock markets declined again over March-April. The S&P500 index has fluctuated with essentially no gains in 2018. Despite declining in March and April, US stock market prices still significantly increased year-on-year and there are still concerns about over-valuation relative to historical averages.
The current level of the price to earnings ratio is sustainable as long as real interest rates remain close to historical lows. Looking at long-term rates, such as those on 30-year real bonds, suggests that real interest rates are unlikely to rise much above 1% over the next 10-20 years. However, there is significant uncertainty surrounding these estimates, which leaves room for a market correction.
Another worrying factor was the approximate doubling of stock market volatility in the first four months of 2018. Stock market volatility declined closer to its earlier lows in the first half of May, however it remains a risk factor. Some analysis (Blackrock 2018) has estimated that a permanent doubling in stock market volatility relative to 2017 could reduce US stock prices by 20%.
Monetary policy and credit conditions: Rising interest rates should not derail the economy
US long-term bond yields have now increased to around 3% (1% in real terms), in line with our long-term forecast for short-term interest rates. The rise in interest rates since mid-2016 has also shown up in rising corporate bond yields. However, so far signs of financial distress are low. The spread between low-grade and high grade bond yields has increased very little (in contrast to its rise during the financial markets’ turbulence of early 2016).
The Federal Reserve increased its policy rate target to 1.5-1.75% in March. With an unemployment rate at around 4%, below its long-term forecast, and inflation recently heading towards 2-2.5%, the Fed is likely to continue raising interest rates. The policy rate is likely to reach 2-2.5% towards the end of 2018 and 2.5-3% by the end of 2019.
Aggregate demand: Consumption growth moderately above trend, business investment accelerating
Consumption growth continues to exceed long-term average growth, especially for goods. Services’ consumption growth is close to long-term average. The robust consumption growth has been mainly sustained by high consumer confidence about the future and low financing costs.
Real disposable income growth has been slightly below its long-term growth rate, due to extremely weak labour compensation growth, partially offset by robust employment growth. However employment growth is likely to start slowing towards 0.5% annually, with the unemployment rate around 4% already below its long-term level and the employment rate almost fully recovered back to its pre 2008 financial crisis level.
In our baseline forecast, consumption is expected to increase by 2-2.6% annually over 2018-2019, down from 2.8% in 2017. However, declining employment growth combined with low labour productivity and wage growth close to 1% in real terms suggest consumption growth is likely to fall towards 1.5-2.5% by 2021.
Strong earnings growth and optimism about future profits, together with favourable financing costs, have driven a fast expansion in business investment, rising by 4.7% in 2017. Equipment investment growth has been especially strong, approaching 9% year-on-year. Business structures growth is also high, but this is mainly due to rising investment in the recovering oil and gas sector. Excluding oil and gas, structures investment year-on-year growth was negative in Q1 2018.
The newly enacted business tax cuts are expected to sustain investment growth in 2018-2019. However, there is significant uncertainty about the responsiveness of capital expenditures to lower taxes. In our baseline forecast, business investment increases by 4.5-6.5% in 2018 and by 3-6% in 2019.
To learn more, download the strategy briefing Global Economic Forecasts: Q2 2018, offering further insights on the global economy and the latest global macroeconomic projections.