US: Spring is in the air!

by: Peter de Bruin

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The economy struggled with the especially adverse winter weather in the first quarter, but we should see substantial payback from the winter slump in the second quarter. Moreover, fundamentals are becoming increasingly healthy. The pace of fiscal consolidation has fallen sharply, which together with a strengthening labour market and improved household balance sheets explains why we expect consumer spending to accelerate sharply. Meanwhile, profit margins are at historical high levels, implying a sound investment outlook, while residential investment needs to increase to facilitate a growing population. Against this background, the Fed will continue to gradually unwind its QE-programmes, though we continue to think that it underestimates the strength of the recovery. That is why we see slightly more rate hikes from the middle of next year onwards than what the Fed currently communicates and markets price in, suggesting that Treasury yields will move higher.

Economy struggled with the bad winter weather in Q1…

Incoming data suggests that the economy struggled with the unseasonably cold winter weather in the first quarter. Indeed, although spending on services held up relatively well, partly helped by higher energy-related expenditures, both durable and non-durable goods consumption declined. As a result, we estimate that total real consumer spending grew by just 2.0% qoq saar, substantially less than the 3.3% recorded in the fourth quarter. Meanwhile, activity in the construction sector was also seriously hampered by the poor winter weather. Housing starts fell by more than 11% in January, and failed to recover meaningfully in February and March, implying that residential investment was a drag on growth in the first quarter. Furthermore, according to capital shipment data, investment in durable equipment was also soft. Again, the weather is to blame, but this is just part of the story. At the end of last year, rules that allowed companies to depreciate their investment at an accelerated pace were ended. This gave a boost to investment in the final quarter of last year, and we are now seeing some payback for this. Finally, monthly trade data suggest that net trade contributed negatively to growth, after it provided a significant lift to growth in the final quarter of last year. Bringing everything together, we think that the economy grew by around 1.5% in the first quarter substantially less than the 2.6% in the final quarter of last year.

…but we should see payback in the spring

However, we think that the economy will bounce back sharply in the second quarter as we are likely to see substantial payback for the weather-related weakness. Indeed, vehicle sales rose by almost 7% in March, following three months of weak sales. Moreover, the ISM non-manufacturing index bounced back sharply from its February dip, while its manufacturing counterpart was up for the second month in a row. Finally, the winter weather’s grip on the labour market loosened substantially in February and March. Indeed, nonfarm payrolls growth fell to 84K in December, but has steadily rebounded reaching 192K in March. All this suggests that the economy at the end of the first quarter was already picking up steam again, and that it will enter the second quarter on a much stronger footing.

Sound fundamentals should support consumption…

Apart from better weather, the recovery should be underpinned by healthy fundamentals. First and foremost, the pace of fiscal consolidation has fallen from 1.8% of GDP in 2013 to around 0.5% in 2014. This should primarily underpin consumer spending, though there are more reasons behind our view that consumption growth will accelerate strongly in coming quarters. As noted above, the labour market recovery is gathering momentum again and we expect job growth to continue to strengthen, pushing down the unemployment rate. This, in turn, should start to exert modest upward pressure on wages, which so far have been growing at a relatively unimpressive 2.1% in year-on-year terms. But households’ balance sheets are also in good shape. Indeed, due to strongly rising stock and house prices, households’ net worth (assets minus liabilities) rose by almost $10 trillion dollar in 2013, greatly reducing the necessity of households to save.



…as well as investment in durable equipment

The fundamentals for investment are also healthy. Profits grew by 2.1% (qoq non-annualised) in the fourth quarter of last year, bringing the share of profits in GDP to 12.7%, the highest level since 1950Q4! Moreover, the economic outlook is substantially healthier than a year ago, while uncertainty on the fiscal front has been greatly reduced. As such, we expect investment in durable equipment to accelerate sharply following the poor performance in the first quarter.

Housing sector to remain supportive to economy

The housing market should also remain a support to the economy, despite the sector struggling with the rise in mortgage rates that we saw last year. Although in February, existing home sales were 7.1% lower compared to a year ago, it still takes just 5.2 months to clear the stock of existing homes. This is well below the eight month threshold, below which house prices, historically, tend to increase. As such, house prices should continue to rise, though the pace is likely to be more subdued after last year’s 13% surge in prices. We are also optimistic about construction activity, as it needs to increase in order to facilitate a growing population. Indeed, according to the Census Bureau, the population is set to grow by 2.5 million persons per year in the coming decade. Given that the average size per household is currently 2.5 persons, and will most likely fall a bit as the recovery gains traction, and that on average 300 thousand homes per year are demolished, housing starts need to rise from their current level of 946K to around 1.3 – 1.4 million in coming years.

Sustained period of above trend growth ahead

All in all, we see growth rebounding sharply in the second quarter as the economy benefits from payback from the winter slump, and, as all the cyclical drivers discussed above will increasingly come to the fore. This should allow the economy to grow above its trend growth rate for a considerable amount of time and we only see the recovery losing some steam at the end of 2015 as financial conditions tighten due to the Fed starting to remove its ultra-accommodative policy.

Core inflation to gradually rise

Meanwhile, a stronger recovery should help inflation to gradually bounce back in the course of the year. Headline inflation rose from 1.1% to 1.5% in March. Meanwhile, core inflation seems to have reached an inflexion point as it edged up from 1.6% to 1.7%. We think that core inflation will move gradually higher during the course of the year. Core inflation had trended downwards since May of 2012, reflecting that a rise in shelter inflation has been offset by falling core goods prices and lower services inflation. However, judging by producer prices, declines in core goods prices should soon start to moderate. Meanwhile, a stronger labour market recovery should gradually start to push up labour costs and hence services inflation. Although rent inflation should ultimately come down when construction activity picks up, on balance there will be upward pressure on core inflation going forward.

Fed set to continue tapering

As was widely expected, the Fed continued to taper its QE-programmes during its March meeting, trimming the size of monthly purchases by $10 billion to $55 billion. Meanwhile, FOMC members generally became more optimistic about the strength of the labour market recovery. As such, they raised their forecasts for the federal funds rate for the end of 2015 from 0.75% to 1.0%. What is more, during the press conference, Chair Yellen said that the time lag between the end of the QE programmes and the first rate hike would be ‘something on the order of around six months’. Although the minutes of the March meeting provided no evidence of an explicit discussion when rates should be raised for the first time, we doubt Ms. Yellen’s remark was a slip of the tongue. As the economy is set to accelerate sharply in coming months, a gradual tapering should continue, with the programmes coming to a halt in October. Given our forecasts for the unemployment rate and inflation, we see the first rate hike at around the middle of next year, which is not too far away from Ms. Yellen’s implied timing. Still, as we see a stronger recovery and a sharper fall in the unemployment rate than the Fed, it should raise the federal funds rate to 1.5% at the end of next year, a sharper pace than it is currently communicating.

Treasury yields set to rise

This is also a stronger pace of rate hikes than what financial markets are currently pricing in and, hence, explains why we think that 10-Y yields will rise later in 2014 and in 2015. Although the softness in the data flow due the adverse winter weather and the release of the more-dovish-than-expected March meeting minutes has so far kept a lid on interest rates, they rose after the FOMC raised its path of expected rate hikes for 2015. With the recovery set to accelerate sharply, we think this process has further to go. That is why we expect 10-Y yields to rise, in particular in the second half of 2014 and in 2015 when rate hike expectations should increasingly start to build.