The economy is on a roll! Economic growth picked up strongly in the second quarter, with a reading of +4.2%, as momentum from the tax cuts and deregulation pushed spending and investment higher. Third quarter growth is also expected to be around +4.0%. Business and consumer optimism have been high. Indeed, equity investors have been optimistic, too, sending stock prices higher this year, although these gains have not come without some extreme volatility earlier in October. Bond investors, on the other hand, are a miserable bunch. The Federal Reserve continues their tighteningThe Fed has now given us eight rate increases totaling 2.00% since December, 2015. By the way, I want to run down the street screaming, “Stop!” At the same time, longer-term rates have risen about .20% to .25% in the past month, while inflation has been falling. Go figure. The ten-year Treasury has topped 3.00% and many economists call for its continued rise. Only a few call for stable or falling rates. Just remember this: Rising rates are always the culprit that derails economic growth, ultimately resulting in a reversal for the Fed and falling rates.
We now have four quarters to go before we set a new record length of economic expansion. I believe that we will. GDP has increased an average of 2.2% since the current recovery began in June, 2009. The longest expansion on record was from March, 1991 to March, 2001, with growth of 3.6%, engineered by Maestro Greenspan. That time period was not without its challenges, especially when the Fed raised rates unexpectedly in 1994. They may have raised rates too much but quickly realized their error and eased to keep the recovery intact. We face challenges, too, but we have a good chance of setting the new record in 2019; even if growth slows, I believe it will be back to the 2% trend line through the middle of next year. The Fed thinks we will make it, too.
Standing in the Way of Growth
I read Dr. Lacy Hunt’s latest newsletter and was surprised when he wrote that the economy appears to be on a downward trend and that long-term rates will fall. Of course, he does not say when…The Federal Reserve’s raising of interest rates has been a drag on the economy. Fiscal stimulus in the form of tax cuts, especially for corporations, led to spikes in investment and spending. But how long can that be sustained as rates rise? Interest sensitive sectors like automobiles and housing are already slowing. The yield curve is much flatter this year than last. The spread between ten year and two year Treasuries is .24% at September 30, 2018 compared to .84% at September 30, 2017. The curve is not close to inverted yet, but if it does, it will be a precursor of tough economic times ahead.
Government debt poses a threat to growth, but more on that later. Trade wars and tariffs dominated the market discussion in the third quarter with talk quieting down for now. Politics is causing concern both here domestically with our upcoming mid-term elections in November and around the world with places like China and the Middle East. Finally, the dreaded rising oil prices, now at $70 per barrel, always have the potential to derail growth.
Too Much Debt
Here I go, sounding like a broken record again. I harp on debt too much, but I strongly believe that it is the primary reason that GDP has only been able to average +2.2% since 2009, compared to 3% to 4% growth in other recoveries. Debt creates a drag on GDP, especially if it is not productive in generating income. US Government debt is at 104% of GDP at the end of the second quarter of 2018 and the ratio is likely higher in the third quarter. Treasury debt exceeds $21 trillion and the growth is on an unsustainable path. Studies show that GDP growth is sub-par in scenarios where debt is above 90% of GDP for over five years. Just look at Japan and Europe and see how sluggish their economies have been. China has slowed from its potential growth rate as debt mounts. Even US growth is weaker than average. As rates move higher here at home, do not forget all of the countries that tie their currency to the US dollar. It is stronger and rates are higher, making it tougher for them to repay debt.
It is not just government debt that is of concern. Here are some staggering numbers: Since the financial crisis of 2008, worldwide debt has increased by $70 trillion to $247 trillion, or 236% of world GDP versus 207% in 2008. US household debt is at $13.3 trillion, up from $9 trillion. Student debt has more than doubled from 2008 to $1.5 trillion and auto loans are higher at $1.25 trillion. Just when you think I don’t have any positives, here is the good news on employment and inflation.
Record Low Unemployment
Wow! The unemployment rate fell in September to 3.7%, matching a low rate first attained in September, 1966 and one that is only slightly above the rate of 3.4% in September, 1968. This has been great for the economy and is quite an achievement by the Fed, but it is also a source of their constant worry about a low rate of unemployment that could lead to high inflation. Those who advocate the Phillips Curve relationship would worry. Those of us who don’t believe in it aren’t too concerned. It has been great for the economy to see millions of workers obtain jobs and spending ability to push our economy further. There are over 7 million job openings nationwide. We still have a large pool of available workers, at over 11 million people, who could jump in to fill jobs. This “excess capacity” keeps inflation in check.
Speaking of inflation… Admittedly, inflation was trending higher early in 2018. Wage growth on a year-over-year basis scared everyone with a reading of +2.9% and subsequently settled back in a range of +2.6% to +2.8%. The consumer and producer price indices were rising vigorously, at +2.8% and +3.1%, respectively, but now the year-over-year changes are falling back to +2.7% and +2.8% for August. The inflation picture in China was very scary in early 2018, with the “world’s manufacturer” reporting producer prices rising at 7.8% in February; in September, price pressures there have eased to 3.5%. A leading inflation index published by ECRI was also rising annually earlier in 2018, but is now falling. Still of concern are oil prices that are up 21% and gasoline prices that are up 11% to 13% year-to-date. Housing price increases continue, but at a decelerating pace. Should inflation worry us? Of course. But is there a risk of huge inflation? Not right now. This will also help us get to the expansion record.
The brightest spot in the economy right now is the movie industry, bringing us films featuring Lady Gaga and Queen, two of my favorites! I also have two great nephews, ages 2 and 4, who want their Aunt Dorothy to take them to see The Grinch.
Thanks for reading! DJ 10/17/18
Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with Penn Community Bank and its predecessor since November, 2004. She is the author of Just Another Good Soldier, and Honoring Stephen Jaworski, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure of devotion.