Although recent hurricanes have created volatility around the data, real growth in the US has quietly accelerated behind the noise. In Q3, the economy created an average of 121k jobs per month, the ISM measures of service and manufacturing activity reached ~10 year highs, and core capital goods orders rose at a 3-month annualized pace of 19%. Here is why this matters:
Although many forecasters mistakenly marked their growth forecasts down following the storms, many have now reversed course and revised both their Q3 and full-year 2017 outlooks upwards. After real GDP prints of 3.1% and 3% in the 2nd and 3rd quarters of the year, we are now on our way to a third consecutive print above 3% (the Atlanta Fed GDP tracker currently stands at 3.2%). The last time this happened was 2004. In some ways, this shouldn’t come as such a surprise since economists are historically too optimistic in the first half of the year and subsequently miss positive growth signals in the latter half. Looking at the average month-over-month change in Citi’s Economic Surprise Index, the pattern becomes evident, and it is especially pronounced this year.
Even the Federal Reserve has been steadily increasing its GDP forecast for year-end 2017 over the past three meetings from 2.1% to 2.4%. Though the Fed is often accused of being overly optimistic, this healthy pace of growth is actually achievable in 2017 and in the context of the recovery.
Though inflation may have been a big downside surprise this year, perhaps the bigger surprise is the fact that the Fed is likely going to be able to hike three times despite this headwind. The Fed has been able to continue normalizing interest rates because central bankers tend to look at a range of economic and financial indicators in order to create a mosaic of the health of the economy, rather than using a simple policy rule. In the US, the dashboard is mainly green, and while the aforementioned inflation data may be blinking yellow, it would not be the first time the Fed hiked before all data points reached their targets. Often times the Fed prefers to focus on leading indicators as opposed to lagging ones since their policy choices take effect over long periods of time. Indeed, producer prices, consumer and business sentiment, and orders for equipment spending have all improved this year. Easing financial conditions (i.e. the stock market and the dollar) have also further incentivized the Fed to act.
Strong real growth is the missing puzzle piece which has allowed the Fed to break the negative feedback loop they faced in 2016 where weak global growth and a strong dollar prohibited them from tightening policy, despite the fact that core CPI was running above 2%. This shift in the correlations between macro variables has defined price action in 2017 and reflects a change in regime where the Fed has been able to raise rates with fewer negative externalities. This “goldilocks” environment of strong growth coupled with low inflation has been a boon for all financial assets, especially riskier ones, and as the outlook continues to brighten, it is hard to argue against this trend persisting.
As we look ahead, it is important to ask ourselves if this virtuous cycle of benign inflation, a soft dollar, strong growth, and a gradual Fed will continue undisturbed or if the paradigm is due to shift again. Idiosyncratic and unforeseen shocks are always possible, but outside of these scenarios, the current low volatility environment is likely only to be jolted if the market believes that the gradual removal of monetary accommodation is no longer appropriate. For monetary policy makers to become uneasy, the risks of overheating in the form of an asset bubble or higher inflation would need to be more evident. Indeed in the US, the unemployment rate continues to grind lower and currently stands at 4.1%, increasing the possibility that wages and realized inflation will accelerate. Currently, however, any acceleration in inflation or wages is not something the market anticipates given 10-year breakevens are only 1.9% (below the Fed’s 2% target). Ten-year nominal Treasury yields are also nearly unchanged since the start of the year.
Another possibility that could break the Fed’s gradual status-quo would be more aggressive fiscal stimulus. A fiscal boost would change the balance of risks for central bankers, causing them to be less cautious in removing accommodation. For now though, all we can do is stay diligent and watch to see if sentiment around inflation or fiscal policy shifts, because when that happens, all eyes will be on the response of central bankers.