2017 Annual Economic Outlook 

Risk and reward in an aging business cycle. 

As the business cycle ages, we explore the potential upside and downside risks to our outlook. On the upside, the U.S. labor market is close to full employment, supporting both consumer spending and housing. On the downside, weak corporate profits, a strong dollar, and modest global growth are limiting business investment and export growth. Inflation is expected to rise gradually toward the Fed’s 2% target, strengthening the case for modest monetary policy tightening. However, capital flows will likely limit rate rises at the long end of the curve.

Executive Summary

“How old would you be if you didn’t know how old you are?” – Satchel Paige

There is no life expectancy for the business cycle. Both the extended expansions of the 1980s and 1990s witnessed a second wind with new stimulus of tax reform and technological applications. When President-elect Donald Trump takes office in January, which will likely be the 91st month of the current expansion, the initiatives he has proposed, along with the cabinet he has assembled, will present private and public decision makers with both potential risks and rewards over the next four years. Already the financial markets have moved in a way that anticipates financial success. Will actual policy actions justify such optimism?

For starters, our outlook for 2017 reflects recent financial market moves, but for now we have not inserted any major impacts from economic policy proposals until we have a better sense of the form of that policy. For the first half of 2017, our baseline forecast looks for trend growth of 2.0-2.5 percent with continued improvement in consumer spending based on the gains in jobs and wages as well as a wealth effect given the gains in financial markets and home prices. Spending on business equipment and structures should also show improvement over 2016 as the drag from energy-related cutbacks continues to wane. Interestingly, recent labor market surveys indicate a pickup in manufacturing sector openings. Rising mortgage rates represent a challenge to the housing market and will likely weigh on the outlook for home sales. Net exports remain a drag on overall growth.

Commercial real estate and the potential for additional infrastructure spending over time represent the two faces of risk and reward. At the current time, risks are on the mind of some officials as property price indices for apartments and central business district office properties stand well above precession peaks. Yet, the demographics of mobility, age and changing family lifestyles do favor recent gains in both these sectors.

Inflation, Rates and Profits: Reversals in Risk and Reward

Inflation trends represent an interesting reversal of risk and reward. While the prior years of the expansion highlighted deflation risks, the outlook now is for a steady rise in the inflation rate towards the Fed’s two percent target. In fact, inflation, as measured by the benchmark PCE deflator, had already started to rise in the second half of 2016 as labor costs, proxied by the employment cost index, began to rise and non-labor costs, benchmarked by oil prices, began to rise as well. A tighter labor market is the most visible source of rising inflation with a resulting increase in unit labor costs.

Rising inflation provides the Fed with the opportunity to raise the funds rate in a way that appears to simply validate prior financial market movements. The fundamentals of continued economic growth, rising inflation and significant capital inflows provide a basis for our expectation that the recent rise in our benchmark 2 and 10-year rates will be sustained and will increase in the year ahead. We expect that the yield curve between 10 and 2-year yields will flatten as the year progresses. Profit trends in 2017 are expected to improve relative to 2016 with significant upside rewards for some sectors if corporate tax reform is initiated by the Trump administration.

The Global Outlook: Credit and Political Risks—Potential Rewards?

Credit adjustments for China and Europe loom large in 2017. For China, the acceleration in house prices is eerily reminiscent of the U.S. experience of the past decade. That said, the leverage of the household sector and of housing in general is more modest than in the U.S. We are cautious, however, of the risks of leverage in the non-financial corporate sector. Political risks in Europe highlight the sovereign debt and financial sector risks in Europe. The path of Brexit has also yet to be determined.

Forecasting the Dark Side of the Moon: Recessions Ahead?

Business cycles do not die of old age. Our six-month ahead model for recession indicates a less than 10 percent probability of a recession six months from now. Our broader set of models average only a 13.4 percent probability. Yet, there are indications, such as the rising rate of noncurrent business loans, which signal a turn in the credit cycle.

The Path Forward: Not a Return to the Past

Our view is that the path of economic policy will diverge from the recent past and such a divergence represents huge rewards, as illustrated by recent financial market movements, but also the realization that risks are present as policy initiatives and the inevitable policy/political conflicts arise in the year ahead. We will stay on top of these to better serve our clients.
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