Orlando's Outlook: Hurricanes pose third-quarter risk

09-08-2017

Bottom Line Several key economic metrics we follow closely suggest the U.S. economy is accelerating. Corporate earnings in the first half of 2017 posted their best year-over-year (y/y) growth in six years; second quarter GDP was revised sharply higher to 3% (versus 1.2% in the first quarter) marking its fastest quarterly growth rate in more than two years; a robust start to the important Back-to-School (BTS) season helped spark nominal July retail sales to their best monthly gains this year; and core manufacturing shipments have been positive all year, with July results the strongest in five months.

Amid this favorable fundamental backdrop, however, is a weather-related Black Swan in the form of two devastating hurricanes. Hurricane Harvey just dumped a year’s worth of rain in the Houston area in the space of a week, and Hurricane Irma has already battered Puerto Rico and the Caribbean and is headed straight for Florida. Based on what we think we now know about Harvey—and what we fear about Irma—they are very likely to join Katrina (2005) and Sandy (2012) as the four most devastating storms in U.S. history.

With gas prices and initial weekly jobless claims spiking in the immediate aftermath of Harvey, and with Irma’s all-but-certain future devastation still unknown, we anticipate a temporary, near-term negative impact on growth in the third quarter, which likely will offset the economy’s strengthening underlying fundamentals. But as the flooding recedes and we sift through the rubble, the efforts to rebuild, funded by government and insurance money, should be additive to fourth-quarter and 2018 GDP growth.

Adjusting our GDP forecast The equity and fixed-income investment professionals who comprise Federated’s macroeconomic policy committee met on Wednesday to evaluate the strengthening global economy, the prospect for fiscal and monetary policy in Washington, and the potential impact from these two monstrous hurricanes:

  • The Department of Commerce revised its second-quarter GDP up from its 2.6% flash estimate to 3%—largely due to stronger consumer-spending trends—versus only 1.2% in the first quarter. The third and final release is scheduled for Sept. 28.
  • Stronger manufacturing and BTS spending trends suggest that third-quarter growth might approach or even exceed the second quarter’s trend line 3%, on the basis of solid underlying economic fundamentals. But the unknown devastation from Harvey and Irma will mitigate that strength. As a result, we’re reducing our 2.5% GDP estimate for the third quarter down to 2.4%, while the Blue Chip consensus is raising its estimate up from 2.5% to 2.7% (within a range of 2.1% to 3.2%).
  • But as we get into the fourth quarter, the massive rebuilding effort from Harvey and Irma will likely commence, adding to the strength from a good Christmas and manufacturing. So we are raising our fourth quarter GDP estimate from 2.5% to 2.9%, while the Blue Chip consensus is raising its estimate from 2.3% to 2.5% (within a range of 2.1% to 2.9%).
  • Commerce announced its annual benchmark revisions on July 28, revising its GDP estimates lower for six of the previous seven quarters dating back to the first quarter of 2014. As a result, our full-year 2017 GDP estimate moves down a tick from 2.3% to 2.2%, while the Blue Chip consensus lowers its estimate from 2.2% to 2.1% (within a narrow range of 2% to 2.2%).
  • We continue to believe the Trump administration and Republicans in Congress (largely due to political self-preservation) will successfully draft much-needed fiscal policy reforms in the fourth quarter and pass them into law in the first quarter of 2018. Combined with rebuilding efforts from Harvey and Irma, that should boost longer-term GDP growth back to perhaps a trend-line 3%. So we are ticking up our constructive full-year 2018 GDP estimate from 2.7% to 2.8%, while the Blue Chip consensus remains unchanged at 2.4% (within a wide range of 1.7% to 2.8%).

Federated’s Macro Policy Committee also made the following investment observations:

Back-to-back hurricanes pummel U.S. The devastation wrought by the pair of 100-year storms striking Texas and Florida within a fortnight is incalculable at present. Houston is our fourth largest city, whose 3.1 million workers (about 2% of U.S. payroll employment) account for $500 billion of economic activity annually (roughly 2.6% of GDP). This flood-driven storm dumped a year’s worth of rain (a record 50 inches) on Houston in a week, taking about 30% of our national refining capacity offline at least temporarily in the Gulf of Mexico, which is wreaking havoc on the price and availability of gasoline across much of the country.

AccuWeather estimates that Harvey could be the costliest natural disaster in U.S. history, with an early price tag of $190 billion, or about 1% of total GDP. While it is too early to know for sure, that would compare with repair bills of $130 billion for Katrina and $70 billion for Sandy.

Irma, in contrast, is a wind-driven storm that is still a few days away from hitting Florida, so we clearly have no idea how destructive it will be. But Credit Suisse estimates that if the storm hits densely populated Miami (our eighth-largest city) as a Category 5, then damage estimates could approach $250 billion, making it the most destructive storm in U.S. history. So if the high-end, worst-case damage estimates for Harvey and Irma at roughly 2.3% of U.S. GDP prove accurate, then our third-quarter GDP estimate of 2.4% will prove to be too optimistic.

Commodity and currency volatility With an estimated 30% of U.S. refining capacity now offline in the Gulf of Mexico due to Harvey, gasoline prices nationally have already spiked 15%, from $2.33 per gallon just before the storm hit to an average of $2.67 today. But many areas have already experienced price spikes of 50 to 70 cents per gallon or more, with some stations running out of fuel. The rule of thumb is that every one-penny increase at the retail gas pumps takes $1 billion of consumer discretionary spending out of the economy, so we could lose 0.35% of GDP temporarily.

Since the election, the dollar has lost more than 17% of its value against the euro, from 1.03 to an oversold 1.20 today, as European economic growth has accelerated compared with the U.S., and questions surrounding the Federal Reserve’s policy intentions are growing. We’ve also seen gold prices leap 13% over the past two months, from $1,210 per troy ounce in the beginning of July to a 1-year high of $1,362 today, in a flight-to-safety rally.

Inflation continues to grind lower The core personal consumption expenditures (PCE) index—the Fed’s preferred measure of inflation—has fallen from 1.9% on an annualized y/y basis in January and February 2017 to 1.4% in July, clearly moving in the wrong direction from the Fed’s oft-stated and aspirational 2% core inflation target. It’s a similar story with conventional inflation trends for core wholesale and retail inflation. Core wholesale producer price index (PPI) inflation (which strips out food, energy and trade) spiked to 2.1% in April and May from 1.6% in January, but has slipped back to a 1.9% gain in July. Core nominal retail consumer price index (CPI) inflation (which strips out just food and energy prices) fell to a 1.7% increase in each of May, June and July, down from 2.3% in January 2017, which had matched its highest reading in four years. Wage growth has been mired at 2.5% y/y growth in June, July and August, down from 2.9% growth in December 2016.

Treasury yields plunge Benchmark 10-year Treasury yields declined from 2.39% in early July to an overbought 2.01% today, marking the lowest levels since the election last November. This massive flight-to-safety rally is driven by concerns about U.S. economic growth and fiscal and monetary policy. Over the balance of 2017, then, benchmark 10’s could rise from their current 10-month lows back up to about 2.40-2.60%, and perhaps retrace the “Taper-Tantrum” peak from 2013 of about 3.00% by the end of 2018.

Fed uncertainty rises Our base case remains that the Fed will hike interest rates once more this year, perhaps in December, with some initial modest balance sheet shrinkage in September or October. The Fed’s inflation forecast has been wrong, so waiting until December for the next rate hike provides the central bank with some additional time to see if disappointing core inflation trends begin to firm and then rise.

With Janet Yellen’s term as Fed Chair set to expire at the beginning of February 2018, we believe that she will announce at one of the Fed’s upcoming policy-setting meetings in September or October that the policymakers will start to shrink the Fed’s balance sheet from its record $4.5 trillion to about $2.5-3.0 trillion over the next five years or so. The plan likely will be to allow some maturing Treasuries and mortgage-backed securities to begin to gradually roll off. We had hoped she would use her recent keynote speech at the Fed’s annual monetary policy symposium in Jackson Hole, Wyo., to provide investors with some details. But instead she delivered an academic speech on the wisdom of the federal government’s post-recession regulatory efforts, which in our view reduced the odds that she would be reappointed by President Trump.

In addition, this week Fed vice chair Stanley Fischer surprised investors by announcing his resignation (effective October 13), well ahead of his term expiring in June 2018. With two existing posts already open on the Fed board, this adds to the central bank’s leadership transition risk.

Earnings growth accelerates The first half of 2017 boasted the best corporate results overall in six years. In the second quarter, better-than-expected revenues and earnings per share were up about 5% and 11% y/y, respectively, with 74% of the companies beating on earnings by an average of about 6%. Profit margins rose about 5% (driven by rising productivity and moderate wage gains), and share repurchases added about 1.4%. Energy, tech and financials were the stars of the season.

Harvey hits auto sales Total auto sales continue to slide, down 4% on a month-over-month (m/m) basis in August 2017 to 16.03 million annualized units, versus 16.69 million in July. August was 12.4% below December 2016’s 10-year cycle high of 18.29 million annualized units sold. While Hurricane Harvey in the Gulf Coast likely affected demand last month, we’re expecting a storm-related snap-back in car sales over the last four months of calendar 2017, much like we saw with Katrina in 2005 and Sandy in 2012, as businesses and consumers replace flood-damaged vehicles.

August payrolls remain quirky August was a disappointment across the board, as nonfarm payrolls missed consensus estimates by 24,000 jobs, with downward revisions totaling 41,000 jobs in June and July. Moreover, household (loss of 74,000 jobs) and government hiring (decline of 9,000) both fell last month, the official unemployment rate (U-3) rose a tick to 4.4%, hours worked slipped to 34.4 hours and temporary hiring, an important leading indicator, was unchanged for the first time in eight months.

Since the recovery from the Great Recession, August tends to be the statistically quirkiest month of the year for the labor market, with sizable underperformance of 45,000 jobs when the initial report is released, and upside revisions averaging 65,000 during the next two months.

Moreover, this weakness is completely inconsistent with broad-based strength elsewhere in the labor market. JOLTS hit an all-time high of 6.163 million job openings in June, August’s ADP report for private hiring was the strongest in five months at 237,000 new jobs, and initial weekly jobless claims for the August survey week at 232,000 remain just off a 44-year cycle low. But Hurricane Harvey will begin to impact the September report, as last week’s jobless claims leapt to 298,000 from 236,000 the week prior.

Retail surges in July On the heels of weak May and June retail sales, July posted the year’s strongest results across the board, with 0.6% nominal and control m/m gains, providing some early support for our forecast of a strong BTS season. An event-driven consumer has elevated the most recent Easter and Christmas selling seasons to their best in five years, but the shoulder months have been soft. With the savings rate hitting its low for the year at 3.5%, however, we could see consumers take another breather in September and October to amass some dry powder ahead of Christmas spending in November and December.

Confidence remains strong:

  • Leading Economic Indicator (LEI) has been positive for 11 consecutive months, rising 0.3% in July 2017 on a m/m basis to 128.3, a new 58-year cycle high.
  • Conference Board’s Consumer Confidence Index soared to a 16-year high of 124.9 in March 2017, up from a 3-month low of 100.8 in October 2016, and hit a 5-month high of 122.9 in August, its second-highest level since 2000.
  • Michigan Consumer Sentiment Index spiked to a 12-year high of 98.5 in January 2017, up from a 2-year low of 87.2 in October, and it hit a 3-month high of 96.8 in August.
  • The National Federation of Independent Business (NFIB) small-business optimism index roared to a 12-year high of 105.9 in January 2017, up sharply from a cycle trough of 94.1 in September 2016, and it hit a 5-month high of 105.2 in July.

New inventory restocking cycle set to take off Inventory accumulation has slowed sharply to only $1.2 billion in the first quarter of 2017 and to $1.8 billion in the second quarter, from $63.1 billion in the fourth quarter. So if GDP is starting to reaccelerate, then inventory restocking may soon follow.

Factory orders enjoyed a powerful 3.2% m/m bounce in June due to strong aircraft orders, but gave it all back with a 3.3% decline in July. Core readings (which exclude volatile transportation orders) were firmer, rising 0.5% in July. Business inventories enjoyed a solid 0.5% gain in June, posting their seventh positive month out of the past eight. Wholesale inventories have risen three months in a row and in five of the past six months, increasing 0.6% in July on a m/m basis. Industrial production and capacity utilization resumed their ascent in June and July after pausing in May, so trends are positive in five of the past six months, with capacity utilization rising to a 2-year high in July at 76.73%.

Manufacturing continues to strengthens The ISM manufacturing index soared to a 6-year high of 58.8 in August 2017, up sharply from a contraction reading of 49.4 in August 2016. This sector accounts for about 12% of the economy, and the recently weaker dollar, shrinking trade deficit and stronger overseas demand have helped stabilize the manufacturing ISM at a healthy level. The trade deficit fell 8% in July 2017 to -$43.7 billion from -$47.6 billion in April. Although nominal durable goods orders plunged 6.8% in July due to volatile aircraft orders, core capital goods shipments rose 1.2% in July, marking their sixth consecutive positive month. Finally, the Empire regional Fed index soared to a 3-year cycle high of 25.2 in August.

Housing-market momentum clearly plateaued in March Despite low mortgage rates, a good labor market and modestly rising wages, pending home sales through July have now been negative for five of the first seven months of 2017. New-home sales (an important housing leading indicator, because they are calculated when a contract is signed, typically several months before closing) plunged 9.4% in July. Existing home sales (a lagging indicator calculated when a purchase contract actually closes), which now account for 90% of total home sales, fell 1.3% in July to an 11-month low.

Housing starts and permits (important leading indicators) have fallen 14% and 6%, respectively, from their recent peaks, and the HMI builder-confidence index has fallen to 68 in August from a 12-year cycle high of 71 in March. Pricing has started to slip, too, as the lagging Case-Shiller pricing index (a rolling three-month average) rose on a m/m basis only 0.11% in June, the slowest pace of the year.

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