Today’s economic landscape may challenge the performance of traditional investments going forward. Recent positive cyclical momentum looks set to continue for some time, but long-term structural headwinds remain firmly entrenched. Despite strong growth, low interest rates could challenge investors throughout 2018 and beyond.
Declining long-run potential growth, contained inflation expectations, and low global yields have all put downward pressure on interest rates for years. Interest rates peaked in the high inflation days of the 1980s, and today’s lower rates mean investors have fewer options to meet their income needs.
We expect interest rates to remain relatively low for some time, particularly by historical standards. To monitor markets going forward, we are watching:
Slowing potential growth
Real GDP growth has trended lower over the last 50 years, caused primarily by slowing labor force growth and productivity. Positive cyclical momentum caused growth to pick up in the second half of 2017, and optimism is high that 2018 will see a further boost from pro-growth policies. Yet the gravitational pull of structural headwinds is powerful, and over the long term we believe investors may need to prepare their portfolios for a lower-for-longer growth environment.
To gauge whether the recent state of positive growth data is cyclical or structural in nature, we are monitoring the following:
Risk of recession?
The shape of the yield curve, as represented by the spread (or difference) between the 2-year and 10-year Treasury rates, has been an important indicator of past recessions.
Average hourly earnings
The multi-decade trend in lower interest rates has been sustained, in part, by stagnant wage growth. We expect inflation to continue to be moderate, a key pillar of our lower-for-longer interest rate outlook. However, the link between inflation, wage growth and interest rates is strong. Wage growth needs to be closely watched as the labor market continues to tighten.
We will be watching: Sluggish wage growth is often cited as a key reason that higher inflation has failed to materialize during this expansion. Average hourly earnings growth showed some signs of life in Q1 2018, rising 2.7% in the quarter. Yet wage growth has shown several “false starts” during this expansion, as recently as 2015 and 2016. However, the unemployment rate is at a cycle low of 4.1%, and anecdotal evidence suggests the labor market is increasingly tight. We are closely monitoring average hourly earnings to see if wage pressure will bubble up. The equity market has been especially jumpy so far this year in regard to wage and inflation data. Our base case is that wage growth continues to accelerate at a gradual pace, as low-skilled jobs continue to be the source of most job creation, enabling the Fed to stay its slow and cautious rate hike course.
Risks to our view: The combination of a sharp rise in wages and a stronger-than-forecast rise in inflation would signal that interest rates could move higher quickly as the Fed raises rates more aggressively to stem the buildup of inflationary pressure.
Fed rate hike cycle
In December 2015, the Federal Reserve began an extremely measured rate hike cycle and, so far, has raised rates only 150 bps over the course of 27 months. As the economy appears to be on solid footing, the Fed expects to quicken the pace of rate hikes, with between 150 and 175 bps of further rate hikes expected by the end of 2019. Yet while the Fed is more intent on “renormalizing” rates, even these expected hikes will leave rates low by virtually every historic comparison. It is important for investors to understand that a more proactive Fed cannot solve the income challenge on its own.
We will be watching: Regardless of the absolute level of rates and the pace of the hikes, there does not appear to be a correlation between the federal funds rate, which is an overnight rate, and longer-term yields, which are the source of the majority of investors’ income returns. The above chart shows the movement of the 10-year Treasury yield during the past four rate hike cycles. Long-term rates reflect investor expectations of growth and inflation rather than Fed policy. Absent a real uptick in wage growth and inflation, we are skeptical that long-term rates will rise significantly, especially with global yields remaining so low.
Risks to our view: U.S. interest rates could begin moving significantly higher due to an increase in wage growth and inflation. Inflation expectations have stumped the Fed during this expansion, which has caused the market to react considerably when inflation data is released. If year-over-year wage growth starts to approach 3.5%, we may finally see an uptick in inflation, which could push long-term yields upwards.
Over the past several years, the Fed has revised downward its estimate of potential GDP growth. Lower potential growth has enormous implications for output, aggregate demand, and revenue generation in our economy. Since 2011, the Fed’s estimate of the potential growth rate has edged down from as high as 2.7% to now only 1.8%,1 with some estimates even lower.2
We will be watching: In June, our current economic expansion is on track to turn nine years old, making it the second-longest period of growth since World War II. Paradoxically, our long expansion can be partly explained by growth that is broadly in line with potential growth. Real GDP has averaged 2.2%,3 a low growth rate historically, even though it is still slightly higher than the Fed’s estimate of potential. The Fed revised its median 2018 GDP estimate higher to 2.7% due in large part to tax reform and increased government spending. But the Fed sees these effects as transitory, and left its long-term GDP estimate unchanged at 1.8%.
Risks to our view: Ironically, one risk to our current expansion could be growth that accelerates sharply ahead of potential. Given currently low productivity, a surge in growth would mean the economy risks overheating, which could cause the Fed to aggressively raise rates. Aggressive rate hike cycles have preceded each of the prior three recessions.
The economy added over 2.2 million jobs in the past year, and this breakneck speed of employment gains pulled the unemployment rate down from 4.5% in March 2017 to 4.1% by March 2018.4 The challenges imposed by long-run demographic trends have not changed, however, and the labor market could increasingly be a headwind for growth in more ways than one.
We will be watching: The monthly payroll report has been front and center of the economic landscape again in 2018. In particular, the unemployment rate has now moved well below the Fed’s long-run equilibrium estimate. The Fed expects the unemployment rate to be 3.8% in 2018, but at the current pace of job growth with the economy averaging 173,800 job gains per month,5 the unemployment rate could breach that threshold as soon as the second or third quarter. Although teachers’ strikes and a series of nor’easters dented the payroll numbers for March, the labor market looks set to get even tighter as 2018 progresses.
Risks to our view: So far, the Fed has shown little concern about the tightening labor market and has continued its slow, cautious pace of rate hikes. However, it remains to be seen if the Fed will tolerate an unemployment rate increasingly beyond its own estimate of equilibrium. An unemployment rate below 3.5% could shift the Fed rate hike cycle into a higher gear.
Productivity growth has been trending downward since 20046 and is a significant contributing factor to today’s low-growth environment. There is a wide range of theories as to why productivity is in secular decline. Weak business investment, which has underperformed during this expansion, is an obvious culprit holding back a productivity-related boost to potential output. Productivity growth would have to recover for several years to return to the 2.2% trend seen from 1950–2000.7
We will be watching: Monthly durable goods orders and shipments data offer a timely indication of whether businesses are investing in capital equipment. The recently passed Tax Cuts and Jobs Act has cut the corporate tax rate from 35% to 21% and altered tax-exempt timing on depreciation to incentivize investment spending. This lineup of pro-business news has created a swell of anticipation that business spending will improve markedly.
Risks to our view: Companies have many choices of what to do with newfound cash on their balance sheet due to tax reform, including engaging in stock buybacks and dividend payouts, which could divert dollars from business investment. A key risk is that companies may react to uncertainty regarding trade tariffs and protectionism by holding off on investment decisions.
Against a historically low growth environment, consumers stand out as the engine of the U.S. economy. Consumption accounts for 69% of U.S. growth and is supporting most aggregate demand and revenue generation in the economy.8
We will be watching: The household savings rate shows savings as a share of personal disposable income. The current level is below that of the previous 1991–2001 expansion and is closing in on all-time lows seen in 2005. Consumers remain a vital, positive contributor to economic growth, but sluggish wage growth has caused consumers to finance spending by dipping into savings. Positives such as a tight labor market and solid equity market performance have buoyed consumers for several years, but a more volatile market without significant wage gains could cause consumption to face headwinds going forward.
Risks to our view: Consumers may disregard the low savings rate and keep on spending, leveraging themselves back to levels seen before the Great Recession. This could create risks should interest rates rise significantly, or should the economy eventually slow again.
Risk of recession?
Slower growth should not be confused with a recession. There is a big difference between slower growth and no growth. The U.S. economy is experiencing positive growth momentum, and pro-growth policies are set to drive growth above current levels in coming years. However, in the interest of education, investors can easily follow this indicator, which is a key ingredient of almost every academic model that attempts to predict recessions. The shape of the yield curve, as represented by the spread (or difference) between the 2-year and 10-year Treasury rates, has been an important indicator of past recessions.
We will be watching: As can be seen in the above chart, yield curve inversion (when long-term interest rates are lower than short-term interest rates) is often seen as a signal of an impending recession. Even as the Fed has consistently raised short-term rates, the longer end of the curve remains stubbornly range-bound. As the yield curve is still more than 50 bps away from inversion, we do not see a recession on the horizon.
Risks to our view: The risks of a recession could rise if the Fed sees inflation start to pick up and becomes more aggressive in its rate hike path. This scenario is generally described as a classic Fed "overshoot.”
1 Economic projections of Federal Reserve Board members and Federal Reserve Bank presidents, March 2018.
2 FRBSF Economic Letter, “What Is the New Normal for U.S. Growth?,” October 11, 2016.
3 The NBER dates the beginning of the current expansion as Q3 2009. The average was calculated by averaging real GDP %q/q, from Q3 2009 until Q4 2017. NBER, U.S. Bureau of Economic Analysis, as of December 28, 2017.
4 U.S. Bureau of Labor Statistics, FS Investments.
5 173,800 is the average for the past year. U.S. Bureau of Labor Statistics, as of March 31, 2018.
6 U.S. Bureau of Labor Statistics, based on a 5-year moving average.
7 U.S. Bureau of Labor Statistics.
8 U.S. Bureau of Economic Analysis, as of March 28, 2018.
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