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April 02, 2018

QUARTERLY ECONOMIC OUTLOOK FIRST QUARTER 2018

by Robert F. DeLucia, CFA

Consulting Economist

Summary and Major Conclusions:

▪ US economic growth slowed suddenly and unexpectedly in the first quarter, with real GDP

expanding at a sluggish 2.2% annual rate, triggered by a sharp slowdown in consumer

spending. A modest temporary slowdown should not be surprising considering the unabated

economic boom of the previous four quarters.

▪ The surge in corporate profitability that began in late 2016 continued in the quarter despite

slower GDP growth. A combination of 7% growth in revenues and widening profit margins

resulted in a greater than 15% increase in earnings per share (EPS), similar to the previous

quarter. Cash dividend payments increased by nearly 10%.

▪ The major financial market event in Q1 was a sharp rise in inflationary expectations. Consumer

inflation increased at a somewhat faster three-month annual rate of 2%, while wage growth

increased by nearly 3%. The Fed raised its policy rate to 1.75% at its March FOMC meeting,

while signaling further rate hikes ahead.

▪ The US economy has reached an inflection point, with the economic landscape undergoing

profound change. The US business cycle has progressed to a mature phase, characterized by

above-average growth and tightening resource utilization.

▪ The upshot for investors is the potential for steady increases in inflation and interest rates over

the next two years along with tightening monetary conditions. Although not now evident,

cyclical imbalances and excesses are likely to emerge as the current year unfolds.

▪ The Federal Reserve raised its policy rate in March to 1.75%, as expected. Three more rate

hikes are likely this year and another two or three in 2019. The federal funds rate could end

this year at 2.5% and 3% at the end of next year. However, monetary policy is unlikely to be a

threat to the expansion until 2019 and 2020.

▪ In the short term, the economic, financial, and policy backdrop is supportive of above-average

US GDP growth. The favorable outlook is underpinned by expansionary monetary and fiscal

policies, low inflation, massive pent-up demand for both housing and business fixed

investment, and elevated private sector confidence.

▪ Underlying demographic trends are positive and point to an accelerating pace of new household

formation over the next five years. Rapid growth in new households should boost aggregate

spending and output in coming years, most notably in housing construction and spending on

consumer durable goods.

▪ The major elements of my economic forecast for 2018 include the following: US real GDP

growth of 3%; moderately higher wage and price inflation; double-digit growth in corporate

earnings; a decline in the unemployment rate to below 4%; and a steady pace of policy rate

hikes by the FOMC.

The US economy has

reached an important

inflection point. GDP

growth was suppressed

during the first eight

years of the business

expansion cycle,

resulting in enormous

economic slack and

historically low inflation.

A protracted

deleveraging cycle

constrained growth in

private credit demand,

while sagging

confidence undermined

healthy growth in

production and

investment. A reversal in

each of these conditions

has been underway in

most recent years, with

important economic

implications for 2018

and 2019.

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April 02, 2018

▪ Market expectations for recession are premature. Classic cyclical economic and financial

imbalances that precede recessions are not evident: Inflation is low, monetary conditions are

expansionary, the housing market is expanding, and the yield curve remains in a normal

upward-sloping position.

▪ Aside from rising interest rates and inflation, the major risk to global economic growth is a

breakdown in world trade triggered by protectionist policies. The most bearish scenario is that

recently announced US tariffs on steel and aluminum along with direct action against Chinese

imports will trigger a ruinous trade war.

▪ Spreading protectionism has emerged as another layer of uncertainty with respect to the future

direction of the world economy, and the outlook for corporate earnings, productivity, and

inflation. While impossible to conclude with conviction, the most likely scenario is that calmer

heads will ultimately prevail and that the threats to world trade will gradually subside.

ECONOMIC REVIEW

The US economy weakened unexpectedly in the first quarter, with real GDP growth

of only 2.2%. Because of a sharp slowdown in consumer spending, real final sales

increased by only 2%. Major contributors to quarterly GDP growth were business

purchases of machinery and business equipment, nonresidential construction, and

inventory investment. The world economy was noticeably stronger with GDP growth

of 3.5%, led by Europe and emerging Asia.

Temporary Pause: A modest temporary slowdown should not be surprising

considering the unabated economic boom of the previous four quarters. While both

spending and output slowed sharply in the quarters, forward-looking indicators

point to a resumption of healthy growth in coming months. The Conference Board’s

Index of Leading Economic Indicators is currently rising at the fastest pace in

nearly eight years, signaling robust growth in coming quarters (see chart 1).

Chart 1: Spike in Leading Economic Indicators Heralds Solid Growth Ahead

Index of Ten Leading Economic Indicators, Six-Month % Growth Rate, Annualized

Source: The Conference Board

-1

0

1

2

3

4

5

6

7

8

9

2013 2014 2015 2016 2017 2018

%

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Wage and Price Inflation: The major economic event in the quarter was a rise in

inflationary expectations. Compared with the pace of recent years, core consumer

inflation increased at a somewhat faster pace of 1.8%, while wage growth

accelerated to nearly 3%. Core wholesale prices are rising at an even faster pace.

As expected, the Federal Reserve raised its policy rate to 1.75% at its March

FOMC meeting, and signaled further rate hikes in coming months and years

(see chart 2).

Corporate Earnings: The escalation in corporate profitability that began in late

2016 continued in the quarter. A combination of 7% growth in revenues and

widening profit margins contributed to a 15% increase in earnings per share

(EPS), similar to the previous quarter. Rising profitability is widespread across

virtually all S&P 500 sectors. Cash dividend payments to shareholders accelerated

in the quarter — partially in response to corporate tax reform — with annualized

growth of nearly 10% (see chart 3).

ECONOMIC OUTLOOK

The US economy has reached an important inflection point. GDP growth was

suppressed during the first eight years of the business expansion cycle, resulting in

enormous economic slack and historically low inflation. A protracted deleveraging

cycle constrained growth in private credit demand, while a super-accommodative

monetary policy held interest rates near all-time lows. A reversal in each of these

conditions has been underway in most recent years, with important economic

implications for 2018 and 2019.

Chart 2: Federal Reserve Raises Its Policy Rate at March FOMC Meeting

Target Yield on Overnight Federal Funds Rate

Source: Federal Reserve

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2012 2014 2016 2018

%

Chart 3: Steady Double-Digit Growth in Corporate Earnings

Earnings per Share, S&P 500 Companies

Quarterly Year-Over-Year % Growth

Source: Thomson Reuters

-8

-3

2

7

12

17

2012 2013 2014 2015 2016 2017

%

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▪ Economic Growth: Compared with anemic growth of close to 2% for the

first seven years of the expansion, real GDP has expanded at an average

rate of nearly 3% over the past year. This trend should continue for the

next four quarters.

▪ Resource Utilization: Expected growth of 3% greatly exceeds the long-term

growth potential of the US economy, estimated at 2.25%. The result will

be continued absorption of productive resources, rising resource utilization,

falling unemployment, and a growing risk of overheating.

▪ Consumer Inflation: Investor fears of deflation in the early years of the

economic recovery have shifted decisively to fears of inflation. After

persistently surprising on the low side in recent years, monthly data on core

inflation are in a mild accelerating trend and likely to surprise on the

upside over the next two years (see chart 4).

▪ Labor Compensation: Following many years of only 2% growth, wages and

salaries have entered a moderately accelerating growth phase. Similar to

consumer inflation, wage inflation is now more likely to surprise on the

upside.

▪ Foreign Central Banks: In addition to the US Federal Reserve, major

foreign central banks are moving closer to an important shift in policy from

massive stimulus to gradual tightening.

Chart 4: Most Recent Monthly Data Point to Higher Inflation

Core Consumer Price Deflator, Excluding Food and Energy

Annual % Growth Rate and Three-Month % Growth Annualized

Source: Bureau of Economic Analysis

0.5

0.7

0.9

1.1

1.3

1.5

1.7

1.9

2.1

2.3

2013 2014 2015 2016 2017 2018

Annual

Three Month

%

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▪ Federal Reserve Policy: The Federal Reserve is expected to gradually

normalize interest rates over the next two years to historical norms. The

main risk is that a worrisome spurt in wage and price inflation will coerce

the Fed to tighten policy with a greater sense of urgency, thereby

undermining growth (see chart 5).

▪ Fiscal Policy: Following an extended period of so-called fiscal drag —

weakness in GDP resulting from a combination of government tax and

spending policies — fiscal policy has shifted into high gear. Recently

enacted tax cuts and additional spending will accentuate the already strong

growth tendency of the US economy, and likely exert upward pressure on

inflation and interest rates.

▪ Long-Term Interest Rates: For the five years ending in 2017, the average

market yield on ten-year US Treasury bonds was 2.25%. Long-term interest

rates averaged 2.82% in the first quarter, and are expected to move

comfortably above 3% as the year unfolds.

The key point is that the economic landscape is undergoing profound change

consistent with a maturing business expansion. Compared with maximum potential

long-term economic growth of 2.25%, US GDP is set to expand at an annual rate

in excess of 3% over the next four quarters. The implications for inflation,

monetary policy, and interest rates could be significant. In particular, the

combination of expansionary fiscal and monetary policies greatly increases the risk

of an overheating economy as the year unfolds.

Chart 5: Federal Reserve Long-Term Normalization Strategy on Track

Target Yield on Overnight Federal Funds Rate, Dotted Line Represents Average Rate Since 1990

Source: Federal Reserve

0

1

2

3

4

5

6

7

1998 2008 2018

%

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TEN MACROECONOMIC DRIVERS

My forecast for accelerating economic growth is predicated upon several broad

economic factors: Massive pent-up demand in key sectors of the domestic

economy; highly expansionary financial conditions; and a major shift in the

direction of fiscal policy.

▪ Massive Pent-Up Demand: Although the business expansion cycle will soon

be entering its tenth year in June, not all sectors of the US economy have

participated. Prolonged weakness in residential and industrial construction,

consumption of household durable goods, and business investment imply

underlying pent-up demand in these areas. These prominent cyclical

sectors of the economy remain unusually depressed as a share of GDP

(see chart 6).

▪ Demographics: Underlying demographic trends are positive and point to an

accelerating pace of new household formation over the next five years.

Rapid growth in new households should boost aggregate spending and

output in coming years, most notably in housing construction and

consumer durable goods.

▪ Financial Conditions: Credit markets remain supportive of robust economic

growth. The financial health of the banking sector is the strongest in

decades while companies are easily able to raise funds in the corporate

bond market on very favorable terms. Credit quality within the private

sector is also healthy.

Chart 6: US Cyclical Economic Sectors Remain at Depressed Levels

Ratio of Construction, Capital Investment, and Autos to GDP

Source: Bureau of Economic Analysis

15

16

17

18

19

20

21

22

23

24

1968 1978 1988 1998 2008 2018

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April 02, 2018

▪ Inflation: Price stability is a prerequisite for healthy and sustained

economic growth. While short-term indicators of inflation suggest that the

cyclical trend is higher, the annual rate of core inflation remains stable at

less than 2%.

▪ Monetary Policy: Monetary policy will gradually shift to a more restrictive

pattern as the next two years unfold — although a sudden and severe

tightening is unlikely.

▪ Fiscal Policy: Recent legislative initiatives from Congress on tax and

spending policies are decisively pro-growth and are almost certain to

augment GDP growth over the next two years.

▪ National Income: Household and business incomes are expanding at a

consistent pace and should support strong spending over the next year.

Income growth is the ultimate source of sustained expansion in spending

and output.

▪ Business and Consumer Sentiment: Confidence surveys for all sectors of

the economy — households, large and small businesses, and homebuilders

— have risen to multi-decade highs (see chart 7).

▪ New Technologies: The rapid pace of technical innovation is opening new

markets and creating efficiencies in the production and distribution of

goods and services.

▪ Household Wealth: Surging equity and real estate prices in recent years

have pushed household net worth to all-time highs — an important source

of consumer spending.

Chart 7: Small Business Optimism Near an All-Time High

Monthly Index of Small Business Confidence

Source: National Federation of Independent Business

85

90

95

100

105

110

2009 2010 2011 2012 2013 2014 2015 2016 2017

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April 02, 2018

The bottom line is that the key drivers of economic growth appear sustainable and

should be supportive of a healthy economy in coming quarters. In fact, the primary

risk is that GDP growth proves to be too strong rather than too weak, therein

accentuating the typical economic and financial pressures that emerge in the late

innings of a business expansion cycle.

ECONOMIC FORECAST

There are no material changes in my economic forecast for the remainder of this

year and 2019, which can be summarized as follows:

1. US real GDP should expand at a 3% annual rate during 2018, slowing to

2.5% in 2019. Consumer durable goods, residential construction, and

business investment in plant and equipment should be sector leaders.

2. US corporate earnings are booming and should experience double-digit

growth for all of this year. My full-year forecast assumes annual increases

of 15% and 8% for this year and next year, respectively.

3. Capital formation should be at the forefront of growth through 2019.

Corporate profitability, business confidence, strong growth in final demand,

a rapidly tightening labor market, and an aging capital stock signal strong

growth in business investment in plant and equipment (see chart 8).

4. Consumer inflation is likely to drift higher over the next two years. Currently

at 1.5%, core consumer inflation could end this year at 2.2% and reach

2.5% by the end of next year.

Chart 8: US Business Investment Cycle in Full Gear

Nondefense Capital Goods Shipments

Annual % Growth Rate

Source: Commerce Department

-15

-10

-5

0

5

10

15

2013 2014 2015 2016 2017 2018

%

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April 02, 2018

5. The labor market should remain strong, with nonfarm payrolls increasing at

an average monthly pace of 175,000 this year and 125,000 in 2019. The

unemployment rate could decline to 3.5% later this year, matching its 50-

year low reached in 1967 (see chart 9).

6. Currently rising at nearly 3%, wage growth should accelerate to 3.25% by

the end of this year and to 3.5% at yearend 2019.

7. The Federal Reserve’s rate-tightening cycle could gather momentum later

this year and in 2019. My forecast assumes four rate hikes this year and

another two in 2019, implying a federal funds target rate of 2.5% at

yearend 2018 and 3% during 2019. A shift to an outright restrictive policy

appears unlikely over the coming year.

RECESSION WATCH

Trade protectionism is the greatest non-business cycle risk to the outlook.

Economic risks associated with the classic business cycle are becoming

increasingly relevant. The current expansion has progressed to a mature stage and

will be entering its tenth year in June. Nonetheless, none of the classic leading

indicators of recession are currently flashing red at this time.

Chart 9: US Unemployment Rate Near 50-Year Low

Unemployed Workers, % of Total Workforce

Source: Bureau of Labor Statistics

2

3

4

5

6

7

8

9

10

11

12

1967 1977 1987 1997 2007 2017

%

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Indicators to Monitor: Although I continue to expect the preliminary precursors of

recession to emerge later this year and during 2019, the US economy is

exceptionally well balanced and cyclical excesses are virtually nonexistent.

Investors should closely monitor the following indicators as evidence of a looming

recession:

▪ Consumer Inflation: Although short-term indicators point to an imminent

acceleration in inflation, the long-term core consumer inflation rate

remains stable at 1.5%, well below the FOMC target of 2%. A rise above

2% would be worrisome.

▪ Wage Inflation: Cost pressures continue to build in the labor market but

growth in total worker compensation remains below 3%. Wage growth

approaching 4% would be worrisome (see chart 10).

▪ Monetary Policy: Because of stability in wage and price inflation, the

current rate-tightening cycle remains benign, posing no threat to the

economic expansion.

▪ Credit Quality: Credit conditions within the private sector remain favorable

with only scattered signs of deterioration. Delinquencies in the banking

system remain in a downtrend in most loan categories, while corporate debt

defaults are expected to decline during the year. According to Moody’s, the

current 3.1% corporate bond default ratio is expected to end this year at

2%.

Chart 10: Wage Inflation in a Moderate Cyclical Uptrend

Annual % Growth in US Wages and Salaries

Source: Employment Cost Index

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2005 2007 2009 2011 2013 2015 2017

%

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April 02, 2018

▪ Profit Margins: Currently at an all-time high, corporate profit margins are

likely to stabilize before a period of erosion begins. An analysis of previous

business cycles reveals that margins tend to peak roughly two years prior to

recessions (see chart 11).

▪ Housing Cycle: Despite periodic weakness over the past year, the housing

market remains in a general uptrend, with construction spending expected

to increase by 8% to 10% for all of 2018. The housing cycle tends to peak

roughly two years prior to the onset of recessions (see chart 12).

▪ The Yield Curve: As the most reliable indicator of recessions, the Treasury

yield curve becomes inverted — long-term yields fall below short-term rates

— roughly 15 months prior to the onset of a recession. Relevant economic

and policy factors strongly suggest that an outright inversion of the yield

curve is well into the future.

The bottom line is that the traditional red flags signaling the onset of a recession

are absent. The crucial implication is that the US economic expansion will

continue for another year, at a minimum, and perhaps into 2020. Investors should

continue to monitor these seven reliable leading indicators as evidence that the

next recession may be approaching.

Chart 11: Corporate Profit Margins Stable at Business Cycle Highs

Operating Earnings, % Share of Company Revenues

Source: Standard and Poor's

%

6

7

8

9

10

11

12

13

14

15

2008 2010 2012 2014 2016 2018

Chart 12: US Housing Construction on a Steady Recovery Path

Housing Starts, Single-Family Units (Thousands)

Source: US Census Bureau

200

400

600

800

1000

1200

1400

1600

1800

2001 2005 2009 2013 2017

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Tariffs and Trade Wars: An emerging risk to the outlook pertains to spreading trade

protectionism following President Trump’s imposition of tariffs on US imports of

steel and aluminum. Although of minimal economic significance in isolation,

Trump’s actions could be a precursor to a broader anti-trade agenda, especially in

the aftermath of his rejection of the Trans-Pacific Partnership (TPP) and

renegotiation of the North American Free Trade Agreement (NAFTA). At a

minimum, further trade restrictions aimed specifically at China appear highly

likely.

▪ Investment Risks: The ultimate risk for the world economy and financial

markets is retaliation by other countries that could escalate into a ruinous

trade war with the potential to derail the global expansion. As such,

spreading protectionism has emerged as another layer of uncertainty with

respect to the future direction of the world economy, corporate earnings,

productivity, and inflation. While impossible to state with conviction, the

most likely scenario is that calmer heads will ultimately prevail and that

the threats to world trade will gradually subside.

Robert F. DeLucia, CFA, was formerly Senior

Economist and Portfolio Manager for Prudential

Retirement. Prior to that role, he spent 25 years at

CIGNA Investment Management, most recently serving

as Chief Economist and Senior Portfolio Manager. He

currently serves as the Consulting Economist for

Prudential Retirement. Bob has more than 40 years of

investment experience.

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April 02, 2018

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