Over the past few years, first-quarter growth has slowed notably from the fourth quarter, often attributed to a phenomenon known as residual seasonality This year was no exception. First-quarter growth came in at 2.3% (annualized) – slower than the 2.9% recorded in the fourth quarter, but still better than market expectations for a 2.0% advance. Economic activity was supported by improved business investment, which recorded a solid performance thanks in part to a surge in activity in the petroleum and natural gas sector (+43% Q/Q ann.), and by an unexpected small positive contribution from net trade (Chart 1).

Following a 4% annualized expansion in the fourth quarter that was partly boosted by post-hurricane recovery spending, consumer spending slowed markedly, contributing just a measly 0.7 percentage points to growth. Consumer spending should regain a firmer footing ahead, buoyed by upbeat consumer confidence, a healthy labor market and tax cuts. This narrative is corroborated by stronger monthly spending toward the end of the first quarter, including the surge in March retail sales and a second consecutive monthly gain in existing home sales. The latter rose 1.1% m/m, but the recent performance would have likely been even better if it weren’t for very tight inventories.

Overall, the better-than-expected GDP outturn and healthy outlook ahead may augur a faster pace of rate hikes. But the evolution of price pressures will be the deciding factor. On that front, higher oil prices this week –WTI reached $68/barrel for the first time since late 2014 – accentuated concerns about rising inflation. This helped push Treasury yields higher, with the 10-year yield briefly breaching the 3% mark for the first time since 2014. The rise in yields propped up the trade-weighted U.S. dollar and weighed on equity valuations midweek. But a slew of broadly positive earnings reports, coupled with the upside surprise on GDP, eventually helped markets recover losses.

This week’s selloff reinforces our view that volatility has made a comeback (see report). The return of volatility, something which is likely here to stay, suggests that investors are now responding to rather than shrugging off negative news. Perhaps one of the best examples of this reality is the market reaction to elevated trade tensions between the U.S. and China earlier this month.

Ultimately, we believe that there is still time for the U.S. and China to settle their trade differences without much collateral damage – something that appears more likely now with the Treasury secretary scheduled to embark on a trip to China shortly. However, there is still a possibility that the talks fail and tariffs are implemented, with this scenario expected to weigh on economic growth. In a recent report that considers the impact on regional economies, focusing on TD’s East Coast footprint, we find that the Eastern Seaboard is roughly half as exposed to trade with China compared to the rest of the country combined (Chart 2). This would enable most states in the footprint to duck much of the blow from the prospective tariffs. That said, South Carolina’s elevated trade with China leaves it’s economy more vulnerable to the economic drag from protectionist trade policy.

Admir Kolaj, Economist | 416-944-6318

Markets moved sideways this week, rising in the first half and sliding thereafter, even as energy stocks rallied. Still, there was no shortage of economic data and Fed speeches, giving investors plenty of news to digest.

For its part, economic data surprised to the upside. After three lackluster months, retail sales jumped 0.6% in March and the core measure rose by 0.4%, beating market expectations. March was the first full month where taxpayers would have felt the impact of tax cuts on their paychecks, raising the bar for retail sales. This week’s report did not disappoint. Consumers responded to higher after-tax income by ramping up spending on most categories of products, particularly on discretionary and big-ticket items, such as autos, furniture, electronics & appliances, as well as at online retailers. While the strong print in March comes a little too late to save first quarter consumer spending, it sets up second quarter for a healthy rebound, with consumer spending likely to grow around 3%.

Housing starts also posted a decent rebound in March, rising by 1.9%. However, details were slightly softer than suggested by the headline. The gain was concentrated in the volatile multi-family segment, while single-family starts declined. For the first quarter as a whole, homebuilding has outperformed our expectations; however, it remains low relative to underlying demand and history. Even though economic fundamentals remain strong, a shortage of workers, available building lots, as well as risings costs of labor and materials continue to weigh on homebuilding activity. These headwinds are contributing to tight inventory of houses on the market.

Rising inflationary pressures also stood out prominently in the latest Federal Reserve Beige Book. Businesses reported rising steel prices in the aftermath of the tariff announcement. Prices for building materials, such as lumber, drywall, and concrete, also continued to rise briskly. Transportation costs, meanwhile, increased on the back of higher fuel prices, with oil prices rising to the highest level in more than three years this week. Labor shortages were also reported across a wide range of industries and skills. All in all, businesses are increasingly facing rising input costs for both labor and raw materials, and with declining unemployment, strong economic growth and the risk of further tariffs, this trend looks set to continue. It is likely only a matter of time before companies pass these higher costs onto consumers, ultimately pushing inflation higher (see our recent report).

Nonetheless, this week’s many Fed speakers downplayed the need for faster rate hikes. New York Fed President William Dudley said that the case for “tightening policy more aggressively is not compelling”. Meanwhile, Federal Reserve Vice Chair Randal Quarles said that he didn’t view recent flattening of the yield curve as a signal of an imminent recession. This suggests that the Fed remains on track (but not in a hurry) for continued gradual interest rate normalization.

Ksenia Bushmeneva, Economist | 416-308-7392

Politics dominated headlines this week. Financial markets recovered from last week’s selloff, as the fear of a full blown trade war between the U.S. and China receded for at least a few days. However, geopolitical tensions remain elevated as more economic sanctions against Russia took effect and the U.S. administration considers military action against Syria, providing a strong bid on gold and oil.

Although there has been more bark than bite on trade protectionism from the U.S. administration thus far, a hot trade war could do a lot of damage. However, events this week provide some hope that a trade war can be averted. Speaking at the Boao forum for Asia, Chinese President Xi repeated past promises to expand intellectual property protections and open various sectors of China’s economy to foreign investment. Later in the week, word spread that President Trump was directing officials to explore returning to the Trans Pacific Partnership, an agreement that he withdrew from shortly after coming to office.

With heightened uncertainty about the future trading relationship between the world’s economic heavyweights, business confidence could start to wane. Small business optimism pulled back in March, but the decline comes after the index reached a 35 year high in February. While a pullback was expected, one cannot rule out that rising trade tensions contributed to the greater-than-anticipated decline. What’s more, the report reinforced the labor market themes we’ve seen from the ISM surveys: rising labor shortages driving up wages as firms act to attract and retain workers (Chart 1).

Rising wages and input costs will eventually drive consumer prices higher. For the month of March, consumer prices rose 2.4% (year-on-year), but a more meagre 0.1% monthly change owing to decline in gas prices. Most importantly, core inflation (CPI ex-food and energy) ticked up to 2.1% y/y from 1.8% in the previous month, largely on the back of base-year effects (Chart 2). Still, core inflation rose a healthy 0.2% on the month, suggesting that a hot economy is leading to a broad build-up in price pressures.

Labor shortages, solid wage growth, and rising prices should reassure the Federal Reserve that higher interest rates are warranted. Although there was little new information in the March FOMC meeting minutes released this week, there were still some discussions worth noting. Strong economic growth along with rising price pressures are evidence that the economy is coping well with past rate hikes and can absorb more. In fact, some participants think that a total of four rate hikes may be warranted this year, while also suggesting that the language in the monetary policy statement be changed to reflect a view that interest rates are exerting a more neutral rather than accommodating impact on economic activity. Still, uncertainty about the ultimate impact of fiscal stimulus on output and the downside risks posed by trade protectionism is more consistent with a total of three rate hikes this year.

Fotios Raptis, Senior Economist | 416-982-2556

Equities have been on a rollercoaster ride this week, driven by shifting headlines on U.S.-China trade tensions. Initially, the U.S. announced details on its plans to levy a 25% tariff on $50 bn worth of goods imports from China, targeting some 1,300 items, including aircraft parts, batteries and medical devices. In a tit-for-tat move, China announced it would respond by mirroring the tariffs on American goods imports. The range of products targeted by China however, which included soybeans, cars, aircraft and chemicals, was narrower at 106 products. Later in the week, Pres. Trump instructed the U.S. Trade Representative to consider an added set of tariffs on $100 bn worth of imports. In what’s looking like a high-stakes poker game, China’s Ministry of Commerce said that China was prepared to “hit back forcefully” – reigniting trade war fears.

It is important to distinguish between tariffs that we already have details on and the latest inflammatory rhetoric. The former are not overly concerning. We estimate that the U.S. tariffs (including enacted tariffs on steel and aluminum) could shave off about 0.1 pp from annual GDP growth over the next few years, and could add up to 0.1 pp annually on inflation. Depending on what’s finally enacted following a consultation period, the price and demand impacts could be somewhat more pronounced if the tariffs are applied largely on consumer goods rather than business investment goods. On the other hand, China is targeting roughly 38% of American goods exports to China, which represent only about 0.3% of U.S. GDP. We estimate that these tariffs would reduce U.S. growth by up to 0.1 pp annually for the next two years. In this vein, slightly weaker U.S. demand could also act to offset some of the price pressures from the U.S. import tariffs.

The potential for the conflict to escalate is much more concerning. U.S. exports to China totaled $130 bn last year. This means that if the U.S. went ahead with tariffs on $100 bn of goods on top of what’s already being considered, and China reciprocated, the direct impact from exports would be much harsher given that all U.S. goods exports to China would face tariffs. The indirect impacts related to supply chain disruptions and the hit to business confidence and investment would also be more pronounced.

Developments on the trade front overshadowed decent signals from the economy. Auto sales came in slightly better than expected in March, and the ISM indices remained well in expansionary territory, despite easing off slightly (Chart 1). Payrolls gains slowed to 103k on the month, but this came atop of a very strong showing in February at 326k (Chart 2). Looking past the monthly noise, the underlying job market remains healthy, as demonstrated by increased wage gains – up 2.7% y/y.

Tax cuts and increased government spending are expected to add fuel to the labor market and the economy, with the latter expected to run at roughly 3% over the next few quarters (see forecast). In short, the U.S. economy remains on a solid course, but further escalation in the trade conflict poses a material downside risk. The hope and expectation is for the conflict to be resolved through the ‘The Art of the Deal’ rather than ‘The Art of War’.

Admir Kolaj, Economist | 416-944-6318

It was a relatively quiet week for economic data with investors turning their attention to political developments. Investor optimism recovered following the softening of China’s stance to the recent U.S. tariffs. The Middle Kingdom appeared to be backing down from retaliatory tariffs previously threatening U.S. cars, wine, and food products, instead appearing increasingly open to improving U.S. access to Chinese markets. This should benefit several regional economies that rely on exports to China. As we noted in our recent State Economic Forecast, over one third of South Carolina’s auto exports are destined for China, and their share is rising. Furthermore, the renegotiated KORUS trade deal with South Korea doubles the number of vehicles allowed to be exported from American carmakers and contains a commitment from South Korea to reduce steel exports to the U.S. by 30%, adding to the positive prospects for domestic producers. The constructive trade developments led the greenback higher over the week, but gains in major equity indices were restrained by tech sector induced volatility.

Global equity markets fared better as trade tensions thawed. However, trade uncertainty still lingers in Europe, with only four weeks until a temporary exemption from U.S. imposed steel and aluminum tariffs expires. The EU is contemplating lowering tariffs on a range of U.S. goods including cars, machinery, pharmaceuticals, and food in hopes of averting a trade war. However, the “carrot” approach is not favored by all members of the EU, including France. That could result in higher volatility in global equity markets in the weeks ahead.

Long-term yields fell this week in the U.S., while yields on two-year Treasury notes rose. Short-term yields are poised to rise further over the medium-term as the Federal Reserve continues along its tightening path amidst higher government spending. President Trump’s $1.3 trillion spending bill, signed last Friday, adds to the early-February commitment of $288 billion in domestic and military spending over the next two years which will amplify fiscal pressures. These will lead to higher Treasury issuance and should lift bond yields that will be further supported by rising inflation expectations and interest rates as the global economic recovery continues.

February’s consumer spending report indicated progress on the inflation front. Core PCE inflation ticked up slightly (Chart 1), with price gains over the recent three months averaging 2.3% in annualized terms. We expect this strength in inflation to continue, supported by diminishing slack in the U.S. economy, rising global economic activity, a relatively weak USD, and the fading of idiosyncratic factors. However, other details of the report were less encouraging. Consumer spending came in soft (Chart 2), adding to January’s disappointment, and weighing on GDP growth in the first quarter, which is still expected to advance by less than 2%. Still, we believe that consumer strength will reassert itself as the year progresses alongside a tightening labor market and tax cuts. Such a backdrop should enable the Fed to continue gradually raising interest rates this year, with another two hikes expected this year before 75 basis points of increases during 2019.

Katherine Judge, Economist | 416-307-9484

Despite good news on the U.S. economy, the announcement of potential tariffs on Chinese imports dented sentiment and took equities sharply lower on the week. Over the past three months, markets have swung from euphoria over tax cuts, to the protectionism pits, as the White House followed up the announcement of forthcoming steel and aluminum tariffs with a 25% tariff on up to $50 billion in Chinese imports.

As expected, China has announced how it would retaliate, with 15% tariff on U.S. imports of steel pipes, fruit, wine and other products, and 25% on pork and recycled aluminum, all in targeting about $3 billion in U.S. goods. The relatively modest size of the planned retaliation suggests China is willing to pursue dialogue with the U.S. to address trade disputes about the continuous violation of intellectual property rights of U.S. firms that operate in China. It’s not clear when or even if the announced tariffs will come into effect. We have already seen the U.S. walk back the scope of recently announced steel and aluminum tariffs, by exempting more countries, suggesting that this week’s announcement is an opening gambit.

The U.S. does have a leg to stand on, when it comes to China’s trade practices. However, even a just war has collateral damage. Many U.S. companies will be hurt if these tariffs come to pass, even if the actions are short-lived. This localized damage, however, would not deal a body blow to the over $19 trillion U.S. economy, which looks set to grow quite strongly over the next two years.

However, as demonstrated by markets this week, it is the indirect effects of a more adversarial global trade environment and the uncertainty it breeds that could hamper investment and trigger volatility on financial markets. And it is unfortunate that these threats come just as growth in global trade flows has accelerated (see Chart 1).

Now, about that good news. The FOMC hiked rates 25 basis points as expected, but more importantly, it an upgraded its economic outlook. Real GDP growth was lifted 0.2 percentage points in 2018, and 0.3 percentage points in 2019, and the unemployment rate now troughs at 3.6% in 2019, down from 3.9% previously. Core PCE inflation is also now expected to rise a hair above 2% in 2019. A modest inflation overshoot following nearly a decade of below target readings should not come as a terrible surprise. But, it speaks volumes to the bias of the FOMC not to push too hard or too soon against the rising fiscal tide.

That bias was demonstrated in just one additional hike by the end of 2019 as a result of its upgraded outlook. This forecast is consistent with our own view. That said, seven of 15 FOMC members now have four hikes penciled in for 2018, up from four in December, suggesting that it won’t take much to tip the number of hikes expected in 2018 from three to four. For now though, the Fed doesn’t look keen to get too far in front of the expected pickup in economic growth, but is happy to make sure its outlook is realized before increasing the speed of rate hikes. Given the risk that too much fiscal stimulus in a hot economy could result in the Fed raising rates too quickly, and contributing to a recession, this cautious approach is reassuring.

This week we released our updated quarterly forecast for the U.S. and global economy. Our outlook for the U.S. economy was revised up relative to our December forecast, as the federal budget bill passed by Congress in February adds more stimulus to an economy that is already running hot. Underlying this improved outlook is a view that domestic demand will grow more strongly, supported by fiscal stimulus. Personal income tax cuts provide a lift to disposable income growth and consumer spending, while corporate tax reform and the boost to federal spending should translate into stronger business investment.

With economic growth expected to average close to 3% over the remainder of this year, capacity pressures are expected to build. Not only should this incent firms to invest, but scarcer labor should support wage growth. Our outlook anticipates that underlying inflation in the U.S. will hit the Fed’s target of 2.0% before the end of the year, and stay slightly above target through 2019 (Chart 1). The CPI data for February supports this view, as price pressures ticked up a touch. Headline inflation rose to 2.2% y/y (+0.1 from 2.1% in January), while core inflation held at a 1.8% y/y pace.

After February’s consensus-busting job gains of 313k, we anticipate monthly job gains of 200k in upcoming months, roughly in line with its average since the Great Recession’s end. This should push the unemployment rate, which already sits at an eighteen-year low of 4.1%, even lower, reaching 3.7% by the end of 2019. Moreover, rising wages should encourage greater labor force participation enough to offset the drag from population aging.

In contrast to the very strong medium-term outlook, the outlook for the first quarter of 2018 is somewhat weaker. Retail sales in the first two months of this year have disappointed expectations, suggesting much softer consumer spending in the first quarter than the 3.8% (annualized) growth recorded at the end of 2017. We anticipate spending growth to re-accelerate in the second quarter, supported by the receipt of tax refunds, strengthening wage growth, and reduced personal income tax rates.

Booming economic activity together with building price pressures suggest that the Federal Reserve is likely to continue to raise interest rates this year and next. With three rate hikes on tap this year, the upper end of the range of the Fed’s policy rate should rise to 2.25% by year end. Moreover, better growth for 2019 suggests an additional 75bps of rate hikes, bringing the upper end of the range to 3.0% at the end of 2019.

This largely sunny outlook for the U.S. and global economy is not all blue skies. For one, higher interest rates have a tendency to expose vulnerabilities as firms and households spend more of their income on borrowing costs. While years of deleveraging have left U.S. households in good stead to handle higher rates, corporate debt has outpaced GDP growth in recent years. Lastly, the U.S. administration’s imposition of steel and aluminum tariffs and rumored forthcoming broad action against Chinese imports is a sign that global trade disruptions are more likely than previously appreciated (Chart 2).

Politics overshadowed economics this week as markets awaited Trump’s announcement on steel and aluminum tariffs. When it came on Thursday afternoon the scope was narrower than first thought. Canada and Mexico are exempt from the tariffs as long as negotiations on the North American Free Trade Agreement continue, and other allies may ultimately be exempt once the tariffs are put in place in 15 days. Together Canada and Mexico represent a quarter of American steel imports and 43 percent of aluminum. America’s neighbors may now benefit from the plan as they take market share from other countries slapped with tariffs.

However, trading partners are expected to retaliate, levying tariffs on U.S. exports. Economic studies have shown that the overall costs to the economy from these trade battles outweigh the job gains in the protected sector. Our own estimates for the steel and aluminum tariffs specifically suggest the overall growth impacts in the large U.S. economy would be fairly modest, but that they could raise inflation a couple of tenths of a percentage point.

The President didn’t stop at steel and aluminum. He reiterated his goal to reverse the U.S. trade deficit, and that he may implement a reciprocal or “mirror tax” to help achieve this. He offered few details, but suggested the U.S. would slap the same level of duties on trading partners that U.S. companies face in those countries. These actions will raise prices for many U.S. businesses that use the materials as inputs in manufacturing, and ultimately raise prices for consumers, adding to budding inflation pressures across the economy.

This week’s economic data certainly doesn’t suggest the U.S. needs economic protection. Payrolls grew by an impressive 313k jobs in February. The unemployment rate stayed at its 17-year low of 4.1%, where it has been since October. Hiring has accelerated in recent months, driven by the goods sector, which had stumbled somewhat in the wake of the oil price crash, but is now making up the lost ground. Wage growth cooled slightly, with average hourly earnings up 2.6% versus a year ago, down from 2.8% in January. However, when this volatile series is smoothed, wage gains have been steady at around 2.6% for about a year, and have been outpacing inflation for over three years.

The Fed’s Beige Book also painted a picture of an economy that is humming along. Fed districts universally reported labor market tightness and heightened demand for qualified workers. Several districts reported increasing compensation as a result of the tax cuts that came into effect at the start of the year. The report also suggested that businesses are increasingly passing on increases in input prices. A variety of forces are expected to push inflation higher this year, the only question is how quickly.

The risks that inflation will accelerate faster than the Fed currently expects are mounting. The FOMC’s next announcement is on March 21st, and a hike at the meeting is essentially a lock. We currently expect three 25-basis point moves in 2018, but the risks are skewed to more hikes rather than fewer.

Leslie Preston, Senior Economist | 416-983-7053

This was a busy and difficult week for financial markets. Economic data releases were overshadowed by the much anticipated first Congressional testimony by the new Federal Reserve chair Jerome Powell and trade tariff announcement from the White House.

In his speech on Tuesday, Mr. Powell struck an upbeat tone on the U.S. economy and inflation, saying that his “outlook for the economy has strengthened since December.” He also highlighted potential upside risks to growth and inflation stemming from fiscal policy and the improved global economic backdrop. Without stating the exact number of rate hikes expected this year, Powell seems to have opened the door to a faster rate of normalization as long as the economic data cooperates. Markets were quick to interpret his comments as hawkish, with equities selling off and bond yields rising. New York Federal Reserve president Bill Dudley added more fuel to the fire by saying that four rate hikes by the Federal Reserve this year would still constitute a “gradual” pace of tightening.  

Market losses extended further on Thursday on fears of trade wars following Donald Trump’s announcement of  a 25% import tariff on steel and 10% on aluminum. While nothing has been signed yet, should these tariffs be introduced, they will lead to higher input prices for many manufacturing and construction industries which rely heavily on steel and aluminum inputs and ultimately result in higher prices for U.S. consumers, thus posing an upside risk to the Fed’s inflation outlook. The Fed may look through a one-time change in prices as a result of tariffs, but will be cautious on the impact on inflation expectations and potential economic growth – trade wars are not typically good for productivity growth.

Still, for the time being there is not much in the incoming data to indicate that the economy is overheating. Inflation-wise, both headline and core PCE inflation remained unchanged in January, coming in at 1.7% y/y and 1.5% y/y, respectively. Real consumer spending fell by 0.1% on the month, despite strong gains in real disposable income (+0.6% m/m) on the back of lower taxes. Indicators of housing activity were also soft. Coming on the heels of a decline in existing homes, January sales of new homes and the forward looking pending sales of existing homes also weakened. Ditto for auto sales, which edged down to 17.0 million units in February from 17.1 million in January. All in all, similar to the prior years, both consumption and GDP will start the year on a softer footing.

That being said, the slowdown will likely be short-lived. Some of the weakness in consumption is likely a pullback from the hurricane-induced ramp up at the end of 2017, and some due to “residual seasonality,” which has become apparent in recent years. Barring unexpected developments trade-side, tax cuts and a tightening labor market will prop up household income this year, supporting robust consumer spending and above-trend growth over the remainder of 2018.

All in all, the latest data does not change the calculus for the Fed with three rate hikes expected this year, however, the central bank will certainly need to keep a close watch of the economy, given rapidly evolving U.S. public policy.

Ksenia Bushmeneva, Economist | 416-308-7392

A holiday-shortened trading week coupled with light data left markets with just the minutes from the January FOMC meeting and the words of wisdom from a slew of Federal Reserve speakers this week to digest.

Existing home sales for January revealed a market that is still beleaguered by low inventory, which exacerbates deteriorating housing affordability in many U.S. cities. January’s decline in existing home sales was broad-based, and concentrated in the larger single-family segment (Chart 1). Unsurprisingly, rising prices and borrowing costs are deterring first-time buyers from buying, as they accounted for only 29% of sales in January, down from 33% a year ago. Looking ahead, job gains and an optimistic outlook for after-tax earnings growth should support a rebound in home sales. What’s more, housing starts ticked up in January, possibly providing some respite for buyers particularly in those markets with a low supply of existing homes.

Fed speakers this week remained broadly optimistic about the outlook for the economy, while also revealing very little news about the number of rate hikes this year. In the December Summary of Economic Projections (SEP), the FOMC communicated that it would likely raise rates three times. Since then, the U.S. Congress approved of a massive tax reform package, and just a few weeks ago an additional package of spending that is expected to provide a substantial lift to U.S. growth (Chart 2; read our report on U.S. fiscal stimulus).