HIGHLIGHTS OF THE WEEK

  • Major U.S. stock indices entered correction territory on Thursday but remain elevated relative to where they were a year ago. The sell-off was spurred by fears of higher interest rates, as the 10-year government bond yield hit a four-year high.
  • The $300 billion increase in the spending cap over two years, laid out in the federal budget deal, could add to inflationary pressures at a time when the economy is already operating at close to full capacity, pressuring yields up further.
  • Next week, investors will turn their attention to hard data, with advanced January retail sales providing an indication of whether or not first quarter growth will be affected by the residual seasonality.

 

Stocks Correct but Fundamentals Remain Solid

Major U.S. stock indices entered correction territory on Thursday but remain elevated relative to where they were a year ago. Despite falling about 10% from highs reached in the final days of January, the S&P 500, Dow Jones Industrial Average and the NASDAQ Composite remain 13-20% higher on a year-on-year basis. The sell-off was likely spurred by fears of higher real interest rates, as last week’s strong January jobs report showed robust wage growth, lifting both market expectations for inflation and fed rate hikes. At 2.85%, the ten-year government bond yield hit a four-year high this week.

What’s important to note is that this sell-off was not triggered by weak economic data either for the U.S. or global economy. Indeed, we learned this week that the ISM non-manufacturing index showed an improvement in the services sector at the start of 2018, with rising price pressures mirroring its manufacturing counterpart (Chart 1).

With tax cut stimulus already expected to keep U.S. growth above trend, there is little need for more stimulus. Yet, that’s effectively what the federal government budget deal signed into law this morning delivers. The $300 billion increase in the spending cap over two years could foster additional inflationary pressures at a time when the economy is already operating at close to full capacity. And, higher issuance of Treasuries could put further upward pressure on yields. Moreover, the plan could have a more material effect on growth than tax cuts, since consumers are likely to save a share of the disposable income accrued from tax reform. Growth in 2019 will likely be augmented the most, assuming that spending gets underway in the second half of this year. But, the increase in the deficit would limit the government’s ability to respond to any large scale downturn in the future (Chart 2). All told, any increase in investment would be a positive for future trend growth, providing further upside risk around our December forecast.

As market volatility surged, Fed speakers this week appeared unconcerned about financial market developments, instead choosing to reinforce their positive economic outlook. FOMC members had previously noted that equities were overvalued and therefore showed no sign of concern over the widespread sell-off. Voting members Dudley and Williams noted in speeches that wage inflation had picked up as expected and that markets are now adjusting to global monetary policy accommodation removal. This may help calm investor fears of faster rate hikes than previously expected, with the first of three hikes this year expected in March.

Next week, investors will turn their attention to hard data. Of particular interest will be advanced January retail sales data that should provide an indication of whether or not first quarter growth will be affected by the residual seasonality that has led to first quarter weakness in three of the previous four years. Although tax cuts have only started to boost pay checks in February, we anticipate that household spending has continued to be propped up by jobs and wage gains and will contribute strongly to economic activity again in the first quarter.

Katherine Judge, Economist

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