Outlook and Market Review - Second Quarter 2017

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Summary: 

The U.S. economy continues to grow at a slow but steady pace with low inflation, low interest rates, and healthy job growth.  The Bureau of Economic Analysis announced a revised second quarter GDP growth rate of 3% following a 1.2% growth rate in the first quarter.  The trend continues for a 2.4% GDP growth rate on an annual basis.  Inflation rates remain lower than the Fed’s target of 2% with little pressure from wages or excess demand.  Higher import prices linked to a weaker dollar appears to be the only factor capable of pushing prices higher in the third quarter.  The aftermath of hurricanes Harvey and Irma resulted in disruption causing temporary price pressures that are not likely to last through the year.  The Fed is expected to raise the short-term Fed Fund rate another 25 basis points before the end of the year and announced balance sheet adjustments will put some upward pressure on intermediate and long-term rates. Even so, the 10-year Treasury yield of 2.3% is about 300 basis points below the long run average.  Job growth around 190,000 jobs per month remains healthy and the unemployment rate is 4.4%, which is either at or near full employment.  The labor force participation rate remains low with 62.9% of the workforce participating in the job market.

The U.S. expansion is the third longest on record but it is also the slowest.  Growth continues to trend below the long-term average of 3.2%.  Nevertheless, the expansion is now broad-based with fewer drags left over from the financial crisis.  Deleveraging at both the consumer and business levels is complete.  Only the government sector continues to follow debt expansion policies.  Concerns over the European debt crisis and debt restructuring in China are easing. Global tension remains with more bluster from Korea and increased commitment by the Soviets in Syria.

Consumer balance sheets and net worth are healthy, allowing room for consumers to continue spending.  Equity market values, home values, and job growth support consumer optimism.  Credit continues to be available and corporate profits are improving.  The global economy is on track for higher growth in all major economies.  While there are factors pointing to improved growth in the U.S., forecasters continue to see GDP growth for the remainder of the year to be around 2.4%.  A more pessimistic outlook likely stems from major political roadblocks to pro-growth initiatives and pending drains from the Affordable Healthcare Act that are not likely to be fixed in the near term. Interest rate increases should be modest but debt service payments on revolving credit and higher short-term financing costs will dampen demand for durable goods somewhat.

The Federal Reserve’s recent announcements mark the beginning of a quantitative contraction based on a slow but steady normalization of its balance sheet and what appears to be one 25 basis point increase in the Fed fund rate this year followed by as many as three next year.  The Fed will need to reduce holdings of Treasury securities and Mortgage Backed Securities by about 1.5 trillion dollars over time in order to reach the pre-recession balance sheet holdings.  Analysts estimate an increase in the 10-year Treasury yield of about 30 basis or less.