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Markets and Economy

4 Lessons From 3Q 2018

Despite escalating trade tensions and an unexpected stock market stumble, the economy appears to be maintaining its momentum as it nears full capacity. From the rebounding energy sector to strengthening North American economies, these are the four lessons that stand out from the third quarter of the year.
Jim Glassman, Head Economist, Commercial Banking
October 31, 2018

The third quarter of 2018 brought a few surprises—including escalating trade tensions and a stock market stumble—but none that suggest the economy’s momentum is slowing. Inflation remains within its target range despite the arrival of full employment, allowing the Federal Reserve to adopt a neutral policy stance that could help prolong the economic expansion. With few apparent imbalances on the horizon, the current business cycle may prove historically durable. These are the four main lessons from the third quarter.

1. Stock Market Volatility May Signal Cycle Maturity

After setting record highs in late September, stock indices suffered a bout of volatility in October. Equities have returned all of their 2018 gains over the past month, erasing almost $2 trillion in wealth from household portfolios. The reasons behind the market’s jitters are still unclear. Most of the headwinds facing corporations have been apparent for some time, yet the market’s rise had been relatively tranquil until this autumn.

The stock market’s stumble may simply be volatility returning as the business cycle matures. In the early years of the recovery, the market’s price-earnings ratio was historically low; as investors grew more confident in the outlook for corporate revenues, equities slowly regained their value. Now that price-earnings ratios have returned to levels seen at the top of previous business cycles, the market’s potential for volatility may be growing.

The outlook for profits is still strong, and last year’s tax reform and fiscal stimulus legislation should continue to boost private-sector earnings over the coming years. But a fully valued stock market could experience more symmetrical bouts of volatility, with sharp downturns occurring as frequently as sudden upticks. Fortunately, households adjust their spending habits gradually, and the market’s recent gyrations have had little effect on consumer spending.

2. Growth in North America Is Lifting Off

North America’s economies are outpacing those of Europe and Asia, where forecasts for the year are being pared down. Growth projections for Germany, France and Japan are expected to undershoot initial forecasts by a full percentage point for the year. Similarly, expansion forecasts in the broader European Union, United Kingdom and Chinese economies are all expected to fall approximately one half-point short of what was initially expected.

In North America, however, the outlook has changed very little. The US has maintained a 3.3 percent annualized growth rate through 2018, and a modest fourth-quarter acceleration could bring its expansion to 3.5 percent for the year. Strong demand from US consumers is buoying the highly integrated Mexican and Canadian manufacturing sectors, and rebounding energy prices are supporting a wave of capital investment across the continent.

3. The Energy Sector Is Rebounding

Rising global demand has pushed energy prices higher, making oil exploration profitable in US shale fields once again. After the 2014 global energy glut, production cutbacks in Venezuela and sanctions on Iran initially spurred oil’s recovery, but stronger demand is now driving the market. As the production glut is finally absorbed, drilling activity is resuming in North America. While the US is still a net importer of oil, rising prices are supporting capital investment and revitalizing the economies of America's oil patch towns.

4. The Peak Appears Durable

Past business cycles have ended when the economy began to overheat and an unsustainable level of demand created an inflationary spiral. Other expansions have abruptly reversed when a burst asset bubble tipped the economy into recession. Neither of those scenarios appears likely today.

Unlike the top of past business cycles, the current expansion appears well balanced, even as the economy approaches its full potential. Inflation’s tame behavior is allowing the Fed to adopt a neutral monetary policy that could prolong the expansion. Despite the flattening yield curve, interest rates have yet to become restrictive—real short-term rates are still resting at zero percent. The Fed is removing its stimulus measures as the economy returns to full capacity, but policymakers are not eager to hit the brakes on the expansion prematurely.

As the labor market tightens and wages begin to lift, a productivity boom could fuel further above-trend growth even during a period of full employment. The expansion’s longevity may be unprecedented, but the economy rarely reaches the peak of the business cycle in such an evenly balanced state.

View our economic commentary disclaimer.

 

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