- In contrast to late-cycle economic conditions evident in the United States, we think Europe — which typically lags the U.S. cycle — may continue to build growth momentum.
- We think global interest-rate normalization will continue, but likely on a slower path.
- We continue to prefer various spread sector risks, including credit, prepayment, and liquidity risks, over interest-rate risks.
In the United States, we see an increasing amount of evidence pointing toward late-cycle economic conditions. This does not mean a recession is imminent or likely, although it probably does mean that the odds of a recession are rising. A consoling thought, of course, is that the economy has shown its resilience in recent years. We have weathered fiscal tightening between 2011 and 2013, sharp movements in oil prices, and rising dollar strength in 2014 and 2015. These protracted events caused fluctuations in the economy's growth rate, but they were not powerful enough by themselves to produce a recession. It is entirely possible, and indeed quite likely, that the current challenges to growth today may also lack power sufficient to cause a contraction.
The limitations of corporate profitsThe key problem the U.S. economy faces today is that the tightening labor market is constraining corporate profits. Firms attempted to regain healthier margins in the first quarter of 2017 by raising prices, but households rebelled, and consumption growth eased. This is most clear in the auto market, but it has happened in other areas, including residential real estate.
We think that labor market conditions and recent weakness in core inflation make the pace of future monetary tightening uncertain. The weight of opinion on the Federal Open Market Committee (FOMC) is to hike at least once more after June and to begin balance-sheet reduction near year-end, but that opinion could change if the outlook changes. Moreover, as we have indicated in recent quarters, the composition of the FOMC could look different in a few months' time, and that could be enough to tip the center of gravity for policy purposes.
The European powerhouseEconomic data show that Europe is currently the fastest growing of the major advanced economies. Europe typically lags the global cycle, so if normal global dynamics hold, it would not be surprising to see Europe staying strong when the rest of the world slows.
As we investigate evidence of Europe's strength, we see continued heavy dependence on exportled growth. Economic powerhouses like Germany are indifferent where they sell their goods. A pickup in demand anywhere in the world — whether in the United States, China, or other emerging economies — provides an export market for German companies. These companies increase production and investment, and their profitability rises. The German labor market tightens, and wages go up. Domestic consumption edges higher, but generally the current account surplus increases and German capital goes somewhere else in the world.
The new wrinkle on this decades-old story is that the euro is probably weaker than the deutsche mark would be, if it still existed, so euro weakness is helping to keep German exports growing a bit more rapidly and German consumption growing a bit more slowly than would otherwise be the case.
Other European bright spotsWith the exception of Greece, Europe's periphery is growing at a decent clip as it recovers from the downturn. This recovery has further to go, which gives the eurozone some added resilience. There are also positive prospects in France, particularly as President Emmanuel Macron has gathered major support in the National Assembly. Coupled with a tailwind of a cyclical recovery in France, this political unity gives Macron a good chance of success in enacting growth-enhancing measures.
The latest revisions to Italy's GDP data paint a better picture of what's going on there. The country remains the laggard among the larger European economies, and the structural challenges it faces are enormous, but we have to acknowledge that Italy looks better. Growth in Q1 is now at 0.4% (quarter-over-quarter, seasonally adjusted), up from 0.2% in the first estimate. Together with an upward revision in GDP for Q4 2016, to 0.3% from 0.2%, the new numbers suggest the economy has some momentum. In our view, it seems likely that Italy can maintain a decent pace of growth for the balance of the year.