VOLUME 36 THE REAL ECONOMY ECONOMY SHOWING SIGNS OF ACCELERATION HOLIDAY SPENDING OFF TO A SIZZLING START THE ECONOMY S IMPACT ON RETIREMENT PLANS

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1 VOLUME 36 THE REAL ECONOMY ECONOMY SHOWING SIGNS OF ACCELERATION HOLIDAY SPENDING OFF TO A SIZZLING START THE ECONOMY S IMPACT ON RETIREMENT PLANS

2 ABOUT THE AUTHORS Our thought leaders are professionals with years of experience in their fields who strive to help you and your business succeed. Thought leaders who have contributed content to this issue include: Joe Brusuelas, Chief Economist, RSM US LLP Eric Carroll, Partner, RSM US LLP Kevin Depew, Director, RSM US LLP Joe Mattia, Director, RSM US LLP 2 DECEMBER 2017

3 TABLE OF CONTENTS Economy showing signs of acceleration 4 Holiday spending off to a sizzling start 7 The economy s impact on retirement plans 8 Economic Snapshot 10 This publication represents the views of the author(s), and does not necessarily represent the views of RSM. This publication does not constitute professional advice. RSM THE REAL ECONOMY 3

4 ECONOMY SHOWING SIGNS OF ACCELERATION Economic growth above long-term trend for first time since Great Recession By Joseph Brusuelas, Chief Economist, RSM US LLP Economic data point to an acceleration of growth in 2018 driven by solid consumer spending and improvement in outlays on capital expenditures. There is now some wind behind the sails of the U.S. economy, and solid growth should result in greater resource utilization in an economy operating above its long-term trend. Our view, based on our recession probability model, is there is only about a 15 percent chance of a recession during the next 12 months. Meanwhile, we expect wage growth should move above 4 percent with core inflation finally moving toward the Federal Reserve s 2 percent target by the end of Base case economic scenario Our base economic case forecasts growth of 2.5 percent next year with the unemployment rate falling to 3.7 percent as the pace of labor market tightening increases. Inflation will start to move higher but remain within the Fed s target. A global synchronous expansion among the G-7 economies, India and emerging markets will support rising demand for U.S. finished goods and materials used at earlier stages of production. The labor market will continue to tighten in 2018 with the economy generating about 150,000 jobs per month as firms find it increasingly more difficult to obtain qualified individuals to fill open positions. We expect overall wage gains will be at or near 4 percent by the end of the year. This should translate into compressed profit margins, which is what one would typically expect later in the business cycle. Even so, we expect corporate profits to increase by about 3 percent next year, with upside risks around the possible implementation of tax cuts. MIDDLE MARKET INSIGHT: According to the third quarter RSM US Middle Market Business Index survey, 71 percent of middle market businesses said they were struggling, to some extent or to a great extent, to fill skilled labor positions. Meanwhile, 64 percent said they were increasing compensation levels to combat a tight labor market. Read the full report here. 4 DECEMBER 2017

5 Better quality of US growth ahead Index Source: RSM US, Bloomberg Economy Weighted Manufacturing & Non-Manufacturing Composite GDP US Chained 2009 Dollars Meanwhile, the strong labor market will underscore another solid year of household consumption. Through the end of the third quarter of 2017, spending has averaged 2.5 percent and we anticipate that will improve this year. This should translate into another strong year of industrial production and manufacturing, as well as the best year for agricultural products in the current cyclical expansion that began after the Great Recession. Under new Fed Chairman Jerome Powell, the central bank will respond to these strong fundamentals by upgrading their forecast from four rate increases of 25 basis points each to five between now and the end of the next year. In our estimation, the term structure for interest rates will flatten with the short end of the curve rising at a slightly faster pace than the long end. We are not as concerned about the flattening yield curve as some fixed income analysts. Because of the size of the Federal Reserve s balance sheet on ongoing central bank bond purchase Year-Over-Year Percentage Change operations around the world, suppression of the long end of the curve will continue, thus reducing the information from the forward-looking components of the yield curve that, under other policy regimes, might point to growing risks of recession. A decade ago, then Fed Chairman Ben Bernanke shifted the central bank communications strategy toward one of forward guidance, a move that was subsequently copied by global central banks. A combination of that new communications strategy, as well as structural changes in the U.S. economy organized around technology and life sciences, has reduced the efficacy of information from the yield curve. However, we do expect the 10-year Treasury yield to finish the year between 2.75 and 3 percent, mostly due to a quicker pace of growth, with the U.S. dollar largely maintaining its trading range against the euro near There is risk of further depreciation linked to political risk in the United States and greater risks around the Trump administration tearing down the North American Free Trade Agreement (NAFTA) and perhaps attempting to dismantle the World Trade Organization. Alternative economic scenario The alternative to the base case is that U.S. growth accelerates above 3 percent for the year if the massive tax cut proposal currently being considered by Congress is passed. If the large unfunded tax cuts are passed, we believe growth would accelerate considerably linked to spending by the upper quintile of income earners and the ensuing increase in the wealth effect acting to stimulate spending by the upper middle class. RSM THE REAL ECONOMY 5

6 MIDDLE MARKET INSIGHT: If tax cuts are aimed at the real economy, including pass-through entities and Subchapter C corporations, we expect that the middle market will lead the way in 2018 by increasing outlays on capital expenditures. If the tax cuts take place, we expect that both the trade and current accounts will widen noticeably, which will cause the U.S. dollar to appreciate against the major trading currencies and a trade-weighted basket of currencies, with yields on long-term U.S. Treasuries putting upside risk on our base case end-of-the-year trading range 2.75 to 3 percent on the 10-year Treasury. Risks to the outlook The major risk around the domestic U.S. outlook is the possibility that the Trump administration will disrupt U.S. trade agreements. There is a significant risk of disruption to the North American supply chain linked to NAFTA if the administration withdraws from the treaty. We expect trade frictions to increase in 2019 as risks to the NAFTA value chain increase due to more rigorous enforcement of trade rules and possible price disruptions along those value chains. Tensions around the U.S.-Korean Free Trade association and the World Trade Organization also figure into the risk matrix for The possible secession of Catalonia, and the outcome of Italian elections should be on the radar along with the ongoing investigations into the Trump White House and the president s business empire are the major political risks to the economic outlook was the worst hurricane season in the U.S. since The storms resulted in an increase of $206 billion in governmental outlays to jumpstart reconstruction in Texas, Florida and the American Caribbean. That number will sharply accelerate in 2018, putting upward pressure on the overall U.S. fiscal deficit. If the tax bill is passed, alongside a major increase in defense outlays and spending on reconstruction, we expect that there is a growing probability the U.S. will run $1 trillion annual operating deficits in 2019 or 2020 at the latest. 6 DECEMBER 2017

7 HOLIDAY SPENDING OFF TO A SIZZLING START Data suggest best sales in a decade By Joseph Brusuelas, Chief Economist, RSM US LLP The holiday shopping season kicked off with a boom over the long Thanksgiving weekend. The most recent data showed that same-store retail sales were up 4.4 percent on a year-ago basis. Meanwhile, Cyber Monday sales are set to hit $6.59 billion, up 16.6 percent from a year ago. This reflects the ongoing structural transformation in the retail sector away from brick and mortar stores toward the more dynamic online shopping environment. That $6.59 billion estimate is larger than the $5.03 billion spent over the Black Friday Thanksgiving weekend. The fact that foot traffic was down 1 percent during the Nov period compared with a year ago was a testament to that trend. The data over the holiday weekend implies a run rate above our forecast of a 4.2 percent increase in holiday spending, which is very encouraging. U.S. household financial conditions have improved markedly since the Great Recession. Given the decline in the unemployment rate to 4.2 percent, and wage growth of 3.6 percent at a three-month average annualized pace, the condition of the American consumer is better than at any time in the past decade. In our estimation, the improvement in employment, wages and overall spending during the past six months strongly suggests that the U.S. household has been quietly building momentum into the holiday season. The data over the post-thanksgiving week confirms the underlying trend in household spending. Moreover, we believe that the data grossly underestimates the true pace of holiday spending, both in terms of online outlays and in terms of understanding how experiential spending has now become a much bigger part of the holiday spending season. This will translate into the best holiday spending season in the current business cycle. Holiday sales to increase 4.2 percent Billions ($) Actual Data Forecast Billions Percentage Change Source: RSM US Percentage Change RSM THE REAL ECONOMY 7

8 THE ECONOMY S IMPACT ON RETIREMENT PLANS Plan sponsors have a variety of options that can help participants stay the course and have a healthy retirement plan. By Eric Carroll, Partner, RSM US LLP; Kevin Depew, Director, RSM US LLP and Joe Mattia, Director, RSM US LLP According to the third quarter RSM US Middle Market Business Index survey, more than half of middle market executives anticipate the economy will improve somewhat or significantly during the next six months. With back-toback quarters of higher-than-anticipated 3 percent gross domestic product (GDP) growth, this may not be surprising. To put things in perspective, the long-term growth trend in the United States since 1945 was 2.5 percent up until the Great Recession. The magnitude of that recession was so severe that it took the long-term trend down to 1.5 percent. While the U.S. is unlikely to experience an economic shock as severe as the Great Recession anytime soon, a return to a more normalized economy means there will continue to be periodic industry sector and geographical recessions. Meanwhile, as the economy continues to normalize, U.S. Federal Reserve policy is beginning to normalize as well, and this could affect retirement plan performance. One of the consequences of an economy where household consumption is growing at a strong 3 percent rate is a shift away from Wall Street to Main Street that is, to the real economy; the goods and services area of the economy as the primary economic driver. As a consequence of this shift, it becomes much more important to pay attention to policy changes in Washington, D.C. Going forward there is likely to be much larger annual operating deficits to pay for defense expenditures; rebuilding after the series of storms in Texas, Florida and elsewhere; and much-needed infrastructure investment. The market is in the early stages of beginning to adjust to this anticipated rise in interest rates. Fiscal operations are likely to push inflation and bond yields much higher over the long term. In this type of environment, what types of investment options or plans should retirement plan sponsors consider? Reviewing investments Whether the company is outsourcing the investment selection to a fiduciary investment manager or working through a committee, the plan sponsor needs to consider overall exposure to mitigate any downside risk and take advantage of opportunities. Which types of investments may be sensitive to rising interest rates? What is the bond and long-term equity exposure? For those working with defined benefit plans or traditional pension plan, what should be on their radar? Interest rate increases can have an impact on a plan s funding status and could lower the annual cash-infusions from plan sponsors. As yields begin to move higher longer term, there will be questions from people who have not experienced it. Risks in the US economic outlook Any sustained economic growth above 2 percent carries with it the risk of rising interest rates and inflation. In the near-term, there are some domestic risks in the auto sector and commercial real estate. But these are cyclical, normalization risks, affecting these specific industries, as compared to the systemic risks seen in 2008 and Likely to become more apparent as 2018 progresses are risks to value chains from the rigorous enforcement of trade rules. If administration rhetoric surrounding the North American Free Trade Agreement negotiations plays out, there could be significant price disruptions along the value chain, resulting in higher prices passed along to consumers. 8 DECEMBER 2017

9 Other trade disputes with China or Canada, for example could produce shocks to the U.S. economy. Political risks across the European Union and the U.S. can also produce a riskier economic outlook in the near-term. But on the positive side, an upturn in global growth to 4 percent and improvement in the fortunes of emerging markets, and Middle East and North Africa states could affect U.S. growth positively. Equity valuations are a modest concern. Corporate profits cannot continue to grow faster than GDP and have the equity values hold up. But this is a cyclical, not structural, issue. The plan investment lineup It is important for plan participants to contribute on a systematic basis over a period of years to deal with the stock market fluctuations, corrections and bear markets, protecting themselves from sharp declines and taking advantage of opportunities. Even when markets look bleak, participants can benefit. Most, if not all, investment lineups will include exposure to U.S. equities and core fixed income. But there are other things to consider: Treasury inflation-protected securities: Referred to commonly in acronym form, TIPS, these are bonds issued by the U.S. Treasury that pay a coupon on the adjusted principal of the bond. The bond is adjusted on a semi-annual basis with the rate of the Consumer Price Index and therefore, can offer a higher yield as rates move up, making it a good hedge against inflation. Diversified international: Also referred to as a foreign fund, these are investments in companies located anywhere outside of the United States. Emerging markets: Invest in stocks of companies located in emerging markets around the world, such as Brazil, Russia, India, Taiwan and China. Stocks of companies in emerging markets tend to be more volatile than those in developed countries, which could imply the potential for greater long-term returns. Global bond: Invest in fixed-income securities, including bonds from global, sovereign governments, investment-grade corporate bonds as well as fixedincome securities from the U.S. By no means are these direct recommendations; in many cases, for example, plans are utilizing target date funds, asset allocation models or custom models as well. The most important takeaway for participants: maintain a long-term perspective, based on the individual time frame for retirement. Plan sponsors can help through plan design features such as auto enrollment and auto escalation that help participants save, and save in larger amounts. These types of features will also help keep participants in the plan. Plan review considerations While no one can predict what the markets will do for the next 10 years, plan sponsors have a variety of options that can help participants stay the course and have a healthy retirement plan. When reviewing plans and evaluating their designs, sponsors should consider: Plan diversification: What is the equity and fixed income exposure? How much cash is sitting on the sidelines? Plan investments: Are there new investments to introduce to take advantage of opportunities or to mitigate risk? Should investment decisions and services be outsourced to investment managers or be done in-house? Plan design: In addition to auto investment and escalation features, are there features to encourage savings and wellness initiatives? As the economy continues to grow and the labor market tightens, is the plan design competitive enough to be leveraged for talent acquisition and retention? RSM THE REAL ECONOMY 9

10 ECONOMIC SNAPSHOT The real economy in brief Unemployment rate by state, seasonally adjusted, October 2017 (U.S. rate = 4.1 percent) Shrinking jobs versus growing jobs Percentage in shrinking jobs Source: New York Times Source: Bureau of Labor Statistics The national unemployment rate is 4.1 percent, but as the economy continues the long process of normalization after the Great Recession, expect an increasing divergence in industry growth, and by extension, in state and regional unemployment. This map helps illustrate that it s no longer all one economy. Unemployment trends are showing increased variance by state and between major metropolitan and rural areas. A New York Times article, A Peak at Future Jobs Shows Growing Economic Divides, took a look at the share of employed residents of the United States who work in shrinking jobs, by county. 10 DECEMBER 2017

11 Producer pipeline pressures building Alternative consumer inflation measures also trending slowly higher 4 PPI final demand (YoY) PPI ex-food, fuel (YoY) Percent 1 0 Percent Nov-11 May-12 Nov-12 May-13 Nov-13 May-14 Nov-14 May-15 Nov-15 May-16 Nov-16 May-17 Source: Bureau of Labor Statistics, Bloomberg, RSM US LLP Source: New York Federal Reserve, RSM While core inflation remains below the Federal Reserve s 2 percent target, at least some measures are showing potential pipeline pressures building. The Producer Price Index (PPI), trending upward since the 2015 low, recently surged to a five-year high. While a portion of the increase in the blue line above is due to hurricane-related energy prices, the PPI ex-food and fuel, green line reached its highest level in more than five years as well. The New York Fed s Underlying Inflation Gauge recently reached its highest level since This alternative inflation measure was designed to capture sustained movements in inflation from information contained in a broad set of price, real activity and financial data. The gauge measures 346 data sets, including goods and services, labor market, money, producer surveys and financial variables such as interest rates, consumer credit volumes, real estate loans and stocks and commodity prices. RSM THE REAL ECONOMY 11

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