The overall mood coming out of the 2019 Market Outlook Workshop was bright: Most end-user industries are seeing some uplift from an economy that’s doing well in many parts of the world. The abundance of natural gas and crude oil in North America and how it will affect the energy markets remain at the top of everyone’s list of developments to watch, especially any of the industries dependent on energy or power.
But two issues of concern also were frequent topics from speakers this year: What will happen to the world in light of possible trade imbalances and how the labor shortage is reaching into almost every industry.
Some key issues that came out of the workshop this year included:
- There is a need to move oil and gas. Several presenters brought up the fact that pipelines are not being built fast enough to transport the oil and natural gas coming from new sources in North America and new technologies used to extract crude.
- While low unemployment is a positive development for consumers, a lack of workers and skills is having an effect on both the U.S. and global economies.
- Inflation is headed our way and with it, challenges in terms of material costs, buying ability, tightening of monetary policies and more.
- The protectionist attitude developing around the world may create trade wars that could slow the current rate of global economic growth.
THE STOCK MARKET
Many Sectors Up
The cautiously optimistic mood of everyone at this year’s event was reflected in comments made by Michael Halloran, senior research analyst, Robert W. Baird.
“Things feel a bit better this year, although nobody has any real idea where the situation is going from here,” he said.
Halloran and many other speakers listed the shrinking labor force as a significant concern. One reason is that, while it seems counterintuitive, low unemployment metrics have been a fairly reliable leading indicator in the past of recessions.
“As unemployment moves lower in the latter stages of any business cycle, employers increasingly struggle to fill their labor needs. Their growth prospects begin to suffer as a result of labor constraints,” Halloran noted. “This is particularly true today because the retiring Baby Boomer generation and crackdowns on immigration are producing structural reductions in the U.S. labor pool,” he added.
In such a situation, employers are often forced to increase wages to attract workers, and they incur training and turnover costs.
This development also can lead to inflation because companies are forced to increase the cost of finished goods to offset rising labor costs. This then can force faster tightening of monetary policy (to avoid hyper-inflation), which typically produces recessions. The situation is further complicated today because “other inflationary levers such as tariffs are contributing to higher inflation metrics,” Halloran said.
Still, the U.S. industrial economy continues to trend positively in the short term, he said. What’s more, resolution of supply/demand imbalances could offer more stable and higher commodity pricing. However, higher transportation and commodity price tags also increase industry costs.
With respect to tax reform, Halloran believes that tax savings and new depreciation rules could encourage additional spending in 2018 and beyond.
“However, having tax reform this late in the cycle doesn’t result in significant stimuli,” he said. Also, because tax reform and trade wars are coming at the same time, “inflation is starting to creep through supply chains and profit/loss statements,” he said.
Demand for Valves/Equipment
Halloran said most process control companies are on track for organic growth in 2018.
Markets exhibiting growth are aerospace/defense, agriculture, chemical, upstream/midstream/downstream oil and gas, general industrial, mining and municipal water/wastewater.
According to Baird’s 2018 survey of process control companies, expectations remain very high for growth this year. “This is the healthiest they’ve [respondents] seen in a long time,” said Halloran.
Regarding specific sectors, Halloran said that, in the upstream oil and gas market, a short-term problem exists for takeaway capacity because there just aren’t enough pipelines. He said he spends much time today addressing the question of what this means for pricing; who has or doesn’t have the capacity today and what the situation means for overall activity levels. Although he anticipates fits and starts in supply, the market is stable over time, he said. Midstream is also healthy but a bit choppier, he added.
The major growth in oil and gas will be downstream and chemical processing in the U.S. gulf, the Middle East and China. Power is in secular decline, but water/wastewater is very healthy.
- Halloran sees inflation being a drag on the economy through 2019.
- Early signs of price inflation are likely to aid pricing over time, particularly in price-positive process control niches.
- Falling regulatory burdens and faster approvals may spur additional investment/projects.
- Historically high government and consumer debt remains a drag on global growth prospects.
OIL AND GAS
John Spears, president of Spears and Associates, also had a generally positive picture to paint for 2019, but warned that the health of the oil and gas upstream segment is dependent upon the ability of U.S. companies to find markets abroad.
“To access export markets, we now have to be very cognizant of issues surrounding midstream infrastructure,” he said. This is because, “Pipeline takeaway issues are constraining opportunities.”
The Oil Market
Globally, the market for oil continues growing at a healthy rate, about 1.5% annually going forward to 2025, Spears said. Emerging nations now account for about 53–54% of global oil consumption, which is key because those nations are growing at 3% per year in consumption.
The U.S. is set to become the largest crude producer in 2019 (12% of the total share) and will continue to supply incremental growth over the near term, he said. However, demand could be impacted by threatened trade disputes, a slowdown in China’s growth or higher oil prices.
As far as pricing, as of August 2018, there was a gap between the two benchmarks used for oil prices, which are the Brent, a proxy for global oil prices, and the WTI, the marker price for U.S. oil. WTI will average close to $66/barrel while the Brent is about $15 higher. That’s because of an excess of production in WTI, a differential that will sustain until sometime later next year when more pipelines can be built in the Permian Basin to transport the oil.
Spot oil prices will continue to increase as the market tightens. As of the Market Outlook event, the near-month prices of oil futures were higher than long-term prices, which is an indication that world oil traders believe a sufficient production capacity is available to meet expected demand increases.
After the end of 2018, the spare capacity will be about 1 million barrels per day (bpd). However, sanctions against Iran and an ongoing crisis in Venezuela will complicate the matter. There is a dwindling overcapacity, so the price of oil could tighten if some geopolitical event disrupts production anywhere.
An increase in consumption of oil in the U.S. is occurring because of increased transportation and industrial (petrochemical) demand. At the same time, exports are up, but Spears warned that if trade wars ensue, exports will go down.
Meanwhile, production in the U.S. is higher than expected previously because shale wells are not declining as rapidly as before—they are expected to reach 3.75 million bpd in the second quarter of 2019 and 4.25 million bpd by the fourth quarter of 2019. However, Permian Basin producers have begun to slow or postpone completion work until takeaway capacity improves.
The Gas Market
The U.S. (at 21%) and Russia (at 17%) are the two largest gas producers of the world today.
U.S. spot gas prices have fallen to about $2.00 per million British thermal units (mmbtu). This is because traders anticipate U.S. gas production to ramp up sharply and zero-bid pricing to temporarily emerge in the next 12–24 months in places where midstream capacity proves insufficient to handle rapidly-growing volumes of associated gas.
U.S. spot prices are expected to be flat for 2019 and reach about $2.65-$2.80/mmbtu over the long term. “People think it’s possible oil production will increase by 50% over the next five to seven years, which also means more gas as a byproduct,” noted Spears. “The trick is to find customers for it.”
On the demand side, the global market for natural gas has been growing at 1.7% compound annual growth rate (CAGR) since 2010. An increase in gas exports will account for virtually all net gain in the demand for U.S. gas next year.
Mexico will account for about 65% of U.S. gas exports by pipeline this year with export pipeline capacity to Mexico increasing 3.2 billion cubic feet per day (bcfd) this year to 14.4 bcfd.
Exports could be affected negatively by trade disputes and additional foreign liquefied natural gas (LNG) supply from Australia, Qatar and Mozambique, among others.
Meanwhile, the biggest issue facing oil and gas producers over the next year is the need for additional infrastructure above what has been announced for the next five years: pipeline takeaway of 3.3 million bpd of crude; 5.1 bcfd of gas; 0.5 million bpd of natural gas liquids; and 7.3 bcfd of gas processing.
- For 2019, the commodity price outlook is U.S. spot oil at $71/barrel (up 9%); U.S. spot gas will be $2.25/mmbtu (unchanged).
- In the U.S., consumption of oil is forecast to average 20.7 million bpd in 2019, up 1.6%. Oil exports are expected to average 7.6 million bpd in 2019, up 12%. Oil production in the U.S. is expected to average 11.4 million bpd in 2019, up 8%.
- U.S. gas exports are projected to average 13.4 bcfd in 2019, up 33%.
- U.S. drilling activity is expected to increase 10% in 2019. Canadian and international drilling activity is still waiting to ramp up.
- The rig equipment market, including wellheads and flow lines/valves associated with that equipment, is expected to be up about 5% to a little over $4 billion in 2019.
A Question of Capacities
While Russia and Iran hold the most reserves of natural gas around the globe, North America tops production growth, according to Jacques Rousseau, managing director of Clearview Energy Partners. He said the International Energy Agency (IEA) anticipated a 16.2% increase in the U.S. from 2017 to 2023. How this affects the LNG market will depend on capacity and demands.
Demand growth is focused largely in the Asia and the Pacific areas; power generation is where most of the world’s natural gas ends up going. That segment will not experience the greatest growth in the near future, however. Growth will come from the industrial side.
2018 will be a significant year for LNG plants to come online in the U.S., and some capacity growth is also occurring in Australia, Rousseau said. There are also several plants in pre-final investment decision (FID) stage. The companies building plants need contracts in place to secure the needed bank financing. However, LNG is a buyers’ market right now, and if overcapacity occurs, it will be harder to get contracts lined up.
Asia is short on gas so that’s where receiving terminals are needed and where they currently are being built. However, twice as many receiving terminals exist as facilities to liquify the gas, Rousseau pointed out.
In the U.S. $50 billion in capital expenditure (capex) is planned for liquefaction: 32% on construction and 30% on equipment, such as valves.
Influences on Pricing
When China began using 7% of global oil in 2003/2004, oil prices started to rise. China’s demand for gas will reach 7% in 2019/2020. That reality won’t be the only factor pushing gas prices up, but it will have an influence, Rousseau said. China is also the key driver for demand growth, so any project must consider China as a market. In 2017 30% of the global demand growth came from China; the IEA thinks it will go to 37% by 2023. China has strategic oil reserves and will need the same for its gas; the country will add 20% onto demand requirements to have the gas the country needs stored.
Japan currently imports twice as much LNG as the rest of the world. But now that nuclear will be coming back online, the country will use less LNG.
Marine/bunker fuel presents an opportunity for additional LNG needs, according to Rousseau. An International Maritime Organization bunker fuel specification change takes effect in 2020 that reduces the marine fuel sulfur limit from 3.5% to 0.5%. One option to meet such a requirement is to change the fueling system of container ships to LNG alone.
While LNG plants don’t run all the time, and they have much unplanned downtime, there is still potential for excess capacity. This means not as many investments and building of LNG plants going forward.
On the supply side, the U.S., Qatar and Australia are building many LNG export facilities. Those countries will have half the global supply next year. Only a natural disaster will cut production and provide a significant price spike.
In the U.S. the Permian Basin has increased gas because it’s a byproduct of oil production there. This gas supply is growing at significantly faster rates than anticipated so there is some question where it will go—pipelines to take some of it out of the region haven’t been built fast enough.
For valve manufacturers, the greatest opportunity for the LNG market is in the pipelines that take the gas out of both the Appalachia and Permian regions and in supplying to the ships that move the LNG around the world.
- Australia, Qatar and the United States could be home to about half of liquefaction capacity by 2020.
- China could account for 37% of global gas demand growth between 2017 and 2023.
- Excess liquefaction capacity could result in declining usage rates thru 2020.
- LNG capex in the coming years could be well below peak levels of 2014.
The energy and chemical industries are facing what Mark Eramo, vice president of Oil/Midstream/Downstream/Chemicals, IHS Market, called a “trilemma”: balancing economics, society and the environment.
“Society wants clean beaches and to get rid of plastics. But it also wants jobs and a healthy economy,” he said.
Everything going forward for the petrochemical industry must take all three into account.
Energy & Feedstocks
Rising crude oil prices are solidifying the North American (gas-based) advantage.
“The spread between oil prices and natural gas means that investors are looking to the U.S. and Canada to build the plants that make the products,” Eramo said. For the foreseeable future, higher crude oil and natural gas production will ensure a significant supply of competitive natural gas liquids and methane feedstocks for chemicals. Meanwhile, Mexico is not developing its oil and gas markets, “so the flow of products will continue from North to South,” he said.
Also, as crude oil prices remain low, people are using less money to buy fuel, which means more money to buy other consumables. Meanwhile, if the price of crude is lower, plastic price tags are lower in comparison to other products such as glass or wood.
As far as capacity expansion, a build-cycle disruption will be seen in 2020/21 as industry awaits FIDs for the next wave.
“Back in 2014 and 2015 when crude oil collapsed, the industry didn’t know what was going on,” Eramo said. “They were heading into the U.S. elections, there was Brexit, Middle East uncertainty and other issues so very few FIDs were made.”
That means less building for 2020/21, but from the producers’ point of view, the situation with competition is better because there isn’t as much online with which to compete.
Supply and Demand
As the economy grows above 3% per year around the world, the level of growth in base chemicals becomes substantial. However, it will take more than economic forecast to drive strong up-cycle conditions from a supply/demand perspective.
Ethylene will grow the most; just to keep up with global demand, industry must start up four to five steam crackers per year, keeping the ethylene market tight until the next wave of steam crackers can be built. Demand for chlor-alkali is also going up, so supplies will be tight there as well.
Currently, a huge risk has been created from uncertainty in geopolitics from Iran, North Korea and some G8 and G7 groups. The growing protectionist approach to trade and government fiscal policy is also creating risk because these are issues that make consumers or businesses less confident. Questions are starting to be raised about what can happen, Eramo said.
The next stage is the evolution of refinery and petrochemical integration.
“There is a view that says higher fuel efficiency and increased use of electric vehicles create a forecast for a declining growth rate in the demand for refined products,” Eramo warned. Because of this “more oil and refining companies are considering putting assets into petrochemicals.” In China, for example, four refineries are being built that also include petrochemical plants.
Many other changes are also occurring in China, which is a significant player in the chemical industry, producing 200 million metric tons of chemicals per year. More plants have combined private/public ownership for example. This reality, combined with the country’s goal of being self-sufficient in getting the petrochemicals they need to manufacture products, is spurring ever more growth in this country. Also, there is a significant cost advantage over North America because it is much cheaper to build plants there.
As far as environmental issues, local communities and corporate entities are exploring bans on single-use plastic applications in answer to the troubles of plastics waste in oceans. This type of mainstream media event may mean a slowdown in growth for commodity plastics demand over the long term. According to Eramo, the industry is taking many steps to solve the problem, but those steps are not out there in the public eye. The solutions to this will come from a cooperative approach that brings all stakeholders together to solve the complex issues.
- The chemical industry likely will carry strong profit momentum into the 2020s.
- Ethylene will grow the most in the near future, reaching 6 million tons per year from 2018 to 2023.
- Sustainability issues from carbon to plastics will remain top priorities.
Renewables Getting Attention
Across the globe today, the energy industry is seeing “huge growth in renewables such as biogas, digester gas, wind and solar,” as well as hydropower, according to Britt Burt, vice president of global research for the power industry, Industrial Info Resources.
Even though solar offers the fewest opportunities for valve use among the renewables, “There are some concentrated solar thermal projects in development and in operation that do use valves.”
The hydropower industry, meanwhile, is growing rapidly.
“There are nearly as many hydro plants being built as there are already in existence,” Burt said.
In the burgeoning countries of India and China, “There is a lot of talk about moving away from coal and more toward renewables,” he noted. However, in the long term there, “I don’t see [those countries] moving away from coal. It will continue to be developed because of the lower cost and availability.”
In North America, new plant and brownfield projects scheduled to kick off from now through 2020 include windfarms, natural gas plants, solar farms, etc., that total $440 billion.
“It looks like a huge increase, but those figures include all [projects] that have even been proposed. There will be some project fallout. There will be cancellations and others that are put on hold,” he said.
One area to watch today is expansion, which includes adding more units to plants. In natural gas, for example, that would mean adding another turbine or expanding combined-cycle capability.
In North America, expansion of power capability may be significant because some traditional types of power sources are diminishing. However, “Not all the nuclear or coal plants are going to close down tomorrow,” he said. “So there will be a lot of activity going on, meaning in-plant capex will be needed to keep what’s there operating efficiently and competitively.”
Maintenance saw a bit of a dip in activity in 2018 from 2017, and Burt said he expects even more of a decline next year and in 2020.
North American Power
Low fuel prices today are keeping natural gas attractive for a new generation of natural gas power plants and for replacement of coal-burning plants. This situation will continue for some time, Burt said. Even if LNG exports increase, Industrial Info Resources doesn’t see a drastic increase in natural gas prices in the U.S. for power generation.
Meanwhile, tax credits and mandates continue to drive the renewables forward. For example, tax credits for wind projects are still in place for any project starting between now and the end of 2019. In solar, a 30% tax credit remains in place through the end of 2019, although that drops to a permanent 10% in 2020.
Investments for the coal-fired and nuclear-powered sectors are limited to operating and maintaining existing assets. Burt predicted more nuclear capacity going offline in the future because of the lower natural gas prices and renewables but warned that the industry will not disappear completely.
From 2012 to the present, most of the generation capacity that’s been closed down has been coal. During that timeframe, 116 gigawatts (GW) of energy has gone offline or been closed, and of that amount, about 65 GW was coal. Some natural gas traditional steam units have closed because they were using less-efficient technology. These are being replaced by higher-efficiency machines.
From now until 2022, Burt expects another 55 GW of coal capacity to go offline and be replaced by renewables and by natural gas. This year has been a banner year for natural gas capacity, he said, and by year’s end “nearly 28 GW of power will be added to the grid.”
Burt also noted a growing sector in the power industry: industrial energy producers such as refineries, chemical plants, and pulp and paper mills that are building energy-producing projects on their sites. There are 743 high-probability projects valued at $10.1 billion from 2018 to 2020, and he said he anticipates even more onsite power generation in coming years.
- In total, IIR estimates 31.5 GW of energy is coming online for 2019 and 34.5 GW for 2020.
- Burt projected that 499 power projects worth $97 billion will start between now and 2020. These projects will largely be comprised of renewables (wind, solar and natural gas.)
- Burt also projected an estimated 116 expansion projects worth $25 billion adding 23 GW of power starting between now and 2020.
A Flat Growth Line
Acccording to Tom Decker, water marketing and business strategy consultant, the water and wastewater market is just hanging on, showing neither great growth nor great decline.
In the U.S., wastewater capex spending is currently about $60 billion, while the fresh water treatment industry is about $40 billion. That compares to global capex of $300 billion, half of that going to fresh water.
While growth in the U.S. has been slow over the last couple of years, the second half of 2017 saw increased activity; during 2018, wastewater construction is up 9% and water is up 6.1% (as of the workshop).
Deteriorating infrastructure is the main driver of growth. Each year there are 240,000 pipe breaks and over 6 billion gallons of non-revenue water lost per day. The Environment Protection Agency’s (EPA) latest water needs survey found that, just to keep systems in respectable condition, it would be necessary to spend $313 billion in pumping stations, including pipes, valves, pumps and attendant equipment over the next decade.
“Fortunately, financing is pretty good right now for the water industry,” said Decker. Also, “Rates [for services] are up about 5−6% per year since 2010.” That’s partly because officials used to be afraid to raise rates, but lately, they’ve had to because they need the money and public perception of the need has changed, he said.
Decker said water infrastructure funding (the Water Infrastructure Finance and Innovation Act—WIFIA, a credit program that’s EPA-administered) projects are starting to get loans. For example, “three WIFIA loans have been put out in 2018 and the funding itself was increased to $63 million in 2018,” he said.
Decker pointed out that, while that seems like a relatively small amount of money given the huge number of projects that need work, the figure is only the amount needed to budget for defaults. “Because the money [for the loans themselves] will be paid back, the full amount doesn’t have to be accounted for in the budget. This can be leveraged into hundreds of billions of dollars of work,” he said.
Still, the federal government funds only about 4% of water/wastewater projects in this country so it falls to municipal bonds to finance about a third of needed infrastructure improvements. Meanwhile ratings are stable and defaults are very low so the bonds remain a solid investment.
There also is public support for water infrastructure spending. The Value of Water survey for 2018 (http://thevalueofwater.org/) found that 88% of respondents supported greater federal investment in infrastructure.
Some feel that technology may be the answer to where money should be spent.
A Bluefield Research study said utilities could save almost $42 billion by 2027 through effective deployment of smart technology. Sensors, networks and data management can make water systems more efficient and effective.
Decker stressed that the brightest prospects for manufacturers is in the distribution and collection systems. “The mass expanse of pipes and pumps between the meters and the plants is where the biggest opportunity is for valve and pump manufacturers.”
Several utilities also are looking at conservation-related projects to save money or gain opportunities. In particular, energy generation from bio solids is happening, though the energy earned is not for running the facilities; rather it provides energy for utilities to sell.
“Ten years ago, we would have seen less than 100 [reuse projects] and 80% are in Texas, California or Florida,” said Decker. That’s expanding. Just this year, for example, “Arizona rescinded its ban on direct potable reuse—now they are going to get into this game. This uses a lot of valves,” he concluded.
Meanwhile, desalination is experiencing solid growth around the world, and in the U.S., California just provided funding for eight different desalination plants in that state.
One of the developments that has the potential to slow down markets is cost to homeowners. Almost 12% of households now cannot afford their monthly water/wastewater bills, Decker said, which has the potential to slow the pace of the rate increases that pay for improvements and maintenance.
Water use also is down, which means less revenue for utilities. Yet even though those utility companies process less water when less is used, fixed costs remain the same, so they will likely have to consider a different way to charge for services.
Creeping inflation and rising interest rates are possible negative influences that are coming. According to Associated General Contractors, material prices in commercial construction were up 9% from May 2017 to May 2018, and construction costs were up 5.6%. Other uncertainties include federal rate hikes that push inflation further upward, and tax cuts and jobs legislation, which impact municipal bond yields and attractiveness. The prospect of tariffs from abroad also threatens costs.
“It’s also harder to find qualified people to build right now,” said Decker, noting that some contractors have refused jobs in the sector because they just do not have the staff. Decker warned: “When things are uncertain, water and wastewater utilities don’t build.”
- Affordability issues could affect more than 35% of households in the next year if rate increases continue at the current pace.
- Bluefield Research says capex spending in the U.S. will be $683 billion over the next 10 years.
- Bluefield Research also projects a 37% increase in water reuse projects in the U.S. by 2027.
- Smart technology will generate $14 billion in capex through 2024.
THE GLOBAL ECONOMY
Even though it’s been a decade since the Great Recession of 2008, the world still feels like it’s living in it, according to David Teolis, senior manager of economic and industry forecasting, International, at GM.
“The reason for protectionism and the populist movement stems from what happened during the post-crisis period,” he said.
Before the recession, globalization was spreading, beginning with the North American Free Trade Agreement in 1994, creation of the Eurozone in 1999 and advancing to 2001 when China joined the World Trade Organization (WTO).
Up until then, the biggest influence on the world’s economies came from advanced countries. Afterward, developing countries began to have a bigger influence. China’s entry into WTO created a commodity super cycle in the world from 2003 to 2014. That created much economic stimulus and global gross domestic product (GDP) growth of 4%.
“When the global financial crisis occurred, China kept things going by stimulating its own economy,” Teolis said. The country already had 600 million people living in poverty so if it hadn’t done something, “it would have created havoc,” Teolis noted.
From 2012 to 2016, the world slowed to below 3% growth rate, the longest period of such low growth. That lasted five straight years and created weak wage growth and unemployment fears.
When such conditions last longer than a couple years, stress builds up everywhere so when the European crisis with migrant/Syrian refugees occurred “people began feeling very anxious,” which contributed to the move toward protectionism, he said.
A key contributing factor to the slow recovery of business fixed investments that has occurred in recent years was low productivity growth.
According to Teolis, overinvestments during the years preceding the global financial crisis contributed to subpar investment spending in the post-crisis period. This development, combined with the weaker labor productivity growth and slower growth of the working-age population, created the slower potential real GDP growth.
He also said a shift has occurred from private sector imbalances and excesses before the crisis to public sector imbalances and excesses after the recession.
High private sector debt, high dependence on commodities, overinvestment in housing, infrastructure and financial sector insolvency all contributed to the severity of the recession. The only way to fix those problems was with structural reforms. Regulations were instituted to protect the economy.
However, some of the protections created during the crisis have been taken away by the current Administration.
Also, an unsustainable picture has been painted by high public debt and deficits, tax revenues that are low because the economy has been slow and governments spending more to limit the degree of recession damage.
This leads to the biggest concern for Teolis. “If there is a fall into a recession because of trade wars,” the world’s governments won’t be able to stimulate what has already been stimulated.
“If we fell into a recession today, the central banks can’t do any more,” he said. “The U.S. can’t spend more or go into more debt,” he said.
Teolis agreed that the largest bilateral trade deficit for the U.S. is with China (at $375.2 billion). But he said tariffs are probably not the answer and noted that nobody complained about trade deficits when economies were good.
He also posed the questions, “Are financial markets fully pricing in the potential impact of a trade war? Is the strong U.S. economy providing a positive offset, or are stock buybacks masking downside risk?” The answer to those issues largely will determine the true impact of potential trade wars, he said.
- Protectionism remains the key downside risk to the global outlook.
- Inflationary pressures could be an overlooked downside economic risk.
- Implementation of structural reforms and new technological advancements should have a positive impact.
- The ability to absorb a negative shock depends, in part, on where the economy is in the cycle.
The Bright Spot
The domestic economy is doing well, according to William Strauss, senior economist and economic advisor at the Federal Reserve Bank of Chicago.
“We are in the ninth year of our economic expansion, the second longest in U.S. history,” he said.
GDP expanded by 2.8% over the past year, which is “well above the trend growth of the economy.” It’s also contrary to what some doomsayers believe, which is “just because we have an economy running well, doesn’t mean it’s going to run out of steam. It continues to grow at trend, which is 2%,” he said.
The Federal Open Market Committee (FOMC) expects GDP to grow above trend this year, just shy of 3%, then continue to do well in 2019, but at a slower pace. By 2020, the growth rate should be around trend again, Strauss said.
The index of leading indicators continues to rise, so economic activity seems to be on very solid footing and no recession is expected for the next two quarters.
”We are continuing to add workers at an unprecedented rate,” Strauss said. However, “you cannot continue if you don’t have the workers to fill the jobs.”
Meanwhile, the low unemployment rate of less than 4% would normally make the Fed nervous about inflation. But wages and benefit costs are also increasing at moderate rates. Real wages are rising less than 1%, which is a frustration for workers not getting raises.
Although businesses say they are considering giving higher wages, they are not doing it, Strauss pointed out. He thinks that’s partially because of low productivity (below 1% growth for several years).
Strauss surmised that the reason productivity has not grown is because of the weak pace of investment (in machinery, etc.). Businesses had a choice between hiring workers or investing as they climbed out of the recession. Because there was so much nervousness about another recession, they opted to hire workers instead of spending what capital they had on equipment.
Now, capital spending is improving, not because of the tax incentives, according to Strauss, but because the economy was moving along, and businesses needed to invest. Thus, productivity growth is bouncing back up, and Strauss hopes that the economy will strengthen further with this capital spending.
When food and energy prices are removed from the picture, the rate of inflation remains below the core rate of 2% and the FOMC anticipates that inflation will be around that level through 2020.
“Manufacturing output is increasing after being unchanged for the past couple of years,” noted Strauss. “Also, capacity utilization has been moving higher over the past year, but, at about 75%, it’s still below full utilization.” Manufacturing employment increased by 327,000 workers over the past 12 months.
- The U.S. economy should expand at a pace above trend in 2018 and 2019 and close to trend in 2020.
- Employment is expected to rise moderately with the unemployment rate remaining very low.
- Inflation is forecast to rise to the Fed’s inflation target this year.
- Manufacturing output is expected to increase at a rate above trend in 2018.