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Economic Outlook | Fall 2016

Economy Shrugs Off Brexit, Campaign Hype

from Anthony Chan, PhD, Chief Economist for Chase

Brexit, volatile jobs reports, a strong dollar, and the U.S. presidential campaign—all of these factors are conspiring to make some investors nervous about the direction of our economy. Is the United States due for another recession? Is our seven-year-old recovery finally coming to an end?

Economic data suggests nothing of the sort. The U.S. economy remains on a path of slow but steady growth with little imminent danger of either recession or inflation. In fact, J.P. Morgan Private Bank still rates the risk of recession in the next 12 months as quite low—an outlook that hasn’t changed in the last year. A deeper look at these issues should provide some comfort.

Brexit Barely Ripples Across the Pond

At the top of many investors’ minds is Britain’s surprising vote to pull out of the European Economic Union—the so-called “Brexit.” Financial markets, which priced in an expected “no” vote, reacted sharply with a wave of fear and negativity. The British pound initially dropped more than 10% relative to the U.S. dollar, while global markets lost more than $3 trillion in value.Footnote 1

Across the pond, the aftermath was short-lived for U.S. equity markets, barely creating a ripple just days after the outcome. You may recall that the Dow Jones dropped nearly 900 points but recovered all of its value and then some—reaching record-breaking highs within three weeks of the vote.

Why such a muted reaction? The simple answer is that Brexit’s impact on the U.S. economy will be limited. While the British economy may flatten or turn slightly negative as a result of Brexit, U.K. trade represents just 4% of world economic output and 0.7% of U.S. exports. Also, Great Britain is only our 7th-largest trading partner— after Canada, China, Mexico, Japan, Germany and South Korea.

To quantify the impact, we anticipate the U.S. economy will shed no more than one-to two-tenths of a percent. Essentially it could bring down expected 2016 growth from 1.8% to roughly 1.7% or 1.6%. In an $18 trillion economy, that’s not remotely enough to send us into recession. Even in the Eurozone, where the U.K. is a much more significant trading partner, we forecast growth will drop only one-quarter to one-half of a percent as a result of Brexit and will stay above 1% over the next year.Footnote 2

Volatile Jobs Reports Mask Continuing Growth

Another cause of investor jitters has been volatile employment data, which seem to jump around unpredictably. The U.S. Employment Report revealed a significant slowdown during the second quarter; however, subsequent reports revealed a healthy bounce in employment during the third quarter, suggesting the U.S. economy remains resilient.

Such volatility highlights the need to treat monthly data with caution. One or even two reports do not make a trend. As the chart below shows, looking at three-month averages helps smooth out the “noise” in month-to-month data and makes it easier to discern the underlying pattern. As you can see, we have not seen the three-month average fall below the 90,000–100,000 new jobs needed each month to keep pace with the growing U.S. population since 2010. Recently, the start of the third quarter showed this three-month moving average growing by almost 200,000 jobs per month.Footnote 3


The Fed Keeps its Foot on the Brakes

While Brexit won’t send us into recession, it did create enough uncertainty for the Federal Reserve to rethink its monetary policy. Even before the Brexit vote, the Fed signaled it would reduce the number of rate adjustments in 2016 from four, as initially announced, to just two or three. Now it seems likely there will be just one increase this year.Footnote 4

This continues to be the case even with a slew of positive monthly jobs reports. The recent reaction of U.S. equity markets to stronger-than-expected U.S. employment figures has been fairly positive in contrast to prior instances where robust outcomes have sent the stock market into a tailspin—as it may have signaled additional tightening by the Fed. Nonetheless, expectations for interest rate hikes remain muted as judged by rhetoric from influential Fed officials.

We do, however, recognize that this too shall pass. As long as the economy stays on its current path, we can expect the Fed to return to its goal of raising interest rates back to “normal” territory, just not until the economy’s growth path is assured.

Strong Dollar Offset by Rising Energy

First, the strong U.S. dollar is not likely to send us into recession. While the dollar remains high compared with the pound, euro and other major currencies— especially after Brexit—it is no longer continuing to strengthen. In fact, after a 20% rise over the last two years, the dollar is actually down more than 1.5% year-todate against a basket of major currencies.Footnote 5 As a result, we anticipate U.S. corporate profits, which fell sharply in 2015, will be flat to slightly negative this year. In 2017, the consensus view is for profit growth of almost 14%.Footnote 6 We project slightly less than half that amount, consistent with our expectation of a 7%-8% return in U.S. equity markets.Footnote 7

Additionally, the impact of the strong dollar is offset to some extent by resurgent energy and commodity prices. Oil is up more than 60% from its first-quarter low.Footnote 8 This not only helps profits in the energy and materials sectors, but also reduces the burden on banks, which have less need to raise capital reserves to accommodate energy loan defaults. Looking ahead, we anticipate that oil prices will inch higher over the next 12 months, although inflation will remain at bay until oil prices move closer to the $80 range.Footnote 9

Consumers are Confident—and Spending

Other economic indicators point to a strengthening economy as well. Consumer confidence, for example, is well above levels seen prior to recent recessions. Based on the University of Michigan Consumer Sentiment survey, our research shows the average level of consumer confidence one month before a recession is 82.4. At the start of the third quarter, we saw U.S. consumer confidence readings remain significantly above this long-term average, thereby illustrating another counterpoint to expectations of a significant near-term downturn in the U.S. economy.Footnote 10


Confident consumers are opening their wallets too. After staying relatively flat since last summer, retail sales surged 1.2% in April, followed by 0.2% in May and another healthy rise of 0.6% in June.Footnote 11 Consumer spending accounts for two-thirds of the U.S. economy and is therefore likely to spur other economic activity, such as employment and wage growth.

Investors are Voters Too

With all of this positive economic news, why are so many investors still concerned about a recession? Well, investors are voters too, with strong feelings one way or the other about the future direction of the country. Given the backdrop of a presidential election year, political polarization and campaign hype can make it difficult to view the economy objectively.

As investors, though, we need to take off our “voter hats” and put on our “investor hats” when we think about portfolios. That means acting on fundamentals, not emotions. While the country may not feel as prosperous as in the late 1990s or mid- 2000s, the economy has clearly improved from the downturn of 2007–2010.

Yes, we still have significant economic challenges ahead of us, but this is the time to be diligent about finding opportunities, not after the economic picture has fallen into place. Seeing that the U.S. economy has indeed proven its strength and resilience, our outlook is that the economy will continue to move in a positive direction.

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