Jeff Jensen and Elizabeth Rust 2017-01-26 13:32:00
REFLECTING ON THE PAST YEAR, 2016 was an economic disappointment. Growth slowed to a crawl in the first two quarters, while equipment and soft ware investment contracted. The economy began to show signs of life in the third quarter and grew at a 3+% annualized rate for the first time in two years, but business investment continued to disappoint.
At the start of 2017, most indicators point to an economy that is solidifying. In the 2017 Annual Equipment Leasing & Finance U.S. Economic Outlook (jointly produced by the Equipment Leasing & Finance Foundation and Keybridge), we projected an above-cons ensus growth rebound of 2.7%, along with a decent 3.0% expansion in equipment and soft ware investment. Despite this optimism, however, there are several potentially significant economic headwinds on the horizon—as well as larger-than-usual “tail risks” that, if realized, would have a major negative effect on both the economy and the equipment finance industry.
On behalf of the Foundation, Keybridge economists produce monthly U.S. Equipment Software Investment Momentum Monitors and quarterly industry-focused economic outlooks. Drawing on these materials, here are nine key industry, policy and macroeconomic factors to watch in 2017.
1 The U.S. economy is strengthening, driven by wage growth and consumer spending.
In recent months, it has become increasingly clear that the U. S. economy has moved past the growth pause that occurred in late 2015 and the first half of 2016, and a return to more decent growth is likely. One of the key drivers of this trend is tightening labor markets—and, by extension, wage growth. Wages stagnated for years following the Great Recession, but with unemployment now well below 5% and jobless claims at near-record lows, businesses will increasingly need to entice new workers with better wages to attract talent. The effect of upward wage pressure would be amplified if federal lawmakers can agree on an infrastructure spending package (which would create jobs) and tax relief for consumers and businesses (which would raise real disposable income), as many political insiders anticipate. The cumulative effect of these market and policy developments should translate into healthy consumer spending in 2017, which typically comprises roughly two-thirds of the economy. One of the downsides of rising wages, however, is increased inflationary pressures, and with core inflation currently running at 2.1%, this will be something to watch in the months ahead.
2 Business investment should improve.
Although fourth quarter data will not be released until late January, 2016 will likely go down as a year of negative growth for equipment and software investment. While we expected business investment to slow in the 2016 economic outlook released with the Foundation in December 2015, the industry performed even worse than we anticipated due to the combination of continued manufacturing weakness, a persistently strong dollar, low oil prices and fading business confidence.
Moving forward, it appears likely that capital spending will pick up in 2017, at least somewhat. Business confidence, especially among small businesses, appears to be rebounding: both the National Federation of Independent Business Optimism Index and the Foundation’s Monthly Confidence Index increased sharply at the end of 2016. In addition, oil prices have stabilized, consumer demand remains relatively strong, credit market conditions are healthy and inventories, which declined for five consecutive quarters, should rise to meet market demand (as they began to do in late 2016). Look for a modest expansion of equipment and soft ware investment of around 3.0% in 2017.
3 Most equipment verticals are exhibiting positive momentum.
As any regular reader of the Foundation-Keybridge U.S. Equipment and Soft ware Momentum Monitor should know, most equipment verticals were “flashing red” for much of 2015 and early 2016, and were a harbinger of the investment slowdown that occurred last year. In recent months, however, most verticals have shown positive signs of momentum. Much of the improvement is related to a more supportive price environment for energy production activities, and substantially higher momentum readings for several equipment investment verticals (e.g., oilfield and mining equipment, railroad equipment, other industrial equipment and materials handling equipment) can be traced back in part, either directly or indirectly, to higher oil prices.
Another equipment vertical to watch in 2017 is construction. Although annualized investment has contracted for six consecutive quarters, construction sector momentum rebounded during the second half of 2016. A key driver of investment in this vertical is the demand for housing, which remains solid. For example, the National Association of Home Builders housing market index is at its highest point since 2005 due to a combination of solid employment numbers, steadily rising incomes and increased business and consumer confidence. Moreover, the prospects of a large infrastructure federal spending bill during the first half of 2017 could provide an additional boost to construction equipment investment.
One of the exceptions to the overall positive story as we enter 2017 is agriculture equipment. Although momentum improved somewhat late last year, it remains subdued and continues to signal weak or negative investment growth.
4 The oil sector will cease to be a major drag on the U.S. economy.
The 18-month oil price freefall that began in mid-2014 was devastating to the U.S. oil sector and led to continued severe contraction in energy-related investment in 2016. Th is sharp decline spilled over into other equipment verticals (e.g., railroad, materials handling and industrial equipment), dampening the environment for capital expenditures and dragging down economic growth.
Looking ahead, oil prices appear to have stabilized at $45–$55 per barrel, which should encourage energy firms to ramp up production and investment. Indeed, oil rig counts have grown consistently since last summer, and oilfield and mining equipment investment expanded in the third quarter for the first time in over two years. These developments suggest that the energy sector will no longer be a large minus for U.S. growth in 2017, and could even turn into a modest plus if prices hover on the high end of the forecasted range.
5 Portfolio performance will likely continue to soften in 2017.
The equipment finance industry has enjoyed superb portfolio performance for several years following the 2008-09 recession. However, while performance remains strong by historical standards, 2016 may turn out to be an inflection point. Delinquencies and charge-off s are above year-ago levels, and a continued rise in both metrics should be expected as the economy expands, industry competition remains intense, and firms look for ways to attract new business. As was the case last year, we do not expect a sharp decline in portfolio performance, but industry executives should prepare for a slow but steady rise in delinquencies and charge-offs this year.
6 Federal policy is likely to become more business-friendly—for the most part.
With the 2016 election finally over and Republicans set to control both Congress and the White House, many political observers expect reduced gridlock and forward movement on long-stalled policy priorities. Th e stars are aligned for Congress to have their best chance at comprehensive tax reform in decades; the result could be legislation that reduces taxes on households and businesses, including a one-time repatriation incentive that could result in $1-2 trillion in off shore profits being reinvested in the U.S. economy. President Trump has also signaled interest in a temporary spending boost that would lift employment while providing needed improvements to key infrastructure across the country. Both proposals would promote business investment and economic growth, but could increase the deficit unless they are paired with other measures that decrease federal spending or increase federal revenues.
Additionally, Republicans may push ahead on other policies that could also promote business investment and economic growth depending on how they are designed. One example is a potential repeal of significant portions of the Dodd–Frank Wall Street Reform and Consumer Protection Act and reform of others, which would be supported by many financial institutions. In addition, the Trump Administration has vowed to reduce the cumulative regulatory burden on businesses (highlighted by a “one in, two out” approach), which could increase business investment and hiring.
However, other parts of the President’s economic plan are viewed skeptically by mainstream economists and could off set some of the benefits discussed above. For instance, eschewing free trade principles by imposing tariff s and other penalties on U.S. companies would increase costs for both U. S. businesses and consumers, while labeling China as a currency manipulator could set off a chain of retaliatory actions that lead to a trade war (and possibly a recession). Further, the President’s hardline stance on immigration reform runs counter to the view among many economists that Equipment Finance Volume Non-Financed Equipment Investment Foreign workers provide net benefits to U.S. households and the overall economy. If millions of undocumented immigrants are deported, respected economic models project it could shave several tenths off economic growth each year.
7 The Federal Reserve Board will resume efforts to normalize interest rates.
In late 2015, the Federal Reserve Board finally increased its benchmark interest rate for the first time since the Great Recession, and most observers assumed that more rate increases would follow in 2016. Instead, the Fed opted to postpone additional rate hikes, largely out of concern for the economy’s sluggish growth. However, the Fed finally raised interest rates again in December 2016, following stronger economic data during the second half of the year. We anticipate multiple additional rate increases this year. With unemployment at 4.6%, steadily rising wages and the potential for growth-friendly federal policies in the months ahead, the Fed will feel pressured to act to keep inflation in check. We expect three more rate increases by the end of the year, and recent comments from Fed officials suggest they are open to a fourth rate increase to protect the economy from overheating and inflation running rampant.
8 Worries about a Chinese hard landing have faded somewhat, but emerging markets on the whole are likely to remain weak.
Th is time last year, many economists worried that China’s economy, marred by overleveraging and overinvestment, was headed for trouble in 2016. This concern has eased somewhat due to increased confidence in the Chinese government’s ability to manage its financial sector, but fears persist that China’s economy is headed toward a long-term slowdown. The Chinese economy is expected to grow 6.3% in 2017, significantly lower than the 7+% growth it averaged aft er the Great Recession and the 10% average annual growth it experienced from 2000–2009. This slowdown is typical of country in the midst of transitioning to a middle-income economy, and may also indicate that an unhealthy investment binge driven by construction is easing.
However, U.S. and global economic performance is closely tied to China’s fortunes, and some analysts worry that China’s slowdown may be worse than the official numbers indicate.
With respect to emerging markets, growth prospects should improve in 2017, but remain weak by historical standards. In Brazil, economists predict just 1.1% growth, which would be a soft rebound from a deep recession in which the economy shrank by -3.2% last year. Likewise, the Russian economy is set to expand 1.3% aft er a contracting by -0.8% in 2016. India remains a bright spot, with growth projected to reach 7.5% this year. On net, however, growth expectations for emerging markets are tepid and could prove to be a headwind to growth in the United States and other advanced economies.
9 Trade is in the cross hairs, and is set to continue a slowdown in 2017.
Although final data are not yet available, global trade volume in 2016 likely grew at the slowest pace since the Great Recession, continuing a five-year slowdown not seen since the 1980s.
Trade has been harmed by a combination of global economic weakness, political uncertainty and a populist backlash. Slowing growth in emerging markets like China and Brazil led to a decline in exports, while soft demand in the United States and other large importers exacerbated the issue. At the same time, trade restrictions (including tariff s, quotas, import duties and other barriers) and the collapse of high-profile trade deals like the Trans-Pacific Partnership (TPP) and Transatlantic Trade and Investment Partnership (TTIP) further impede growth.
Trade policy was at the forefront of U.S politics during both parties’ primary races as well as the general election, and according to the Pew Research Center, more Americans now believe that U.S. engagement in the world economy is a negative (49%) rather than a positive (44%).
Although underlying conditions for economic growth are expected to improve, trade will likely continue to underperform in 2017. Despite the view among many economists that pro-trade policies benefit the U.S. economy and improve living standards for Americans in aggregate, the new administration has sent signals that it will take a tougher stance against free trade in an effort to protect vulnerable U. S. workers (particularly those in the manufacturing sector).
These efforts are likely to include cancelling the TPP and renegotiating the North American Free Trade Agreement (NAFTA), and may lead to the United States labeling China a currency manipulator—which would likely trigger a retaliation from China against U.S. firms that export to China or rely on Chinese factories, including Boeing and Apple.
Accounting for these nine factors…
In sum, expect a better year for equipment investment than we experienced in 2016. U.S. economic fundamentals are reasonably strong already, and the combination of solid wage and consumer spending growth, improved oil markets and a policy landscape more amenable to business interests should drive economic growth even as interest rates continue to rise. While significant headwinds remain and tail-risk events are more likely this year than usual, equipment finance executives have reason to be cautiously optimistic about the year ahead.
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