Services

Highlights Neither the weakness in emerging market economies nor political turmoil in Europe are likely to significantly affect the U.S. economy. Although the U.S. economy is increasingly service-oriented, financial markets have become more bound to the manufacturing economy in the past 30 years. The U.S.'s large trade surplus in services fosters faster job creation and better pay than in the goods-producing area where the U.S. has a trade deficit. Our energy strategists believe that the risks for oil prices remain biased to the upside, although we are less bullish in view of OPEC 2.0's possible production increases in the near future. Feature U.S. risk assets are rebounding amid solid economic news and rising hopes that another Eurozone financial crisis has been averted. Still, investors remain concerned about rising rates, protectionist trade policies, and the health of emerging market economies. In addition, market participants continue to scan the U.S. economic data in both the manufacturing and service sectors looking for signs that the late-cycle phase of the expansion is ending and that a recession is nigh. The NASDAQ and small cap U.S. stocks rallied past their February peaks last week, but the S&P 500 remains 3.7% below its early 2018 heights. Moreover, BCA's stock-to-bond ratio continues in an uptrend and we expect stocks to beat bonds in the next year. However, neither U.S. high-yield spreads nor the VIX have returned to their January lows. 10-year Treasury yields are 53 bps higher and the dollar is up by 5%. West Texas Intermediate oil prices peaked at $72.26/bbl on May 21. We discuss BCA's latest view on oil later in this report. U.S. economic growth remains solid. May's reading (58.6) on the ISM non-manufacturing index released last week is consistent with 3.5% real GDP growth. Moreover, the May sounding (58.7) on manufacturing indicates that the U.S. economy is growing near 5%. We discuss the signal from both the ISM's manufacturing and non-manufacturing indicators in the next section. In any case, U.S. economic activity in 1H 2018 will easily surpass the FOMC's view of both potential GDP growth (1.8%) and its estimate for actual growth in 2018 (2.7%) (Chart 1). The Fed will provide a new set of dot plots and economic forecasts this week. BCA expects the Fed to bump up rates this week and then gradually during the next year. The Fed and the market's view of the path of rates in the next 12 months is aligned (Chart 2). However, BCA's stance is that inflation will accelerate in 2019, which would elicit a more aggressive response from the central bank starting in the second half of 2019. Our view is that the Fed will stick to its gradual path unless economic growth is much weaker than expected or inflation spikes higher. Moreover, because inflation is at the Fed's 2% target and the economy is at full employment, the price at which the Fed's "policy put" gets exercised is much lower than earlier in the cycle. The implication is that neither the weakness in emerging market economies nor political turmoil in Europe are likely to significantly affect the U.S. economy. Still, a wider trade war is a risk to U.S. and global growth, and we address this issue in the service sector below. Chart 11H GDP Tracking Well Above##BR##Potential & Fed's Forecast Chart 2Fed And Market Aligned##BR##On Rate Path In Next 12 Months On The Same Page The ISM surveys - manufacturing and non-manufacturing - are aligned. The top panel of Chart 3 shows that both metrics have climbed since their troughs in late 2015 (manufacturing) and early 2016 (non-manufacturing). These lows occurred amid EM-related economic and market turbulence. The 2015 nadir in the manufacturing series was more pronounced, thus the rise outpaced the non-manufacturing indicator (panel 2). U.S. financial markets, and the stock market more specifically, are sensitive to the performance of the manufacturing sector. The service sector accounts for 62% of U.S. economic activity and 86% of private-sector employment (Chart 4). Charts 5 and 6 show the relationship between the year-over-year change in BCA's stock-to-bond ratio and the level of manufacturing (Chart 5) versus non-manufacturing (Chart 6) composites. The relationship (r-squared 0.56) between our stock-to-bond ratio and the manufacturing sector is more robust that the r-squared (0.43) between the stock-to-bond ratio and the non-manufacturing sector. Chart 3Manufacturing And Non-Manufacturing ISM Are Aligned, But That's Not Always The Case Chart 4U.S. Economy Is 60% Services... Although the U.S. economy is increasingly service-oriented, Charts 7 and 8 show that the financial markets have become more bound to the manufacturing economy in the past 30 years. Between 1958 and 1988, the r-squared between our stock-to-bond ratio and manufacturing data was 0.19 (Chart 7). That increased to 0.34 from 1988 to 2018 (Chart 8). Chart 5Tighter Relationship Between##BR##Stock-To-Bond Ratio And Manufacturing ISM... Chart 6... Than With##BR##Non Manufacturing ISM Chart 7ISM Manufacturing Vs.##BR##Stock-To-Bond Ratio 1958-1988... Chart 8... And##BR##1988-2018 Chart 9 shows that there have been six other periods when the manufacturing index recovered more quickly than non-manufacturing. Five of the intervals were associated with EM stress.1 Moreover, as is currently the case, the economy was at or below full employment in four of the six occasions when manufacturing outpaced the service sector. Furthermore, the Fed initiated rate hikes in four of the seven episodes, including the current one (Appendix Chart 1). EM stocks tend to outpace U.S. equities as the non-manufacturing index rises faster than the manufacturing index. In addition, when the U.S. manufacturing sector is accelerating relative to the service sector, China's growth prospects (as measured by the LI Keqiang Index) improve. Chart 9Performance Of EM Assets When Manufacturing ISM Outpaces Service Sector ISM The peak in our Relative ISM composite index is consistent with BCA's view that the economic expansion that began in 2009 is nearing an end. Our Relative ISM Composite dipped prior to the 2001 recession, but began to rise as the 2007-2009 downturn commenced. Both the manufacturing and non-manufacturing indices collapsed at the same pace prior to the 2007-2009 recession, because the breakdown of the banking system related to the housing crisis weighed on the non-manufacturing data. Unfortunately, the ISM non-manufacturing data only begins in 1997. However, using the goods and service-sector GDP as proxies for the ISM metrics, we find that the manufacturing sector tends to underperform the service sector in the late stages of an expansion (Chart 10). Our earlier work2 details the performance of U.S. financial assets in a late-cycle environment. Chart 10Manufacturing Sector Tends To Underperform The Service Sector In Late Cycle Environments Bottom Line: Last year's "global synchronized growth" story is showing signs of wear. While the U.S. economy will enjoy a strong rebound in the second quarter, leading economic indicators in most of the other major countries have rolled over. The advanced stage of the U.S. business cycle, heightened geopolitical risks and our bias for capital preservation keep us tactically cautious on risk assets again this month. Service Sector: An Update Even with the increasingly dominant role of the service sector (Chart 4 again), the majority of high frequency economic data measures activity in the manufacturing sector. However, the Quarterly Services Survey (QSS) initiated in 2003-2004 by the Bureau of Economic Analysis (BEA), measures the service sector which includes small- and medium-sized companies3 and produces timely revenue figures on a quarterly basis. The dataset is used primarily by the BEA to paint a more accurate picture of national accounts, notably personal consumption and the intellectual property segment of private-fixed investment. The survey is also essential for FOMC policymakers because it is very useful to track economic performance. Moreover, the QSS is an important source of revisions to real GDP because over 40% of the quarterly estimates of personal consumption expenditures (PCE) for services is based on the QSS. The "key services statistics" include information services, health care services, professional, scientific and technical services, administrative and support, and waste management and remediation services. The QSS for Q1 2018 found that total revenues for selected services fell by 1.2% over the previous quarter but rose 5.2% over the last four quarters (in nominal terms and only non-seasonally adjusted data available). Nominal GDP climbed 4.7% year-over-year in Q1 (Chart 11). Several areas of the service economy saw sales growth in Q1 outpace nominal GDP. Sales were strongest in finance and insurance (+7.8%) followed by information (+7%). Real estate and rental leasing sales increased by 4.7% in the past year while revenue in health care & social assistance rose +3.4%. Together, sales in finance & insurance and health care & social assistance make up about 50% of total revenues. Chart 11Many Areas Of Service Sector##BR##Advancing Faster Than Nominal GDP Chart 12Sales Growth In The Service Sector##BR##Is Broad Based However, revenue growth in several categories decelerated in Q1 and grew more slowly than nominal GDP. Arts, entertainment and recreation, administration support and waste management, and other services are in this category. Bottom Line: Given that the majority of service industries from the QSS sample survey continue to show upward momentum, perhaps we will see a similar revision to real consumer spending for services for the third estimate of Q1 real GDP in late June (Chart 12). We continue to expect U.S. GDP growth to match or exceed the Fed's modest target for 2018. This above-trend growth will continue to put downward pressure on the unemployment rate and push inflation higher, setting the stage for a more aggressive Fed next year and a recession in 2020. The Wrong Trade War? The large trade surplus in the U.S. service sector is a hidden source of strength for the economy and labor market (Chart 13). President Trump campaigned on his ability to create high-paying manufacturing jobs and he has focused his attention on the goods side of the U.S. trade deficit. Nonetheless, his America First rhetoric threatens jobs in the high-paying service sector. Since the mid-1970s, the U.S. has imported more than it has exported, acting as a drag on GDP growth. The trade gap reflects a large and persistent goods deficit, which more than offsets a growing trade surplus on the service side (Chart 14). U.S. imported goods exceeded exports by $807 billion in 2017. Service exports reached an all-time high of $798 billion in 2017 - $255 billion more than imports - up from $249 billion in 2016. It is too soon to tell if the smaller surplus in services is related to Trump's protectionist trade rhetoric. Exports of services have increased by 6% a year on average since 2000, which is nearly twice as fast as nominal GDP. Service exports expanded by just 4% in 2017 versus 2016, which is below the pace of nominal GDP (4.7%) The trade surplus in services subtracted 0.08% from real GDP in Q1 2018, but added 0.05% in 2017. Moreover, the trade surplus in services has consistently added to GDP growth over the past few decades, although the trade surplus in services is swamped by the large drag on GDP due to the trade deficit on goods. Industries where the U.S. enjoys a trade surplus have experienced job growth that is faster than in industries where the U.S. runs a deficit. In addition, median wages ($30.07 as of April 2018) among surplus-producing industries are more than 20% higher than in industries in the goods sector ($24.94) where there is a trade deficit. Moreover, wages in the trade-oriented service sector have escalated quicker than in the goods-producing sector in the past year (Chart 15). Chart 13The U.S. Runs Trade##BR##Surplus In Services... Chart 14...But It's Not Large Enough To Offset##BR##The Big Trade Deficit In Goods Chart 15Wages In Export-Led Service Industries##BR##21% Higher Than In Goods Sector Furthermore, exports in the U.S. service sector tend to compete on quality (not on price) and, therefore, will not be as affected as U.S. goods exports if the dollar meets BCA's forecast for a modest increase this year (Chart 16). That said, the Trump administration's trade policies threaten to reduce the U.S.'s global dominance in services. Chart 16Services Exports Compete On Quality, Not Price Table 1 shows that the U.S. has the largest trade surplus in travel ($82 billion surplus in 2016), intellectual property ($80 billion), financial services ($73 billion) and other business services ($43 billion), which includes legal, accounting, consulting and architectural services. The U.S. also runs a surplus in maintenance and repair services. Table 1Key Components Of U.S. Trade Surplus In Services Trump's trade and immigration policies put this trade surplus at risk. In 2016, foreigners spent $82 billion more to vacation in, travel to, and be educated in the U.S. than what U.S. citizens spent on those services overseas. Moreover, a recent U.N. report4 noted that "Global flows of foreign direct investment fell by 23 per cent in 2017. Cross-border investment in developed and transition economies dropped sharply, while growth was near zero in developing economies." If foreign governments continue to react to Trump's directives on trade and immigration, then the U.S. trade advantage in financial services ($73 billion), software services ($29 billion), TV and film rights ($12 billion), architectural services ($5 billion) and advertising ($10 billion) will also be at risk. Bottom Line: The U.S.'s large trade surplus in services fosters faster job creation and better pay than in the goods-producing area where the U.S. has a trade deficit. The Trump administration's rhetoric and actions on trade and globalism potentially risks America's dominance in the service sector. In theory, U.S. trade restrictions could add to U.S. GDP growth via increased manufacturing output and a smaller goods trade deficit. However, many U.S. trading partners have already announced tariffs on U.S. goods which will put the brakes on growth. Even so, any gains on the manufacturing trade front could be largely offset by damage to the U.S. surplus in services trade. BCA's Geopolitical Strategy service expects that trade-related uncertainty will persist at least until the midterm elections in November.5 On a related note, an increase in onshore oil production in the past 10 years reduced the U.S's large trade deficit in petroleum and petroleum products. BCA's energy strategists recently updated their oil price and production forecasts for this year and next. Still Bullish On Oil BCA's Commodity & Energy Strategy service remains bullish on oil, although two key elements of the outlook makes forecasting particularly difficult.6 Our base case forecast has been bullish for some time, based on our assumption that OPEC 2.0 would retain its previous output cuts, at least through the end of 2018. Venezuela's production has contracted sharply and we penciled in a further modest decline. Iranian exports will also shrink due to the re-imposition of U.S. sanctions. The only substantial growth on the production side is expected to come from U.S. shale producers. The supply/demand backdrop pointed toward higher prices with world demand projected to remain robust. We estimated that Brent could reach $90/bbl early next year. Chart 17Ensemble Forecast Accounts For##BR##Collapse In Venezuela's Exports However, some major oil consumers, including the U.S., are starting to complain. The U.S. has asked the OPEC 2.0 countries to increase output, which may remove further upward pressure on prices. OPEC 2.0's leadership has signaled that it will consider reversing the production cuts during the second half of this year. This could add an extra 870 b/d of production. The other major unknown is how much further Venezuelan production will slide. Our oil strategists have run alternative scenarios to gauge the risks to the base case. The optimistic case sees OPEC 2.0 retaining production cuts and Venezuelan production dipping by another 1m b/d. The pessimistic case sees OPEC 2.0 reversing the production cuts, while Venezuelan production erodes modestly compared with the base and optimistic cases. Chart 17 shows that Brent hits $100/bbl in 2019 in the optimistic case, but drops to $60 in the pessimistic scenario. The ensemble forecast, shown in red in Chart 17, is a weighted average of the three scenarios. It shows that the price of oil will be roughly flat over the next 18 months. Bottom Line: Our energy strategists believe that the risks for oil prices remain biased to the upside, although we are less bullish in view of OPEC 2.0's possible production increases in the near future. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com Appendix Appendix Chart 1Fed Policy And Labor Market Slack When Manufacturing ISM Outpaces Service Sector ISM 1 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Cleanup On Aisle Two", published June 4, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," published October 16, 2017. Available at usis.bcaresearch.com. 3 https://www.census.gov/services/qss/about_the_survey.html 4 http://unctad.org/en/PublicationsLibrary/wir2018_overview_en.pdf 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," April 4, 2018. Available at gps.bcaresearch.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Guiding To Higher Output; Volatility Set To Rise ... Again", published May 31,2018. Available at ces.bcaresearch.com.