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Outlook 2018: Slow but Steady Growth

By Oxford Economics Press Release

Solid fundamentals support a 2% growth rate for the US economy in 2018; prospects for aerospace, automotive, energy and medical vary.

The US economy remains in a steady and sustainable moderate growth mode. Solid employment gains and gradually firming wage growth have supported household income, consumer confidence and outlays. The same dynamics should persist into 2018 and support a steady, modest pace of consumer spending. Businesses, meanwhile, have responded to stronger global demand, a rebounding energy sector and a weaker dollar with a robust revival in investment. Residential investment, too, is expected to contribute modestly to growth, underpinned by both stronger balance sheets and wages. With stability in the US dollar, net trade flows will be a small offset to otherwise steady and sustainable 2.0–2.5% real GDP growth in 2017–18.

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With negotiations ongoing in Congress, we expect a modest fiscal stimulus package of about $500 billion over the next decade. While we estimate this will boost real GDP growth to 2.4% in 2018, we also note upside and downside risks to this view. On one hand, many Republicans appear willing to support a pro-growth tax plan that would boost the deficit by up to $1.5 trillion. This could lift 2018 real GDP growth to 3.0%. But, at the same time, intra-party tensions may prevent swift tax reform progress. Indeed, while lawmakers have temporarily suspended the debt limit and funded the federal government through December 8, the risk of a shutdown still lingers on the distant horizon, thereby heightening tension. Should there be no stimulus, 2018 real GDP growth would be about 2.0%.

With labor markets near full employment and slowly firming wage growth, the Federal Reserve is expected to continue tightening monetary policy. Since its 2009 peak of almost 10%, the unemployment rate has fallen toward 4% as the US has added over 16 million jobs. Unlike past episodes, today’s labor market strength has coincided with modest inflation–a flatter Phillips curve. Although this has given some policymakers at the Federal Reserve pause, the central bank is expected to continue its “gradual pace” of rate hikes, while also reducing the size of its balance sheet (by ceasing reinvestment of proceeds from Treasury and mortgage-backed securities). Both actions will continue to drive interest rates higher, albeit at a gradual and manageable pace.

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Over eight years into recovery, the economy appears to be on a sustainable path, but risks cloud the outlook. First and foremost is policy uncertainty. On this front, risks include the likelihood, timing, and magnitude of the administration’s proposed tax plan, in addition to risks of increased protectionism, especially as it pertains to the North American Free Trade Agreement (NAFTA). A second notable risk is the recent savings dip, in which households have drawn down savings to finance spending. Only higher incomes or lower spending can correct this otherwise unsustainable situation. Other risks to US economic prospects include elevated asset prices, tightening of financial conditions, restrictions on immigration, and slower global growth.

Aerospace: US to Gain Share Against Solid Global Backdrop

In the near-term, pressures remain in US aerospace production. After contracting 2.0% in 2016, the US aerospace industry is expected to shrink a further 3.4% in 2017. Boeing and its suppliers have struggled to ramp up deliveries, contributing to a year-to-date output drop of 3.9%. The US (in addition to Brazil and Russia) has dampened global aerospace growth, which is expected to be negative in 2017 for the first time since 2009.

Weighing on production prospects are (i) terror threats in the developed world, (ii) escalating tensions between President Trump and Kim Jong-un, and (iii) the ability to fly planes efficiently longer-distance without stopovers. Upside risks, on the other hand, include (a) significant civilian plane order backlog, and (b) a turning defense cycle. Looking forward, we expect US aerospace to rebound to 2.6% growth in 2018 and then at a 3.5% annual rate between 2019 and 2026.

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With so much worry about the competitiveness of American products and the associated impact on jobs and economic activity, it is easy to forget that there are more than a few manufacturing sectors in which US dominance has persisted for decades. There is no better example of this than aerospace, where the US accounts for half of global production. Within the important defense component—which accounts for about 25% of the sector—the US is even more dominant, comprising about 60% of global military sales.

Aerospace is a great industry in which to be competitive. The underlying demand drivers are very strong, enabling global air travel to grow by 6.5% per annum since 2009. Indeed, since the recession, new commercial aircraft orders have typically been double, and in some years triple, the number of deliveries. Rising incomes and falling ticket prices in emerging markets are making air travel affordable for more households. Simultaneously, low crude oil prices have pushed airline profits to historic highs, thereby increasing scope for further investment in fleet modernization. A continuation of these trends means that global aerospace production is expected to grow 3.5% per annum for the next 10 years, almost a percentage point faster than global GDP.

Global competitiveness supports the US aerospace industry, and we find several reasons to be optimistic. First is the wide and growing aerospace products trade surplus, which reached $80 billion in 2015 on exports of $135 billion. Both were record highs. This surplus keeps the total US trade deficit 10% smaller than it would be otherwise. Second, more fundamental indicators—such as production per unit of capital and production per unit of labor—have continued to improve dramatically. The use of ERP systems and lean manufacturing techniques have contributed to a 40% improvement in overall productivity of aerospace industry capital and labor over the past 15 years. This is quadruple the 10% improvement achieved for US manufacturing as a whole.

Finally, the US has a well-earned reputation for safety and reliability. While China has made a concerted push to develop a commercial airliner, test flights of the Comac C919 have been delayed, causing many to conclude that the plane’s cost-efficiency, comfort, and safety will be insufficient to challenge Airbus and Boeing. We think China’s share of global aerospace production will not exceed 5% by 2030.

We therefore expect the US to maintain, even enhance, competitiveness. Over the next decade, we forecast US export growth to exceed the 3.5% global production growth. This, coupled with robust outlook for domestic air travel, means US aerospace may slightly increase its already-dominant share of global production: the already soaring US aerospace industry is set to fly higher.

Automotive: Structural Decline Fears Excessive, but Cycle Ending

The US is nearing the end of a cyclical recovery in automotive production. The industry grew at a 6.0% annual rate between 2011 and 2015, as households replaced an aging vehicle stock induced by purchases delayed during the Great Recession. That replacement demand began slowing in 2016, when vehicle sales grew 3.4%. This year, the industry is expected to contract 1.2% as demand plateaus and competitively-priced used vehicles become increasingly available.

Looking forward, many of the structural factors are still in place to support an industry that should grow at a moderate 1.4–1.6% average rate through 2026. Continued employment growth and wage gains should further support the real household disposable incomes needed to support big-ticket vehicle purchases. While initial growth spurts from accommodative monetary policy have passed and loan rates are expected to increase (alongside tightening lending standards), financial conditions broadly are better characterized in terms of ease, not tightness.

Worries about US competitiveness have also mounted in the automotive manufacturing space in recent years. The share of US car sales accounted for by the “Big Three” has fallen from nearly 70% in 2000 to 45% in 2014. The bailout and subsequent shrinkage of GM during the Great Recession left the impression that this trend might continue. A growing trade deficit and the rise of Mexico as a regional automotive hub only reinforced these worries.

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While we acknowledge these trends in US automotive manufacturing, our look under the hood tells quite a different story. First, the fall in Big Three share of US car sales is misleading. From a global production perspective, the US share stands at 17%, recovering from the low 14% reached during the recession. In fact, since 1980, the US share of the global auto market has rarely deviated by more than a few percentage points from its 20% long-term average. In sharp contrast are other historical automotive powerhouses. In the past 25 years, Japan’s share has dropped by 15 percentage points as manufacturers relocate to lower-cost locations, such as South Korea and (more recently) China. Germany has also seen its share drop 7 percentage points in favor of Eastern European producers. In contrast, Mexico—which has had access to the US market for more than 20 years via NAFTA—has seen its share of global production increase by just 1 percentage point over that period.

Regarding the broader trade situation, it is true that the automotive sector is chronically in deficit to the tune of about $100 billion per year. There was a dip during the financial crisis, but since then the trade deficit has returned to, and even begun to exceed, historical levels. But one of the main reasons imports (and by extension the trade deficit) have been rising in recent years is that US automotive demand has soared, more than doubling in value terms. As a result, both domestic and foreign producers have benefited. Indeed, the import penetration rate has actually declined in value terms over the past four years. This implies that domestic producers have taken a small amount of market share back from imports in a fast-growing market.

The fact that import penetration has been stable or declining even as the Big Three lose significant market share is a testament to the attractiveness of the US as a regional manufacturing hub for foreign manufacturers. According to the most recent data available, foreign-owned firms accounted for 36% of US automotive output in 2014, up from just 23% seven years prior. Further anecdotal evidence suggests that share continues to rise. Honda opened its twelfth US factory in Ohio last year, while other Japanese, South Korean and German manufacturers have significantly boosted investment in southern states. While additional investment may be encouraged by protectionist measures taken by the Trump Administration, the economic case for investment in these states is sufficiently compelling on its own, given highly-skilled, non-union labor forces in these states.

A final point is that direct indicators of US automotive competitiveness strongly corroborate the evidence from patterns of sectoral production, trade and investment discussed above. Labor productivity in automotive manufacturing has increased an average of 4.2% per year since 2000, second-fastest among major manufacturing sectors and a full percentage point above that for overall manufacturing—though a stall in 2016 warrants concern. Embedded in this performance are significant investments in capital equipment and automation, a myriad of product and process innovations, and a cost-effective skilled labor force that delivers excellent value for money. So even as Mexico continues to develop as a complementary manufacturing hub, the US automotive sector, far from being down and out, is and will remain a dominant force in North American automotive supply chains—not only serving its own large domestic market, but export destinations elsewhere in North America and beyond.

Energy: Producers Have Adjusted to Low Prices

Oil and gas extraction activity contracted by 8.0% in 2016. We forecast a solid 4.7% recovery in 2017, followed by a further 6.7% acceleration in 2018 against a stable price backdrop and healthier producer financials. Indeed, after a 70% plunge in crude oil and natural gas prices in 2014–15, the energy sector appears to have largely recovered. As producer margins and profitability were decimated, the entire industry focused keenly on efficiency. In 2016, some pricing relief came as producers continued to adjust to lower prices. Now, after a volatile first half of 2017, energy prices have demonstrated some stability with crude oil around $50/bbl and natural gas near $3/MMBtu.

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We see evidence the industry has adjusted to lower energy prices. Indeed, by the end of 2016, productivity measures (i.e. bbl/day) in the Bakken, Eagle Ford, and Permian basins had more than tripled from 2013 levels. The effect is starting to show in producers’ financials. As of Q2 2017, nine of 15 US tight-oil producers were profitable. That’s exactly nine more than were profitable a year prior. We now believe that most major producers are at break-even with these oil prices.

Looking forward, we expect energy prices to edge up modestly, supported by both developed and emerging market demand growth. Of course, global oil demand is driven by transportation, so the commodity stands to benefit from the positive dynamics we’ve identified with both passenger miles (aerospace) and vehicle miles traveled (automotive). On the supply side, the OPEC-led cutbacks that commenced in January 2017 have been moderately successful with higher-than-expected compliance levels of around 75%. While the cuts are set to expire in March 2018, some period of extension is widely anticipated. We therefore expect another year of stable oil prices in 2018, and moderate appreciation in 2019. This price environment should continue to support a solid pace of investment in the US energy sector.

Medical: Solid Fundamentals, but Policy Uncertainty

The medical sector is much less cyclical than the automotive and energy spaces. The general detachment from the economic cycle is a result of the public sector’s involvement in financing healthcare spending. In OECD countries, for example, approximately two-thirds of healthcare spending is financed by government. Roughly half of this is general government expenditure, while the other half is social insurance. Relative to other investment-driven GDP components, government expenditure—and by extension medical spending—experiences relatively stable growth over time.

Longer-term dynamics should continue to support above-GDP growth in the US medical sector. First, an aging population will continue to drive medical spending through 2050 as the population aged 65 and older grows by about 1% per annum. Second, the US remains a high-quality, value-added producer of medical equipment. Measures of US competitiveness, including innovation, bilateral trade flows, and import penetration, continue to demonstrate remarkable stability and are indicative of the US ability to out compete other countries in both developed and emerging markets.

While long-term prospects for the medical sector are healthy, many risks cloud the near-term outlook. Despite early failures to repeal the Affordable Care Act (ACA), there is renewed interest in passing reform after President Trump stopped subsidy payments to health insurers. In the event a repeal is achieved, the number of uninsured would rise substantially, thereby reducing healthcare demand. Even if the ACA is not repealed, general government efforts pertaining to entitlement spending threaten to impact investment growth in the medical space.

Oxford Economics is an independent global advisory firm, providing reports, forecasts and analytical tools on 200 countries, 100 industrial sectors and over 4000 locations. Based in Oxford, England, with regional centers in London, New York, and Singapore, Oxford Economics is a key adviser to corporate, financial and government decision-makers and thought leaders around the world.

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