Key Factors for the Equipment Finance Industry
A YEAR AGO, the U.S. economy was beginning to show signs of life after limping to an anemic 1.5% growth rate in 2016. Over the next 12 months, business and consumer confidence rebounded sharply, labor markets continued to tighten, business investment strengthened, and the global economy finally began to fire on all cylinders (or at least most of them).
As we enter 2018, businesses and consumers are optimistic about the direction of the economy, and the industry is well-positioned for a banner year. In the recently-published 2018 Equipment Leasing & Finance U.S. Economic Outlook (jointly produced by the Equipment Leasing & Finance Foundation and Keybridge Research), we forecast an above-consensus 2.7% growth rate for the economy and 9.1% growth for equipment and software investment. These forecasts reflect our belief that the U.S. economy has a lot of things working in its favor, and relatively few headwinds—though trade is a potential 2018 wild card that should be monitored closely.
On behalf of Equipment Leasing & Finance 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 2018.
2018 should be a bright year for the U.S. economy.
The economy got off to a slow start in 2017, prompting concerns of yet another year of sluggish activity following the “growth pause” of late 2015 and early 2016. However, growth kicked into gear in the second quarter and shows no immediate signs of letting up. A key factor behind this acceleration has been the release of pent-up consumption and investment demand that accumulated over the last two years, which should continue into the first half of 2018.
Several other factors will likely drive solid economic growth this year, including:
- Growth synchrony among all major blocs of the world economy—the first time this has occurred since the recession;
- An exceptionally strong labor market that shows no signs of deterioration;
- Elevated consumer and business optimism, due in part to the promise of tax reform and a lighter-touch approach to regulation;
- Energy price stability, allowing the U.S. oil and mining industry to get back on its feet; and
- The potential for investment and consumption to rebound early this year following large-scale hurricane damage.
While not everything is rosy—a strengthening dollar may dampen exports, construction investment has been very weak and interest rates will almost certainly rise substantially—the U.S. economy is witnessing a broad-based cyclical upturn that should make 2018 one of the strongest since the recession (though we expect growth will fall short of the elusive 3% rate last achieved in 2005).
Business investment should continue to surge.
After several quarters of anemic growth or contractions, business investment rebounded in 2017 and should continue to thrive in 2018, particularly in the first half of the year. One reason for this recovery is the rebound in the oil and gas sector over the last 12-18 months. Another factor is persistently strong business confidence, which increased substantially following the 2016 election and remains elevated by most measures (including the Equipment Leasing & Finance Foundation’s Monthly Confidence Index).
Two factors to watch on the investment front are the effects of tax reform and the steady decline in business demand for commercial and industrial loans. On the positive side, a lower tax burden on most businesses and consumers will likely provide a modest boost to U.S. GDP and business activity. However, the demand for business loans declined noticeably throughout 2017, despite solid investment growth. This latter trend is something to keep an eye on, as it could signal a shift toward other types of financing or, potentially, a decline in capex spending during the second half of the year
Most equipment verticals are currently well-positioned for growth.
In mid/late 2016, many of the equipment verticals tracked by the Foundation-Keybridge U.S. Equipment and Software Momentum Monitors were exhibiting signs of a turnaround, and most were “flashing green” throughout 2017. At present, most verticals continue to show strong momentum, driven by a cyclical economic upswing that should lead to strong growth in Q1 and Q2. However, we expect momentum in some verticals to ease in the months ahead, raising the potential for slower equipment investment growth during the second half of the year.
One vertical to monitor closely in 2018 is mining and oilfield equipment. Over the last 12-18 months, the Mining and Oilfield Equipment Momentum Monitor has tended to lead the performance of other verticals that are indirectly tied in varying degrees to the oil and gas sector (e.g., railroad transportation, truck transportation, materials handling and industrial machinery). Among these verticals, the Mining & Oilfield Momentum Monitor was the first to show signs of life; now, the Momentum Monitors associated with these other sectors are thriving while the Mining & Oilfield Momentum Monitor may have recently peaked. As such, we would not be surprised to see a modest deceleration in railroad, trucking, materials handling and other industrial equipment investment growth during the second half of the year.
Portfolio performance unexpectedly improved in 2017 and should remain strong in 2018—but there are a few storm clouds on the horizon.
While the industry has enjoyed superb portfolio performance for several years, delinquency rates were slowly rising since bottoming out in late 2014—until last year, that is. After rising nearly 60 basis points in 2016, the C&I loan delinquency rate actually fell more than 30 points in 2017 according to the Federal Reserve. Other data, such as PayNet’s Small Business Delinquency Index and AbsolutePD tool, also indicate that portfolio performance improved last year.
However, as the economic expansion enters its 10th year, it is only a matter of time before portfolios begin to soften. The industry remains hypercompetitive, and in the drive for new business volume, some firms (particularly new entrants who didn’t experience the last downturn) may find themselves overextended if economic conditions change. Moreover, there are signs of declining credit quality in other industries, such as credit cards and automobile loans (particularly the subprime segment). This has led to some tightening in consumer credit standards, and a similar effect could quickly materialize in the C&I loan market if loan quality begins to deteriorate. We do not expect a sharp decline in portfolio performance this year, but industry executives should keep a close eye on their portfolios, as winter will come eventually.
Federal policy will continue to favor businesses—for now.
After Republicans swept the field in the 2016 election, it seemed the stage was finally set for policymakers to move forward on long-stalled priorities, including tax reform and infrastructure improvement. Although there have been relatively few legislative successes for the GOP thus far, the recently passed tax bill was a significant political achievement. While we have significant concerns about the bill’s cost and its impact on the country’s long-term fiscal health, it should kickstart business investment and provide a modest boost to economic growth this year.
With tax reform out of the way, Congress will likely make another push at an infrastructure spending bill in 2018. A priority of the Trump administration, an infrastructure bill has the potential to infuse hundreds of billions of dollars into the economy each year to rebuild roads, bridges, airports and other critical infrastructure. If successful, it could be a major boon for the equipment finance industry. However, unlike tax reform, such a bill would likely require support from at least 60 senators, and the parties differ on how large the package should be, how to fund it, and what projects it should promote. Perhaps more importantly, convincing 9+ Democrats to support a Republican legislative initiative in an election year will be a challenge.
Another key policy area to watch in 2018 is deregulation. The administration made significant progress in 2017 toward reducing the cumulative regulatory burden on U.S. businesses. Most notably, several executive orders (including a “one-in, two-out” order that caps the incremental cost of new regulations) have led to a dramatic reduction in new regulatory activity. These efforts are likely to continue in 2018—though it is worth remembering that deregulatory actions typically follow the same process as regulatory actions and must be supported by sound economic analysis, which often takes years. Regardless, it is a near-certainty that regulatory agencies will continue to employ a lighter touch than they did under President Obama.
However, the business-friendly leanings of Congress may shift depending on the midterm elections. While Republicans currently enjoy a sizable majority in the House and have a built-in advantage in several states due to current district boundaries, midterms are traditionally bad for the incumbent party, and President Trump’s low approval numbers (if sustained) could portend a strong showing for Democrats in November. The GOP majority in the Senate appeared to be safer given that 10+ Democratic incumbents face difficult races while few Republican seats (most notably Arizona and Nevada) appear to be vulnerable. However, the special election result in Alabama is the latest evidence that a “blue wave” may well materialize in November. If this occurs, a left-leaning populist backlash against the business-friendly policies of the Trump administration is a real possibility.
A global growth resurgence should provide the U.S. economy a boost…
For the first time since the Great Recession, the global economy is finally clicking. A robust cyclical upturn in manufacturing activity, recovering energy and commodity prices and accommodative monetary policy from most major central banks has driven global growth forecasts near 4%, a significant improvement. The Euro area is expected to exceed the 2% threshold in 2017 and remain on track in 2018 and 2019, while most emerging markets are accelerating. Although China’s growth rate is expected to decelerate slightly, India’s should ramp up significantly, while Brazil is set to bounce back from its deep 2015-2017 recession. This is all good news for the United States, which should benefit from increased global demand for U.S. goods and services. However, the benefits will be limited if trade relationships worsen.
…but protectionist U.S. trade policies carry many downside risks.
Last year, we noted that global trade and U.S. export growth could suffer in 2017 amid a global backlash against free trade and protectionist rhetoric from the Trump administration. Fortunately, global trade was solid in 2017 due to a broad-based growth resurgence and the absence of major shifts in U.S. trade policy. However, 2018 is likely to be the year in which trade tensions come to a head.
First, NAFTA renegotiations have taken a negative turn in recent weeks. One area of contention is a U.S. proposal that would require NAFTA members to opt-in to the agreement every five years. Another is the U.S. preference for more stringent rules of origin that require a higher percentage of goods to be manufactured in North America or the United States. Thus far, Canada and Mexico consider both of these positions to be non-negotiable. In our view, the likelihood that the United States pulls out of NAFTA in 2018 is significant, which would likely trigger a mild to moderate negative effect on the U.S. economy (particularly the agricultural sector).
Second, the unfolding trade dispute with China is another major area of concern. Certain key advisors who advocated for a moderate approach to China are expected to depart the White House in early 2018, while the influence of “China hawks” is increasing. We will be closely monitoring developments relating to the steel and aluminum industries, as well as intellectual property protection. These three issues have the potential to upend the trading relationship with China and negatively impact growth in both countries if a trade war is triggered.
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Residential investment may improve, but a strong rebound in construction activity is unlikely.
Residential investment was remarkably weak last year, posting its two largest quarterly contractions since 2010. Housing starts and permits both lagged for most of the year, held back by regional shortages of skilled construction labor and high lumber prices (among other factors). Ironically, the demand for homes remains robust, and the combination of strong demand and weak supply has predictably led to rapidly rising home prices.
Looking ahead, the Fed’s plan to continue normalizing interest rates will drive up mortgage rates and exacerbate existing affordability concerns. The good news is that, as the old adage goes, “there’s no better cure for high prices than high prices.” In theory, current market conditions should incentivize builders to break ground on new homes—and indeed we began to see some evidence of that late last year (e.g., builder optimism is rising, housing permits are at a 2-year high and the number of “authorized” housing units is up 14% compared to a year ago). The recently enacted tax legislation may help to alleviate rising housing prices, as the National Association of Realtors expects prices to grow more slowly this year due to changes that reduce the tax-related benefits of home ownership. Overall, we expect the housing market will continue to muddle through, with marginal gains in housing starts and the return of positive, but not robust, residential investment growth.
This could finally be the year of 3% wage growth.
Though the U.S. economy was substantially stronger in 2017 than it was the previous year, one area of relative disappointment was wage growth. After steady improvement throughout 2015 and 2016, wage growth improvements stagnated last year and failed to eclipse the 3% barrier last achieved in 2009.
This year, however, could finally signal a wage growth rebound. As measured by the unemployment rate (currently at 4.1%), the labor market is as tight as it’s been in nearly two decades. Many economists expect unemployment to fall below 4% in the months ahead, as there are nearly 6 million job openings in the economy (just shy of an all-time high). Clearly employers are looking to hire, and as spare workers become increasingly scarce, there will be increasing upward pressure on wages to attract and retain talent.
