What has changed? What remains the same?Jun 2017
A lot has seemingly happened so far in 2017. Whether it be the global economy or the financial markets, it is important to distinguish between historical data versus future expectations and “substance” versus “noise.” This is not a simple exercise. Economic trends develop over time, and patterns often appear only in hindsight. So we ask: What has changed? What remains the same? What should we expect going forward? TEST
What Has Changed?
First, President Trump was inaugurated and has begun the process of identifying those who will serve in his administration, framing his agenda, and formulating policy. Expectations are high that he will promote policies broadly aligned with Ronald Reagan’s model of “fiscal reflation.” We do not yet know important details, but his agenda is generally understood to include elements of the following:
- Increased government spending on infrastructure and defense
- Lower corporate taxes so corporations are incentivized to repatriate cash held overseas
- Adjustments to personal income tax rates and deductions
- Barriers to free trade – potentially in the form of a “border tax”
This is a very full agenda, much of which requires congressional approval, which will develop and crystallize over the course of the next year. We expect challenges, concessions and some compromise. There will be surprises and setbacks – we have already experienced both. President Trump is a dealmaker, not a diplomat, who will be judged ultimately on political outcomes, not on “tweets.” In the aggregate, we believe fiscal spending and deregulation will stimulate economic output, and lead to GDP growth in the range of 2.0 to 2.5% annualized. But many of these proposals will require an extended period of time to make their way through the legislative process.
There is also a time lag between when fiscal spending is approved and the resultant economic impact. As we write this Commentary, market expectations have diminished relative to the scope, timing and impact of a Trump fiscal package. While we believe expectations around the time frame necessary to achieve legislative agreement are still too ambitious, we are cautiously optimistic that measurable stimulus will occur later this year and into 2018.
Second, monetary policy in the United States is moving from “ultra-accommodative” towards “less accommodative.” The Federal Reserve has now increased the short-term benchmark rate three times to 0.75%. Despite concerns surrounding the impact of higher interest rates, this is good news because it signals both confidence in the labor market and a positive outlook for consumer spending. Furthermore, it results in a higher investment return to short-term borrowers – savers rejoice! While we expect two or three additional interest rate increases this year, our belief is that the result will be net-positive for investors. We also expect an orderly reduction of the Fed’s balance sheet as investments purchased over the past few years “roll off” upon maturity. These signs point to an economy that is a few steps closer to functioning on its own, with less artificial support from central banks. The European Central Bank is behind the U.S. Federal Reserve as it is just now shifting to a less accommodative monetary stance, a dynamic which we see supporting European equities prices and taken advantage of in client portfolios by increasing European exposure.
What Remains The Same?
The U.S. economy continues to expand gradually, and we believe growth will continue through this year at a 2%+ pace. The economy still has room to run, though expectations for accelerated growth have risen rapidly in large part due to confidence in the above-mentioned fiscal policy change. As policy begins to take shape and with the revival of “animal spirits” that drive business and consumer spending, the probability of a recession in the near term remains low. While we are eight years into this muted recovery, it is important to remember that economic expansions do not die of old age or duration; they wind down when capacity constraints, wage growth and inflation must be tempered with much higher interest rates. Speaking of which……
The labor market remains generally strong, with unemployment low and the pace of job creation steady. However, two critical components are constraining the economy. First, wage growth remains very subdued and second, productivity growth has not improved for quite some time. We attribute these to long term structural changes that will persist.
The risk of deflation has dissipated and long-term future inflation expectations have stabilized around 2%. This is also positive as stable but low inflation expectations afford businesses the flexibility to raise prices and offer an incentive to spend on capital improvements and new projects. Steady inflation has historically resulted in rising stock dividends and a rising term-premium (i.e. more income) for fixed income investors.
What Should We Expect Going Forward?
While the President will continue his recent rhetoric around a stronger dollar and protectionism, we expect his actions on these issues to be more moderate than advertised. Tempered by his advisors, he will likely concede that meddling with foreign exchange rates and the free flow of capital are not in the best long-term interests of the United States, and would not be without retaliation from global trade partners.
Emerging Markets have struggled amid the correction in energy and commodity prices over the past several years, but are starting to show signs of improved growth. In China, there has been a credit-fueled expansion and more recently a recognition by the government of the need to shift to more stable growth. Still, we expect China to grow close to the government’s target of around 6%, while certain parts of the economy, namely the consumer sector, will likely continue to grow faster. Reasonable relative valuations in many of these markets are appealing as is exposure to the burgeoning consumer class.
Overall in terms of economic risk, we see greater potential shocks from outside the United States. France and Germany will hold major elections in the coming months, and are also confronting rising populism. The United Kingdom is slowly working through a parliamentary solution to the Brexit referendum, which is likely to constrain though not collapse growth. North Korea appears to be a growing military power, with an enigmatic young leader who is determined to develop broader nuclear capabilities. The Administration has adopted a hardline approach. Escalation is possible, and could lead to greater instability in the region, with broad ripple effects globally. But with geopolitics, the more things change, the more they stay the same.2