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Note for August Investment Committee MeetingSubmitted by The Wealth Consulting Group on August 14th, 2015
Summary and Conclusion:
Asset prices increased during July. The S&P500 index of U.S. equity market prices increased by 2.3 percent. The VIX remained relatively low at levels below those preceding the election. The yield on 10 year U.S. government bonds traded near 2.3 percent, the approximate level preceding the election. The dollar depreciated 2.3 percent against the major currencies -- a level 7.7 percent weaker that its January 2 reading. I attribute the weaker dollar to a combination of slightly stronger than expected growth abroad, slightly weaker than expected growth in the United States, and the perception of President Trump’s views on trade policy. I believe the lack of volatility and the modest positive direction of the markets are due to market participants waiting for the resolution of Health Care and Tax Reform legislation and the hoped-for capital gains tax cut. The bond market is telling us that nothing much has changed with respect to the real economy since President Trump’s inauguration. I believe that Trump’s de-regulation policies will have a positive effect on output (as we have seen in the energy industry), so I think that we will eventually have higher 10 year yields and lower bond prices as these regulatory policies boost productivity and economic activity.
Washington policy officials have achieved little, during the past month (excluding continued progress on deregulation which is already resulting in positive effects on growth – primarily in energy investment and output). The Senate was unable to develop a health care bill that could garner enough Republican support in order to pass the Senate. Of primary interest to us is the fate of the ACA taxes. The House is still determined to find a way to repeal the ACA taxes, even if such a repeal is attached to legislation not associated with Health Care. Some in the Senate want to extend the wider coverage of Medicaid and there are some reports that they will pay for this and subsidies to cover those with pre-existing conditions by retaining the ACA investment income tax. At this point in time, Health Care legislation is dead. The Senate and House will move on to crafting Tax Reform legislation, passing a budget, and increasing the debt limit. Given the dysfunction in both houses of the legislature, the essential elements of the budget (or a continuing resolution), the debt limit, and confirming Presidential appointments in the Executive Branch and the Judiciary may well be too difficult a set of tasks to accomplish by the end of September without excessive drama Therefore, I would expect little progress on tax reform and a risk of a sell-off in equity and bond markets if market participants surmise that there will be no substantive legislation on health care or tax reform before the 2018 mid-term elections.
I still believe the most likely outcome is that sellers will be reluctant to enter the market until there is a resolution of the legislation relative to the capital gains tax rate – the investment income tax in the Affordable Care Act (ACA) and the capital gains tax rate in the personal income tax legislation that is expected to be part of tax reform legislation. Thus I still see equity markets rising slowly on little volume with a relatively low VIX. Given the uncertainty to the policy outlook, the consensus forecast for U.S. GDP growth in 2017 is in my view too optimistic by about 0.25 percentage points, although growth will receive a boost from the deregulation efforts of the Trump Administration.. Firms will be unwilling to invest and equity traders will remain on the sidelines (perhaps putting a floor on any attempt at a market correction) until there is more certainty about what is in the tax reform (and perhaps a provision in a bill unrelated to health care that repeals the ACA taxes) legislation and when or if it will pass. The administration seems keen on a middle income tax cut, but appears to be less enthusiastic about eliminating tax breaks – their outline includes retaining the deductions for mortgage interest and charitable contributions.
The Federal Reserve left the Federal Funds rate unchanged at 100 to 125 basis points on July 26. Chair Yellen indicated that the Fed would begin the process of reducing the size of the balance sheet this year, so-called balance sheet normalization, during her testimony to Congress on July 12. We should receive further information on the Fed’s plans with the release of the minutes of the July 26 meeting on August 12th. Market participants expect her to lay out the magnitude and timing of these actions at her September 20th Press Conference. While the median of FOMC members’ projections of the Fed Funds rate at yearend is 1.4 percent, the dot plots indicate that 4 members project a yearend rate of 1.15 percent – the current target rate. I doubt that the FOMC will raise rates with 4 dissents. Recent data on economic activity and inflation have come in weaker than the FOMC’s June 14 projection putting at risk the prospect of an additional rate increase this year. So, I share the markets skepticism regarding an additional rate hike this year; the market assesses a 55 percent chance of an additional rate hike this year.
Recent Asset Market Behavior
Since the election, equity markets have moved upward on low volatility and unimpressive volume reflecting the expectation of lower capital gains tax rates (with at least the repeal of the 3.8% ACA investment income tax that had been expected to accompany a repeal or reform of the ACA). Thus, as the market finally climbed above the 2160-2240 level on the S&P500 in a sustainable way following the results of the Presidential election, sellers once again were motivated to step aside from the market in anticipation of at least a 16 percent reduction in capital gains tax rates. The result is an imbalance of buyers to sellers placing upward pressure on equity prices.
There is still some hope for a repeal of the ACA investment income tax and lower capital gains tax rates in tax reform legislation. Thus the passage of health care legislation in the House did not bring sellers back to the market because of the uncertainty of the content of the both the bill that is passed by the Senate and the resulting legislation that emerges from the reconciliation process. My explanation for the rally, which I assume will continue until tax reform legislation is passed or scuttled, is the perceived high probability that the 3.8 percent net investment income tax will be repealed either in tax reform legislation or an unrelated bill. This perceived high probability prospect means that a seller with capital gains can sell now and pay a 23.8 percent tax or sell later at a 20 percent tax (under Trump’s plan) or a 16.5 percent rate (under Speaker Ryan’s plan). That is, they can wait until the ACA investment income tax is repealed and pay at least 16 percent less in capital gains taxes. Since there are more buyers than sellers at existing prices as sellers wait for the lower capital gains tax rates, prices will continue to rise, although slowly, with restrained volatility, and with a reduced volume of transactions. At current valuations and the prospect that there will be some significant losers as well as winners in the business tax reform legislation, I would expect a selloff on relatively high volume once tax reform legislation is signed and implemented. (That is, if the ACA tax is repealed effective this year and the capital gains tax rate remains at 20 percent, the selloff would be immediate. If the ACA tax is repealed effective 2018, I would anticipate a selloff in January 2018). I believe, net, the effect of the tax reform legislation will be negative in the short run and positive in the long run depending on the content of the legislation. There no doubt will be losers and my belief is that these losers (as well as those affluent tax payers that will enter the market to cash out capital gains at the prospective lower rates) will drag the entire market down until investors have a view of the quantitative effect of the legislation on the winners.
Following the election, long-term (but not short term) interest rates (the 10 year and 30 year) rose substantially (and bond prices fell) but rates have retreated and bond prices rallied somewhat this year, and 10 year Treasury yields stand at pre-election levels.. I believe this outcome is based on the belief of faster growth under a Trump administration based on deregulation, increased investment, higher productivity growth and higher inflation. As difficulties with executing the Trump agenda became apparent, investors’ expectations of higher growth and inflation cooled, and long-term interest rates declined. I believe 10 year rates will increase as the economy responds favorably to President Trump’s de-regulation policies, and the Federal Reserve begins balance sheet normalization and raises the Federal Funds rate..
I believe that volatility will pick up once we see more specificity in the content of the tax reform legislation and a better idea of the likelihood and the timing of tax and health care reform legislation passing. Market participants are now less certain of Federal Reserve interest rate policy in 2017 (a 55 percent probability of an additional rate increase this year and a 45 percent probability of the rate remaining at current levels.. The Fed dot plots project 1 additional rate increase during 2017 by 12 of 16 FOMC members. The Fed left the Fed Funds rate unchanged at 1.15% at its July 26 meeting. The Fed will hold a Press Conference following the September 20th FMC meeting that will address their economic outlook, members’ projection of the future path of the Fed Funds rate -- the dot plots, and their discussion regarding their planned reduction of the Fed balance sheet – balance sheet normalization. The Fed will release the minutes of the July 26 FOMC Meeting on August 17th. These minutes should include additional information regarding the timing and size of its plans for balance sheet normalization.
The President’s (and Congress’s) Policy Agenda
At this point in time, the President’s focus is on national security, immigration issues, and changes in staffing in order to implement his agenda and communicate his message to the electorate. (President Trump and many Republicans believe that border security (illegal immigration) is a national security issue.) He appears to be taking a more aggressive stance on deporting those residents with no or expired immigration documents. The Administration also has threatened to restrict H-1 visas presently given to skilled tech workers and demanding preferences to U.S. workers (presumably citizens rather than permanent resident visa holders). Thus at this point in time, it appears that the Administration will move to restrict legal immigration as a means of protecting the incomes of American workers – both laborers and professional and technical workers -- rather than encourage more legal immigration as a way of raising economic growth and providing the necessary tax revenue to support Mr. Trump’s stance of saving old age pensions, disability payments, Medicare, and Medicaid.
President Trump has directed reductions in both financial and environmental regulations. We are hearing the first proposals regarding infrastructure investment – the privatization of Air Traffic Control. Commerce Secretary Wilbur Ross has been working to revise U.S. trade policy.
The contentious issues regarding the Budget and the increase in the Debt ceiling have been pretty much ignored by the financial press. With the poisonous political atmosphere in Washington, smooth reconciliation of both issues is not assured. A rocky resolution could give markets the jitters – especially bond and credit markets. Thus, September and October could be vulnerable months for the bond and equity markets.
As I mentioned in earlier posts, achieving President Trump’s policy agenda through legislative action will be difficult. So, as was the case with the Kemp-Roth tax reform under Ronald Reagan, the tax changes may not be effective until 2018 – the Kemp Roth tax rates did not take effect until January 1987, the year after the bill was passed (August 1986). At this point in time, there are major differences among the Senate, House, and the White House on tax reform legislation. If the tax changes do not take effect until 2018, the analysts and the markets should lower their projections for U.S. economic growth in 2017 as businesses postpone investment and defer income to take advantage of fully expensing investment and lower tax rates on income in 2018.
Foreign exchange markets have also remained stable. There has been little change in international reserves among our major trading partners since May. This is in stark contrast to the $250 billion drawdown of reserves by a combination of China, Saudi Arabia, and Japan during the previous 8 months that led to an appreciation of the U.S. dollar..
The path of oil prices and the pace of development policies, especially in China, with their effects on the level of international reserves will affect the economic outlook and may contribute to asset market volatility as well. China maintained its level of international reserves since the beginning of the year, but their reserves are still $150 billion lower than in July 2016. (Net, international reserves have been flat over all major managed exchange rate countries during the past five months leading to the dollar first stabilizing and then depreciating by 6.3 percent since the beginning of the year.) The decision of the People’s Bank of China (PBOC) to stabilize the value of the Renminbi will likely lead to further volatility in asset markets if the outlook for economic activity in China changes. With the recent relatively stable dollar, the weakness in U.S. exports reflects weak activity abroad as much as the lagged effects of a strong dollar. Most economic forecasters that have updated their predictions preceding the IMF meetings last April. The IMF released its updated forecast for the G-20 Meeting. The IMF made no change for the world outlook in their July update. Prospects for fiscal expansion in the United States has cooled, so the consensus of forecasters has reduced the prospects for growth in the United States but raised their outlook for Europe because the populist candidates in Netherlands and France have not managed to gain power and for Japan. Without fiscal expansion in the United States, most forecasters see 2017 looking much like 2015 and 2016. Growth in Japan is projected to be higher, Russia is expected to recover due to the rise in oil prices and the recession in Brazil is projected to end. The outlook for the global economy in 2018 looks a little brighter as higher growth in the Advanced Economies with continued low dollar interest rates and a depreciated dollar has reduced the risk of financial crises and gives a slight boost to emerging market economies.
Economic activity in the Advanced Economies is moving along its full employment growth path. Most analysts have reduced estimates of growth in 2016 due to weaker data for trade among the Advanced and Emerging Market economies. The U.S. economy grew 1.8% (Q4/Q4) (revised) during 2016. The third estimate of 2017Q1 GDP growth was revised down to 1.2 percent, somewhat below its estimated full employment growth rate. The BEA’s initial estimate of 2017Q2 growth is 2.6% yielding growth during 2017H1 of 1.9%, SAAR. The Atlanta Fed’s estimate of 2017Q2 growth (GDPNOW) is 2.8%. The consensus forecast for U.S. growth in 2017 is 2.2%, in line with the last FOMC forecast of 2.2 percent; but above the full employment growth rate given recent anemic readings on productivity. (The Fed has gradually reduced its estimate of full employment growth to 1.8 percent.) I would expect U.S. growth just below 2.0 percent as the economy receives a boost from deregulation – especially in the energy sector. Investment will experience a headwind from tax reform, especially if tax reform legislation does not take effect until 2018 (and tax reform legislation includes expensing of investment expenditures). Note that despite an average growth rate of 2.1% during the past 4 years, the unemployment rate has declined by 2 percentage points. Thus it is doubtful that the full employment growth is as high as 2.1%. In addition, with the 1 percent growth rate of the economy during 2016H1, the unemployment rate was steady. The combination of slow GDP growth combined with healthy gains in employment is easily explained by our convergence hypothesis. As firms shift the higher productivity manufacturing jobs abroad, new service oriented firms hire workers for lower productivity jobs at lower wages thus accelerating the convergence process. In the more sclerotic labor markets of Europe, the result of the process is more unemployment. This shift in manufacturing jobs abroad will likely slow or even reverse due to demographic and wage inflation headwinds in China – Chinese firms are shifting jobs abroad to Viet Nam, Indonesia, and other ASEAN states – and a shift in U.S. trade policies in a Trump Administration, especially if the United States adopts a border adjustment tax. Forecasters that assume a positive U.S. fiscal stimulus next year project U.S. growth in the 2.5-to-3.5 percent range for 2018. Forecasters that don’t assume a fiscal stimulus (such as the FOMC) project U.S. growth in the 2 percent range.
Wage inflation, hence U.S. goods and services inflation, declined during the past two months. U.S. core PCE prices rose 1.5% (June17/June16). The increase in wages appears to be the pass-through of minimum wage increases as wages have shown their sharpest increases at the beginning of the year when the increases take effect. There are also indications of a tight labor market in the construction industry which has been explained in part as a reaction to the Administration’s immigration policies. Many technical jobs are remaining unfilled as employers are unwilling to offer a high enough wage to attract qualified candidates.
The Euro Area is estimated to have grown at a 1.7% rate in 2016, despite the BREXIT vote. The Euro area as a whole has recovered from its latest recession but the migration crisis along with the political fallout from the influx of migrants lends a distinct down-side risk to the outlook for 2017. Most economists have reduced the negative effect of BREXIT on Euro area growth and have raised the growth outlook to the 1.9% range for 2017 and 1.6% for 2018.
The consensus estimate for U.K. growth in 2016 has been lowered to 1.8% due to the outcome of the vote to leave the European Union. Economists assume a negative effect of BREXIT on U.K. growth in 2017 and 2018, and project 2017 growth at 1.6%, and the 2018 outlook to 1.2%..
Looking at the Advanced Economies as a whole, they are estimated to have grown 1.7% in 2016 and are projected to advance 1.9% during 2017. With a U.S. fiscal stimulus, Advanced Economies are expected to grow 2.0 percent during 2018. Without U.S. fiscal stimulus, Advanced Economies are projected to grow 1.8 percent in 2018.
The Emerging Market Countries growth has been slowing down, but is expected to pick up a bit in 2017. Brazil and Russia have been in recession but are expected to recover during 2017, although Brazil’s recovery is expected to be weak and is not yet apparent in the data. Brazil is struggling from poor policies and a political crisis due to corruption (in Petrobras no less); Russia is slowing down due to sanctions and low commodity prices, but should be helped by the rise in oil prices. China’s economy is slowing from its 7.3% pace of 2014, but there is little consensus on how much they have or will likely slow down (as well as little belief in the validity of their published numbers). The data currently circulated for China estimate growth in 2016 of 6.7%. China’s economy is projected to grow 6.7% in 2017 and 6.3% in 2018. China’s international reserves declined by $150 billion since July of last year but have remained stable during the last several months. The stabilization of China’s reserves and small increases (net) in the reserves of other managed exchange rate countries has allowed the dollar to depreciate since the end of December. Saudi Arabian international reserves continued to decline at a steady pace and have dropped by $62 billion during the past year (July17 – July16).
In addition to U.S. and China monetary policy actions, oil prices will also move with news of OPEC and non-OPEC producers production decisions. Oil prices will end up where the Saudi’s are comfortable with the combination of price and Saudi output levels. The Saudis signaled to other producers at the recent (May 2017) OPEC meeting that they are comfortable with the current higher oil prices, as well as with cutting production. While higher oil prices that signal higher aggregate demand are on balance good for equity markets (because of the higher aggregate demand), higher oil prices due to cuts in production reduce aggregate demand and reduce profits, raise long term interest rates, and are therefore negative for both bond and equity prices. Thus far, U.S. shale production is offsetting much of the effects of OPEC cuts in production.
The consensus forecast of economic growth in the Advanced Economies appears promising, as most forecasters project an acceleration of growth in the United States in 2017. I remain skeptical that growth will rise above its potential rate, which is somewhere between 1.5 and 2 percent, although the economy should receive a boost in energy production from the Administration’s de-regulation efforts. The United States expansion is getting ‘mature’, so U.S. growth should advance close to potential barring a pro-growth fiscal policy action. Therefore, I would expect growth during 2017 to be close, but still below, to the Fed’s projection of 2.1%. In addition, I don’t expect the past election outcome (the combination of Presidential and Congressional) to be positive for U.S. economic growth in the short run (2017). In the medium-term (2018 and beyond), growth should improve as long as the Fed increases interest rates and the legislature passes comprehensive tax reform which should stimulate investment and productivity growth. (In the short run, capital adjustment costs will likely depress growth, even if the tax plan takes effect in 2017.) The weak investment on machinery and equipment, both past and current, dictates continued low productivity growth – consistent with our convergence thesis, and with our view of the way that low policy interest rates affect inflation and savings and investment. Without higher productivity growth, it will be difficult to reach above 2% GDP growth absent an unanticipated large growth in the labor force.
If the Trump Administration’s economic policies provide incentives for private investment and legal immigration, then economic growth should begin to improve in 2018 and beyond. However, the uncertainty over the content of tax reform legislation and trade policy could give us more of a negative bump in 2017 than is contained in the consensus of forecasts of the U.S. economy. While tax reform should be bullish for economic growth and equity prices in the medium term, the uncertainty of the effects of complex legislation often results in short-term slower growth due to capital adjustment costs and declines in equity prices in sectors most negatively affected by the legislation. With a lower rate of potential output growth, it is more likely that a significant shock will push the economy into a recession. One such shock that has pushed the U.S. economy into a recession – late 1980, late 2000, and late 2008 – is a slowdown in government spending during the change in administrations due to the uncertainty of agency budgets and the absence of leadership at the top tier of the executive branch agencies. This is probably much of the story of the weak first quarter GDP data. Another such shock occurs when firms and individuals defer income given the prospect of lower taxes the following tax year(s). I see no evidence of firms deferring profits, dividend payments, or individuals postponing income into 2018 as yet. We should pay attention to this possible development. (At this point it does not make sense for firms to defer dividend payments to 2018 until tax legislation on tax reform and the ACA are passed.) To the extent that markets price in higher productivity growth from Trump’s policy agenda, the higher outlook for productivity growth should reinforce the increase in long-term bond prices as the FOMC continues to raise short-term rates. The other Advanced Economies face headwinds similar to those experienced by the U.S. economy from 2010 to 2014, so growth above potential in these areas seems a bit of a ‘rosy’ scenario.
William L. Helkie
William Helkie is not affiliated with LPL Financial.
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