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Note for May Investment CommitteeSubmitted by The Wealth Consulting Group on May 12th, 2017
Summary and Conclusion:
Asset markets remained reasonably stable during April. U.S. equity markets rose roughly one percent as measured by the S&P500. The VIX remained relatively low and the yield on 10 year U.S. government bonds traded near 2.3 percent. While commentators have attributed this stability to reassuring political outcomes (the French election outcome and the U.S. budget deal), 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.
Washington policy officials were active last month, but their activities bore little fruit save the resolution of U.S. government spending for fiscal year 2017. The Federal Reserve left the Federal Funds rate unchanged following its May 2-3 meeting. The content of its Press Release was generally expected by markets resulting in little change in market expectation of the future path of rates. The Fed presented an upbeat assessment of the economic outlook that supported further increases in the Federal Funds rate. There was no mention of plans to reduce the size of the Fed’s balance sheet. We should learn more about its plans on reducing the size of its balance sheet when the Fed releases the minutes of its meeting on May 24.
The House is still struggling to put together Health Care Reform legislation that could garner the support of enough Republican members in order to achieve a majority of positive votes in the House. There are reports that the House will vote on a bill on May 3. Political analysts say the content of comparable legislation that comes out of the Senate will be much different than that contained in the House bill. Of particular interest to markets is the repeal of the ACA taxes – especially the investment income tax.
Market participants received a little news on the substance (but not the timing) of tax reform legislation as the White House revealed (on a one-pager) the general structure of their view. Of note is that the White House is not advocating any reduction in capital gains taxes save the repeal of the ACA investment income tax. There remain wide divisions among the House, the Senate, and the White House/Treasury on key elements of tax reform legislation – not just between Republicans and Democrats, but among Democrats and especially among Republicans. Thus, this raises the risk that no significant legislation will be enacted before the 2018 mid-term elections, including no repeal of the ACA taxes. If such a risk manifests, the result would most likely be a selloff in equity markets. 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 0.5 percentage points. 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 revised health care bill) 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 – the outline includes the deductions for mortgage interest and charitable contributions.
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 is 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 hope for a repeal of the ACA investment income tax and lower capital gains tax rates in tax reform legislation. Thus the failure to put together health care reform legislation that could pass the House and move to the Senate did not bring sellers back into the market. My explanation for the rally, which I assume will continue until tax reform legislation is passed or scuttled, is the high probability that the 3.8 percent net investment income tax will be repealed either in tax reform legislation or a revived Health Care bill. This 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. 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 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 more certain of Federal Reserve interest rate policy in 2017 (an 89 percent probability of an additional rate increase this year and a 52 percent probability of two). The Fed dot plots project 2 additional rate increases during 2017 by 14 of 17 FOMC members. The Fed will release the minutes of the May 3 FOMC Meeting on May 24. These minutes should include additional information regarding the timing and size of its plans for reducing the size of the Fed’s balance sheet. The Fed will update its economic forecasts and the dot plots following the FOMC meeting on June 14.
The President’s (and Congress’s) Policy Agenda
At this point in time, the President’s focus is on national security and immigration issues. (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.
The President does not support the repeal of the ACA without an immediate replacement. That puts the timing of the repeal of the ACA investment income tax in limbo. Thus, it is possible that the ACA investment income tax may be retained in the bargain to reform the ACA once the legislation goes into Conference assuming it ever gets through the House and the Senate. President Trump has directed reductions in both financial and environmental regulations. We are not hearing much about infrastructure investment except for the Border Wall. The Border Wall has become a very contentious, partisan issue which may well hold up progress on Health Care and Tax Reform legislation.
The committee should follow the process on the ACA; markets will respond to the ACA repeal depending in a large part upon whether the ACA investment income tax is repealed and when the repeal is effective (i.e. 2017 or 2018). (The ACA investment income tax was repealed in the legislation that repealed the ACA last year that President Obama vetoed.) Repeal of the ACA tax is the preponderant relief to taxes on capital gains; the Ryan plan provides relief in a complex way that may well end up being removed from the tax reform plan and the Trump plan provides no relief (outside of the repeal of the ACA tax) to capital gains taxation. Thus, we should see sellers return to the market once the repeal of the ACA tax is effective.
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 revise downward 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 during March and April. This is in stark contrast to the $300 billion drawdown of reserves by a combination of China, Saudi Arabia, and Japan during the previous 9 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 $200 billion lower than in March 2016. (Net, international reserves have been flat over all major managed exchange rate countries during the past two months leading to the dollar stabilizing and then depreciating by 2.5 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. Economic forecasters that have updated their predictions preceding the IMF meetings last April. The 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 (yet!). Without fiscal expansion in the United States, most forecasters see 2017 looking much like 2015 and 2016 with the exception of a recovery in Russia due to the recent rise in oil prices and an end to the recession in Brazil. The outlook for the global economy looks a little brighter as the higher growth in the Advanced Economies with continued low dollar interest rates has reduced the risk of financial crises in emerging market countries.
Economic activity in the Advanced Economies is moving along its full employment growth path. Most analysts have reduced growth forecasts due to a weaker outlook for trade among the Advanced and Emerging Market economies. The U.S. economy grew 1.9% (Q4/Q4) during 2015. The economy is estimated to have advanced at a 2.0 percent rate during 2016. The first estimate of 2017Q1 GDP growth was 0.7 percent, well below the estimated full employment growth rate. The Atlanta Fed’s estimate of 2017Q2 growth (GDPNOW) is 4.3%., based on very sketchy data. The consensus forecast for U.S. growth in 2017 is 2.2%, pretty much in line with the last FOMC forecast of 2.1 percent; but above the full employment growth rate given recent anemic readings on productivity. I would expect U.S. growth somewhat below 2.0 percent, especially if tax reform legislation does not take effect until 2018 (and tax reform legislation includes expensing of investment expenditures). Note that despite the 2015 (Q4/Q4) growth rate of 2.0%, the unemployment rate continued to decline indicating that it is doubtful that the full employment growth is as high as 2%. 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 is beginning to pick up. U.S. core PCE prices rose 1.8% (March17/March16). The increase in wages appears to be the pass-through of minimum wage increases. Wages are rising the fastest in the hospitality category – a category with a high percentage of minimum wage jobs – while employment growth in that sector is declining. Wages rising while demand for labor is declining is an indication of a supply side wage shock rather than a pull from aggregate demand. 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.
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 1.7% 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 reduced the effect of BREXIT on U.K. growth in 2017 and 2018, and project 2017 growth at 1.9%, and the 2018 outlook to 1.5%..
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 will likely grow 2.0 percent during 2018.
The Emerging Market Countries growth has been slowing down, but is expected to pick up a bit in 2017. Brazil and Russia are 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 6.6% in 2017 and 6.2% in 2018. China’s international reserves declined by $200 billion since March 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 $73 billion during the past year (March17 – March16).
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 (December 2016) 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.
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. 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 closer to 1.5% than the Fed’s projection of 2.1%. In addition, I don’t expect the 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 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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