The financial markets have advanced significantly since the U.S. presidential election, and domestic economic fundamentals continue to strengthen in 2016. Thomas Dillman, President of Mutual of America Capital Management LLC, reviews the data to check on the strength of the U.S. financial markets and economy and also examines the potential impact that some of President-elect Donald Trump's campaign proposals might have on sustained economic growth during 2017.
Financial Markets Advance Significantly Since Election
Over the last few months, financial markets have gone through rapid and dramatic changes. The 10-Year U.S. Treasury bond yield jumped more than 120 basis points since its 2016 low of 1.37% on July 6, with 75 basis points of that move coming since the presidential election on November 8. The U.S. dollar advanced 11% since its 2016 low on May 3, 5% of which came after the election. Crude oil prices are up 39% since the year low on January 21, including 15% since the election, with an assist from an OPEC deal to cut production modestly. The Thomson Reuters/CoreCommodity—CRB Index, which tracks oil and natural gas, metals and agricultural commodities, is up 24% since its low in early September and 9% since the election. And the S&P 500® Index is up 24% since its closing low on February 11 and 9% since the election. The Russell Small Cap and Mid-Cap Indexes have done even better. Few foreign markets have fared as well, except those with high commodity exposure that have recovered after severe collapses, such as Russia, Brazil, Peru and Canada.
In short, all asset classes have advanced substantially this year and accelerated even more since the election. There are two explanations. The first is that investors correctly anticipated improving economic conditions over the past several months, and interpret President-elect Trump's agenda as beneficial to future economic growth and corporate profits. The improvement in the economic data is documented below. The expectation that the Trump administration will implement the key proposals on which investors have focused, namely tax cuts and reform, infrastructure spending and deregulation (especially of the financial and environmentally sensitive sectors), is more out of hope than certainty at this time. This judgment is based on the political reality that legislation takes compromise and time. Furthermore, despite Republican majorities in both houses of Congress, Republican legislators by no means universally agree with the Trump platform.
Domestic Economic Fundamentals Continue to Strengthen
The improvement in the domestic economic fundamentals is indisputable. Gross Domestic Product (GDP) registered 3.5% at an annualized rate for the third quarter, up from 1.4% in the second quarter and 0.8% in the first. The unemployment rate as of November was 4.6%, down from the 5.0% level through most of 2016 and approaching the lows of the last two expansions. Unemployment claims are running at historical lows; job cuts are down; and voluntary job quits—a measure of worker confidence—are up. Auto sales and new home sales plateaued at cycle highs, but housing starts and permits, as well as existing home sales, recently improved. Retail sales strengthened over the past few months, supported by improving wages and personal income increases. And an increase in personal savings, as well as lower gas and oil prices compared to last year, is providing incremental spending power to consumers. Consumer confidence is also showing strong recent improvement.
Even manufacturing, which has been the weak link during most of this extended recovery, has firmed substantially both domestically and globally. Confidence is up among small businesses. This is important because most jobs are generated by small businesses in this country. Almost all domestic regional manufacturing surveys registered strong improvement. Surveys from the Institute for Supply Management Purchasing Managers Index show acceleration in most economies across the globe. The same is true for most leading indicators, a measure of future economic growth. The Economic Cycle Research Institute's Weekly Leading Index has reached a cycle high, indicating a positive economic outlook. The Citi Economic Surprise Index, a measure of how economic data compare with expectations, has shown acceleration since midyear. This series has a very strong historical correlation with S&P 500 Index price moves. Even nonfarm productivity registered a positive 3.1% advance after several negative quarters.
Keeping an Eye on Inflation
On the inflation front, inflation expectations are rising, as indicated by the recent increasing spread between U.S. Treasury bonds and Treasury Inflation-Protected Securities. The most recent reading of the Consumer Price Index (CPI), exclusive of food and energy, and referred to as Core CPI, was 2.1%, which is in line with the Federal Reserve's (Fed) target goal. Similarly, the Producer Price Index (an index of inflation within the manufacturing sectors and a driver of ultimate consumer prices), excluding food and energy as well as trade, most recently registered at 1.8%, up from 1.6% during the prior period.
In response, the Fed just raised the Federal Funds Rate 25 basis points to a range of 0.50% to 0.75%, the first increase since December 2015. Recall that the stock market's meltdown and bond market's dramatic yield drop at the beginning of 2016 was due to the Fed's signal in early January that there would be three to four additional 25-basis-point increases this year. The markets' reaction expressed the belief by investors that if the Fed were to do so, the result would be a recession. Subsequent economic data soon made it apparent that the economy was already deteriorating. As mentioned, first quarter GDP came in at a very weak 0.8%, well below the 2.0% average maintained over the prior four years. In late January and early February, the Fed began to aggressively back away from its hawkish bent, and markets began to reverse immediately. However, it took until the second half of 2016 for economic data to show signs of improvement before markets recovered to beginning-of-year levels and then to move to new highs following the election in November.
Are Markets Accurately Foreshadowing the Future?
We believe that the market's positive response to the tax, infrastructure and deregulatory components of President-elect Trump's campaign proposals is premature. The positive response also ignores the potential, and likely, negative consequences of his protectionist policies, especially threats to raise tariff rates on import products manufactured abroad where labor costs are much lower, with a particular focus on American products manufactured outside the U.S. Such an action would almost assuredly lead to retaliation in kind, which, in turn, would undermine global trade and global growth.
Let's take a look at Trump's tax proposal. First, his plan, so far as we can tell given the limited information provided to date, is different in many ways from the other Republican proposals already advanced within Congress, most notably Speaker of the House Paul Ryan's. This means compromise will be required, as well as the political reality that any final plan will differ, perhaps substantially, from the one to which investors are so enthusiastically responding. Second, investors do not seem totally clear as to whether the plan that ends up being sponsored will only propose tax cuts or will involve wholesale tax reform. A pure tax cut proposal would be more difficult to pass because it would not be deficit neutral—in other words, it would not pay for itself without increasing the deficit. As a result, such a proposal would require 60 votes to break a likely Democratic filibuster and allow a vote on the bill. Senate rules allow tax issues to pass with a majority vote through a process called "budget resolution" only when the law is deficit neutral, which tax cuts are not. Tax reform that is deficit neutral would qualify under this budget resolution rule but would take much longer to negotiate and implement. Stock prices seem to reflect a belief by investors that tax reduction, whether through tax cuts or reform, would be quickly forthcoming once Trump takes office. We think this unlikely.
With regard to infrastructure spending, Trump pledged a program to spend $1 trillion over 10 years. Given that U.S. debt is currently running at nearly 80% of GDP, such an amount is unlikely to get the support of Republicans, who have been staunchly fiscally conservative, consistently resisting or blocking Democratic spending proposals and tax increases to pay for them. This means Trump will have to negotiate, or "make a deal," with his own party despite its control of both houses of Congress. The same goes for many of Trump's other proposals. In addition, infrastructure spending requires specific "shovel-ready" projects and a sufficient labor pool to implement them. There are few such projects, and there are already too few workers to fill existing job openings, to say nothing about the availability of people willing to do that work. Stagnation and even reversal in immigration growth, especially from Mexico and other Central and South American countries where the manual labor pool has come from over the past 30 years, exacerbates the situation. Trump's anti-immigration policies further compound it.
Deregulation, as is the case with tax reform, will take time, except perhaps for environmental regulations. Many of the latter were implemented by executive orders issued by President Obama and can be eliminated by Trump with the stroke of a pen. But financial deregulation will require overhauling the Dodd-Frank Wall Street Reform and Consumer Protection Act—a lengthy, complex piece of legislation with an already entrenched bureaucracy. In addition, many Dodd-Frank regulations should probably remain intact. After all, it is evident with hindsight that financial deregulation during the Clinton and Bush administrations had no small part in leading to the housing market collapse that spawned the Great Recession. The repeal of the Glass-Steagall Act of 1933, which separated commercial from investment banking because of implicit conflict of interest, is now generally thought to have been one of the leading causes of excessive bank leverage and reckless lending. That's to say nothing of the creation and marketing of increasingly exotic and risky investment vehicles such as collateralized debt obligations (CDOs), especially the class of CDOs called collateralized mortgage obligations (CMOs). The so-called Volker Rule incorporated into Dodd-Frank essentially reestablished constraints on investment banks. Unraveling parts of Dodd-Frank without eliminating those sections that serve as necessary constraints on risky activities will be a tedious, difficult and drawn out process.
Seeking Realistic Expectations for the Economy in 2017
The recent robust market rally, characterized by almost daily all-time highs, has stretched stock valuations toward historic upper bounds. Analysts and strategists are beginning to raise earnings estimates, some extremely aggressively, which will make valuations seem more reasonable. However, in our opinion, a large part of the market ebullience is based on unrealistic expectations regarding proposed policy changes of a presidential administration that has not yet been installed. Trump's key cabinet nominees will have to be approved by a majority of the Senate. Given that a number of these nominees are considered controversial by certain members of the Senate, the process may well be protracted. Moreover, as discussed, policy proposals are just that—proposals, not legislative fact.
Finally, this entire economic expansion in the U.S. has been characterized by oscillations in growth prospects and a subpar, suboptimal average growth rate of 2%. If the pattern holds, the recent strength will recede and fears of a recession will reassert themselves. Markets would almost assuredly retrench in response. The recent rise in the dollar and interest rates are both potential restraints on economic growth and earnings and could derail the recovery if the increases continue. And, as noted, a number of the president-elect's policy proposals are not supportive of growth.
We would like to be less cautious and more confident in the sustainability of the recent acceleration in economic growth, as well as prospects for quick implementation of growth-enhancing policy proposals. We hope we are being overly conservative. But years of experience, and a solid knowledge of the history of economics and markets, counsels skepticism that this time is different. GDP growth of 2% with sequential up-and-down periods looking ahead remains our best case scenario in the short term. In the long run, an extended cycle without excesses is, after all, not necessarily a bad thing. We'd rather the economy experience sustained, compounded low growth than a short-lived, dramatic blow-off followed by a collapse. It would seem preferable to accrue wealth for a long period of time than to become wealthy and then poor in quick succession.
The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.
Mutual of America Capital Management LLC is an indirect, wholly owned subsidiary of Mutual of America Life Insurance Company. Mutual of America Life Insurance Company is a registered Broker-Dealer.
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