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Economic Perspective

September 2017

Financial markets keep reaching new highs and economic activity continues to increase globally; however, some near-term issues may present some turbulence for markets. Thomas Dillman, President of Mutual of America Capital Management LLC, examines the strength of economic activity in the U.S. and globally, including the impact that the following may have on sustained economic growth: key legislative issues facing the U.S. federal government; decisions by the Federal Reserve on whether to raise interest rates; and critical geopolitical issues.

Markets Reaching Historical Highs

The vast majority of market strategists and economists in the U.S., including those on the Federal Reserve Board, are concerned about stock market valuations. It's true that most stock market and bond market valuations are at historical highs. However, as we've emphasized repeatedly in past editions of Economic Perspective, we believe markets are driven by economic fundamentals at both macro and micro levels. From that perspective, valuations may be a bit stretched but are supported by low interest rates, low inflation and improving global economic conditions.

The domestic economy continues to grow at a 2.0% rate, with quarterly variations around that range. For instance, first quarter Gross Domestic Product (GDP) growth came in at 1.2%, while second quarter GDP registered at 2.6% in the initial report, which was then revised up to an impressive 3.0%. Third and fourth quarter GDP is likely to see growth modestly in excess of 2.0%. Extrapolating these quarterly numbers, it looks reasonable to project a 2.0% rate for the year, in line with the average growth rate since 2010 and current consensus estimates of 2.1%.

Economic Activity Picking Up

Globally, economic activity continues to pick up. Europe has shown steady improvement in GDP growth since the end of 2014 and is likely to hit 2.0% for the current year. Japan is showing signs of possible sustainable growth and should also see a 2.0% annual growth rate after second quarter annualized growth came in at 4.0%. China seems to have stabilized its growth rate at about 6.5% and concerns about the resumption of a slowdown have abated for now. Longer term, it's inevitable that China will continue to slow as its economy expands, since the larger an economy becomes the more difficult it is to maintain rapid growth. In the meantime, 6.5% growth contributes substantially to global economic well-being. In addition, emerging markets remain robust in Asia, while Mexico and Brazil are in recovery mode.

In short, we're experiencing a period of solid—and synchronized—global economic performance and stability. The International Monetary Fund projects global GDP growth of 3.5% in 2017 and 3.6% in 2018, up from 3.2% in 2016. All 45 countries for which growth is projected by the Organization for Economic Coordination and Development are expected to show growth this year, with 33 showing accelerating growth.1 The macroeconomic fundamentals supporting global economic health are reassuring. Inflation remains contained, interest rates remain low, employment is growing, and thus, incomes are, too.

The result is that corporate earnings in all of these regions show above-expectations results, and forward earnings projections continue to rise in most markets. For instance, second quarter results for the S&P 500® had the highest positive surprise ratio (results exceeding expectations) in years for both sales and earnings while profit margins hit a level not seen since at least the 1960s. Rising expectations are driving valuations up. Should those expectations be realized or exceeded, current valuations will have been justified. And if growth proves sustainable for an extended period of time (i.e., years, not months), valuations will likely continue to rise. Of course, at some point, growth will slow; expectations will be disappointed; fears of recession will take over; and valuations and, by extension, markets will decline. That is the nature of the economic/profit cycle. Our last Economic Perspective examined a number of conditions that would signal potential for recession, none of which seem evident in the current data. In the meantime, conditions seem to indicate "all clear ahead."

Federal Government Progress Is Key

Nevertheless, there is still plenty to worry about. Top of the list is probably the fate of U.S. tax reform and infrastructure spending. The failure of the Republican-controlled Senate to pass a health care bill to repeal key parts of the Affordable Care Act (i.e., Obamacare) raised serious doubts about senators' ability to legislate tax reform, or even a tax cut. This doubt applies to infrastructure spending as well. These promised presidential campaign agenda items by Donald Trump were arguably behind the powerful surge in stock prices since the November election. The increasing skepticism that they can be legislated and implemented is, in our opinion, one important reason why the bull market has plateaued for the past two months. The reason the markets haven't sold off more is that there is a chance that a tax bill of some kind can still be passed within the next six to nine months.

Before tax legislation can be taken up by Congress, the debt ceiling will need to be raised, a budget for the next fiscal year agreed upon and the necessary appropriations authorized. Most commentators believe that neither party—especially the Republicans, who control Congress—wants to bring the government to a standstill and will find a way to pass these measures. But the process will be tumultuous, especially around the budget, which requires consideration of spending levels and, therefore, taxes. The traditional issues of controversy will be present: Many Democrats will want to spend more and resist tax cuts, while Republicans, especially the Conservative wing, will want major tax cuts. However, the differences are less stark than in recent years. Tax cuts, especially corporate tax cuts, are viewed by both parties as necessary to ensure our global competitiveness. And both parties favor spending, although with different priorities. As a result, there seems to be more room for compromise. These issues will have to be settled quickly when Congress returns from its August recess before tax reform can be addressed.

What Will Federal Reserve Do?

Another concern for the markets is Federal Reserve (Fed) policy. Will the Fed decide to raise rates again before the end of the year or defer until 2018? When will it begin to shrink its balance sheet as it promised to do within the near future? The probability of a rate increase in September is essentially zero, while the probability of one in December is declining and now stands at 35%. The Fed continues to express its desire for one more rate hike this year on top of the two earlier in the year, but the fact that inflation has actually declined over the past few months to well below the Fed's target rate of 2.0% has raised skepticism among investors that they will follow through. However, the plan to begin to shrink the Fed's balance sheet systematically, which currently stands at $4.5 trillion, will probably be implemented this fall or early next year. The Fed will proceed slowly in this process, and given the pre-notification, it should come as no surprise to markets.

A related concern is that Janet Yellen's term as Chair of the Federal Reserve expires early next year. President Trump has acknowledged that she has guided the Fed well during her tenure but has kept open the possibility that he will nominate someone else rather than appoint her to a second term. While there are a number of worthy candidates in terms of credentials, investors are concerned that to change leadership during a transition in Fed policy could disrupt the process and yield unanticipated consequences. Most commentators believe the president will give Yellen another term, but markets don't like uncertainty and will remain uncomfortable until the choice is announced.

Quantitative Easing Wrapping Up in Europe

Additionally, the European Central Bank (ECB) has suggested it is approaching the end of its quantitative easing program. By initial agreement, the program only permits the ECB to purchase 30% of the sovereign debt of each nation in the Eurozone. The bulk of this debt is German, French and Italian, and total purchases from each are now approaching the limit. The cessation of liquidity injections into the global economy by both the U.S. and Europe in the same time frame is particularly concerning to investors. The global economy has been sustained by quantitative easing for years, and withdrawal poses the risk of undermining global growth. Yet ultimately, it's necessary for economies to stand on their own feet, and this has been the end goal of quantitative easing since its start. However, the transition from life support to self-sufficiency could temporarily spook markets or, worse, curtail the expansion. Nevertheless, we believe the central banks will demonstrate the same caution in reversing quantitative easing as they have throughout its implementation.

Global Politics Loom Large

On the geopolitical front, conditions are fluid and partnerships and alliances seem to be shifting. The impetus behind this process of realignment appears to be the "more muscular" American foreign policy promised by the Trump administration. The U.S.-NATO relationship remains intact but is strained by President Trump's insistence on compliance with agreed expenditures from members. The U.S. Congress recently instituted additional sanctions on Russia for meddling in the U.S. presidential election and, importantly, limited the power of the administration to unilaterally order sanctions against another nation. Additional sanctions were levied on Iran for its ongoing missile testing. China and the U.S. were forced to work together to encourage North Korea to back off from its provocative missile launches, recent underground nuclear test, and hostile pronouncements and, ultimately, curtail its race to fully develop a nuclear military capability. This "cooperation" between China and the U.S. was prompted by the exchange of increasingly inflammatory rhetoric between President Trump and Kim Jong-un that threatened to escalate into a more serious situation. China and the U.S., however, will continue to have conflicts over trade, intellectual property rights, direct investment and global leadership.

President Trump's first formal address to the American people reiterated the U.S. commitment to Afghanistan, without a timeframe or magnitude. More importantly, he made it clear that the U.S. alliance with Pakistan would change dramatically, invoking the newly buttressed relationship between the U.S. and India, the prime enemy of Pakistan, as a balancing factor in the region.

The Middle East is perhaps the most fluid of all regions in terms of shifting alliances. President Trump's first international political visit was to Saudi Arabia. The visit shored up a relationship that had soured under President Obama. The U.S. also secured a $100 billion defense contract from the Saudis. ISIS is near defeat as a geopolitical entity in the region but has dispersed its terrorist activities to other areas of the world, especially Europe. The war in Syria continues but has all but disappeared from the news, except for the refugee crisis it has spawned. The Trump administration has improved relations with Israel and has vowed to find a solution to the Israel-Palestine impasse. The larger issues underlying the diplomatic shifts are too complex to examine here, but the region remains one of the most volatile and dangerous in the world.

As we often note, unless geopolitical shifts have significant economic impact, markets historically take them in stride—though not without temporary downdrafts. In fact, of 18 major international events, ranging from the German invasion of France in 1940 to last year's referendum in Great Britain to leave the Eurozone (i.e., Brexit), the S&P 500® was up in two-thirds of those occasions within 250 days. Admittedly, other factors could have contributed to those results. But those cases in which the market remained in decline included such economically significant events as the 1973 Oil Embargo, the 9/11 terrorist attacks and the collapse of Bear Stearns and Lehman Brothers in 2008 during the Great Recession.2 And in the end, such dramatic events are inherently unpredictable.

Outlook

That said, geopolitical turmoil does affect investor sentiment. The surprising thing is that the global stock markets have remained strong and relatively stable during the past year despite what's going on in the world. Corporate sales and earnings growth determine stock and credit market performance.

Our outlook remains unchanged. We see 2.0% domestic GDP growth for the next 12 to 24 months. We agree with Ed Yardeni of Yardeni Research that this growth will be accompanied by an inflation rate around 2.0% and a federal funds rate at approximately 2.0% as well. Such a scenario could last a long time. Steady as she goes.


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