Through the first three quarters of 2017, financial markets continued to hit record highs while expansion both in the United States and globally followed suit. But where is the tipping point and is there a correction on the horizon? Thomas Dillman, President of Mutual of America Capital Management LLC, examines the potential impact that various factors may have on sustained economic growth, including investment by corporations in their infrastructure, the unwinding of quantitative easing programs, tax reform legislation and interest rate increases.
Expanding Global Growth
Global markets have continued to advance throughout the year, with minor pauses, but no serious corrections. The U.S. stock market, represented by the S&P 500®, is notable for recently advancing to new highs for six trading days in a row, a feat not witnessed in 20 years. Most global markets have actually gone up more than U.S. markets in dollar terms. The primary driver of such strong performance is improving economic data from around the world. Other positive factors include low inflation and low interest rates. Finally, the prospects of tax cuts in the U.S. continue to provide optimism about the future despite the fact that successful tax legislation by Congress is by no means assured.
First, with regard to the global economy, it is clear that we are in the midst of a global synchronized expansion. As discussed in the September issue of Economic Perspective, Gross Domestic Product (GDP) growth is accelerating in Europe and Japan, and perhaps even in the U.S. The final posting of GDP growth in the U.S. for the second quarter was 3.1% versus the initial report of 2.4—a strong showing, especially compared to the 2.0% average during this expansion. In addition, emerging markets have witnessed accelerating growth with declining inflation, while China’s growth has stabilized around a 6.5% rate.
The Institute of Supply Management’s (ISM) Purchasing Managers Indexes (PMI) in September showed all 18 major market manufacturers’ PMIs were in expansion territory (greater than 50), up from 16 of 18 in August. Half of those registered above 55 and all had advanced over August readings.1 Although these numbers are probably not sustainable, their current strength suggests the persistence of global expansion, barring an unforeseen economic dislocation. These kinds of statistics led the International Monetary Fund (IMF) to raise its estimates for global growth for 2017 and 2018 twice in the last three months—from 3.5% and 3.6% to 3.6% and 3.7%, respectively, versus growth of 3.2% in 2016.
U.S. Economy Continues to Advance
Focusing on the U.S. economy, the ISM manufacturing index hit 60.8 in September, while the ISM nonmanufacturing index accelerated to 59.8 from 55.3 the prior month, the fastest rate of growth during the expansion. Nondefense capital goods orders rose 1.0% in August, versus an expectation of 0.3% and following 0.9% and 1.2% in the prior two months, respectively. Capital goods were among the weaker aspects of the domestic expansion until this recent sign of strength. Hopefully, this represents a new willingness by corporations to invest in new plants and equipment rather than allocate most capital to dividends, share buybacks, acquisitions and debt pay-downs. Investment is important because it stimulates current growth in a leveraged manner and, more importantly, provides the basis for future growth. On the labor market front, the unemployment rate for September fell to an expansion low of 4.2%, while average hourly earnings advanced 2.9% year over year, up from 2.7% in August. While personal consumption advanced 3.3% in both the first and second quarters, spending was more muted during the third quarter. Housing has also been constrained by lack of supply and high prices. While third-quarter GDP may not match the second quarter’s 3.1%, the current consensus forecast stood at 2.7%, although this number is likely to be revised downward because of the series of hurricanes sustained in September. However, the fourth quarter likely will see a reversal on rebuild spending.
Monetary policy has the potential to undermine global growth, but in our opinion, that is unlikely. The U.S. Federal Reserve is in the process of raising short-term interest rates. The probability of its third rate cut for the year at the upcoming December meeting is currently in the 80–90% range. The Fed signaled it expects to raise the Fed Funds rate three additional times in 2018, subject to the data. That would bring the policy interest rate to a 2.0–2.25% range from its current level of 1.0–1.25%. In addition, the Fed is in the process of shrinking the Federal Reserve’s balance sheet after dramatically expanding it through several quantitative easing programs.
Unwinding Quantitative Easing
Both of these actions result in less liquidity in the economy, and thus represent a tightening in monetary policy. Normally, such moves raise concern in markets, but as we’ve discussed, markets have proven surprisingly sanguine in the face of this change in monetary policy. Part of this seeming complacence may be because the Fed clearly telegraphed its intended actions well in advance. Another explanation is that the Fed has made it clear that this unwinding of quantitative easing will be very gradual. We estimate that at the pace planned for the balance-sheet reduction, it would take 10 years to reduce by half the amount by which the balance sheet was expanded during the first several years of the recovery. Furthermore, the Fed has shown flexibility in modifying its rate hike plans to changes in economic data as these are released. Finally, Europe and Japan are continuing their QE programs, thus providing incremental liquidity to the market. While the employment data in the U.S. has given an emphatic green light to monetary tightening, inflation has not behaved as the Fed expected, or would like to see, to validate the current schedule for rate increases. Thus, markets may experience more volatility going forward than they have recently as the Fed adjusts to unfolding events that are not within the range of expectations.
The one monetary issue that could rattle markets is who President Trump selects to be the next Federal Reserve Chairman when Janet Yellen’s term expires in February of next year. We have thought Mrs. Yellen would be reappointed to ensure continuity during the delicate task of reversing long-standing monetary policy. However, current betting polls show Fed Governor Jerome Powell and former Fed member Kevin Warsh leading Yellen. Trump’s decision is expected before year-end.
Tax Reform on Front Burner
On the fiscal policy front, tax policy has taken center stage. Congress is in the midst of negotiating a tax bill. The first step is to pass a budget resolution that incorporates a tax-cut proposal as well as a reconciliation clause that will permit the Senate to ratify the budget, and the tax plan, with 50 votes rather than the customarily required 60 votes. The House of Representatives has already approved its version of a budget resolution, and the Senate is likely to follow suit shortly. However, the resolutions will differ and will have to be sorted out in a House-Senate conference so that the same bill can be voted on by both houses of Congress. Any tax cut will hinge on whether or not an agreement can be reached. Since the Republicans control both houses of Congress, they also control the conference committee to reconcile differences between the House and Senate versions of the budget. Any failure to produce a compromise budget that can be voted on will be a Republican failure. Internal disagreements among Republicans were recently highlighted by their failure to repeal and replace, or for that matter modify in any way, the Affordable Care Act. Passage of a tax bill is vital to the Republicans to deliver on one of their key promises before the midterm elections next fall.
The Senate Budget Committee unveiled a budget proposal that calls for a $1.5 trillion tax cut. In early October the full Senate approved its budget resolution. That same day, House Speaker Paul Ryan announced that the House would take up the Senate bill as its framework for debate rather than go through a joint House-Senate conference committee to iron out differences in the respective budget resolutions. Once the House approves the budget, a proposed tax-reform bill will be released for debate. At that point, the real work will begin, including focus on and debate of the specific proposals. Both the House and Senate will still have to approve the final tax-reform legislation. However, the rapidity with which the budget resolution was adopted makes passage of a tax bill by the end of the year more likely than previously thought. A couple of general points regarding actual issues in the tax plan taking shape should be made. First, the tax plan envisioned includes both corporate and individual tax cuts. Second, in order to fund tax cuts, cost cuts or revenue raisers must be found. Third, many of the current proposals are extremely controversial because they involve eliminating some current tax deductions that are considered almost sacrosanct. One example is the proposal to eliminate the deduction for state and local taxes. Most states and cities have an income tax; this deduction is often the largest for individual taxpayers in those states. Another example is the proposed elimination of the estate tax, which would be a boon to the very wealthy and thereby undermine the claims by Republicans that the aim of individual tax cuts is to aid the middle class. On the corporate side, changes in treatment of interest expense, dividends and capital investment credits all entail controversy. The proposal to move to a territorial tax system, whereby U.S. corporations will only pay taxes on income earned in the U.S., involves taxing on a one-time basis repatriated earnings from abroad, including the amounts of cash invested in plants, equipment, inventories and other tangible assets. Corporate America is opposed to this proposal.
In short, tax reform is one of the most difficult tasks to deal with for any Congress and the respective political parties. The last successful tax reform legislation came in 1986 during the Reagan administration. That effort took several years to successfully negotiate and pass. The Republicans optimistically hope to have a final bill passed before the end of this year or in early 2018. Given the many tradeoffs that will have to be made between the parties and within the Republican Party itself, successful passage has at best a 50/50 shot, in our opinion and in that of many strategists. While markets seem more optimistic, we expect progress and setbacks during the negotiation process to produce volatility in a market that has shown the historically lowest volatility on record. A failure to pass any tax cut, or to pass one that will have limited impact, would likely result in a negative reaction from markets given that expectations have been raised about the significant positive impact the current proposals would have on corporate profits.
Tax Cuts or Not, Economy Should Continue Expansion
That said, we believe the economy will continue to expand despite a tax-cut disappointment. It is our constant refrain that events that do not have an outright negative economic impact generally do not lead to a recession. A tax cut would be an incremental benefit to economic growth, but at this point a tax change remains in the realm of expectations. A failure of expectations in this case would almost assuredly roil markets, probably prompting the first significant correction in stock prices in over a year. But disappointed expectations would not necessarily hurt the economy, except if corporations respond by taking actions that hinder growth and consumers retrench. One risk is that without tax cuts, corporations will pull back on capital spending, thereby curtailing spending on equipment and impairing the long-term potential of the economy.
On the more immediate horizon, third-quarter earnings are about to be reported, and sales and earnings are expected to be up 5% and 4%, respectively. As in recent quarters, we anticipate that these numbers will actually prove a bit low because analysts tend to be overly conservative prior to earnings releases, resulting in positive earnings surprises. We don’t anticipate the third quarter to be as strong as the second quarter, especially given the probable negative impact from the spate of hurricanes that wracked Texas, Florida, Puerto Rico and other Caribbean islands. But they will almost assuredly be positive, continuing their multiquarter uptick. If we are correct, this continuation of earnings growth will support stock prices by encouraging corporations to invest in capital and labor, thereby sustaining economic growth.
The next three to six months could prove trying for markets, but as long as global growth remains firm, U.S. growth continues at its average 2% pace, inflation does not accelerate quickly and the Federal Reserve does not raise rates too fast or too much, this expansion could continue for some time.
1Strategas Research, Daily Notes, “Broad-Based Expansion Evident,” October 4, 2017.
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.