Unwrapping the Present
A wrapped present is always an object of optimistic speculation. When I was very young, in the days leading up to Christmas, I would shake the presents under the tree, making some very unreasonable assumptions about both the affections and the finances of my various uncles and aunts. I always smiled when I tore the presents open – even then I knew it was impolite to do otherwise. However, as I got older, my expectations became more reasonable and my disappointments less severe.
Since the election, U.S. investors have, at times, manifested an almost childlike faith in what the unopened box of policy change might mean for the stock market. In the week ahead, some of the wrapping paper will be torn off, potentially setting the stage for disappointment.
More specifically, the next week should provide us with some insight on the three key issues shaping the U.S. investment environment: monetary policy, fiscal policy and the economy to which these policies are being applied.
On the third issue, data due out this week should be revealing.
Fourth-quarter GDP is likely to be revised up, reflecting more strength in retail sales and inventories than was initially reported. Numbers on real activity for the first quarter should also look a bit more positive, with potentially strong gains in January Durable Goods orders and Pending Home Sales on Monday, and equally impressive strength in Manufacturing PMI data, due out on Wednesday. However, readings on the consumer may be less upbeat, with a slight retrenchment in Consumer Confidence on Tuesday as well just moderate January Consumer Spending numbers and February Light-Vehicle Sales on Wednesday. Unemployment Claims should follow their recently extremely low path, confirming that the labor market is essentially at full employment.
Perhaps most significantly, the Personal Consumption Deflator could hit 1.9% or 2.0% year-over-year for January, achieving the Fed’s long-elusive target of 2% inflation. On Wednesday, the current economic expansion will enter its 93rd month, making it the third longest expansion since the civil war. While this is a very positive milestone, it remains a stubbornly slow expansion and shows no sign of near-term acceleration.
Various Federal Reserve communications this week, including the Beige Book and speeches by Chair Yellen and Vice Chair Fischer, could note recently stronger readings on inflation. These communications will likely sound somewhat hawkish, if only to foster expectations that the Fed could well hike rates on March 15th and thus allow the Fed to do so, if it wishes, without shocking the market.
Most important for the market, however, will be the President’s address to Congress on Tuesday night. The speech itself is unlikely to be detailed in terms of policy proposals. However, it will be important to see how optimistic the Administration is about the economic outlook and how willing it is to boost the deficit in an attempt to fulfill the President’s campaign promises.
The new Treasury Secretary has argued that changes in tax policies and regulation could boost real growth to a sustained pace of 3%. The problem with this is that the economy is essentially at full employment. Boosting demand in the economy, without increasing the economy’s potential to provide more goods and services, would primarily lead to higher inflation and interest rates.
Lower corporate taxes and less regulation could help boost potential GDP growth some. However, it is crucial to recognize the extent of the challenge. Over the past decade the economy has achieved just 1.3% real GDP growth, reflecting weakness in both labor-force and productivity growth. Unless the former can be boosted through higher immigration or the latter can be increased through much higher capital spending, maintaining growth at 2% would be an achievement and sustaining growth at anything close to 3% seems highly unlikely. Moreover, policies that had the effect of curtailing either trade or legal immigration would almost certainly make the problem worse.
The budget situation is also very difficult. According to CBO forecasts, under current law, the federal debt will rise to almost 89% of GDP by 2027 from 77% of GDP today. These forecasts are based relatively optimistic assumptions of 2% real growth, unemployment that never exceeds 5% and 10-year Treasury yields that never exceed 4%.
Tax cuts and spending increases would clearly worsen these numbers. Moreover, if the Congress adopts significant fiscal stimulus to try to boost demand in the economy, the result would likely be a hotter economy, inducing the Federal Reserve to raise interest rates faster, increasing the cost of servicing the national debt and thus worsening the fiscal problem.
The President’s words will be important – equally, important, however, will be the response of House and Senate Republicans.
A congressional adoption of both economic optimism and very expansionary fiscal policy could have negative implications for the bond market. If, conversely, congressional Republicans take a more conservative stance in opposing both optimistic economic assumptions and unfunded tax cuts and spending increases, the stock market may have to abandon its hope of dramatic stock-friendly policy change, threatening the post-election rally.
Even without a policy boost, the stock market still has the potential to move higher. However, investors would be wise to temper their hopes for a surge in U.S. stock prices and recognize that strong gains from here will require both broader global diversification and a more parsimonious approach to security, sector and asset-class selection.
Chief Global Strategist