Highlights:
· The recently enacted Tax Cuts and Jobs Act increases the probability of the continuation of an already very long domestic economic expansion. However, the long-term effects on economic growth, wages and the deficit will likely not be known for some time.
· New Fed Chair Jerome Powell would likely prefer to continue Former Fed Chair Yellen’s policy of gradual interest rate increases and balance sheet reduction, but will have to monitor stagnant wage growth and inflation closely.
· Europe and Japan are following the roadmap provided by the U.S. with ultra-loose monetary policies that should moderate the negative effects of U.S. monetary tightening on global equity markets.
· The re-elections of Prime Minister Abe in Japan and President Xi in China should bode well for a commitment to economic policies in those countries.
Commentary:
“Death, taxes and childbirth! There’s never any convenient time for any of them.”
-Margaret Mitchell, Gone with the Wind
This joke seemed appropriate coming out of a quarter dominated by a push by the GOP to enact major tax reform that ultimately resulted in the Tax Cuts and Jobs Act. It will take some time to flush out many of the changes enacted by this new legislation, but for now, it is reasonable to conclude that pro-business tax cuts are likely to enhance the chances of continued domestic economic expansion. U.S. Corporations are likely to benefit from these tax cuts in the form of improvements in earnings and levels of free cash flow. Further, the tax cuts should improve the competitive stance of domestic firms globally. What is less certain is whether these tax cuts will boost growth, create jobs and drive up wages for the middle class as promised by President Trump or if most U.S. corporations will simply turn over most gains from these tax cuts to their shareholders.
If tax cuts do significantly improve economic and wage growth and kick-start inflation, that might prompt the Federal Reserve (Fed) to raise interest rates at a faster pace. In 2017, the Fed delivered on their projections at the start of the year to raise rates three times plus to begin shrinking their large bond portfolio. Former Fed Chair Janet Yellen had previously indicated that another year of gradual rate increases and balance sheet reduction was the plan for 2018, a plan that new Fed Chair Jerome Powell would likely prefer to adhere to if employment and inflation reports cooperate. As we have noted in previous reports, wage growth and inflation remain stubbornly soft despite strong job growth and corporate earnings. If consumer incomes do not rise fast enough to sustain growth and consumers start to lose faith in the credibility of the Fed’s inflation objective, they are likely to resist paying up for goods and services. This would likely cause companies to avoid handing out wage increases, creating a vicious circle that can constraint the Fed from lifting inflation, which has been under 2 percent for most of the past five years.
Thus, Fed Chair Powell will face the same dilemma as his predecessor – raise rates too fast and risk cooling the stock market and holding inflation below the central bank’s target; raise rates too slowly and risk creating an equity market bubble that is likely to create problems down the road.
By demonstrating the success of monetary stimulus, the U.S. has provided a roadmap that other countries have followed, but with long and variable lags. Japan started full-scale monetary stimulus in 2013, five years after the Fed. Europe did not begin enacting quantitative easing until March 2015, lagging the Fed by seven years. In many emerging economies, monetary stimulus and economic recovery only began last year. This has resulted in business cycles and monetary policy being less synchronized than in previous global expansions.
While the Fed is raising interest rates, Europe and Japan are planning to keep theirs near zero for the near future. This should moderate the negative effects of U.S. monetary tightening on global equity markets. While U.S. corporate profits have been rising for seven years, the cyclical upswing in profits outside the U.S. have only recently entered the sweet spot of their investment cycles with strongly rising profits and very low interest rates. Indeed, the Eurozone is enjoying its strongest growth in a decade and, unless wage growth unexpectedly accelerates, has a high propensity to remain in a prolonged period of low-inflationary expansion just like the U.S. Likewise, following his re-election in October, Japanese Prime Minister Shinzo Abe re-affirmed his commitment to an ultra-easy monetary policy. Mr. Abe will continue to face pressure to increase stagnant wage growth and overhaul a labor market that is characterized by a rapidly aging workforce and productivity that trails other leading nations. Nevertheless, Japan’s economy is in the midst of its longest growth streak in 16 years and its stock market hit a 25-year high during the fourth quarter.
Similarly, Chinese President Xi Jinping was extended a second five-year term during the quarter and given expanded powers to implement substantial long-term policy initiatives. Mr. Xi’s empowerment endorses the continued shift of China’s economy away from export-driven manufacturing and toward domestically focused consumer goods and services. Consumption now accounts for approximately two-thirds of China’s economic growth. Mr. Xi emphasized that his administration will continue to prioritize economic development over other policies in his second term. This would be welcome news for other emerging markets countries who are currently benefiting from a combination of strong global growth, stabilizing commodity prices and improving domestic fundamentals.
The duration of the current bull market in global stocks has investors around the world wondering if a bear market is overdue. However, expansions do not just die of old age. Rather, bull markets are typically brought down by the bursting of asset bubbles, oil price spikes, government austerity, a credit crunch, shocks like natural disasters or political upheaval, or errors by central banks. Aside from one of these unforeseen events, the conditions that have promoted equity prices the last several years -reasonable economic growth, strong corporate earnings, low inflation and accommodative monetary policy - remain in place. A downturn will inevitably come, but as always, we emphasize that predicting the markets is not a fruitful exercise. We continue to suggest that remaining disciplined in one’s commitment to equity exposure is a more rational and sustainable long-term investment strategy than trying to guess the highly variable discounting mechanisms of the market.
Urban Financial Advisory Corporation - January 2018