Market Outlook: 4Q18
We find ourselves in the unusual situation where the Fed is tapping the brakes with monetary policy while Congress is stepping on the gas with fiscal policy. It appears that fiscal policy is winning.
Mojo Workin’
While the US stock market couldn’t get out of its own way for the first half of the year, in the third quarter investors got their mojo back, sending the S&P 500 up 8% for the quarter and 11% for the first nine months of 2018.
A variety of factors came together to restore investor confidence. Trump’s bark and his bite on trade proved less damaging (so far) to the economy than initially feared. The effects of last December’s Congressional tax legislation began to register throughout the US economy, with plunging unemployment and accelerating growth. And China took aggressive measures to stimulate its economy, which had begun to falter.
So what you had, in effect, were the world’s two largest economies—the US and China—both of which had been decelerating in 2017, simultaneously applying huge amounts of stimulus to their economies.
When Will It End?
As we’re now in the longest bull run in stock market history—having outlasted the bull that ran from October 1990 to March of 2000—everyone is wondering when it will end. That, in itself, is a positive for the markets. If everyone’s wondering when it will end, they’re not fully committed and have buying power held in reserve—which represents future demand for stocks. As the old saying goes, bull markets climb walls of worry.
That said, whatever your estimate of when the bull market will end, the stimulative measures undertaken by China and the US have extended it.
The Classic Model
Historically, bull markets end when the Federal Reserve raises interest rates sufficiently to slow the economy and risk tipping it into recession. The Fed does this to quell the inflation that an overheating economy generates.
The stock market sniffs this out six to twelve months in advance and starts to decline.
As we know, the Fed has been raising interest rates very gradually since December of 2015. It has done so not to quell inflation, but to bring rates back to a more normal level after keeping them artificially low for seven years following the Great Recession. Still, rising rates are rising rates, which makes all forms of borrowing more expensive. This generally slows consumption by making mortgages and purchases on credit more costly. As consumption accounts for roughly two-thirds of the US economy, if you slow consumption, you slow the economy. And this has weighed on investors’ confidence about the longevity of the current bull market in stocks.
An Unusual Divergence
Generally, the Fed’s interest rate (monetary) policy works in harmony with Congress’s fiscal policy, which governs federal spending—they tend to be expansive or restrictive together. This time, not so. We find ourselves in the very unusual situation where the Fed is tapping the brakes with monetary policy while Congress is stepping on the gas with fiscal policy. And it appears that fiscal policy is winning.
The tax reform Congress passed last December will have a powerful effect on the economy. It’s estimated the fiscal stimulus provided by the new tax law will add 1.2% onto the US economy’s growth rate in 2018 and 1.6% in 2019. As the US economy’s inflation-adjusted growth rate has averaged around 2% over the past decade, these are big increases in the pace of growth in the US.
We’re seeing this in a plunging unemployment rate that just hit 3.7%—lowest jobless rate since 1969. Perhaps even more importantly in the long run, we’re seeing it in surging capital investment by newly more-profitable companies. And, yes, we’ve heard the skeptical claim that all companies will do with their greater profits is buy back their own shares, benefiting shareholders and management but nobody else. It’s simply not the case. In the second quarter of 2018, US companies invested 23% more in capital equipment than they did in share buybacks.
Why Capex Matters
Capital investment or “capex” (for capital expenditure) matters because an economy can only be as productive as its equipment—the stuff you make things with. As every business owner knows, if you don’t expand your physical plant, your IT equipment, your tools, etc., then there is a limit to how much your business can grow. And if you don’t invest to maintain your equipment and it deteriorates, then your business will shrink.
This is pretty much what US corporations have done for the past decade or so: Let their capital equipment age. The result in the US has been plummeting productivity and sluggish economic growth. Surging capital investment, if sustained, should lead to surging productivity growth and a faster baseline pace of US economic growth.
What Could Go Right?
If we’re entering an era of sustained reinvestment in the capital stock of the US economy, and thereby a secular era of greater productivity and faster economic growth, we should expect three unusual outcomes: First, an economy with more productive equipment will need to hire more people to run it, pushing the unemployment rate even lower. Second, a more productive economy with better wages will increase the participation rate of eligible workers in the actual workforce, as is already happening. That is, there are unemployed people sitting on the sidelines not looking for work, who are not counted in the official unemployment rate. Some will start looking for work again.
So, third, as the demand for workers rises so will the supply of workers. And that means that wage inflation won’t overheat as soon as it would if the supply of workers was stable. As wage inflation typically leads to more general inflation down the road, the rising supply of workers joining the workforce should help keep inflation contained in general. And that would help keep the Fed calm and allow the bull market to run further than many expect.
What Could Go Wrong?
That said, we shouldn’t forget the fact that this boom in corporate capital investment is being financed by the US Treasury, as the lost corporate tax revenues Congress surrendered with their tax cuts have caused the federal budget deficit to explode. It’s now projected to exceed $1 trillion next year. In 2016 it was $585 billion.
This is clearly unsustainable but follows a formula long employed by the Republican Party: Run up huge deficits with tax cuts and fiscal spending—usually on defense spending and/or wars—and then campaign to slash social benefits like Medicare and Social Security in order to bring the deficit back under control. Reagan did it. The second Bush did it. And now Trump’s doing it.
How this will be resolved is a political question and we’ll have more insight to that a month from now. But the way we should resolve it, in our opinion, is to leave the new corporate tax rate roughly where it is, maybe a few points higher, but pay for those lower corporate tax rates with progressively higher personal income-tax rates, which is how Germany, the UK, Japan and other developed economies structure tax policy.
We think the corporate tax cut rationalized a screwy corporate tax system, which incentivized all sorts of tax-dodge schemes and made US firms less competitive with foreign firms on an after-tax basis. And we do think the broadly distributed, positive outcomes described above are realistic possibilities. But the wealthy need to pay for them, not the poor and the aged for whom federal programs like Medicare and Social Security are lifelines.
Farnum Brown, Chief Strategist
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