Investment Outlook

The recent healthcare “thud” has diminished some of the positive outlook that sprung from our Fall election results. And to an extent, some of those positive sentiments were perhaps overdone. The economic outlook for this year was constructive before the election, and it still is. The growth outlook was constructive and is, perhaps, even more so now. Economic fundamentals appear sound. This underlying economic reality is taking place even with the inevitable political noise emanating from Washington. We could still get results, on healthcare and fiscal policy, but it is likely to be in terms of smaller steps, later this year or next. Meanwhile, Chair Yellen said that the US economy is recovering and the job market has improved since the recession, yet pockets of persistently high unemployment remain a policy challenge. This would suggest a gradual course in any policy normalization. It is now that fiscal policy, clumsy though it may be, should stumble its way toward economic support, enhancing the economic outlook.

Certainly, disappointment that the GOP was unable to agree on a healthcare bill raised questions about the overall Republican agenda. However, markets could increasingly be of a view that it is better to get the healthcare debacle out of the way for now to address corporate taxes, something that might garner more Party cohesion. Congress will still need to address the revenue side of any fiscal change, suggesting perhaps smaller undertakings in healthcare and tax repair, at least for now. Importantly, we likely do not need the pro-growth fiscal agenda for 2017 to be one of the best growth years since the Recession. Fiscal policy changes can best be thought of in a 2018-19 context.

Beside consumer confidence, the ISM business sentiment reports have been strong, near cycle highs, supporting an above trend growth forecast, even assuming a lackluster Q1 growth profile. Moreover, export orders surged to the best in four years, a leading indicator of US export strength in the quarters ahead. Still, business investment depends on non-farm business output, not changes in business sentiment. Moreover, the ISM report, consistent with other recent surveys on manufacturing activity, has not translated into an acceleration in manufacturing output of the same scale. Softening in economy-weighted ISM service and manufacturing index to a five-month low suggests the election sentiment is fading and slowing hard economic gains. As Bradley Holcomb, head of the ISM survey has said, these surveys are often all about attitude rather than fundamentals, and the November election spurred expectations. Favorable tax policy may be necessary to support these expectations and foster growth. Investment spending follows activity, a necessity for productivity growth. It stems from growth in output and changes in the effective cost of capital. Economic growth this year should be moderate, picking up in 2018 when tax cuts drive activity and investment.

The current economic expansion could surpass the decade of the 1990’s in length if not underlying strength. The reality of healthy balance sheets, especially those of banks, after our moderate eight-year expansion suggests an economy’s ability to expand despite shocks to the system, political or monetary. Continuing negatives, potentially divergent fiscal and monetary policies, bank lending constraints, global excess supply and a huge debt overhang could limit growth above the long-term trend. While political realities could limit longer-term growth for now, there are signals Washington’s key players are likely to find that working together on fiscal solutions is in everybody’s interest. Further, some measure of healthcare system repair is likely a necessary precondition to coming together on any meaningful fiscal policy and tax reform. There is some talk of making healthcare reform and tax cuts part of an upcoming 2018 Budget Reconciliation Bill which could make bipartisan support easier since there is far more room for compromise. This likely begins with passage of a 2017 fiscal year continuing resolution and focus on the task at hand, not an alienating social agenda. Parenthetically, the Chair of the Senate Banking Committee just suggested they would “go slow” and nibble at Dodd Frank legislation reforms. Slow and nibble might get things done. If there is no legislative progress this year, economic growth should remain moderate, especially given global growth, while monetary policy should continue on a moderate path.

The synchronized upswing in the global economy continues. For the first time in years, major regions seem to be improving together. The US economy is approaching full employment and a closing output gap. However, with consumption the primary driver, GDP growth may still come below consensus. Acceleration could be expected into next year with some measure of fiscal support (tax cut and infrastructure), though longer term breakout growth would need productivity growth not yet on the screen. Continued 2% GDP growth appears likely for now, while equities appear fairly valued to the profit outlook. Recent surveys on manufacturing activity have highlighted strong momentum since November, yet this has not translated into an acceleration of manufacturing output of the same scale. The flow of robust US survey data continues unabated; now to get it translated to growth.

JP Morgan CEO, Jamie Dimon, is reported to have written to JPM shareholders that, even if the US is “truly an exceptional country,” probably stronger than ever, “something is wrong—and it’s holding us back.” He goes on to say that the US has been growing more slowly in the last decade or two with lower real median household incomes and a shrinking percentage of middle class households. He offers a number of practical causes and solutions, including investment for productivity growth amid excessive student loans and health care costs, low labor force participation, and excessive regulatory environment.

The yield curve shows growth is still a worry. While like all market indicators, the yield curve is subject to the “ebb and flow” of investor sentiment, a flattening curve gets special investor attention. A flattening curve generally reflects a perceived risk of slowing growth, where monetary policy is seen as perhaps tightening prematurely. However, marginal runoff of the Fed’s portfolio, a step toward normalization, could be a curve steepener over time. Importantly, the Fed’s two big observations at their March meeting—the economy is at or near full employment and apparent softness are an apparition. The pace of hourly earnings and not the jobs total are therefore most important from the Fed’s perspective.

Douglas J. Robbins

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