Investment Outlook

Slow and steady is how the markets and media see economic prospects, and it’s hard to argue even amid the considerable event noise. The Q2 economy rebounded to a 2.6% annual rate, getting us back up to the tepid 2% “cruise control” into which we’ve seemed locked since 2009. Other recent, lengthy expansions have produced considerably higher growth rates but they were driven by what became recognized as excesses which ended with serious corrections. While there are questions about equity valuations today, they are nothing of the nature of the 90’s and inflation is clearly not an issue.

Some think central banks are fighting “bubbles” now, but reality is they are probably more concerned about leverage and getting ahead of asset price valuations. Slow and steady has resulted in our current, lengthy job creation, but with none of the kinds of excesses that have prompted Fed policy tightening and otherwise derailed earlier expansions. Instead, underlying but modest growth seems in place for a time, helped along by business and households, supporting corporate equity and profit growth amid low volatility.

Q2 growth was supported by private consumption and non-residential fixed investment though hampered by soft motor vehicle sales. Net trade added to growth as it appears healthy—and synchronized—foreign economic activity got together with the soft dollar since year-end to grow exports. On the negative side, personal savings were revised sharply lower for the last year or so which together with a slowdown in personal income raises downside risk to consumption.

Parenthetically, the WSJ reported that recent credit losses for credit card issuers are beginning to warn of possible reversal of a positive six-year trend there, though while the losses are rising, they are still historically low. Importantly, the losses are occurring at a time of near record-low US unemployment, suggesting at least a degree of vulnerability in any kind of correction. The low unemployment is not providing the consumer income protection that might have been expected.

Fed Vice Chair Fischer observed that political uncertainty has probably slowed US, and global, growth. This and related legislative and event risk have undoubtedly created a bottom-line drag, making one wonder how quickly the outlook might change when some sort of political joins monetary policy normalization and is able to provide appropriate, pro-investment fiscal policy. Just to have promising light at the end of the tunnel on this would be an economic positive. Tax reform is necessary for sustained 3%+ growth. Treasury Secretary Mnuchin and Economic Advisor Cohen have been meeting with 200+ members of Congress on tax issues, aimed at broadening the base of a pro-growth tax plan. Entitlement reform should be back on the table as part of a healthy, highly necessary fiscal reform. Congress must get it together. Bring back Simpson Bowles?

Details of Fed policy and portfolio normalization should begin to be clear in Q4, if not sooner. The only likely interruption of that timing could be a debt-ceiling log-jam in Congress and that is highly unpredictable at this point. It seems likely that the Fed should want to see a steeper Treasury curve as a result of their portfolio normalization runoff, but the market will make that call. The message of an ultra-flat or flattening yield curve is generally an economic negative, and the Fed will do all it can to be sure their policy is not the flattening agent. They will want a normal, market driven yield-curve as soon as possible. It helps them effect policy because it reflects the market’s call on the economy. It is natural for the Fed to want this curve normalization since it was the economic emergency and their necessary QE response to the 2009 Recession that flattened the curve. This portfolio/curve normalization should be a relatively easy undertaking, lasting for several years.

The weak dollar, driven by a cautious Fed amid a lower than expected growth and the policy breakdown in Washington has complicated things for global central banks by strengthening their currencies versus the dollar, putting downward pressure on inflation for them just when many were contemplating normalizing their policies. It’s hard to capture a breakout picture on this background.

Fiscal policy is, as we’ve mentioned, the most important but for now most uncertain component to a balanced growth outlook. Meanwhile, the Fed’s job is to anticipate where it’s going and where the risks are for creating optimal support. Right now, determining the neutral interest rate is key. How FOMC members view where the terminal neutral rate of interest is key and there is considerable academic divergence on it. How the FOMC view of neutral evolves will have important implications for where the terminal fed funds rate is in this cycle. The neutral rate is the level at which policy should be set when the economy is operating at the dual mandate of full employment and inflation.

Right now, the market seems to be pricing a sub2% terminal rate. How the terminal rate is defined will have a governing effect on Fed policy. Importantly, markets and the shape of the yield curve can help the Fed determine the accuracy of their academic work. And the market’s message becomes far more important as it reflects existing and likely supply of Treasury and related securities. Fed portfolio normalization will obviously help the process, making monetary policy more authentic and reliable in the process of normalization. The curve’s message can tell the Fed where they are or should be on policy. The Treasury curve becomes more credible with Fed policy normalization.

As mentioned, consumer income has become as or more important to markets than employment growth. Recent revisions suggest it was income that failed to keep up with spending, dropping the savings rate below 4% for the first time in a decade and creating more of a drag on growth and the outlook than had been anticipated. Meanwhile vehicle sales disappointed for the fifth consecutive month, adding to concerns about retail sales momentum. Bottom line, the apparently tightening labor markets have not benefitted consumers as expected, leaving consumers less likely to power an economic resurgence, at least for now.

The monthly jobs report reiterates a slow-and-steady GDP theme for 2H. Job growth was solid but nonetheless consistent with gradual employment slowing and soft earnings growth. Balance sheet normalization is still the Fed’s likely next move. Fiscal policy is the missing and increasingly important ingredient in the growth outlook.

Douglas J. Robbins

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