Investment Outlook

The US tax plan has moved a bit closer to reality. Approval of such a plan should mean slightly better growth prospects for next year, implying a possible upward revision to the Fed’s growth and employment outlooks. Meanwhile, the second estimate of Q3 GDP suggests even stronger growth momentum than had previously been believed, though Q4 moderation seems likely. Political momentum behind the tax reform has been building and, if passed, could imply a Q4 slowing would be short-lived.

Both House and Senate have passed their respective versions of the Tax Cuts and Jobs Act, making it reasonably certain we will get a package of tax cuts early next year. While this should provide a modest boost to economic growth and inflation next year, such legislation could be a longer term drag if not structured carefully. There are a few key differences between House and Senate version, perhaps most significant being the timing of the corporate tax cut.

Actually, with real US growth going forward probably a little softer than headlines have suggested, a positive jolt from prospective tax cuts could be a timely positive since there is still room for such a pickup in US growth; particularly given the pickup in real global growth. A lower tax rate attracts capital investment and business here, boosting productivity and real wage growth. We very much need big-picture fiscal management, including long-term entitlement programs. Debt to GDP probably matters most and we need pro-growth, pro-investment fiscal policy to address these areas.

The US economy has been in a bit of slowing as recent strength has resulted more from temporary factors like a narrowing trade deficit and increase in inventories; fiscal policy could be a timely positive. US monetary policy should remain focused on gradual monetary normalization. A flattening yield curve will tell the tale should the Fed be perceived as moving (normalizing or tightening) too fast. Importantly, falling unit labor costs raise questions about any interest rate hike cycle; revisions suggest they are the weakest since 2010 with unit labor costs unexpectedly falling 0.7 YOY in Q3, following the productivity increase.

Unit labor cost is the ratio of workers’ compensation to their productivity, which itself showed the biggest quarterly gain in three years. Unemployment near historic lows and economic growth ticking higher would normally put some degree of upward pressure on wages. Many economists are scratching their heads at this point—probably including some policymakers.

It is increasingly clear that the issues of modified tax or fiscal policy can become quite complicated as affected parties become acquainted with the detail of proposed changes; efforts to achieve such changes over short periods can become politically challenging at a minimum, suggesting perhaps more work than had been expected. Current economic conditions are still relatively balanced and given improving global growth, could well continue amid a relatively unchanged fiscal and gently normalizing monetary policy.

Parenthetically, the ISM service index remains well above its average of the last several years, consistent with healthy GDP growth. And while the ISM manufacturing index weakened a touch last month, a weighted average of the two business surveys is still consistent with annualized GDP growth of around 3.5%, possibly reflecting expected pro-investment tax changes.

Record global corporate earnings certainly reflect global recovery. The biggest winners of the GOP tax plan are, initially, corporations. It is likely they will respond to the spectre of global demand by investing their tax gains in capital equipment—boosting employment and productivity amid an ultimately normalizing, broader monetary and fiscal policy.

It is interesting that much discussion around the prospective tax reform is whether such a pro-growth fiscal move will pay for itself. The budget estimates by the Congressional Budget Office are based on a 1.9% growth rate. If the economy were to grow more like 2.5% as a result of the $1.5 trillion 10-year tax reform, it might pay for itself. Parenthetically, the American economy actually grew by an average of 3.4% from the end of WWII through 2008, raising the prospect that a more pro-investment fiscal policy could normalize or return us from the so-called “secular stagnation” that has become the new normal taking advantage of global growth.

Monthly payroll growth was healthy supporting the as-expected Fed rate moves; however, the most interesting component of the employment report was the continued sideways movement of wage growth. Actually, real wage growth is probably the best since the 1990’s because inflation is structurally low. Parenthetically, there is no obvious imbalances at the household level that could elicit a recession. Household deleveraging is ongoing and net worth at a record high without a credit-based multiplier.

Stay tuned.

Douglas J. Robbins

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