The US economy is recovering momentum, effectively becoming a more traditional expansion with business investment beginning to lead the way. Housing is beginning to reflect maturing millennials while a gradually tightening labor market, growing global competition and fiscal policy spur a ramping up of capital spending. Wages and prices will begin the more traditional, though still moderate, upswing—moderate because deflating influences from globalization, tech innovation and changing demographics are factors. Domestic US firms compete with foreign firms’ cheaper labor and borrowing costs, fostering downward price pressure, at least at the margin. The tax package, already having a positive impact, seems unlikely to achieve a significant re-allocation of business investment from abroad. Still, the boost in business sentiment from stronger growth and success of a major legislative initiative is a positive for market confidence.
Synchronized global growth amid subdued inflation is the broad global prospect. Indeed, the main concern going forward is likely central bank policy. The Fed has raised rates while signaling a preference for letting fiscal stimulus pass through to economic activity, with little offset from monetary policy for now given expectations for at least two, maybe three, rate increases down the road. Monetary policy in the US and EU are still bent toward expansion and a gradual policy normalization, i.e., “less loose” but not tight, not yet, perhaps not for a while. The bond yield curve will continue to be an important indicator about how markets are assessing the wisdom of Fed policy and, as we know, a flattening curve draws attention as perhaps the market’s traditional signal of suspected policy drag; the Fed would probably prefer to see a curve erring on the side of some steepening, signaling markets expecting an improving economy, thus giving them a little more policy room.
A fairly positive macroeconomic scenario would seem likely for this year, as economic conditions prevailing in H2 of last year should in all likelihood continue, at least for a good part of the New Year. Equity performance should be driven largely by earnings growth with relatively little multiple expansion, if any. Valuations are arguably above average, largely because of unusually low interest rates. Fading QE distortions will perhaps allow markets to assess distortions in interest rates and thus related valuations. Policy risks and an ensuing, unnecessary bond tantrum could be a factor as the year progresses. Meanwhile, risks for equities would seem balanced even after last year’s powerful rally, leaving perhaps a more subdued yet “benign” central case. Again, policy would seem to be the risk. Indeed, the Fed minutes suggest they are unsure of the economic boost from the Trump tax cuts. Gradual policy normalization is in order. Geopolitical risk is of course a factor and must be monitored.
Parenthetically, strength in consumer and business spending is clearly responsive to expectations of a positive fiscal policy. The consumer seems to have “partied harder” than expected during the holiday season, leading one to speculate about remaining demand and “firepower” given the “plunge” in the consumer saving rate since July. A similar case can be made regarding business investment spending as well as the negative impact of a flattening yield curve on short-term borrowing. The rebound in December’s ISM manufacturing index leaves it close to a 13-year high, at a level that “historically” has been consistent with GDP accelerating to more than 4% in annual terms. Indeed, the upshot in consumer spending and business investment data could be suggestive of a 3% Q4 GDP. Again, these surveys have been influenced by the prospect of fiscal stimulus, so it’s possible a good part of the fallout has happened; however, it could still be suggestive of a healthy H1.
There is still a Fed view that “much of the softness in core inflation this year reflected transitory factors.” Not surprisingly, inflation has become the most important economic variable steering the Fed’s policy right now. While the Administration believes its economic program of tax cuts and deregulation will boost economic growth to a sustained rate of 3%, the Fed is projecting growth of 2.5% this year, up from the earlier forecast of 2.1%; however, it then foresees growth slowing to 2.1% and 2% in 2019 and 2020.
If the outcome of the December FOMC meeting was a touch more dovish than expected, the just released minutes of the December FOMC meeting “tack” back toward a bit more hawkish side. The minutes would seem to suggest the Fed sees policy risks as indeed balanced. The majority of participants expect further cyclical improvement to push inflation higher and that gradual rate increases remain appropriate. Adherence to this approach is viewed by markets as appropriate. Global markets rallied on signs the global economic expansion that pushed benchmarks to records last year remains intact. Positive US payroll numbers continue to show the growth story and markets are reflecting this. Tax reform is probably having its maximum market benefit now.