Investment Outlook

Global economic recovery continues, though at different paces, and central banks seem more confident. European political concerns should ease with the Macron victory though while signs of progress on healthcare legislation could boost confidence here the tax reform outlook remains murky. Significant questions remain about the Senate vote, meaning limited healthcare and tax reform could be year-end or even next year. The likely budget reconciliation process suggests a transformative and potentially erratic environment for local governments and healthcare providers should something like AHCA move forward. It’s noteworthy that as potentially stressful as those issues are, markets seem largely stable and focused on existing economic progress. The employment report and other data this week seem supportive of the notion that recent US economic slowing was transitory. Modest wage growth, a relative soft spot in April, was offset by an increase in employment and hours worked while the ISM indexes suggest Q2 rebound. The Fed seems on that tack too. The economy seems “well-anchored” to a 2% growth trajectory even after the 0.7% Q1 dip given healthy balance sheets, low nominal rates and labor markets generating enough income to support trend growth.

It is likely that long-term rates will be under upward pressure as we go forward given the gradual improvement in US and global economic growth. The normalization of Fed policy, meaning we get a gradual reduction of the Fed’s Treasury and mortgage portfolio together with a rising Fed funds target rate, should place upward pressure on the term structure of interest rates, if markets perceive the Fed’s timing is right. The introduction of much anticipated fiscal policy stimulation should place additional upward pressure on the structure of interest rates, particularly if such fiscal stimulation is not seen as offset by increased government revenues, a likely scenario at least early on. New supply of longer-dated Treasury bonds to finance such policy moves should place most of the upward pressure on longer dated bonds as that’s where most of the new supply will be on a relative basis, i.e., relative to outstanding supply. Financing for fiscal policy growth could eventually come from modification of long-term entitlement programs, something that could eventually ease Treasury borrowing needs but only after the likely, lengthy policy debate over priorities. If markets perceive Fed policy normalization as being premature relative to the economic outlook, the yield curve would tell the story by flattening or even inverting, a negative economic signal and something not likely on any near-term basis.

The economic outlook has taken an interesting ride, beginning in November with initially high expectations that the new Washington would be able to agree on and enact significant fiscal measures including tax cuts and infrastructure spending largely financed by changes in healthcare, to realization that such changes would be very difficult in the new political environment, at least for now, on the scale originally expected. The economic outlook and interest rates have reflected these dynamics in a fairly dramatic way, with rates initially moving much higher, then lower as the growth outlook returned to post-Recession, new normal, levels. Expectations were too high, and have become more reasonable from an investment standpoint. We are still likely to get needed fiscal change, but it will likely take time particularly now. The Fed’s policy talk has changed, from defending foot-dragging on normalization, or rate rise, as they looked through elevated expectations relative to the reality of still moderate growth and excess capacity post-election and Q1, to the opposite: getting ready to defend additional steps toward policy normalization amid reduced economic expectations the Fed believes were exacerbated by one-off Q1 negatives.

Quarter one was certainly a victim of seasonal measurement problems and weather. The Fed’s policy statement noted that the Q1 slowing was expected to be “transitory.” After all, nearly eight years after the Great Recession ended, unemployment is at a low 4.4% while key sectors of the economy from home sales to consumer confidence and the stock market appear healthy, not to mention a softer dollar and narrow junk bond spreads. Still, consumer spending and factory output have slowed and inflation remains below the Fed’s target. The Fed clearly views the economy as moving through a soft-patch, acknowledging household spending rose “only modestly” they added that “the fundamentals underpinning” consumption growth “remained solid” and business spending “firmed”, an improvement from six weeks ago when business fixed investment “appeared to have firmed somewhat.”

The Fed’s take that inflation was simply running just below 2% with and without food and energy is interesting given six weeks ago they noted “inflation has increased in recent quarters.” Essentially, the Fed seems to believe the economy is finally at a point where more predictable lead/lag relationships between monetary policy and inflation are back. Cleveland Fed President Mester said in a speech last week that the Fed must remain “very vigilant” against falling behind in any necessary policy normalizing, especially given the low level of interest rates and the large size of the Fed’s balance sheet; that monetary policy effects the economy with long and variable lags, policy actions need to be taken before the policy goals are fully met. The question for 2H 2017 may well be whether the Fed will allow inflation to spend time above 2% to make up for the last several years.

The economic future has everything to do with improving business investment, productivity and wage growth and Washington could be on this path. Meanwhile, consumers appear set to spend again. The economy is close to a normal ebb and flow; we could see something toward the kind of pro-business investment people have anticipated since November. Recent productivity data, lowest in a year, suggest business waiting until they see the kinds of legislative progress so widely anticipated, or signs thereof. Productivity growth is key to improving growth.

Business and infrastructure investment can source productivity and the kind of economic growth that we haven’t seen in this post-Recession cycle. Although orders to US factories turned in the weakest performance in four months, business investment is showing signs of life. American manufacturers continue to enjoy an export recovery as the dollar stabilizes and major overseas markets post stronger growth. Parenthetically, China’s internal leverage crackdown is just beginning to bite and their regulatory fortitude is actually an important global macro issue. If they push hard enough it could delay Fed tightening. China’s bond market is now showing a negative yield curve, suggesting caution.

This has been a generally uninspired post-Recession secular expansion, perhaps best distinguished from its 1930’s cousin by a Federal Reserve that grasped what was unfolding and quickly moved from tightening to accommodation. Growth in this recovery has largely been uninspired, absent obvious excesses. Now, signs of possible fiscal improvement together with US companies reporting the best quarterly profits in five years, support a positive outlook. A generation of renters are now buying, the nation’s infrastructure needs investment and core CPI inflation has softened over the last three months while retail sales remain steady but unspectacular. Periods of low volatility can be a calm before the storm but this economic calm could last a long time.

Douglas J. Robbins

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