Most of the sentiment measuring surveys posted dramatically higher results after the election on optimism over what a Trump Administration might do for the economy. But, there is a big difference between hope and reality. Beginning in mid-December, the U.S. equity markets shifted into neutral, and have slowly drifted lower, perhaps waiting for the political changeover. The Fed is now in tightening mode. In my experience, the Fed tightens and a bear market begins in bonds when the economy is overheating and there is inflation on the horizon.
The Skeptic
So, call me a skeptic, but I don’t see either robust economic growth or inflation ahead! This doesn’t mean I think there is a recession on the horizon. But, much of the hard data still pegs the U.S. economy at a growth rate below 2.5%. The World Bank just forecast that real GDP growth in the U.S. in 2017 would be a mere 2.2% (coming off 2016’s 1.6% growth rate) and the International Monetary Fund’s forecast is a similar 2.3%. There are some positive signs around, as the regional Fed activity indexes are all pointing to rising manufacturing activity, and claims for new unemployment insurance have reached lows not seen in decades. But the latter is likely because businesses can’t find qualified employees, so they hold on to who they have. But, we are in the eighth year of the current business cycle, quite old by any standard, and, despite record fiscal and massive monetary stimulus, we haven’t had a year of 3%+ real GDP growth.
Inflation
We continue to see little cost pressure from the labor markets. It is clear that the world has significant overcapacity in many areas – just look at U.S. Retail. The holiday sales results from Macy’s Kohl’s Sears, and Target were poor. And observe the empty spaces at U.S. malls and strip centers. The capacity utilization rate in the U.S. is 75%, at recessionary levels. We have had several years of capex underinvestment. China has such overcapacity in heavy industries (iron and steel) that they dump the resulting excess goods in the U.S. at prices below free market producers’ costs (a Trump campaign issue).
The Fed – Demographics and Productivity
But, perhaps the biggest reason for my skepticism comes from the Fed’s own economists. Those who regularly read my blogs know that I believe that demographics and lagging productivity have been significant issues impacting potential economic growth in the developed world (Japan, U.S., Europe). Last October, three Fed economists (Gagnon, Johannsen, and Lopez-Salido) put out a paper entitled Understanding the New Normal: The Role of Demographics (available online). Their major conclusions:
- The U.S. and other advanced economies are undergoing dramatic demographic transformations resulting in a low labor force growth rate;
- Such demographic factors account for a permanent 1.25 percentage point decline in real interest rates;
- The same demographic trend also accounts for a 1.25 percentage point decline in real GDP growth potential in the U.S.
Another Fed economist, John Fernald, has studied productivity since the early 1990s. He believes that the slow economic growth we have had since the Recession was partly caused by a slowdown in productivity gains. According to the Wall Street Journal (1/6/17 Economist is Fed’s Point Man on Productivity), “Long-term economic expansion is the result of a growing workforce, investment in capital…, and then combining them in new ways to boost efficiency – an element called ‘total factor productivity.’” That “productivity grew an average of 1.8% a year from the end of 1995 through 2004, but growth has slowed since then to an average of 0.5% annually.” Fernald’s research leads him to conclude that productivity is unlikely to bounce up in the near-term.
Lower taxes and fewer regulations might make a difference in this file, but one thing is for sure, any increase in productivity as a result of policy making is unlikely to occur in the next quarter or two.
Bonds
Since the election, more than $41 billion in traditional bond funds have been redeemed, and there are record short positions in the 10 Year Treasury futures markets, signs that investors believe interest rates are going to rise. Fed Chair Yellen has done nothing to dissuade such market sentiment resulting in a belief that the Fed won’t monetize any Trump deficits – thus the view that rates will rise. But, if economic growth disappoints, which I believe is a likely scenario, the Fed and market participants would have to rethink their view about rates.
Conclusions
While most of the post-sentiment indexes are riding a huge wave of optimism, the reality is that the economy is not growing at a pace that requires concerns over inflation or overheating. In addition, given the world’s overcapacity, inflation is unlikely to accelerate anytime soon. And given the age of the current cycle, we should be more concerned about recession (none in sight yet), especially with the Fed now tightening. Unless the economy surprises significantly to the upside in Q1, equity markets may have to correct from current levels. Will the markets have the patience to wait for results, if and when they occur? If they do, it will be a first. Finally, unless inflation and an overheating economy soon become issues, there won’t be a need for rising interest rates.
Robert Barone, Ph.D.
