Equity markets surged in 2017, with the S&P 500 gaining 20.8% and the Dow Jones Industrial Average climbing 25.1% (reaching more new highs – 71 total – than any in its history). Technology stocks played the starring role , with the S&P 500 Technology Index lapping everyone else with a whopping 38.8% return. With an economy seemingly going from strength to strength, a puzzle was the lack of inflation and a flattening yield curve – long-term treasury yields fell over the year despite three rate hikes by the Federal Reserve. Also curious was small-cap under- performance – the Russell 2000 Small-Cap Index rose 14.7% in 2017, quite a ways behind its large cap counterparts.
As always, we shy away from making forecasts and predictions. The previous year ended with President Trump signing into law a tax bill that significantly restructures the US tax code, especially on the corporate side. So the big question is what will be the impact of this, and that is where we begin.
The Trump administration came in promising a more attractive landscape for US businesses via tax reform and a drastic reduction in regulations. One could argue that animal spirits were indeed unleashed in the business world and the stock market. Business confidence, especially on the small business side, surged to record levels in 2017 and PE multiples expanded. Business spending was rising at a pace close to 8.0% (year-over-year) as of November 2017 , which is the strongest pace of growth since April 2012 – though some of this may be due to a base effect (low numbers a year ago).
Corporate tax cuts will certainly raise the level of cash on corporate books but it remains to be seen whether businesses will use excess cash to boost spending over and above current trend (which is already strong). Or if the result will be increased M&A activity, buybacks, dividends and/or debt repayment. More broadly, the new tax bill adds several new layers to the existing base (as opposed to scrapping the prior tax code altogether). Provisions governing international taxation are among the most significant, with potentially huge implications – so the full impact of the tax bill may not be known immediately. Over the years multinationals have spent millions restructuring themselves to minimize tax liability, and so they are unlikely to make sudden drastic changes.
The promised regulatory rollback has not really materialized to a large extent. Only a handful of existing regulations have actually been eliminated , mostly due to rules that prevent policy from swinging wildly back and forth every four (or eight) years. However, the fact that no new regulations are forthcoming may be an under-appreciated factor in boosting business confidence, and if anything, 2018 may see even more of this. We will be watching to see if this translates into higher business spending.
The lack of wage growth, and more broadly inflation, remains a puzzle. Wage growth was higher in 2016 (2.9% year-over-year) than in 2017 (2.5% year-over-year), despite the unemployment rate falling to 4.1% by the end of 2017. The pace of job growth also slowed in 2017, reflecting a tighter labor market – 2017 saw 2.1 million net jobs created, compared to 2.2 million in 2016, 2.7 million in 2015, 3.0 million in 2014 and 2.3 million in 2013. One would expect wage pressures to show up as this trend continues.
Inflation also saw a slowdown in 2017 – core inflation, excluding food and energy, was rising at pace of 1.5% as of November 2017 compared to 1.9% at the beginning of the year. Federal Reserve officials maintained that the lack of inflationary pressure in 2017 was a result of transitory factors, like falling cellphone plan prices. However, our research indicates that the slowdown was broader. The question is whether this is likely to change, especially in the face of disinflationary effects like demographics and even online purchases – like ‘ the Amazon effect ’, which provide consumers online platforms to price-shop and limits the ability of retailers to raise prices even in the face of rising demand. To top it off, e-commerce share of retail is only growing and so the effect is unlikely to subside.
Despite inflation coming in below target, the fact that the unemployment rate continues to fall keeps the Federal Reserve on their projected policy path. They met their forecast of three rate hikes in 2017 and stayed true to that. They forecast three more rate hikes in 2018, based on their baseline assumption of approximately 2.5 percent GDP growth.
What will be interesting is if GDP growth actually edges closer to the 3 percent mark in 2018, perhaps due to a boost from tax cuts. This would in all likelihood drop the unemployment rate further below the committee’s forecast of 3.9 percent for 2018. One can easily envision a scenario in which committee members start to worry about an overheating economy, especially if inflation also picks up (their forecast for 2018 is 1.9 percent), and perhaps include a fourth hike to slow things down. Additionally, concerns about financial stability in the wake of overly accommodative monetary policy could also bias members towards tighter policy than they currently forecast.
Of course, as the Federal Reserve looks set to tighten policy and raise rates on the short end of the yield curve, the question on a lot of investors’ minds is whether the yield curve will invert by the end of 2018. Yield curve inversion, coupled with tighter monetary policy, is a high probability recessionary signal. Essentially, the question boils down to whether we will see yields on the long end of the curve move up in tandem with short-term rates.
Despite forecasts of rising long-term interest rates since 2013, yields have consistently fallen over each of the past four years. Our own work has shown that external demand, especially from Europe – which faces negative yields and a shortage of safe assets – exerts downward pressure on yields. With the Federal Reserve looking to hike rates, even as monetary authorities in Europe maintain status quo (or even mild tapering), the yield differential between U.S. and European rates will probably increase. So the situation is unlikely to reverse quickly.
We have written about how the Trump administration would like to completely rewrite the terms on which the US trades with its partners. Administration officials laid down a tough line during recent NAFTA renegotiations, rolling out a controversial set of proposals that shocked Canada and Mexico. These include higher domestic content for autos, restricted access for Canada and Mexico to the US government procurement market, changing the dispute settlement mechanism (companies use this to take legal action against foreign governments that undermine their investments ) and auto-termination of the agreement after five years unless all three countries renew the pact (a sunset clause) – all of which are opposed by Congress as well as the business and agricultural community, let alone Canada and Mexico. The high-stakes negotiations are set to continue in 2018.
The Trump administration also initiated a Section 301 investigation into Chinese trade practices, especially those around intellectual property. Section 301, from the Trade Act of 1974, allows the US to impose trade barriers on countries if they engage in unfair practices – the US. used it successfully in the 1980s to pry open Japanese markets but has not employed the tool since WTO was created in 1995. It remains to be seen what the investigation will conclude – however, in the event that the trade representative recommends tariffs, or even blocking China’s access to certain US markets, one could expect a swift retaliation from the Chinese. The irony is that even if China relents on some of its practices, this would only make it easier for companies to invest in China, thereby increasing the problem of outsourcing.
The probability of NAFTA falling apart and/or a trade war with China may be low but it is not insignificant. The consequences, especially unintended ones, for the global economy if countries revert to a protectionist stance in response to the US could be severe.