GDP growth came in a bit below expectations on Friday, but reaffirmed the broader strength of the U.S. expansion.

Solid growth, amidst a tight labor market, remains an encouraging sign for the future health of the economy and of stock markets. While some may worry that a recession must be just around the corner, given the length of this recovery and expansion, we see room for further growth and, possibly, even some modest acceleration.

 

Recessions are devilishly hard to predict and, disappointingly, even hard to explain in retrospect.  This is likely because no two recessions are exactly alike, and so we have very little repeat experience (and data) upon which to build robust models of recession dynamics.  One area of research into recessions attributes some downturns to adverse “productivity” shocks, a catch-all phrase for any decline in GDP not attributable to changes in labor or capital stocks. Most economists agree that the lengthy recession of the 1970s, as one case in point, was triggered by OPEC’s oil embargo, which caused a sharp rise in global oil prices. This, in turn, led to sharply higher energy costs for manufacturers, service providers and households in the US. Here was a perfect example of a negative “productivity” shock. In response, firms cut costs where they could, including laying off some workers, while households reduced spending. The result? An economy-wide drop in economic activity.

 

In 2018, we face a very different situation created by two important changes in the economic landscape, one very recent and another from a few years ago. First, the U.S. continues to benefit from the sharp drop in oil prices in mid-2014: West Texas Intermediate (WTI) saw its price drop sharply that year, and even after bouncing off its mid-2015 bottom, remains nearly 50% lower today than it was from 2011-2014.  Just as costlier oil can crimp economic activity, less costly energy provides an immediate boost to profits and can trigger new capital investments—especially by chemical and other manufacturers that depend heavily on energy as an input. And within the energy sector, investment rebounded after oil prices came off the lows of 2015 and in the wake of further technology improvements in extracting shale oil and gas.  Oil production will soon exceed 10 million barrels/day, and the U.S. has become a net exporter of natural gas.  Lower-for-longer oil prices have likely provided a nice tailwind to economic activity beginning in 2014.

 

Second, corporate tax rates have been significantly reduced. Like cheaper energy, a lower tax rate falls into the category of a positive “productivity” shock. Moreover, both of these improvements in economic fundamentals are likely to be long lasting. The reduction in the corporate tax rate is unlikely to be reversed regardless of the outcomes of the midterm and subsequent elections The lower tax rate allows firms to take the same amount of inputs and turn them into greater (after-tax) profits. Firms have stronger incentives to hire more people (more about our tightening labor market later) and to invest in more productive capacity, while households have more disposable income to spend. It looks very much like our post-recession expansion has had new life breathed into it.

 

But all is not rosy in the U.S. outlook.  The current administration is considering changes to international trade arrangements and has already imposed tariffs on imports in areas where imports were deemed to have caused harm to U.S. producers. In its efforts to promote U.S. industry, negotiations may very well lead the U.S. to abandon NAFTA. This is happening when we are already seeing rising global commodity prices—from precious metals to pulp. Restrictions on imports would raise costs for many firms that rely on imported raw materials and intermediate goods (most obviously, the auto sector), and would raise prices for many consumer goods, impinging on household budgets. Friday morning, President Trump in his speech from Davos noted that he preferred bilateral trade agreements, a clear nod to his intention to reduce trade deficits with certain countries (such as China).  Trade deficits are not bad things for a country and attempts to reduce them are counterproductive.  All of us run “trade deficits” with our favorite grocery stores; we “import” more goods from them than we “export” to them. Yet we would surely be worse off if government stepped in to reduce such trade deficits by imposing extra taxes (“tariffs”) on Whole Foods’ broccoli and bananas. We would indeed run smaller deficits with Whole Foods because we would buy fewer of those items as a consequence of the now-higher prices. But we wouldn’t be better off for it. There are several aspects of NAFTA that need to be updated, but a wholesale dissolution of the agreement would be bad news indeed.

 

The U.S. economy is also facing a challenge from the tightness of its labor market. Unemployment is hovering around 4.1%, so there simply are very few people available for firms to hire. Wages are rising and will likely continue to do so. That, alone, isn’t such a bad thing—it puts more money in consumers’ pockets—and firms, by virtue of lower energy costs and taxes, have the money to spend.  But higher wages will eventually feed into prices and prompt higher inflation and so higher interest rates. That will raise the cost of capital for firms. This has already begun and will continue almost certainly this year—the market is expecting two rate hikes. For now, though, interest rates and the cost of capital remain cheap by historical standards. Eventually, rising wages, inflation, and interest rates will curtail further expansion as firms reduce investments in new capacity. The U.S. economy could use an influx of labor, so hopefully, upcoming reforms to immigration will increase our labor supply, rather than constrain its growth. Recent negotiations look to be pointed in the right direction, but we’ll have to wait to see.

 

The stock market is forward looking so these two semi-permanent positive “productivity” shocks should be expected to continue to increase firm valuations. Profit margins are expanding and are likely to continue to do so as the full effects of the tax cuts kick in this year and next. Oil prices are unlikely to spike higher any time soon. Provided trade policy and immigration reforms are well managed, we see some room yet for valuations to expand.

 

GDP growth came in a bit below expectations on Friday, but reaffirmed the broader strength of the U.S. expansion.

Solid growth, amidst a tight labor market, remains an encouraging sign for the future health of the economy and of stock markets. While some may worry that a recession must be just around the corner, given the length of this recovery and expansion, we see room for further growth and, possibly, even some modest acceleration.

 

Recessions are devilishly hard to predict and, disappointingly, even hard to explain in retrospect.  This is likely because no two recessions are exactly alike, and so we have very little repeat experience (and data) upon which to build robust models of recession dynamics.  One area of research into recessions attributes some downturns to adverse “productivity” shocks, a catch-all phrase for any decline in GDP not attributable to changes in labor or capital stocks. Most economists agree that the lengthy recession of the 1970s, as one case in point, was triggered by OPEC’s oil embargo, which caused a sharp rise in global oil prices. This, in turn, led to sharply higher energy costs for manufacturers, service providers and households in the US. Here was a perfect example of a negative “productivity” shock. In response, firms cut costs where they could, including laying off some workers, while households reduced spending. The result? An economy-wide drop in economic activity.

 

In 2018, we face a very different situation created by two important changes in the economic landscape, one very recent and another from a few years ago. First, the U.S. continues to benefit from the sharp drop in oil prices in mid-2014: West Texas Intermediate (WTI) saw its price drop sharply that year, and even after bouncing off its mid-2015 bottom, remains nearly 50% lower today than it was from 2011-2014.  Just as costlier oil can crimp economic activity, less costly energy provides an immediate boost to profits and can trigger new capital investments—especially by chemical and other manufacturers that depend heavily on energy as an input. And within the energy sector, investment rebounded after oil prices came off the lows of 2015 and in the wake of further technology improvements in extracting shale oil and gas.  Oil production will soon exceed 10 million barrels/day, and the U.S. has become a net exporter of natural gas.  Lower-for-longer oil prices have likely provided a nice tailwind to economic activity beginning in 2014.

 

Second, corporate tax rates have been significantly reduced. Like cheaper energy, a lower tax rate falls into the category of a positive “productivity” shock. Moreover, both of these improvements in economic fundamentals are likely to be long lasting. The reduction in the corporate tax rate is unlikely to be reversed regardless of the outcomes of the midterm and subsequent elections The lower tax rate allows firms to take the same amount of inputs and turn them into greater (after-tax) profits. Firms have stronger incentives to hire more people (more about our tightening labor market later) and to invest in more productive capacity, while households have more disposable income to spend. It looks very much like our post-recession expansion has had new life breathed into it.

 

But all is not rosy in the U.S. outlook.  The current administration is considering changes to international trade arrangements and has already imposed tariffs on imports in areas where imports were deemed to have caused harm to U.S. producers. In its efforts to promote U.S. industry, negotiations may very well lead the U.S. to abandon NAFTA. This is happening when we are already seeing rising global commodity prices—from precious metals to pulp. Restrictions on imports would raise costs for many firms that rely on imported raw materials and intermediate goods (most obviously, the auto sector), and would raise prices for many consumer goods, impinging on household budgets. Friday morning, President Trump in his speech from Davos noted that he preferred bilateral trade agreements, a clear nod to his intention to reduce trade deficits with certain countries (such as China).  Trade deficits are not bad things for a country and attempts to reduce them are counterproductive.  All of us run “trade deficits” with our favorite grocery stores; we “import” more goods from them than we “export” to them. Yet we would surely be worse off if government stepped in to reduce such trade deficits by imposing extra taxes (“tariffs”) on Whole Foods’ broccoli and bananas. We would indeed run smaller deficits with Whole Foods because we would buy fewer of those items as a consequence of the now-higher prices. But we wouldn’t be better off for it. There are several aspects of NAFTA that need to be updated, but a wholesale dissolution of the agreement would be bad news indeed.

 

The U.S. economy is also facing a challenge from the tightness of its labor market. Unemployment is hovering around 4.1%, so there simply are very few people available for firms to hire. Wages are rising and will likely continue to do so. That, alone, isn’t such a bad thing—it puts more money in consumers’ pockets—and firms, by virtue of lower energy costs and taxes, have the money to spend.  But higher wages will eventually feed into prices and prompt higher inflation and so higher interest rates. That will raise the cost of capital for firms. This has already begun and will continue almost certainly this year—the market is expecting two rate hikes. For now, though, interest rates and the cost of capital remain cheap by historical standards. Eventually, rising wages, inflation, and interest rates will curtail further expansion as firms reduce investments in new capacity. The U.S. economy could use an influx of labor, so hopefully, upcoming reforms to immigration will increase our labor supply, rather than constrain its growth. Recent negotiations look to be pointed in the right direction, but we’ll have to wait to see.

 

The stock market is forward looking so these two semi-permanent positive “productivity” shocks should be expected to continue to increase firm valuations. Profit margins are expanding and are likely to continue to do so as the full effects of the tax cuts kick in this year and next. Oil prices are unlikely to spike higher any time soon. Provided trade policy and immigration reforms are well managed, we see some room yet for valuations to expand.

About the Author

Dr. JoAnne Feeney

Dr. JoAnne Feeney

Dr. JoAnne Feeney is a Portfolio Manager and a member of the investment committee with Advisors Capital Management, LLC (ACM). Prior to joining ACM, Dr. Feeney was senior equity analyst for more than 10 years at boutique sell-side firms including...
About the Author

Categories

Archives