by Gene D. Balas
When creating any outlook, one must necessarily consider a range of potential outcomes since there is, of course, more than one plausible trajectory the markets and economy could follow. With that caveat in mind, the following is one possible trajectory the economy could follow, though any forecast is obviously subject to risk in either direction.
Analysis of Market and Economic Conditions
In this possible trajectory:
The market is positioned for an outcome with: moderate, yet strengthening, growth and an increase in inflation.
Interest rates globally are currently suppressed by central bank actions, such as by the European Central Bank, which is seen with interest rates relative to expected inflation being close to zero for longer term Treasuries and which is negative relative to actual inflation for the Fed funds rate.
Lower interest rates than what we might expect present a conundrum. Either:
real rates must rise (though rates are currently suppressed by central bank actions),
inflation fails to match investors’ expectations (see Cleveland Fed research that indicates inflation is unlikely to rise above 2%), or
growth is so tepid there is little demand for credit in the private sector.
The most likely of these three hypotheses is a combination of the first two: real rates rise, but inflation expectations fall from current levels as inflation increases, but does not quite meet market expectations (as measured by market-based metrics).
Netting these two out, that still leaves nominal rates higher compared to where they are now. There is some risk that yields could spike even higher, placing investors at significant risk (see my blog post here). A mitigating factor to that risk is that central bank suppression of rates is likely to continue, as the ECB pledged to keep its bond purchase program in place through the end of 2017.
Note that the Cleveland Fed’s model for inflation is for it to be just 1.6% in each of the next three years, versus 2% that Fed officials themselves see. This supports the view that inflation may be less than what Fed officials believe, supporting the market’s view that inflation will be 1.8% over the next five years per TIPS breakevens. Thus, lower inflation expectations may offset somewhat higher nominal interest rates further out on the yield curve.
Inflation Forecasts | 2017 | 2018 | 2019 |
Average of Cleveland Fed’s models | 1.6 | 1.6 | 1.6 |
Survey of Professional Forecasters (median) | 1.9 | 2 | n.a. |
Fed officials’ views (median) | 1.9 | 2 | 2 |
More on Inflation
The market expects more inflation over the next five years than it did just a month or two ago, as the election results changed investor thinking. Note the five year breakevens below:
Evidence is lacking that a low unemployment rate, by itself, is sufficient to substantially increase inflation, or that deficit spending on infrastructure or tax cuts will accomplish the same.
Will infrastructure spending and tax cuts boost economic growth? One factor is they might not approved by Congress. Another factor is that any increase in interest rates (e.g., from substantial deficit spending, etc.) can cause the stimulus to act as its own brake. Still, even if not enacted in full, some measure of a tax cut can have a stimulative effect on the economy, especially if a component would allow businesses to repatriate profits from abroad and invest more at home.
More investment is arguably a more likely outcome of a low unemployment rate and competition for qualified labor than is a surge in inflation. As the President-elect has pledged to punish companies who offshore jobs and production, in order to make production here more inexpensive, corporations need to make it more efficient. That can allow these companies to generate higher profits and greater production with a less-than-proportional increase in the number of hours worked by employees. In turn, that allows companies to remain relatively competitive on prices and still potentially pay their employees more, particularly if they still need to coax workers off the sidelines and back into the labor force.
The Role of Productivity
Productivity is enhanced by pairing gains in technology and better equipment with labor, which is different from the image of a single employee producing ever more toasters on an assembly line.
So, couple potential infrastructure investment from the new administration with capital spending by businesses on equipment and technology, the end result benefits the industrials, technology and materials sectors in the short term.
This is likely even if Trump’s infrastructure plan is scaled back, and any reversal in these sectors as Congress debates spending and tax plans may create buying opportunities in the coming year. However, care must be taken to avoid overpaying for these sectors.
Over the longer term, business investment in equipment and technology may improve productivity, which can increase worker pay relative to inflation, benefiting consumer discretionary stocks.
And what is the other likely outcome?
Greater productivity benefits companies’ cost structures, meaning that inflation is likely to remain under control, even with low unemployment.
A return to a positive term premium as central bank actions eventually fade means higher real rates, especially if there is more demand for credit and use of capital by companies making these investments. However, lower inflation than currently forecast by the markets may offset some of this increase in rates. And the Fed may not feel quite as much of a need to aggressively tighten rates if wages don’t surge dramatically in the near term.
The Final Caveat
The qualification to this outlook is that the big variable in this scenario is time: it takes a while to plan and then implement new investments and for them to pay off, more time than might be evident in market movements between now and then. As such, for these theses to pan out, patience is required. And by then, a completely different scenario may have begun to take hold. Investing always requires not just patience, but vigilance as well.
Disclosure
Investing involves risk, including possible loss of principal, and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this piece is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances.
The information and opinions expressed herein are obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital. Opinions expressed are current as of the date of this publication and are subject to change. Certain statements contained within are forward-looking statements including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties. Indices are unmanaged, do not consider the effect of transaction costs or fees, do not represent an actual account and cannot be invested to directly. International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and different accounting methodologies.
