By: Francis P. Rybinski, CFA, Chief Macro Strategist D. Harris Kere, CFA, Investment Strategist
The See-Saw Years
Before President Trump was elected, we had believed that the current expansionary cycle would likely start coming to an end by the second half of 2019 and in 2020. Now, after substantive pro-growth tax reform, we believe this cycle could extend into the next decade, with one caveat – the Federal Reserve.
These are the see-saw years, where the economy is balanced between late-cycle fiscal stimulus on one side and the potential for tighter-than-expected monetary policy on the other. As lower tax rates and wider deficits add inflationary heft to the recovery, the Federal Reserve may react with tighter policy, trying to tilt the economy back.
This natural tension is not likely to end in a perfect balance; see-saws rarely do. Investors should be prepared for the ups-and-downs. To help, we present our latest macroeconomic and interest rate forecasts, the main risks to these forecasts, and key implications for positioning in credit markets.
For all of 2017, our 2018 real GPD growth forecast was 2.5%, with the risks to that forecast skewed to the downside. We were above consensus, based on expectations that any tax cuts would be unfunded, creating stimulative fiscal policy. The final tax reform legislation had larger deficits than we had initially forecast, and thus we have raised our 2018 GDP estimate to 2.75%. Given the pro-growth fiscal stance and emphasis on de-regulation, the risks to our current forecast are skewed to the upside.
First, we believe believe the consumer will continue to anchor economic activity. With growing disposable income and gains in household net worth, the American shopper could fuel faster GDP growth.
Second, changes in the corporate tax rate and structure will likely accelerate capital investment, particularly in the near term, but not necessarily over the long term. The following reforms may improve capital intensity relative to labor, which has fallen noticeably off-trend as illustrated in Exhibit 2.
- Capital Expensing – Changes to the expensing tables will likely stimulate investment now, as property, plant, and equipment (PPE) can be fully expensed for the next five years. After that, the tax advantages dwindle on a sliding scale to zero by 2027.
- Research & Development – Currently, R&D can be fully expensed in the tax year it occurred. This remains the case until 2021, when it will switch to a five-year amortization schedule (which, incidentally, is not supportive of future productivity growth in the out years and beyond).
While we still believe that structural factors have driven the real neutral federal funds rate lower, we now anticipate the terminal funds rate will be 2.5%, below the Fed’s median longer-run rate forecast of 2.75%. We expect a total of four hikes by the end of 2019—either two per year for the next two years, or possibly three this year and one next year. Any more hikes would, in our opinion, start to constrain economic activity and risk tipping the economic see-saw.
Further out the yield curve, we expect an upward drift in the 10-year US Treasury yield to 3.0% this year and next. However, yields could certainly range above 3% over that time, as the bond market digests the fact that the terminal rate has been reached.
The Phillips Curve—which describes an empirical, inverse relationship between unemployment rates and wage growth—remains a dominant paradigm in central banking. Despite being deeply entrenched in the Fed’s reaction function, the prevailing low unemployment and low inflation environment have many academics and policy makers questioning the Phillips Curve’s validity. Notably, the San Francisco Federal Reserve looked at the relationship between wage inflation and aggregate price inflation and concluded that the “weak forecasting power of wages for prices suggests that unexpectedly high or low inflation could occur regardless of the recent behavior of wages.”
While we expect inflation will rise cyclically this year and next, we believe there are persistent, structural headwinds keeping inflation rates low.
- Technology is disrupting traditional supply chains and business models. For example, well-established consumer goods firms must deal with falling average prices for their products as firms like Amazon change the retail landscape.
- Demography affects prices in two distinct ways: (1) older workers are on the downside of their productivity curve, and (2) older consumers have different consumption patterns (lower aggregate demand).
- Flexible labor markets and the decline of labor unions both hinder labor’s ability to extract wage increases. Union participation has been on a secular decline for years, now accounting for just over 10% of the total workforce (versus a high of 25% in 1970), and only 6% of the private workforce (all-time low).
The next upcycle
Whenever this current business cycle ends, elements of the tax reform legislation could help build a sound foundation for the next upcycle. A few examples include:
- Lower corporate taxes and a territorial tax system both should increase American business’ global competitiveness; the former lowers hurdle rates for attractive projects while the latter reduces the incentive for tax inversion deals. In general, lower taxes also could spur competitive pricing (which is good for consumers) as some of the margin gains from lower taxes could be used to improve market share.
- Limiting interest deductibility is akin to raising taxes on leverage, and should therefore reduce the credit risk from leverage buyouts. Conversely, it provides an incentive to use equity capital, which is naturally more oriented with long-term growth than debt capital. There will clearly be a transition period for affected corporations, but when they come out on the other side, lower leverage profiles should be beneficial for the high yield market.
- Repatriating profits at a friendlier tax rate ought to enable companies to bring resources back into the country for more efficient uses. Some examples include stock buybacks and dividends payouts, new capital expenditures, mergers, acquisitions, or to shore-up underfunded pension plans.
Overweight Credit Risk
A favorable US growth outlook, inflation in check, and a continued global search for yield should support the domestic credit market, and we remain overweight credit risk relative to interest rate risk, with a modest preference for HY over IG. However, we expect modest spread tightening and we believe meaningful investment results will likely be derived from minding idiosyncratic risks and exploiting opportunistic situations that occur in stressed parts of the credit market.
EM vs DM: Keep going with the flow
Our forecasts describe an environment that is quite favorable for emerging markets and supports a core macro thesis of ours—outlined in a 2016 paper titled “Go With the Flow” —that the growth differential between emerging market (EM) and developed market (DM) countries would begin to widen, in favor of EM. A widening growth differential is price-supportive of EM assets, as higher relative growth will encourage new investment flows. Since we don’t foresee a recession on the near-term horizon, risk-off capital flows from EM are unlikely to materialize anytime soon. As such, we continue to believe in our macro relative value asset allocation thesis from early 2016, which favored emerging markets over developed markets, both in local currency credit and equity.
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