by Mark Bern, CFA
Estimates Rising
The range of forecasts for Q2 (quarter 2) GDP growth is
huge. The lowest forecast found by the
Wall Street Journal Quarterly
Forecasting Survey this June was 2.9% and the highest was 4.2%, with
the average at 3.58%. But forecasts
have moved higher recently because of a shrinking trade deficit and
higher than expected consumer spending.
As of June 27th, Macroeconomic Advisors, said to be provide
the most detailed forecast on Wall Street, predicted an increase of 5.3%. GDPNow, provided by the Atlanta FED, is
predicting 4.5% and the NY FED’s NowCast
is calling for only 2.9% growth.
Q3 and Q4 forecasts range broadly by the averages were about
3.05% and 2.9%, respectively. These
forecasts are likely to be raised as well.
But if those older predictions turn out to be close and the more modest
rate of 3.6% for Q2 becomes reality the average for the full year will be about
2.94%, which would be the highest full-year rate of growth since the financial
crisis. If, on the other hand, the more
recent forecasts are closer to what will become reality, then the full-year GDP
growth rate would turn out to be about 3.2% (this would include the lower rates
for Q3 and Q4). Now, if Macroeconomic
Advisors is right (and theirs was the best estimate on record for all of 2017)
the rate could be 3.5%, assuming Q3 and Q4 also surprise to the upside by a
little (about .2% per quarter). My best
guess is 3.3% for 2018.
Less or More for 2019
& 2020?
Most economists believe that the economy will slow in 2019
and 2020. I agree, but with a caveat; I
do not believe it will slow as much as most.
The reasoning goes like this: the USD gets stronger and exports go down
leading to an expanding trade deficit, consumers will be tapped out because
wages are frozen and credit is already too high, the impetus of tax reform will
reduce over the next two years and asset prices are too expensive (stocks,
bonds, real estate) so in order for valuations to normalize prices will need to
either fall or remain relatively flat which could undermine future expectations
and limit spending by both consumers and businesses.
The above position assumes that the Trump Administration and
Congress do nothing for the next two years.
I have to say, based upon the last year and a half, I expect much more
to come from Washington DC. Of course,
if the Democratic Party can gain control of one or both houses of Congress then
those other pundits could be right. I am
not making a prediction, per say, but I don’t think the numbers are
advantageous for the Democrats in the Senate.
They must defend 26 Senate seats to 9 for Republicans. And, while all House seats are being
contested the majority to overcome is considerable: 235 Republicans to 193
Democrats and 7 seats vacant. Five of
the resignations were by Republicans with two being Democrats, but two of the
Republican seats are in strong Republican districts and unlikely to turn. That may give Democrats a one seat potential
advantage in the races for vacant seats.
They would need to turn 41 other seats to gain a majority. Again, no prediction, but by the numbers it
looks like a tough uphill battle. So, I
expect the Republicans to retain control of both houses and keep moving
legislation to improve the economy.
The other thing that most economists must be assuming is
that trade negotiations will go nowhere and will result in either the status
quo or a full out trade war. Again, my
baseline expectation is that the rhetoric coming from the White House is more
negotiating tactic than real. However, I
do believe that if China decides to call his bluff the President is likely to
turn the screws tighter with real action in order to force the issue. In the end, I think both the U.S. and China
will find a way to make some headway toward leveling the trade barriers more
evenly (still to China’s advantage, but less so than the present) while saving
face for Xi Jinping, China’s leader. If
I am right, then the U.S. economy is likely to get another boost by 2019 and
into 2020. That is in sharp contrast to
most forecasts. So, I believe that GDP
may trend lower slightly but remain at or close to 3.0% and I will not be
surprised if, assuming there is no trade war, to see some quarterly GDP growth
numbers closer to 4%.
US Dollar Strength
The U.S. dollar (USD) is strengthening against other major
currencies as the FED continues to raise interest rates while the ECB (European
Central Bank) and BoJ (Bank of Japan) carry on with their easier monetary
policies. The USD is also gaining due to
the strength of our economy relative to other developed countries.
This could, in fact, hurt exports of U.S. goods if nothing
positive results from trade negotiations.
On the other hand, if trade negotiations realize at least some positives
those losses could well be offset through better access by U.S. companies to
foreign markets from which they are currently blocked from doing business. As a matter of fact, with less costly
regulations and lower taxes American companies may actually be able to compete
much better in some of those markets on price and quality. So, the reality could be much less black and
white with some improvements offsetting the negatives of a stronger dollar and
the trade deficit could actually improve more.
Wage Stagnation
Once again, the assumption is nothing changes. The problem with that view is that unemployment
is at its lowest level since 2000 at 3.8% and it has not been that
low any other time since 1971. There are
now more job openings than people out of work in the U.S. Yes, many of those unemployed either do not
have the desired skills or are unable/unwilling to move for employment. At some point in the relatively near future,
wages will rise and consumer incomes will begin to catch up with rising
inflation. It always happens, but this
time has been delayed due to greater global competition, lower labor costs
overseas, lower tax rates overseas, less costly regulation overseas and trade
barriers that keep U.S. companies from competing.
When we add in the improvements in automations and robotics
(not to mention Artificial Intelligence) U.S. workers are becoming more
competitive. Our workers are already
more productive and, when we add machines to improve that productivity even
more, combined with lower corporate costs for regulations and taxes, we are
heading for another period of rising wages in the U.S. as well as improving
competitiveness. With that renewed
competitiveness, American companies will be able to capture market share
(again, assuming lower barriers on imports in foreign markets similar to those
applied in the U.S. currently) and export more.
But with that rising demand will come a rising need for more employees
and a need to retain skilled workers.
That will lead to higher wages and more business/public funding for
training programs to teach those capable of learning the new skills needed to
fill the jobs. It could also lead to
relocation bonuses for those who could otherwise not move.
American business can figure out what it needs to do to
leverage its new-found advantages to create increased demand and it can also
figure out what it must do to fill the jobs to increase production. Part of the solution is highly likely to take
the form of rising wages.
Also, many major retail chains have developed new policies
to systematically raise the wage rate of all their workers including Wal-Mart
and Target. Others will follow or lose
good employees. And such movement will
not be contained to just retail and low wage work. It will spread across the economy at all
levels. In the end, consumers will find
themselves to keep spending as incomes rise.
Impact of Tax Reform
I will grant you that the initial impact of tax reform will
slow over 2019 and 2020 compared to 2018.
In Q1 corporate earnings were up an amazing 25% over 2017. That cannot continue even over the course of
the full year but it will remain elevated at least in the mid-double digit
levels. But remember that this is the
average increase across all companies, good and bad. That includes many companies that are losing
money. So, the improvement in earnings
of the really great companies with strong growth will be much higher than the
average. In the end, quality companies
will continue to post strong earnings growth throughout the rest of 2018, and
many (quality companies) will be above the 20% level of increase compared to
2017.
The thing is that I believe that trade negotiations will
improve, not hurt, the U.S. economy in the end.
There may be some difficult quarters in between, but the end result
should be additive to both top and bottom lines for American businesses. And, as long as the tax reform rates remain
in place, that means that the impact of rising profits before taxes due to
increased sales will continue to rise at a faster pace than in previous
years. So, the impact of tax reform will
remain positive for several more years, in my humble opinion, just maybe not
quite as significant as in the current year.
If corporate earnings only rise 12% in 2019 and 2020 it would still be a
huge win for U.S. companies and their investors.
Asset Prices
Asset prices for all three major classes of assets,
equities, bonds and real estate are expensive today on a relative basis
compared to historical levels. But if
wages grow those home prices will become more affordable as long as interest
rates don’t go too high. Stock P/E
(price to earnings) ratios will come down if stock prices rise more modestly
than increases in earnings. Bond prices
will eventually fall as interest rates continue to rise. As long as the economy continues to grow at
nearly 3% instead of the 2% average experienced since 2009, there is a strong
probability that asset prices will normalize without falling (except for
bonds).
All my arguments above are my own opinion of what could
happen and there, of course, are no guarantees of anything. There are risks in every forecast. Just I have pointed out the many risks of
assumptions held by most economists, my own assumptions are at risk of being
off the market as well.
The two main events that could derail my expectations are a
huge Democratic win in the fall elections which would mean a return to gridlock
in government again; and a prolonged trade war with China and possibly
Europe. If either of those two events
occurs my forecasts will be out the window.
But my sense, after many decades of watching the markets, the economy
and the political scene tells me that neither of those events are above a 30%
probability. So, I will continue to
invest selectively.
Respectfully,
Mark Bern, CFA
Bern Factor LLC
540-241-1963
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