No More Plow Horse

January 23, 2018

We’ve called the slow, plodding economic recovery from mid-2009 through early 2017 a Plow Horse.  It wasn’t a thoroughbred, but it wasn’t going to keel over and die either.  Growth trudged along at a sluggish – but steady – 2.1% average annual rate.

Thanks to improved policy out of Washington, the Plow Horse has picked up its gait.  Under new management, real GDP grew at a 3.1% annualized rate in the second quarter of 2017 and 3.2% in the third quarter.  There were two straight quarters of 3%+ growth in 2013 and 2014, but then growth petered out.  Now, it looks like Q4 clocked in at a 3.3% annual rate, which would make it the first time we’ve had three straight quarters of 3%+ growth since 2004-5.

Some say a government shutdown would make it tough to get another 3% quarter to start 2018, but we disagree. Yes, some “nonessential” government workers might pull back on their spending temporarily, but there’s no historical link between government shutdowns and economic growth. 

The economy grew at a 2.8% annual rate in late 1995 and early 1996 during the two quarters that include the prolonged standoff under President Clinton.  That’s essentially no different than the 2.7% pace the economy grew in the year before the shutdowns.  The last time we had a prolonged standoff was in late 2013, under President Obama.  The economy grew at a 4% rate that quarter, one of the fastest of his presidency.      

Right now, taxes are falling, regulations are being reduced, and monetary policy remains loose.  With these tailwinds, the acceleration of growth in 2017 should continue into 2018. 

Here’s how we get to 3.3% for Q4.

Consumption:  Automakers reported car and light truck sales rose at a 16.4% annual rate in Q4, in part due to a surge after Hurricanes Harvey and Irma.  “Real” (inflation-adjusted) retail sales outside the auto sector grew at a 6.6% rate, and growth in services was moderate.  Our models suggest  real personal consumption of goods and services, combined, grew at a 3.9% annual rate in Q4, contributing 2.7 points to the real GDP growth rate (3.9 times the consumption share of GDP, which is 69%, equals 2.7).

Business Investment:  Looks like another quarter of solid growth, with investment in equipment growing at about a 16% annual rate, and investment in intellectual property growing at a trend rate of 5%, but with commercial construction unchanged.  Combined, it looks like business investment grew at an 8.8% rate, which should add 1.1 points to real GDP growth.  (8.8 times the 13% business investment share of GDP equals 1.1).

Home Building:  Given the major storms in Q3, we expected a larger pickup in home building than was realized in the fourth quarter.  But it still grew at about a 2.6% annual rate in Q4, which would add 0.1 points to the real GDP growth rate.  (2.6 times the home building share of GDP, which is 4%, equals 0.1).

Government:  Both military spending and public construction projects were way up in the quarter, suggesting real government purchases up at a 2.7% annual rate in Q4, which would add 0.5 points to the real GDP growth rate.  (2.7 times the government purchase share of GDP, which is 17%, equals 0.5).

Trade:  At this point, we only have trade data through November.  Based on what we’ve seen so far, it looks like net exports should subtract 1.2 points from the real GDP growth rate in Q4.  

Inventories:  We have even less information on inventories than we do on trade, but what we have so far suggests companies stocked shelves and showrooms at a slightly faster rate in Q4, which should add 0.1 points to the real GDP growth rate.

Some more reports on inventories and trade due this week could change our forecast slightly, assuming a shutdown doesn’t interfere with the data schedule.  But, for now, we get an estimate of 3.3%.  The US economy is confirming the optimism behind the stock market rally.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist
 

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Don’t Time A Correction

January 17, 2018

The stock market is on a tear.  The S&P 500 rose 19.4% in 2017 excluding dividends, and is already up over 4% in 2018.  It’s not a bubble or a sugar high.  Our capitalized profits model, says the broad U.S. stock market, is, and was, undervalued.

We never believed the “sugar high” theory that QE was driving stocks.  So, slowly unwinding QE and slowly raising the federal funds rate, as the Fed did in 2017, was never a worry.  But, now a truly positive fundamental has changed – the Trump Tax Cut, particularly the long-awaited cut in business tax rates.  With it in place, we think our forecast for 3,100 on the S&P 500 by year-end is not only in reach, but could be eclipsed.

Before you consider us overly optimistic, we did not expect the stock market to surge like it has so early in the year.  In fact, we would not have been surprised if the market experienced a correction after the tax cut.  There’s an old saying; “buy on rumor, sell on fact.”  So, with tax cuts approaching, optimism could build, but once they became law, the market would be left hanging for better news.

We would never forecast a correction, because we’re not traders.  We’re investors.  Anyone lucky enough to pick the beginning of a bear market never knows exactly when to get back in.  In 2016, it happened twice and we know many investors are still bandaging up their wounds from being whipsawed.

The market got off to a terrible start in 2016, one of the worst in years.  The pouting pundits were talking recession and bear market, only to experience a head-snapping rebound.  Then, during the Brexit vote, the stock market fell 5% in two days – which was seen as another indicator of recession.  But, it turned out to be a great buying opportunity, like every sell-off since March 2009.

The better strategy for most investors is don’t sell.  Some sort of correction is inevitable but no one knows for sure when it will happen and few have the discipline to take advantage of the situation.

This is particularly true when risks to the economy remain low and the stock market is undervalued, which is exactly how we see the world today.

Earnings are strong (even with charge-offs related to tax reform), and according to Factset, since the tax law passed analysts have lifted 2018 profit estimates more rapidly than at any time in the past decade.  Even the political opponents of the tax cuts are saying it will likely lift economic growth for at least the next couple of years.

Continuing unemployment claims are the lowest since 1973, payrolls are still growing at a robust pace, and wages are growing faster for workers at the lower end of the income spectrum than the top.  Auto sales are trending down, but home building has much further to grow to keep up with population growth and the inevitable need to scrap older homes.  Consumer debts remain very low relative to assets, while financial obligations are less than average relative to incomes.

In addition, monetary policy isn’t remotely tight and there is evidence that the velocity of money is picking up.  Banks are in solid financial shape, and deregulation is going to increase their willingness to take more lending risk.  The fiscal policy pendulum has swung and the U.S. is not about to embark on a series of new Great Society-style social programs.  In fact, some fiscal discipline on the entitlement side of the fiscal ledger may finally be imposed.

Bottom line: This is not a recipe for recession.

It’s true, rising protectionism remains a possibility, but we think there’s going to be much more smoke than fire on this issue, and that deals will be cut to keep the good parts of NAFTA in place.

Put it all together, and we think the stock market, is set for much higher highs in 2018.  If you’re brave enough to attempt trading the inevitable ups and downs of markets, more power to you, but as hedge fund performance shows, even the so-called pros have a hard time doing this.  Stay bullish!

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Bond Bull – Market Is Over

January 9, 2018

Bonds have been in a “bull market” for the past thirty-seven years.  Not every quarter, or every month, but bond yields have fallen consistently since Paul Volcker ended the inflation of the 1970s.

And just like any long-term bull market or bubble justifications proliferate.  The current 10-year Treasury yield is 2.46%, which equates to a 40.7 price-earnings multiple.  If the stock market had a P-E multiple anywhere near that, the nattering nabobs would be screaming from the mountaintops.

But the bond market has become the “knower of all things” – it’s never wrong according to the bulls.  Low yields are not only justified, they tell us the future.

There are three main bullish arguments.

  1. The U.S. faces secular stagnation – permanently low growth and low inflation.
  2. Foreign yields are lower than U.S. yields, so market arbitrage will keep U.S. yields from rising.
  3. The Fed is raising short-term rates which will cause the yield curve to invert, leading to recession and lower yields over time.

But there are serious issues with all these arguments.  First, it’s not true the bond market is never wrong.  In 1972, the 10-year U.S. Treasury yield averaged 6.2%, but inflation averaged 8.7% between 1972 and 1982.  In 1981, the U.S. Treasury yield averaged 13.9%, but inflation averaged just 4.1% between 1981 and 1991.  In other words, the bond market underestimated inflation in the 1970s and severely overestimated it in the 1980s.

The main reason was that the Fed artificially held down short-term interest rates in the 1970s, which pulled the entire yield curve too low.  And in the 1980s, it did the reverse, and held short-term interest rates artificially high.

The past nine years are similar to the 1970s.  The Fed has pulled the entire yield curve down, while big government (taxes, regulation, and spending) have held growth back.  Now, growth and inflation are picking up, while the Fed lifts short-term rates.  Just like in the 1980s, tax cuts, regulatory rollback, and contained government spending will disprove secular stagnation.  Fed tightening will push the yield curve up and bond yields will rise.

We’ve never believed the low foreign bond yield story.  Japanese bond yields have been near zero for at least two decades.  If international arbitrage works to bring rates together, why aren’t U.S. yields near zero (and why did Japanese bonds never move higher)?  Isn’t 20 years enough time for this arbitrage to take place?  It comes down to fundamentals.

Every country has different growth rates, different currencies and inflation, different trade flows, credit ratings, tax rates, and banking rules.  Every country is unique; why should bond yields be the same? The currency futures market signals that investors expect the Euro and Yen to appreciate versus the Dollar, which helps offset different interest rates. As we said earlier, bubbles twist logic to support the bubble, but that twisted logic doesn’t hold up under intellectual scrutiny.

This year, the Fed is on track to ratchet the federal funds rate higher in three, possibly four, quarter point moves.  With real GDP growth picking up to roughly 3%, and inflation moving toward 2.5%, or higher, nominal GDP will grow at roughly a 5.5% rate.  That’s the fastest top-line growth the U.S. has experienced since 2006.  And in 2006, the 10-year Treasury yield averaged 4.8%.

We don’t think yields are headed back to 4.8% any time soon.  Our forecast for the 10-year Treasury is 3.0% in 2018.  But, the risk is to the upside on bond yields, not the downside.  The bullish case for bonds has finally run out of steam.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Revolution

January 4, 2018

One word that could describe Donald Trump’s unexpected ascendancy to the presidency is – “revolt.”  Revolt against the “establishment.”  Revolt against the “status quo.”

After all, status quo bureaucracies, tax rates, institutions, regulations, and narratives promised prosperity, yet the economy was mired in slow growth and many felt it was hard to get ahead.  Reliably blue states tilted red, and the pendulum swung the other way.

Since 1993, the top federal tax rate on US corporations has been 35%, one of the highest in the world.  This has forced US companies to expand overseas.  Both sides of the political spectrum knew it was a problem, yet nothing was ever done.

Now the rate is 21%, and full expensing of business investment for tax purposes is law.  These changes will boost the incentive to invest and operate in the US, leading to more demand for labor, which means lower unemployment and faster wage growth, as well.  From an economic perspective, this is a revolution.

But there’s more.  We’re referring to the new limit for state and local tax deductions.  That change, combined with a larger standard deduction, will launch an overdue revolution in the policy choices of high tax states as well as the geographical distribution of business activity.    

California’s top marginal income tax rate is 13.3%.  Under the old tax system, tax payers who itemize could deduct their state income taxes from their taxable federal income.  So for the highest earners, the effective marginal rate was 8.0%, not 13.3%.  [Deducting 39.6% of 13.3% saved them 5.3%.  13.3% minus 5.3% is 8.0%.]  

Politicians in California could raise state income tax rates, and up to 39.6% of the cost would be carried by taxpayers in other states.  The same goes for New York City residents, where the top income tax rate is roughly 12.7%.

Now taxpayers are limited to $10,000 in state and local tax deductions (with a 37% top federal tax rate).  The financial pain of living in high tax states is now exposed.  California and New York City – and many other high tax jurisdictions – look a lot less attractive than states like Texas, Florida, and Nevada. 

This change may limit the measured income and wealth gap in the US between the rich and poor.  California and New York don’t just have high taxes, they also have a high cost of living.  So, if some high earners in these places leave to take lower pay in places with lower taxes and a lower cost of living, the income and wealth gap would narrow.

But incentives work on all institutions, and policymakers in high-tax states have massive pressure to cut tax rates.

Meanwhile, the Supreme Court is set to rule on Janus vs. American Federation of State, County, and Municipal Employees.  Based on a similar case from a few years ago, it’s likely the Court will rule that all government workers (state, local and federal) will have a choice to pay union dues, or not.  We know from experience that, when given a choice, many workers stop supporting the political activities of unions. This would be another force significantly altering the balance of power.

Whether you agree with these developments or not, the U.S. hasn’t seen economic policy changes like this in a long time.  The forces that support markets and entrepreneurship over government control are reasserting themselves.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist
 

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2018: Dow 28,500, S&P 3100

December 20, 2017

Last December we wrote “we finally have more than just hope to believe that this year, 2017, is the year the Plow Horse Economy finally gets a spring in its step.” We expected real GDP growth to accelerate from 2.0% in 2016 to “about 2.6%” in 2017.  Our optimism was, in large part, based on our belief that the incoming Trump Administration would wield a lighter regulatory touch and move toward lower tax rates.

So far, so good.  Right now, we’re tracking fourth quarter real GDP growth at a 3.0% annual rate, which would mean 2.7% growth for 2017 and we expect some more acceleration in 2018.

The only question is: how much?  Yes, a major corporate tax cut (which should have happened 20 years ago) is finally taking place.  And, yes, the Trump Administration is cutting regulation.  But, it has not reigned in government spending.  As a result, we’re forecasting real GDP growth at a 3.0% rate in 2018, the fastest annual growth since 2005.

The only caveat to this forecast is that it seems as if the velocity of money is picking up.  With $2 trillion of excess reserves in the banking system, the risk is highly tilted toward an upside surprise for growth, with little risk to the downside.  Meanwhile, this easy monetary policy suggests inflation should pick up, as well.  The consumer price index should be up about 2.5% in 2018, which would be the largest increase since 2011.

Unemployment already surprised to the downside in 2017.  We forecast 4.4%; instead, it’s already dropped to 4.1% and looks poised to move even lower in the year ahead.  Our best guess is that the jobless rate falls to 3.7%, which would be the lowest unemployment rate since the late 1960s.

A year ago, we expected the Fed to finally deliver multiple rate hikes in 2017.  It did, and we expect that pattern will continue in 2018, with the Fed signaling three rate hikes and delivering at least that number, maybe four.  Longer-term interest rates are heading up as well.  Look for the 10-year Treasury yield to finish 2018 at 3.00%.

For the stock market, get ready for a continued bull market in 2018.  Stocks will probably not climb as much as this year, and a correction is always possible, but we think investors would be wise to stay invested in equities throughout the year.

We use a Capitalized Profits Model (the government’s measure of profits from the GDP reports divided by interest rates) to measure fair value for stocks.  Our traditional measure, using a current 10-year Treasury yield of 2.35% suggests the S&P 500 is still massively undervalued.

If we use our 2018 forecast of 3.0% for the 10-year yield, the model says fair value for the S&P 500 is 3351, which is 25% higher than Friday’s close.  The model needs a 10-year yield of about 3.75% to conclude that the S&P 500 is already at fair value, with current profits.

As a result, we’re calling for the S&P 500 to finish at 3,100 next year, up almost 16% from Friday’s close.  The Dow Jones Industrial Average should finish at 28,500.

Yes, this is optimistic, but a year ago we were forecasting the Dow would finish this year at 23,750 with the S&P 500 at 2,700.  This was a much more bullish call than anyone else we’ve seen, but we stuck with the fundamentals over the relatively pessimistic calls of “conventional wisdom,” and we believe the same course is warranted for 2018.  Those who have faith in free markets should continue to be richly rewarded in the year ahead.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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The Fallacy of Weak Productivity

December 13, 2017

Models of the economy are pretty useful tools.  And simple models are some of the most useful.  They help people envision how the world works.  They help organize thinking.

For example, the model that says potential U.S. economic growth is determined by “population (labor force) growth” plus “productivity” is an elegant model that shows how adding workers, or having them become more productive, leads to more economic growth.

But, even an elegant model can lead people astray when the inputs are misunderstood.  As they say: Garbage in, Garbage out!

Population growth is relatively straight-forward and doesn’t change much.  It’s growing at about 0.8% per year over the last decade.  Yes, immigration and the participation rate add some complexity, but labor force growth is the easiest part of the model to deal with.

Productivity growth, on the other hand varies, and is the true key to this model.  Non-farm productivity growth, as measured by the government, has averaged slightly above 1% per year lately.  That’s slow by most historical standards.

Add these two up (Population, 0.8%) + (Productivity, 1.0%) = 1.8% growth; which is why many economists argue that the U.S. economy has a potential growth rate of just 2% per year, possibly less.  And they also say it can’t be fixed.

But, can this really be true?  New technologies are boosting productivity everywhere.  As recently as 2009 it took over a month to drill and complete a new oil well; now it takes around a week.  Farmers have boosted the bushels of corn they get from every acre of farmland by 2.4% per year since the early 1990s – while new tech (drones, GPS, ground sensors) helps save on inputs of hours, water, fuel, and fertilizer.

Smartphones, tablets, apps, the cloud, 3-D printing, drones, and many other new technologies are clearly boosting productivity.  And not just in tech industries.

So, why do so many people think productivity is weak?  Yes, government data sources say it’s weak.  But anyone who goes outside instead of living in the data knows nearly everything is getting better, faster, and cheaper.

That suggests something is wrong with the government data.  One problem is that things that are free – like maps, step counters, language translators, radios, or calculator apps on your smartphone – are hard for the government to count.

But there’s a bigger problem.  The government is a negative productivity machine.  For example, productivity in electric power generation and distribution fell 13% between 2006 and 2016.  And commercial banking productivity has risen less than 0.1% per year in the past seven years.  How could this be?  Why are these industries stagnating despite constant improvements in technology?

The answer:  Too much government.  The government has subsidized wind and solar electricity power generation, which are far more labor intensive and less productive.  And, excessive banking regulations shifted many jobs from profit generation to oversight and reporting in that industry.  The tax code itself absorbs millions of hours in non-productive labor.

In other words, while productivity in private activity hums along, big government is throwing a wet blanket over entire industries, and dragging down total market productivity.  It’s simply not true that potential growth is as weak as the model says.  What is true is that shrinking government burdens will boost real (and reported) productivity, growth, wages, and living standards.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Don’t Fear Higher Interest Rates

December 6, 2017

The Federal Reserve has a problem.  At 4.1%, the jobless rate is already well below the 4.6% it thinks unemployment would/could/should average over the long run.  We think the unemployment rate should get to 3.5% by the end of 2019 and wouldn’t be shocked if it got that low in 2018, either.

Add in extra economic growth from tax cuts and the Fed will be worried that it is “behind the curve.”  As a result, we think the Fed will raise rates three times next year, on top of this year’s three rate hikes, counting the almost certain hike this month.  And a fourth rate hike in 2018 is still certainly on the table.  By contrast, the futures market is only pricing in one or two rate hikes next year – exactly as it did for 2017.  In other words, the futures markets are likely to be wrong for the second year in a row.

And as short-term interest rates head higher, we expect long-term interest rates to head up as well.  So, get ready, because the bears will seize on this rising rate environment as one more reason for the bull market in stocks to end.

They’ll be wrong again.  The bull market, and the US economy, have further to run.  Rising rates won’t kill the recovery or bull market anytime in the near future.

Higher interest rates reflect a higher after-tax return to capital, a natural result of cutting taxes on corporate investment via a lower tax rate on corporate profits as well as shifting to full expensing of equipment and away from depreciation for tax purposes. 

Lower taxes on capital means business will more aggressively pursue investment opportunities, helping boost economic growth and the demand for labor – leading to more jobs and higher wages.  Stronger growth means higher rates.

For a recent example of why higher rates don’t mean the end of the bull market in stocks look no further than 2013.  Economic growth accelerated that year, with real GDP growing 2.7% versus 1.3% the year before.  Meanwhile, the yield on the 10-year Treasury Note jumped to 3.04% from 1.78%.  And during that year the S&P 500 jumped 29.6%, the best calendar year performance since 1997.   

This was not a fluke.  The 10-year yield rose in 2003 and 2006, by 44 and 32 basis points, respectively.  How did the S&P 500 do those years: up 26.4% in 2003, up 13.8% in 2006.

Sure, in theory, if interest rates climb to reflect the risk of rising inflation, without any corresponding increase in real GDP growth, then higher interest rates would not be a good sign for equities.  That’d be like the late 1960s through the early 1980s.  But with Congress and the president likely to soon agree to major pro-growth changes in the tax code on top of an ongoing shift toward deregulation, we think the growth trend is positive, not negative.

It’s also true that interest on the national debt will rise as well.  But federal interest costs relative to both GDP and tax revenue are still hovering near the lowest levels of the past fifty years.  As we’ve argued, sensible debt financing that locks in today’s low rates would be prudent. However, it will take many years for higher interest rates to lift the cost of borrowing needed to finance the government back to the levels we saw for much of the 1980s and 1990s.  And as we all remember the 80s and 90s were not bad for stocks.

Bottom line: interest rates across the yield curve are headed higher.  But, for stocks, it’s just another wall of worry not a signal that the bull market is anywhere near an end.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist
  

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Consumer Fundamentals Are Strong

November 29, 2017

Now that Black Friday has come and gone and Cyber Monday is upon us, you’re going to hear a blizzard of numbers and reports about the US consumer.  So far, these numbers show blowout on-line sales and a mild decline in foot traffic at brick-and-mortar stores.  Both are better than expected given the ongoing transformation of the retail sector.

But Black Friday isn’t all that it used to be.  Sales are starting earlier in November and have become more spread out over the full Christmas shopping season, so the facts and figures we hear about sales over the past several days are not quite as important as they were in previous years.  Add to that the fact that this year’s shopping season is longer than usual due to an early Thanksgiving holiday.

But all this focus on the consumer is a mistake.  It’s backward thinking.  We think the supply side – innovators, entrepreneurs, and workers, combined – generates the material wealth that makes consumer demand possible in the first place.  The reason we produce is so we can consume.  Consuming doesn’t produce wealth, production does. 

Either way, we expect very good sales for November and December combined.  Payrolls are up 2 million from a year ago.  Meanwhile, total earnings by workers (excluding irregular bonuses/commissions as well as fringe benefits) are up 4.1%.

Some will dismiss the growth as “the rich getting richer,” but the facts say otherwise.  Usual weekly earnings for full-time workers at the bottom 10% are up 4.6% versus a year ago; earnings for those at the bottom 25% are up 5.3% from a year ago.  By contrast, usual weekly earnings for the median worker are up 3.9% while earnings for those at the top 25% and top 10% are up less than 2%. 

Yes, that’s right, incomes are growing faster at the bottom of the income spectrum than at the top.  A higher economic tide is lifting all boats and helping those with the smallest boats the most.  This is not a recipe for stagnating sales.

And so the voices of pessimism have had to pivot their story lately.  Just a short while ago, they were still saying the economy really wasn’t improving at all.  Now some are saying it’s a consumer debt-fueled bubble.

It is true that total household debt is at a new record high. But debts relative to assets are much lower than before the Great Recession.  Debts were 19.4% of household assets when Lehman Brothers went bust; now they’re 13.7%, one of the lowest levels in the past generation.  Meanwhile, for the past four years the financial obligations ratio – debt payments plus the cost of car leases, rents, and other monthly payments relative to incomes – has been hovering near the lowest levels since the early 1980s. 

Yes, auto and student loan delinquencies are rising.  But total serious (90+ day) delinquencies, including not only autos and student loans, but also mortgages, home equity loans, and credit cards are down 61% from the peak in 2010. 

The bottom line is that investors should be less worried about consumer debt today than at any time in recent decades.  Some think this could change if the Fed continues to raise interest rates, while selling off its bond portfolio.  But interest rates are still well below normal levels and the U.S. banking system is sitting on trillions in excess reserves.  

The US economy is less leveraged and looking better in recent quarters than it has in years.  And better tax and regulatory policies are on the way.  The Plow Horse is picking up its pace and consumer spending is in great shape.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist
  

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Investing vs. Trading

November 14, 2017

Are you an investor or a trader?  Investors think long-term, while traders focus on short-term price movements.

Trading furs, cloth, commodities, or tulips, has gone back centuries, if not millennium, but was about adding value and moving goods to markets.  In other words, through trading many ran businesses that looked a great deal like investing.

The “ticker tape” allowed the trading of financial products, but after the Great Depression many wouldn’t touch stocks for decades.  Now, financial market news and quotes are on TV all-day and pushed out over smartphones.  This can encourage “trading” over “investing.”  Or another way of saying the same thing, the short-term over the long-term.

For example, many people have zero idea what Bitcoin is, why it is needed, or what gives it value, but they are mesmerized by it nonetheless.  It’s just digital scrip – an alternative to sovereign currency.  It pays no dividend and isn’t widely accepted.  No one knows if it will last.

In the meantime, there are monumental events taking place that get missed if one focuses on the trees and not the forest.  Horizontal drilling and fracking are one of those.

Remember when the world was about to run out of natural gas and oil?  Remember when the Middle East and Russia, because of their energy reserves, could dominate geopolitics?

Well, all that has changed.  The US is now the world’s biggest energy producer and, by 2020, the US is likely to become a net energy exporter to the rest of the world.  This explains the political upheaval in Saudi Arabia as the royal family moves slowly toward a more free-market friendly environment.  Russia faces similar forces that, in the end, will create more global stability.

Because of US supplies, Europe can become less dependent on Russian oil and natural gas.  In addition, just like when Ronald Reagan was president of the US, as the pendulum swings toward less regulation, lower tax rates and smaller government, Europe must follow suit.

The combination of these developments causes stronger global economic growth, which is great news for investors.

However, the dominance of governments in recent decades, and the reporting of every utterance of Federal Reserve or foreign central bankers, creates anxiety among many investors.  Some investors are worried about a flattening, or inversion, of the yield curve as the Fed tightens.

But these concerns are overdone.  It’s true that an inverted yield curve signals tight money, but inversions typically don’t happen until the Fed pulls enough reserves out of the system to push the federal funds rate above nominal GDP growth.  Right now, that’s about 3.5%, which means the Fed is likely at least two years away.  And, the banking system is still stuffed with over $2 trillion in excess bank reserves.  Monetary policy, by definition, is not tight until those excess reserves are gone.

Focusing on trading, and not investing, misses these longer-term developments and highlights short-term fears.  Patience, persistence and optimism help avoid the pitfalls of short-term thinking.  The current environment will continue to reward those who stay focused on investing.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Clearing a Path for Tax Reform

November 8, 2017

Washington D.C. used to complain that Ronald Reagan employed a strategy of “starving the beast” – cutting taxes so that new spending was tough to legislate.  Now, D.C. seems to employ the strategy of “gorging the beast” – spending so much that tax cuts are hard to pass.

Persistent over-spending, and costly entitlements have created permanent deficits.  In addition, arcane budget rules and “scoring” models (which estimate the budget impact of legislation) make tax reform very complicated.

In order to let it pass with just 51 votes in the Senate, the cost of the legislation must not increase the deficit by more than $1.5 trillion over 10 years.  And any increase in the deficit in year 11, or beyond, must be paid for.  These arcane hurdles are why the tax reform bill passed by the House of Representatives last week looks like it does.

In essence, the tax bill cuts taxes on companies and just about anyone in the bottom 60% of the income spectrum, but pays for this by shifting an even larger share of the income tax burden onto high earners.  So, while we think the tax plan will boost economic growth, it falls well short of what we would call an “ideal” supply-side tax cut.

The corporate side of the tax plan is very positive.  At 35%, the US has the highest corporate tax rate in the developed world.  Bringing that rate down to 20% makes the US competitive, will bring more investment to the US, and will boost economic growth.  In addition, it allows 100% expensing of most investment for the next five years.

Notably, the proposal makes the 20% corporate tax rate permanent (not just 10 years, like the changes to individual tax rates).  Combined with the budget rules against showing revenue losses beyond ten years, that’s why the proposal treats high individual earners so harshly.

Congress says companies won’t invest if they think their tax rate will go back up in 2028.  But we think this fear is overblown.  US economic growth will pick up, and future lawmakers are not going to risk upsetting that by letting the rate jump back to 35% overnight.  Politicians are always worried about the next election, and the threat of a stock market selloff or rising recession risk would spook even the most liberal Democrats.

In turn, extra economic growth should generate lots of extra revenue, which means the deficit would not rise as much as the official budget scorekeepers (the Joint Committee on Taxation or the Congressional Budget Office) say it would.  For example, an extra 1 percentage point of real GDP growth per year would close the budget gap by $2.7 trillion over ten years, which is more than the cost of the tax cut itself.

In fact, there are early signs that the economy is accelerating already.  The Trump administration has rolled back an incredible amount of regulation.  That regulatory rollback – combined with expectations of tax reform and a more business friendly government in general – has lifted economic growth.

In spite of the double-whammy of Hurricanes Harvey and Irma, US economic activity has accelerated this year.  In fact, we have had two quarters of real GDP growth at or above 3% so far this year, with our fourth quarter growth forecast at 3.5%.

But the Joint Tax Committee is expecting only a 1.9% real GDP growth rate over the next ten years.  We think this is way too pessimistic.  The economy has been stuck in the doldrums since 2009 because government grew too large.  Between 1985 and 2005, real GDP averaged 3.2% growth.  Using those growth rates (which we believe are achievable) would allow for more robust tax reform that actually cuts tax rates across the board.

To be blunt, we are not particularly enthusiastic about the way the proposal treats individuals, and think it’s a huge missed opportunity.  For one thing, the top tax rate of 39.6% is unchanged, and that’s the tax bracket where earners respond the most to incentives.

And while we wholeheartedly support the idea of limiting the deductibility of state and local taxes – because it creates political pressure for shrinking government at the state and local level – we’re concerned about the downside incentive effects for some high earners who would then pay even higher marginal tax rates.  Put it all together, and some earners in high tax states like California are going to pay a marginal rate north of 60% once Medicare taxes are included.

With full GOP control of the House, Senate, and White House, Republicans have a rare opportunity to adopt policies to get the US back on the path of faster economic growth.  Instead, they remain hampered by rules set up long ago that are hostile to growth, the same kind of rules that underestimated the costs of programs like Obamacare, but also underestimate the benefits to growth from lower tax rates.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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