The Powell Fed: A New Era

March 20, 2018

In the history of the NCAA Basketball Tournament, a 16th seed has never, ever, beaten a one seed…until this year.  But, on Friday, the University of Maryland, Baltimore County (UMBC) beat the University of Virginia – not just a number one seed, but the top ranked team in the USA.

We don’t expect the unexpected, however, when the Federal Reserve finishes its regularly scheduled meeting on Wednesday.  Based on the federal funds futures market, there is a 100% chance that the Fed will boost the federal funds rate by 25 basis points, to a new range of 1.5% to 1.75%.

The markets are even giving a roughly 20% chance that the Fed raises rates 50 basis points.  That’s better odds than UMBC had, but we suspect it’s highly unlikely given that this is Jerome Powell’s first meeting as Fed chief.

The rate hike itself is not worrisome.  It’s expected and, at 1.75%, the federal funds rate is still below inflation and the growth rate for nominal GDP.  There are also still more than $2 trillion in excess bank reserves in the system.  The Fed is a very long way from being tight.

Instead, investors should focus on how the Fed changes its forecast of what’s in store for the economy and the likely path of short-term interest rates over the next few years.

Back in December, the last time the Fed released projections on interest rates and the economy, only some of the policymakers at the Fed had incorporated the tax cuts into their forecasts.  Prior to the tax cut, the median forecast from Fed officials expected real GDP growth of 2.5% in 2018 and 2.1% in 2019.  Now that the tax cut is law, we expect Fed forecasters to move those estimates noticeably higher, to near 3% growth for 2018 and 2019, which should lower unemployment forecasts.

In December, the median Fed forecast was that the jobless rate would reach 3.9% in the last quarter of 2018 and remain there in 2019 before heading back to 4.6% in following years.

We’re forecasting the unemployment rate should get to 3.3% by the end of 2019, which would be the lowest since the early 1950s.  Beyond 2019, it’s even plausible the jobless rate goes below 3.0%, as long as we don’t lurch into a trade war or back off tax cuts or deregulation.

We doubt the new Fed forecast gets that aggressive, but with the jobless rate already at 4.1%, faster economic growth should push Fed forecasts well below 3.9% in spite of faster labor force growth.

For the Fed, lower unemployment rates mean faster wage growth and higher inflation.  This may force a change in the Fed’s “dot plot,” which puts a dot on each member’s expected path of short-term interest rates.

Back in December, the dot plot showed a median forecast of 75 basis points in rate hikes this year – basically, three rate hikes of 25 bps each.  Four Fed officials expected four or more rate hikes in 2018, while twelve expected three or fewer.  This time, we expect the dots to show a much more even split between “three or fewer” and “four or more.”

At present, the futures market is pricing in three rate hikes as the most likely path this year, with a 36% chance of a fourth rate hike (or more).  Look for the market’s odds of that fourth rate hike to go up by Wednesday afternoon, which means longer-term interest rates will also likely move higher.

In addition, the markets will be paying close attention to Jerome Powell’s performance at his first Fed press conference.  With journalists planning “gotcha” questions, some negative headlines could result.  If so, and if equities drop, the smartest investors should treat it as yet another opportunity to buy.

Since 2008, the Fed has embarked on unprecedented monetary ease.  Rather than boosting the actual money circulating in the economy, however, quantitative easing instead boosted excess bank reserves, which represent potential money growth and inflation in the years ahead.

The Fed has decided that it can pay banks to hold those reserves, and not push them into the economy.  Four rate hikes in 2018 mean the Fed will be paying banks 2.5% per year to hold reserves.  Never in history has the Fed tried this.  The jury is out.  The Fed thinks it will work, we’re not so sure.  The odds of rising inflation in the next few years, because of those excess reserves, are greater than the chance of a number 16 seed beating a number one seed.  Granted, that’s not high odds, but we suggest investors, especially in longer-dated fixed income securities, should be worried.  Stay tuned.

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

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Stay Invested: Economy Looks Good

March 13, 2018

The current recovery started in June 2009, 105 months ago, making it the third longest recovery in U.S. history.

The longest – a 120-month recovery in the 1990s – saw real GDP expand an annual average of 3.6%.  The current recovery has experienced just a 2.2% average annual growth rate – what we have referred to as “plow horse” economic growth.

That’s changing.  In particular, the labor market is gathering strength.  In February, nonfarm payrolls rose 313,000, while civilian employment, an alternative measure of jobs that includes small-business start-ups, rose 785,000.

Hourly wages rose a tepid 0.1% in February, but in the past six months, average hourly earnings are up at a 2.7% annual rate while the total number of hours worked is up at a 2.6% annual rate.  Total earnings are up at 5.4% annual rate in the past six months, which is faster than the trend in nominal GDP growth the past few years.

New orders for “core” capital goods, which are capital goods excluding defense and aircraft, were up 6.3% in the year ending in January, while shipments of these capital goods were up 8.7%.  Sales of heavy trucks – trucks that are more than seven tons – are up 17.4% from a year ago.

The pace of home building is set to grow in the year ahead, in spite of higher interest rates or the new tax law limiting mortgage and property tax deductions.  In the fourth quarter of 2017, there were 1.306 million new housing permits issued, the highest quarterly total since 2007.

A better economy also means higher interest rates, but this doesn’t spell doom.  Housing has been strong despite rising mortgage rates many times in history.  In fact, both new and existing home sales were higher in 2017 than they were in 2016 in spite of higher mortgage rates.

Yes, the new tax law will be a headwind for homebuyers and builders in high-tax states, but it’s going to be a tailwind for construction in low tax states like Texas, Florida, and Nevada.  Housing starts have increased eight years in a row.  Look for 2018 to be the ninth.      

In the past two months, both ISM surveys – for Manufacturing and Services – have beaten consensus expectations.  The US economy is not going to grow at a 3.0% pace every quarter, but all this data suggests that our forecast for an average pace of 3% growth this year is on steady ground.   

The bottom line is that the U.S. economy is accelerating, not decelerating, and the potential for any near-term recession is basically zero.  Corporate earnings growth, and forecasts of future earnings, have accelerated, and our 2018 year-end forecast for Dow 28,500 and S&P 500 3,100 remain intact.   Even with higher interest rates!  Stay invested.

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

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Deficits, the Fed, and Rates

February 28, 2018

Forgive us our incredulity.  The bond vigilantes were certain that as the Federal Reserve hiked short-term rates, long-term interest rates would barely budge, the yield curve would invert, and the economy would fall into recession.

That theory has been blown to smithereens, so now we hear that it’s rising long-term rates that will cause a recession.

According to the vigilantes, which ascribe deep meaning to every move in long-term interest rates, the U.S. has gone from secular stagnation and permanent low rates, to huge (impossible to fund) deficits and rising rates – overnight.

No wonder the average investor is completely confused.

So, let’s start at the beginning.

Yes, the Fed drove short-term interest rates to zero and held them there for seven years.  And, yes, the Fed bought $3.5 trillion in bonds during Quantitative Easing.  And, yes, the Fed is reversing course.  It’s lifted the federal funds rate five times since 2015, and it’s slowly allowing its bond portfolio to shrink.

The federal government enacted tax cuts and spending increases, and the budget deficit ($665 billion in 2017) is now expected to approach $1 trillion or more in 2018 and beyond.

So, how much impact does each of these things have on interest rates?

Here’s our list:

1) If the budget deficit were no higher in 2018, than it was in 2017, long-term bond yields would still be higher today.

2) If the Fed had just lifted short-term interest rates, but had not started unwinding QE, longer-term bond yields would still be higher today.

3) When the Fed promises to hold short-term interest rates down, they pull longer-term rates down as well.  Long-term rates (say a 5-year bond) are just a series of short-term rates (five 1-year bonds).  So, rising 1-year yields mean rising 5-year yields.

When tax cuts and regulatory reform lead to stronger economic growth, a pick up in the velocity of money, and rising inflationary pressures, the bond market begins to realize that short-term interest rates need to rise – across the yield curve.  Rising interest rates have everything to do with better economic data and nothing to do with QE and deficits. 

Every dollar the government spends has to be paid for with either tax revenue or borrowing from bondholders.  Either way, the money is “crowded-out.”  If you pay higher taxes, but need to buy a machine, you have to borrow; if the government borrows the money first and doesn’t tax you, you still need to buy the machine.  Either way, debt is created.  But, it’s not the debt itself that drives interest rates up or down.

So, what about the QE-unwind? At this point, the Fed is only reducing its holdings of Treasury debt by $12 billion per month, versus a total pool of publicly-held Treasury debt of $14.8 trillion.  A drop in the bucket.

Interest rates are determined by fundamental factors, not who owns what, or how many, bonds.  Right now, fundamental factors in the US – faster growth, rising inflation and a tightening Fed – are pushing yields up….not deficits.  In other words, the Vigilantes may think they have us on the run, but they’re not close to being dangerous.

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

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QE and Its Apologists

February 21, 2018

On March 9, 2018, the bull market in U.S. stocks will celebrate its ninth anniversary.  And, what we find most amazing is how few people truly understand it.  To this day, in spite of massive increases in corporate earnings, many still think the market is one big “sugar high” – a bubble built on a sea of Quantitative Easing and government spending.

While passing mention is given to earnings (because they are impossible to ignore), conventional wisdom has clung to the mistaken story that QE, TARP, and government spending saved the economy from the abyss back in 2008-09.

A review of the facts shows the narrative that “Wall Street” – meaning capitalism and free markets – failed and government came to the rescue is simply not true. 

Wall Street was not the driving force behind subprime mortgages.  In his fabulous book, Hidden in Plain Sight, Peter Wallison showed that by 2008 Fannie Mae, Freddie Mac and other government programs had sponsored 76% of all subprime debt – not “Wall Street.”  Everyone was playing with rattlesnakes and government was telling them it was OK to do so.  But, when the snakes started biting, government blamed the private sector, capitalism and free markets. 

At the same time, Wall Street did not cause the market and economy to collapse; it was overly strict mark-to-market accounting.  Yes, leverage in the financial system was high, but mark-to-market accounting forced banks to write down many performing assets to illiquid market prices that had zero relationship to true value.  Mark-to-market destroyed capital.

QE started in September 2008, TARP in October 2008, but the market didn’t bottom until March 9, 2009, five months later.  On that day in March, former U.S. Representative Barney Frank, of all people, promised to hold a hearing with the accounting board and SEC to force a change to the ill-advised accounting rule.  The rule was changed and the stock market reversed course, with a return to economic growth not far behind.

Yes, the Fed did QE and, yes, the stock market went up while bond yields fell, but correlation is not causation.  Stock markets fell after QE started, and rose after QE ended.  Bond yields often rose during QE, fell when the Fed wasn’t buying, and have increased since the Fed tapered and ended QE. 

A preponderance of QE ended up as “excess reserves” in the banking system, which means it never turned into real money growth.  That’s why inflation never took off.  Long-term bond yields fell, but this wasn’t because the Fed was buying.  Bond yields fell because the Fed promised to hold short-term rates down for a very long time.  And as long-term rates are just a series of short-term rates, long term rates were pushed lower as well.

We know this is a very short explanation of what happened, but we bring it up because there are many who are now trying to use the stock market “correction” to revisit the wrongly-held narrative that the economy is one big QE-driven bubble.  Or, they use the correction to cover their past support of QE and TARP.  If the unwinding of QE actually hurts, then they can argue that QE helped in the first place.

So, they argue that rising bond yields are due to the Fed now selling bonds.  But the Fed began its QE-unwind strategy months ago, and sticking to its plans hasn’t changed a thing. 

The key inflection point for bond yields wasn’t when the Fed announced the unwinding of QE; it was Election Day 2016, when the 10-year yield ended the day at 1.9% while assuming the status quo, which meant more years of Plow Horse growth ahead.  Since then, we’ve seen a series of policy changes, including tax cuts and deregulation, which have raised expectations for economic growth and inflation.  As a result, yields have moved up.

Corporate earnings are rising rapidly, too, and the S&P 500 is now trading at roughly 17.5 times 2018 expected earnings.  This is not a bubble, not even close.  Earnings are up because technology is booming in a more politically-friendly environment for capitalism.  And while it is hard to see productivity rising in the overall macro data, it is clear that profits and margins are up because productivity is rising rapidly in the private sector.

The sad thing about the story that QE saved the economy is that it undermines faith in free markets.  Those who argue that unwinding QE is hurting the economy are, in unwitting fashion, supporting the view that capitalism is fragile, prone to bubbles and mistakes, and in need of government’s guiding hand.  This argument is now being made by both those who believe in big government and those who supposedly believe in free markets.  No wonder investors are confused and fearful.

The good news is that QE did not lift the economy.  Markets, technology and innovation did.  And this realization is the key to understanding why unwinding QE is not a threat to the bull market.

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

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Snatching Slow Growth from the Jaws of Fast Growth

February 13, 2018

The U.S. economy continues to be lifted by an incredible wave of new technology.  Fracking, 3-D printing, smartphones, apps, and the cloud have boosted productivity and profits.  Yet taxes, regulation and spending all increased markedly in the past decade, raising the burden of government and dragging down the real GDP growth rate to a modest 2.2% from mid-2009 to early 2017.

Then 2017 saw the tides start to shift. Regulation was cut dramatically and the U.S. saw the most sweeping corporate tax reform in history.  Guess what?  Growth picked up to almost 3% annualized in the last three quarters of 2017 and real GDP looks set for about 4% growth in the first quarter of 2018.

But the dream of getting back to long-term 4% growth died this week in a bipartisan orgy of government spending.  Congress lifted the budget caps on “discretionary” (non-entitlement) spending by about $300 billion over the next two years, and spending is now set to rise by 10% this year.

No, this won’t kill the economy tomorrow (or this year), but unless the Congress gets control of federal spending, the benefits from the tax cuts and deregulation will be short-lived.

Many argued that making corporate tax cuts temporary would limit their effectiveness because corporations would not change their behavior.  So, what does a corporate CFO do now?  Trillion dollar deficits as far as the eye can see mean Congress has a reason – and an excuse – to raise tax rates in the future.  This doesn’t mean they’re going back to 35%, but massive deficits will make it hard to sustain a 21% tax rate over time.  In other words, while Congress passed permanent tax cuts, it now makes them almost impossible to sustain.

Every dollar the government spends must be either taxed or borrowed from the private sector.  The bigger the government, the smaller the private sector.  Not only does increased spending mean higher tax rates are expected in the future, but also a smaller private sector as it’s forced to fund a bigger government.  It’s the Spending that crowds out growth, not deficits themselves

Look, we get it.  The world is a dangerous place and we are sure there are parts of our military that need better funding.  But the government can’t do everything.  If we need more spending on defense, those funds should be found by reducing spending elsewhere. Otherwise, eventually, the country won’t be able to afford to defend itself, either.

But, in order to reach the minimum of 60 votes needed in the US Senate, Republicans capitulated to Democrats demands for more non-military spending.  The result was a budget blow-out.

So, where does that leave us?  Optimistic about an acceleration in growth this year and 2019, which will help lift stock prices as well, but not as optimistic beyond that as we were before the budget deal.  The Plow Horse is not coming back overnight, but unless we get our fiscal house in order, it’s still lurking in the barn.

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

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New Policies, New Path

February 8, 2018

Back in the 1970s, supporters of the status quo said there was nothing to be done about stagflation (high inflation and slow growth).  It was a “fact of life” that Americans had to accept after experiencing faster growth and lower inflation during the decades immediately following World War II.

Then, along came the supply-side and monetarist economists with new ideas about how the “policy mix” mattered, that marginal tax rates affected the incentive to work and invest and that the supply of money helped determine inflation.  Simple ideas, in retrospect, but decried as radical notions at the time by supporters of the stagflation status quo.  Supply-side economics was dismissed as “voodoo economics.”

Similar arguments have come back into vogue in the past decade, with apologists for slow growth arguing the US simply can’t grow as fast as it used to.  “Secular stagnation” means growth will be permanently slow.  Rapid growth, they claim, is a thing of the past.

In the 1980s, when supply-side policies were tried, they worked.  Growth picked up, inflation fell.  Now, the U.S. is going through another major shift in the “policy mix,” with the federal government focusing on deregulation and tax cuts.  In a nutshell, we’ve gone from a political philosophy that said “you didn’t build that” to one that says “please build that.”

As a result, expectations about the economy are changing rapidly.  The Atlanta Fed is now projecting real GDP growth at a 5.4% annual rate in the first quarter, which would be the fastest growth for any quarter since 2003.  We think that’s on the optimistic side and expect growth at more like a 4.0% annual rate, but, either way, the economy is showing signs of an overdue acceleration and we are now projecting growth of 3.5% for 2018 (the fastest “annual” growth since 2003). 

Friday’s jobs report brought news that wages are now accelerating as well.  Average hourly earnings grew 0.3% in January and are up 2.9% from a year ago.  Some analysts said wages were probably lifted in January due to unusually bad weather, which was also the culprit behind the drop in the number of hours worked for the month. 

It is true that the number of workers missing work due to weather was the second highest for any January in the past 20 years.  But we’ve had other months with nasty weather since 2009, and this is the first time since then that wages were up 2.9% over a twelve-month period.  Meanwhile, jobs increased 200,000 for the month, so we doubt bad weather was the key trigger.                     

Surprisingly, even uber-dove Minneapolis Fed President Neel Kashkari, who has dissented against rate hikes in recent Fed meetings, waxed enthusiastic on Friday about the faster pace of wage growth, saying it “could have an effect on the path of interest rates.”  Kashkari and the rest of the policymakers at the Fed will have more than six more weeks to mull over the incoming data and decide whether they warrant a new path for short-term interest rates.  We think a steeper path is not only warranted, but likely.  

At the last meeting in 2017, which was the last time the Fed issued it’s “dot plot” for the expected path of interest rates over the next few years, the median forecast was three rate hikes this year, with the odds of two rate hikes or less outweighing the odds of four rate hikes or more. At the press conference following that meeting, Fed Chief Janet Yellen said some, but not all, of the policymakers had incorporated the tax cut into their forecasts.

But now that the tax cut is a fact and the economy is accelerating, we think the new forecast to be released on March 21 will show close to an even split between advocates of three or four rate hikes.  We’d put our money on four, and we don’t see a slowdown in economic growth during 2018, like we might have seen in some recent years, giving the Fed an excuse to pause its rate hikes during the year.    

No wonder the yield on the 10-year Treasury has gone from 1.86% on Election Day 2016 to 2.84% on Friday.  The “animal spirits” are restless, monetary policy is gaining traction, and the “secular stagnation” of the past several years is looking less secular by the day.  

In this environment, as markets reassess what’s possible, we may have more days like Friday in the equity market.  But more economic growth will ultimately be a tailwind for equities, not a headwind.  Stock market investors who can’t take a one-day 2.1% drop in equities, or even a 10% correction, shouldn’t be in the stock market to begin with.  Those who can remain calm and stay invested will be rewarded.  

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

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Clear Skies Ahead

January 30, 2018

You know the old saying about every cloud having a silver lining?  Well, if you listen to some of the financial press, you’d think their motto was that clear skies are just clouds in disguise.

Friday’s GDP report showed the economy grew 2.5% in 2017, an acceleration from the average rate of 2.2% from the start of the recovery in mid-2009 through the end of 2016.  Notably, what we call “core” GDP – inflation-adjusted GDP growth excluding government purchases, inventories, and international trade – grew at a 4.6% annual rate in the fourth quarter and was up 3.3% in 2017.

However, some pessimistic analysts were calling attention to a drop in the personal saving rate to 2.6% in the fourth quarter, the lowest level since 2005.  The pessimists’ theory is that if the personal savings rate is so low, consumers must be in over their heads again, so watch out below!

But this superficial take on the saving rate leaves out some very important points.

First, consumers don’t just get purchasing power from their income; they also get it from the value of their assets.  And asset values soared in 2017 as investors (correctly) anticipated better economic policies.  The market cap of the S&P 500 rose $3.7 trillion, while owner-occupied real estate looks like it increased about $1.5 trillion.  That could be a problem if we thought stock market or real estate was overvalued, but our capitalized profits approach says the stock market is still undervalued and the price-to-rent ratio for residential real estate is near the long-term norm, not wildly overvalued like in 2005.

Second, the tax cut that’s taking effect is going to raise after-tax income.  According to congressional budget scorekeepers, the tax cut on individuals should reduce tax payments by $189 billion in 2019, which is equal to 1.3% of last year’s after-tax income.  So, consumers are going to be able to save more in the next few years, even if we don’t include the extra income that should be generated by extra economic growth.

Third, the personal saving rate doesn’t include withdrawals from 401Ks and IRAs, many of which are swollen with capital gains.  So, let’s say a worker contributed $5,000 of their income into a 401K at the end of 1988 and kept that money in the S&P 500 ever since.  Today they can withdraw more than $97,000 and spend it.  When calculating the saving rate, the government counts every penny of that spending while not counting a penny of it as income.  As the population ages and spends down wealth they’ve already made, the saving rate tells us less and less about the saving habits of today’s workers.

Sometimes good news is really just good news.  Unfortunately, some analysts can’t look at clear skies without imagining clouds.

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

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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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