Modest Growth in Q1

April 25, 2018

From mid-2009 through early 2017, the US economy grew at a real average annual rate of 2.2%.  Not a recession, but not robust growth either, which is why we called it a Plow Horse Economy.

For the first quarter of 2018, we expect growth of 1.9% at an annualized rate, right in-line with a Plow Horse. 

But that doesn’t mean the economy is still a Plow Horse.  It isn’t.  Growth has picked up, even if last quarter doesn’t show it.  Even with a 1.9% growth rate in Q1, real GDP is still up 2.7% from a year ago, and we anticipate an average growth rate of around 3% this year and next year with higher odds of growth exceeding that pace rather than falling short.

Taxes and regulations have been cut and monetary policy remains loose.  Look for a significant acceleration in growth in the quarters ahead. 

Here’s how we get to 1.9% for Q1.  But, keep in mind that we get reports on shipments of capital goods on Thursday as well as early data on trade and inventories, so we could end up tweaking this forecast slightly later this week. 

Consumption:  Automakers reported car and light truck sales fell at a 12.4% annual rate in Q1, in large part due to a return to trend after the surge in sales late last year following Hurricanes Harvey and Irma.  Meanwhile, “real” (inflation-adjusted) retail sales outside the auto sector declined at a 0.8% annual rate.  However most consumer spending is on services, and growth in services was moderate.  Our models suggest  real personal consumption of goods and services, combined, grew at a 1.2% annual rate in Q1, contributing 0.8 points to the real GDP growth rate (1.2 times the consumption share of GDP, which is 69%, equals 0.8).

Business Investment:  It looks like another quarter of solid growth, with investment in equipment growing at about a 5% annual rate, and investment in intellectual property growing at a trend rate of 5%, as well.  Meanwhile, commercial construction looks unchanged.  Combined, it looks like business investment grew at a 4% rate, which should add 0.5 points to real GDP growth.  (4.0 times the 13% business investment share of GDP equals 0.5).

Home Building:  It looks like residential construction grew at a 5% annual rate in Q1, roughly the same pace as the average over the past five years.  This should add 0.2 points to the real GDP growth rate.  (5.0 times the home building share of GDP, which is 4%, equals 0.2).

Government:  Public construction projects were up in Q1, but military spending declined.  Looks like overall real government purchases rose at a 0.6% annual rate in Q1, which would add 0.1 points to the real GDP growth rate.  (0.6 times the government purchase share of GDP, which is 17%, equals 0.1).

Trade:  At this point, we only have trade data through February.  Based on what we’ve seen so far, it looks like net exports should subtract 0.7 points from the real GDP growth rate in Q1. 

Inventories:  Like with trade, we’re also working with incomplete figures on inventories.  But what we do have suggests companies were accumulating inventories more rapidly in the first quarter than at any time in 2017.  This should add a full 1.0 point to the real GDP growth rate.

Add it all up, and we get a 1.9% growth rate.  More data will come, and we could adjust, but hopes of a blow-out quarter have dimmed in recent months.  Nonetheless, the year-over-year growth rate has accelerated, and this slower quarter is just a temporary pause.  Corporate sales, incomes, jobs growth, investments, and construction are all accelerating.  So will GDP.

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

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Thoughts on Trade

April 18, 2018

When the report on international trade came out earlier this month, protectionists were up in arms.  Through February, the US’ merchandise (goods only, not services) trade deficit with the rest of the world was the largest for any two-month period on record.  “Economic nationalists” from both sides of the political aisle, think this situation is unsustainable. 

Meanwhile, some investors ran for the hills when President Trump started announcing tariffs on steel, aluminum, and other goods, thinking this was the reincarnation of the Smoot-Hawley tariffs that were a key ingredient of the Great Depression.      

We think the hyperventilating on both sides needs to stop.

In general, nothing is wrong with running a trade deficit.  Many states run large and persistent trade imbalances with other states and, rightly, no one cares.  We, the authors, run persistent trade deficits with Chipotle and Chick-fil-A, and we’re confident these deficits are never going away.

Running a trade deficit means the US gets to buy more than it produces.  In turn, we have this ability because investors from around the world think the US is a good place to put their savings, leading to a net capital inflow that offsets our trade deficit.  Notably, foreign investors are willing to invest here even when the assets they buy generate a low rate of return.  As a result, this process can continue indefinitely.  

It’s important to recognize that free trade enhances our standard of living even if other countries don’t practice free trade.  Let’s say China invents a cure for cancer and America invents a cure for Alzheimer’s.  If China refuses to give their people access to our cure, are we better off letting our people die of cancer?  Of course not!

Imposing or raising tariffs broadly would not help the US economy.  Nor would imposing tariffs on specific goods, like steel or aluminum.  Giving some industries special favors will only create demand for more special favors from others.  It’ll grow the swamp, not drain it.   

All that said, we understand the frustration policymakers have with China, in particular, which has been levering access to its huge market to essentially steal foreign companies’ trade secrets and intellectual property.  It has a long-term track record of not respecting patents or trademarks.

In theory, letting China into the World Trade Organization was supposed to stop this behavior.  But no company wants to bring a WTO case against China when it thinks China would respond by ending its access to their markets and letting in competitors who are more willing to be exploited.         

In addition – and this is very important – China is unlike any of our other trading partners in that it is a potential major military rival in the future.  There is a national security case to be made – even if one takes a libertarian position on free trade in general – that the US could accept a slightly lower standard of living by limiting trade with China, if the result is a lower standard of living for China as well.          

And China doesn’t have much room to fire back at recent US proposals (none of which have yet to be implemented, by the way).  Last year, China exported $506 billion in goods to the US, while we only sent them $130 billion. 

That gives our policymakers room to raise tariffs on China much more than they can raise them on us.  If so, China would generate fewer earnings to turn into purchases of US Treasury debt.  Yet another reason for fear among bond investors.  However, don’t expect China to outright dump Treasury securities in any large amount.  They own our debt because it helps them back up their currency, not as a favor to the US.            

We’re certainly not advocating a trade war.  But an approach that focuses narrowly on China’s abusive behavior could pay dividends if it moves the world toward freer trade.

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

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A Generation of Interest Rate Illiterates

April 13, 2018

An entire generation of investors has been misled about interest rates: where they come from, what they mean, how they’re determined. 

Lots of this confusion has to do with the role of central banks.  Many think central banks, like the Fed, control all interest rates.  This isn’t true.  They can only control short-term rates.  It’s true these can have an impact on other rates, but it doesn’t mean they control the entire yield curve.

Ultimately, an interest rate is simply the cost of transferring consumption over time.  If someone wants to save (spend less than they earn today) in order to consume more in the future, they must find someone else who wants to spend more today than they earn, and then repay in the future. 

Savers (lenders) want to be compensated by maintaining – or improving – their future purchasing power, which means they need payment for three things: inflation, credit risk, and taxes.

Lenders deserve compensation for inflation.  Credit risk – the chance a loan will not be repaid – is also part of any interest rate.  And, of course, those who earn interest owe taxes on that income.  After taxes, investors deserve a positive return.  In other words, interest rates that naturally occur in a competitive marketplace should include these three factors.

So, why haven’t they?  In July 2012, the 10-year Treasury yield averaged just 1.53%.  But since then, the consumer price index alone is up 1.5% per year.  An investor who paid a tax rate of 25% would owe roughly 0.375% of the 1.53% yield in taxes.  In other words, after inflation and taxes (and without even thinking about credit risk, which on a Treasury is essentially nil), someone who bought a 10-year bond in July 2012 has lost 0.35% of purchasing power each year, in addition to capital losses as bond prices have declined.

Something is off.  The bond market has not been compensating investors for saving, it has been punishing them.

Some blame Quantitative Easing.  The theory is that when the Fed buys bonds, yields fall. It’s simply supply and demand.  But this is a mistake.  Bonds aren’t like commodities, where if someone buys up all the steel, the price will move higher.  A bond is a bond, no matter how many exist.  Just because Apple has more bonds outstanding than a small cap company doesn’t mean Apple pays a higher interest rate.

If the Fed bought every 10-year Treasury in existence except for a single $10,000 Note, why would its yield be less than the current yield on the 10-year note (putting aside artificial government rules that goad banks into buying Treasury securities)?  It’s the same issuer, same inflation rate, same tax rate, same credit risk, and the same maturity and coupon.  It should have the same yield.  It didn’t become a collector’s item; it still faces competition from a wide array of other investments.  It’s still the same bond.

The real reason interest rates have remained so low is because many think the Fed will keep holding short-term rates down below fundamental levels well into the future.  If the Fed promises to hold the overnight rate at zero for 2-years then the 2-year Treasury will also be close to zero.  And since the 10-year note is made up of five continuous 2-year notes, then Fed policy can influence (but not control) longer-term yields as well.  The Fed’s zero percent interest rate policy artificially held down longer-term Treasury yields, not Quantitative Easing.  That’s why longer-term yields have risen as the Fed has hiked rates.

And they will continue to rise.  Why?  Because the Fed has held short-term rates too low for too long.  Interest rates are below inflation and well below nominal GDP growth.  The Fed has gotten away with this for quite some time because they over-regulated banks, making it hard to lend and grow.  Those days are ending and low rates now are becoming dangerous.

With inflation and growth rising, and regulation on the decline, interest rates must go higher.  It’s true the Fed is unwinding QE, but that’s not why rates are going up.  They’re going up because the economy is telling savers that they should demand higher rates.

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

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Ignoring the Invisible Hand

April 4, 2018

One of the most important questions we have about our country’s future is whether prosperity itself will make the American people lose sight of where that prosperity comes from; whether we’ll forget to cultivate the attitudes about freedom, property rights, and hard work that have made not only us great but also all the other places that have followed the same path.

To be clear, this has nothing directly to do with who is president or which party controls Congress.  It has nothing to do with the tax cut passed late last year, or recent tariffs, or increases in federal spending, or red tape being cut or added.  Instead, it runs much deeper than that and will affect all of these issues over the very long term, multiple generations into the future. 

The issue comes to mind for personal reasons, as a couple of us travel around the country with our high school juniors looking at colleges, hither and yon.

We’re not here to shame any particular school, so we’re not going to name any.  But here’s what we notice on our visits:  at some point, the college admissions officers in charge of the meeting will talk about great accomplishments by students or recently-graduated alumni.  Invariably, the accomplishments are volunteer efforts of various sorts that help people in some far-off land or, sometimes, here in the US.

Don’t get us wrong, stories like this deserve to be told.  They’re important and worthy of honor.  But, not once, in all our collective college tours have we ever heard a school bring up someone who, say, grew up in tough circumstances, was maybe the first in their family to go to college, and has since gone on to become a very successful entrepreneur, investor, or key officer at a large company, like a CEO or CFO,…someone who has gone on to create wealth for their own family and others as well.       

Not once. 

Which is odd because we know these colleges must have tons of these stories to tell.  You can tell when you’re taking the tour after the admissions sessions when you walk through the campuses and see the dorms, classrooms, and athletic centers many of which are named after alumni who’ve cut enormous checks.

Maybe stories of business-oriented success are just not on the radar of the kinds of people who run admissions offices.  Or, worse, maybe they think it’s embarrassing or that there should be some sort of shame associated with striving to generate wealth. 

Either way, they seem out of touch with why so many of their students want to go to college in the first place.  “Making the world a better place” is not just about volunteer work; it’s about personal ambition and desire mixing with the invisible hand to raise the standard of living for everyone.        

Capitalism isn’t a dirty word and the long-term success of our civilization means making sure our children know it.

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

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When Volatility is Just Volatility

March 27, 2018

Stock market volatility scares people.  But, volatility itself isn’t necessarily bad.  Only if there are fundamental economic problems, something that could cause a recession, would we think volatility itself is a warning sign.

So, we watch the Four Pillars.  These Pillars – monetary policy, tax policy, spending & regulatory policy, and trade policy – are the real threats to prosperity.  Right now, these Pillars suggest that economic fundamentals remain sound.

Monetary Policy:  We’re astounded some analysts interpreted last Wednesday’s pronouncements from the Federal Reserve as dovish.  The Fed upgraded its forecasts for economic growth, projected a lower unemployment rate through 2020 and also expects inflation to temporarily exceed its long-term inflation target of 2.0% in 2020.

As recently as December, only four of sixteen Fed policymakers projected four or more rate hikes this year; now, seven of fifteen are in the more aggressive camp.  Some analysts dwell on the fact that the “median” policymaker still expects only three hikes in 2018, ignoring the trend toward a more aggressive Fed.

But all of this misses the real point.  Monetary policy will still be loose at the end of 2018, whether the Fed raises rates three or four times this year.  The federal funds rate is about 120 basis points below the yield on the 10-year Treasury (which will rise as the Fed hikes), and is also well below the trend in nominal GDP growth.  Meanwhile, the banking system still holds about $2 trillion in excess reserves.  Monetary policy is a tailwind for growth, not a headwind.            

Taxes:  The tax cut passed last year is the most pro-growth tax cut since the early 1980s, particularly on the corporate side.  Some analysts argue that the money is just going to be used for share buybacks, but we find that hard to believe.  A lower tax rate means companies have more of an incentive to pursue business ideas that they were on the fence about.

And there is a big difference between who cuts a check to the government and who truly bears the burden of a tax, what economists call the “incidence of a tax.”

Cutting the tax rate on Corporate America will lift the demand for labor, meaning workers and managers share the benefits with shareholders.  Yes, some of the tax cut will be used for share buybacks, but that’s OK with us; it means shareholders get money to reinvest in other companies.  Buybacks also move capital away from corporate managers who might otherwise squander the money on “empire building,” pursuing acquisitions for the sake of growth, when returning it to shareholders is more efficient. 

Spending & Regulation:  This pillar is a little shaky.  On regulation, Washington has moved aggressively to reduce red tape rather than expand it.  That’s good.  But, Congress can’t keep a lid on spending.  That’s bad.

Back in June, the Congressional Budget Office was projecting that discretionary spending in Fiscal Year 2018 would be $1.222 trillion.  (Discretionary spending doesn’t include entitlements like Social Security, Medicare, or Medicaid, or net interest on the federal debt.)  Now, the CBO says that’ll reach $1.309 trillion, a gain of 7.1% in just nine months.

Assuming the CBO got it right back in June on entitlements and interest, that would put this year’s federal spending at 20.9% of GDP, a tick higher than last year at 20.8% – despite faster economic growth.  This extra spending represents a shift in resources from the private sector to the government.  The more the government spends, the slower the economy grows.             

Trade:  Trade wars are not good for growth.  And the US move to put tariffs in place creates the potential for a trade war.  We aren’t dismissing this threat, but a “full blown” trade war remains a low probability event.

The bottom line:  taxes, regulation and monetary policy are a plus for growth, spending and new tariffs are threats.  Things aren’t perfect, but, in no way do the fundamentals signal major economic problems ahead.  The current volatility in markets is not a warning, it’s just volatility.

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

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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

Approved For Public Use