Macro keys for the rest of the year
25 July 2017
The first half of 2017 will be remembered fondly by most investors (see Table 1). The cyclical lift in corporate earnings has pushed equity prices to new highs. Investments in credit products continue to generate an income stream well above what ‘risk free’ products can generate. And though the Fed’s policy rate is creeping up, long-end government bond yields are lower than they were at the beginning of the year, meaning that most bond owners are ‘above water’ as well. Our house view is that this benign environment will continue into the second half of the year, with most major asset classes delivering excess returns over cash. But precisely how high those returns are and how they are distributed partly depends on the answer to a number of key macro questions. One is whether growth in manufacturing and business investment growth will broaden out more from inventory rebuilding and the energy sector. Both have made outsized contributions to growth over the past 12 months, but neither is likely to be sustained at their current pace. Moreover, stronger fixed non-energy business investment is one of the keys to fixing the country’s productivity malaise, as the slow pace of capital deepening is one of the reasons why labour productivity growth has been so weak during the post-crisis recovery. If private investment growth were to pick up more substantially, corporate earnings can continue to grow solidly even if nominal wage growth picks up as the labour market tightens.
That brings us to the second key question. However measured, wage growth and core inflation remain very sluggish compared with historical norms and there are few signs in the data that the trend is turning. This is puzzling for economists, for whom belief in a downward sloping Phillips Curve verges on religious and most continue to expect that some acceleration is imminent. The inflation outlook is critical for investors for a number of reasons. First, current pricing implies that market participants doubt central banks’ ability to meet their long-term objectives. If inflation were to pick up, market-implied inflation expectations would almost certainly rise, dragging nominal interest rates up (see Chart 2). In addition, at least some of the gap between market pricing of Fed policy and Fed officials’ own view of the outlook would likely be resolved in the Fed’s favour, weighing further on bond prices. The most benign scenario for markets is one in which business investment and productivity growth pick up strongly, but inflation edges up only gradually, allowing the Fed to continue its gradual policy normalisation. This is more likely to become a reality if structural reforms that boost the supply side of the economy are enacted. That therefore brings us to the final key question facing investors - will Congress and the Trump administration get their act together to pass legislation that boosts the long-term performance of the economy? Here the thing to look for is not tax cuts; for the most part tax cuts without tax reform would simply boost growth in the short term and force the Fed into more aggressive policy tightening. No, the key to supporting longer-term returns is genuine tax and regulatory reform, as well as a public investment package large enough to alleviate the infrastructure bottlenecks that are inhibiting private sector productivity. Unfortunately the current gridlock in Washington leaves us relatively pessimistic about the likelihood that the capital’s competing factions can come together to pass the necessary legislation.