Despite all of the chaos coming out of
the early days of the new Trump Administration stocks continued to rally on the
prospects for “pro-growth” tax cuts, regulatory reform and infrastructure
spending. (See Figure 1) However, the rally in bond yields and the dollar
stalled as those markets began to exhibit a higher degree of skepticism about
President Trump’s still vague proposals and the ability of the Congress to
expeditiously pass them. (See Figures 2 and 3) As a result we have pushed back
the effective date of the tax cuts to the first quarter of 2018 compared to the
third quarter of 2017 that we previously forecast.[i]
Figure 1. S&P 500, Feb. 25, 2016 –
Feb. 24, 2017, Daily Data
Source: Standard and Poor’s via
Bigcharts.com
Figure 2. 10-Year U.S. Treasury Bond
Yield, Feb. 25 2016 – Feb. 24, 2017, Daily Data
Source: Bigcharts.com
Figure 3. Dollar Index, Feb 25, 2016 –
Feb. 24, 2017, Daily Data
Source: Bigcharts.com
Similar to last quarter we are still
penciling in about $500 billion/year in personal and business tax reductions, a
repatriation holiday for accumulated foreign earnings, increased defense and
infrastructure spending, Medicaid cuts, relaxed regulations, modest changes to
trade and immigration policies, and reductions in food and aircraft exports as
several trading partners react to the policy changes. It remains to be seen to
what extent the Affordable Care Act will be amended and its impact on the giant
healthcare sector. Further because of
the controversy that it has engendered we do not believe that Congress will
pass a border adjustment import tax combined with exempting export sales from
corporate taxation.
We
have, however, become more concerned about the administration’s tone with
respect to trade and immigration policies. The changes could be far more
drastic than what we are now anticipating thereby increasing the risk level to
our forecast. The roll-out of the
administration’s partial travel ban and the scandal surrounding the firing of
the national security advisor certainly were not a confidence building measures.
Trillion
Dollar Annual Deficits Ahead
The impact of a large tax cut on an
economy at or very close to full employment will be to explode the federal
deficit. We expect the federal deficit to exceed a trillion dollars in 2019
which would amount to about 5% of GDP. (See Figure 4) Simply put there is not
enough slack in the economy to enable the 4% economic growth the administration
is calling for and it will likely lead to more inflation.
Figure 4. Federal Deficit, FY 2007 –
FY2019F
Sources: Office of Management and Budget
and UCLA Anderson Forecast
The
Fed will become More Aggressive
As
of April there will be three vacancies on the seven member Federal Reserve
Board which will likely be filled by more hawkish and less economics oriented
members. The era of the very easy Bernanke-Yellen Fed is over and
that will be confirmed when Chair Yellen’s term expires in January 2018.
Moreover with inflation rising we expect that even under Chair Yellen the Fed
will become more active in raising the Fed Funds rate and we believe that the
Federal Open Market Committee will increase the fed funds rate by 25 basis
points in March. By yearend the funds rate is expected to approach 2% and reach
3% by the end of 2018. (See Figure 5) Similarly the yield on 10-year U.S.
Treasury bonds is forecast to increase to 3% by year end and exceed 4% by
yearend 2018.
Figure 5. Federal Funds vs. 10-Year U.S.
Treasury Bonds, 2007Q1 – 2019Q4F
Sources: Federal Reserve Board and UCLA
Anderson Forecast
2018
GDP Growth Spike that Fades
With $500 billion in tax cuts arriving
in the first quarter of 2018 we expect a short term growth spike that will soon
fade as the economy bumps against its full employment ceiling. Our forecast
calls for real GDP growth of 2.4%, 3.0% and 2.2% annual growth in 2017, 2018
and 2019, respectively. (See Figure 6) And note that real growth really trails
off on a quarterly basis in 2019 as higher interest rates weigh on the economy.
As we noted last quarter, in order for growth to be sustained at 3%, the
economy requires a “productivity miracle.” The administration believes that its
tax and regulatory reforms will enable a sustainable growth pick up. We, on the
other hand, remain skeptical, but, of course, we can’t rule it out.
See Figure 6. Real GDP Growth, 2007Q1 –
2019Q4F
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
In this environment, the labor market
will remain robust with job growth coming in on the order of 170,000 a month in
2017 and 2018, before trailing off to about 110,000 a month in 2019. The recent
increase in the labor force participation rate has made us more optimistic
about job growth over the near term. (See Figure 7) In tandem with the job
gains the unemployment rate now looks like it will bottom out at 4.1% in late
2018, before gradually rising. (See Figure 8) Of course if the administration
embarks on a large scale deportation program for unauthorized immigrants
employment growth will be far slower than what we are now forecasting. Moreover
should the administration restrict the issuance of H1-B visas for highly skilled
immigrants there would be negative consequences for high technology industries.
Figure 7. Payroll Employment, 2007Q1
-2019Q4
Sources: Bureau of Labor Statistics and
UCLA Anderson Forecast
Figure 8. Unemployment Rate, 2007Q1 –
2019Q4F
Sources: Bureau of Labor Statistics and
UCLA Anderson Forecast
Inflation
on the Rise
Both headline and core inflation rates
as measured by the consumer price index are already increasing at a 2%+ clip.
It will not take much for inflation to ramp up to between 2.5% - 3%. (See
Figure 9) Oil prices continue to rebound and the very tight labor market will
bring with it rising wages. (See Figure 10) Although we were too early in our
prior forecasts in predicting accelerating wage inflation, we now believe that
the table has been set for sustained 4% annual increases in compensation. (See
Figure 11) We believe that the unusually slow 0.1% increase in average hourly
earnings reported for January was a fluke and it was inconsistent with other
labor market data.
Figure 9. Consumer Price Index, Headline
vs. Core, 2007Q1 – 2019Q4
Sources: Bureau of Labor Statistics and
UCLA Anderson Forecast
Figure 10.Compensation/Hour, 2007Q1 –
2019Q4
Sources: U.S. Bureau of Labor Statistics
and UCLA Anderson Forecast
Consumer Strong, but Housing Stalls
The growth in consumer spending has been
strong since 2014 and automobile sales have been running at a record rate. (See
Figure 11) Now throw in a large tax cut and real consumer spending will ramp up
from a forecast 2.8% increase this year to 3.6% in 2018. In this tax cut fueled
environment the saving rate will exceed 7%. (See Figure 12)However, housing
starts will plateau out in the 1.2 – 1.3 million unit range. (See Figure 13)
Simply put the rise in interest rates will offset the positive factors of
higher employment and wages. By 2019 the rate on the 30 year fixed rate
mortgage is forecast to exceed 6%, up from the current 4.25% and the recent low
of 3.5%. Moreover, because there are numerous signs that high income
multi-family housing is becoming over-supplied, that once white hot sector of
the economy will soon cool.
Figure 11. Real Consumption Spending,
2007 -2019F
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
Figure 12. Saving Rate, 2007 -2019F
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
Figure 13. Housing Starts, 2007Q1 -2019Q4F
Sources: U.S. Bureau of the Census and
UCLA Anderson Forecast
Capital
Spending Rebounds in the Face of Export Weakness
With the prospect of a general reduction
in corporate income taxes and the likelihood of 100% expensing, equipment
spending is forecast to rebound from 2.8% decline in 2016 to increases of 3.5%
and 7.1% in 2017 and 2018, respectively. Equipment spending will also be buoyed
by the recovery in oil and gas drilling being spurred on by the rebound in oil
prices.
Figure 14. Real Equipment Spending, 2007
-2019
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
On the other hand, despite all of the
rhetoric coming out of the administration the strong dollar and the large tax
cuts will ignite an import boom. After increasing by only 1.1% in 2016, imports
will increase by 4.3% and 7.3% in 2017 and 2018, respectively. (See Figure 15) On
the other hand export growth will be minimal as the high dollar and retaliation
from the administration’s protectionist views by some of our trading partners
will limit export growth especially in the aircraft and agricultural sectors.
(See Figure 16)
Figure 15. Real Imports, 2007 -2019F
Sources: U.S. Department of Commerce and
UCLA Anderson forecast
Figure 16. Real Exports, 2007 -2019F
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
Moreover the administration’s outspoken
hostility to NAFTA, especially with respect to Mexico risks a major disruption
in economic activity. In 2015 the U.S. exported $236 billion to Mexico while
importing $309 billion. Aside from disrupting supply chains, a significant
reduction in U.S.-Mexico trade would have significant macroeconomic effects.
(See Figure 17)
Figure 17. Schematic of NAFTA Trade
Source: Geopolitical Futures
Defense
Spending on a Roll
As we have been discussing for several
years the geopolitical threats coming from Russia, China, Iran and ISIS will
force the U.S. to increase defense spending. After six years of real declines,
defense purchases are forecast to increase by 1.2% in 2017 and then increase by
4.1% and 2.5% in 2018 and 2019, respectively. (See Figure 18) As we noted last
quarter, this is one spending priority that is expected to receive broad
support, especially with the increased hostility toward Russia coming from the
Democratic Party. Further with the administration pressing NATO members to
increase defense spending to 2% of GDP, domestic defense outlays will be
augmented by increased international demand.
Figure 18. Real Defense Purchases, 2007
-2019F
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
Conclusion
We continue to believe that the election
of Donald Trump represents a major regime change with respect to economic
policy. We expect significant reductions in personal and corporate income taxes
along with a relaxing of regulation in the energy, environmental and financial
arenas. However, because the economy is
already operating at or close to full employment, the growth spurt caused by
the policy changes will be short-lived but the deficits that it will create
will be with us for a long time. Moreover the policy changes will elevate
both inflation and interest rates that will have a negative effect on the
housing sector.
Because of the Trump administration’s
rocky start, we have become more concerned about the risks associated with
their stated trade and immigration policies. For the time being we have not
modeled in serious trade disturbances with our major trading partners and a
reduction in the labor force caused by a significant change in deportation
policies. Nevertheless those risks are rising.
[i] See Shulman, David, “First Pass at
Trumponomics: From a Reckless Monetary to a Reckless Fiscal Policy,” UCLA
Anderson Forecast, December 2016.
