United States: Tug of war & trade war
Congress is slated to inject a lot of fiscal stimulus over the next two years. The Fed’s job will be to carefully take that away to prevent risks of an overheating economy. This late-cycle tug of war between fiscal policy and monetary policy is highly unusual. We believe the outlook for the U.S. economy and corporate profits in 2018 is strong, but the challenge for markets is that this optimism is already priced in. We maintain an underweight preference for U.S. equities and see better value in other regional markets.
Tug of war between fiscal and monetary policy
President Trump has signed two fiscal stimulus packages since our annual outlook report was issued in early December. The first – the Tax Cut and Jobs Act of 2017 – significantly lowers the tax burden on corporations and high-income individuals. This bill should provide a strong tailwind for U.S. corporate profits in 2018. The second – a two-year budget deal signed in February – allows for large increases in discretionary government spending in 2018 and 2019. Taken together, this stimulus is significant; and it’s larger than the tax cuts that President Bush enacted to combat the recession in 2001 (see chart below). On the back of these developments, we have raised our 2018 forecasts for real GDP growth (to 2.6%) and S&P 500 earnings growth (to 12-15%).
Late-cycle stimulus of this magnitude is highly unusual
Source: Bureau of Labor Statistics, Congressional Budget Office, Bridgewater Associates, Russell Investments.
However, two factors prevent us from turning more optimistic about the cyclical outlook for U.S. equities.
- Industry consensus expectations for the U.S. economy and corporate earnings have soared in recent months. This increases the hurdle for future data to satisfy markets and suggests a more subdued return environment ahead.
- Injecting more growth this late in the expansion comes at a price – namely, faster inflation and a faster pace of Fed tightening. In his first testimony as Fed Chair on Feb. 27, Jerome Powell sounded more confident about both the growth and inflation outlook and hinted that the Federal Reserve may now be on track to raise rates four times this year. Against the backdrop of what is already a full employment economy, it will be the Fed’s job to take away this stimulus to prevent the risk of overheating. Longer-term Treasury yields have moved up in sympathy with these concerns to their highest level since early 2014. At 2.8%, 10-year U.S. Treasury yields are now in-line with our estimate of fair value.
After a century of U.S. policies that have generally trended in favor of globalization, President Trump has now lived up to his America First campaign pledge, imposing tariffs on steel and aluminum products and threatening the world with a trade war. We see this as a dangerous development for global markets. Directionally, trade wars are "stagflationary" in that they simultaneously damage growth and stimulate inflation. Today, U.S. businesses source more than 40% of their revenues from overseas, and they have complex global supply chains for bringing products to market. In this context, a disruption in either the volume or price of global trade could be very damaging in the short run.
The tariffs that have been imposed thus far on aluminum and steel imports do not materially impact our outlook. But we are wary that conditions could escalate further. An investigation by the United States into Chinese intellectual property theft is a major concern in this regard. Our watch points will include the severity of any punitive measures that the United States imposes on China, the severity of China’s retaliation to these steps, and whether these steps appear to be leading toward a constructive negotiation or a destructive tit-for-tat trade war. The final outcome of this is difficult to forecast. Our baseline is that the Trump Administration will leverage these tools to work towards a better deal for America. But nine years into the expansion, we recognize there is a small, but non-zero probability, that the situation could escalate into an end-of-cycle event for markets.
- Business cycle: Corporate profits have come in ahead of schedule as a weak dollar and stronger global cycle helped U.S. businesses deliver 15% earnings growth in Q4. We expect earnings growth to hover around this same, strong level in 2018 given the tailwinds from tax reform. The challenge: industry consensus expectations have shot up to 20%, increasing the risk that a good earnings year will still end up as a disappointment for markets.
- Valuation: U.S. equities remain very expensive. The Shiller P/E ratio1 for the S&P 500 stands at 33x – its highest level outside of the late 1990s.
- Sentiment: Positive momentum is offset by some evidence that U.S. equities have re-entered overbought territory.
- Conclusion: We continue to have an underweight preference for U.S. equities in global portfolios. With 10-year U.S. Treasury yields hovering around our 2.8% fair value estimate, we move back toward a neutral preference on U.S. government bonds for the first time in several years.
1The Shiller P/E ratio is a cyclically adjusted valuation measure defined as price divided by the average of 10 years of earnings (moving average), adjusted for inflation.
2NAIRU (non-accelerating inflation rate of unemployment) refers to a level of unemployment below which inflation rises – in percentage points (ppts) on the chart.