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Economic Outlook | Winter 2016

Donald Trump‘s Moment of Truth

from Anthony Chan, PhD, Chief Economist for Chase



Anthony Chan - Winter economic outlook

Summary

After what felt like the longest campaign ever, the 2016 election is finally over. It’s time to sit back, take a deep breath and reflect on where we stand as we await the inauguration of America’s next president, Donald J. Trump, whose remarkable come-from-behind victory puts the Republican party firmly in charge of the national agenda.

From an economic policy perspective, President-elect Trump is not entirely on the same page as his colleagues in the Senate and House of Representatives. However, we expect them to quickly iron out their differences and take advantage of their party’s dominant position to pass sweeping legislation that could re-energize U.S. growth as the country boosts infrastructure spending, which can generate positive spillover effects to the global economy and markets.

The End of Gridlock

With Republicans controlling both ends of Pennsylvania Avenue, we can expect them to move quickly on areas of common ground. Tax cuts are likely to be at the top of their agenda. While candidate Trump sometimes spoke of higher taxes on the wealthy (e.g., eliminating carried interest for the wealthy), his actual policy proposals look quite similar to traditional Republican tax relief. Trump’s plan and that of House Speaker Paul Ryan would result in similar reductions of approximately $9.5 trillion in federal revenue over the next 10 years, according to the nonpartisan Tax Policy Center.Footnote 1 This would provide powerful fiscal stimulus in the short term, although the resulting deficits could crowd out private investment over time.

Other areas of common ground between congressional Republicans and President Trump could be to repeal Obamacare and reduce regulation of the pharmaceutical, biotech, energy and financial industries. Sharp differences are likely to remain in areas such as entitlements and trade. To be sure, if President Trump believes that the U.S. has been hurt by unfair trade practices, he could impose higher tariffs on Mexico and China, and could also begin implementing other trade policies on his own, such as withdrawing from NAFTA or labeling China a currency manipulator. Increased trade barriers could spark a revival in U.S. manufacturing but potentially lead to renewed inflation or layoffs by U.S. exporters.

U.S. Jobs Machine Keeps Rolling Along

Despite (or perhaps because of) the government’s inability to pass significant economic legislation in recent years, the U.S. economy continues to be the envy of the developed world. We’ve created nearly 2.5 million net new jobs in the past 12 months.Footnote 2 While our anticipated 2016 GDP growth of 1.6% is down from last year’s 2.6%, it looks downright robust compared to 1.4% in Europe and 0.6% in Japan.

Not only are new jobs being created, but we are seeing a huge surge in the number of people rejoining the labor force. One reason cited by the Fed when it delayed its September rate hike was that its members wanted to see whether there would be an improvement in labor force participation. Now they’ve seen it. The labor force grew by 2.6 million in the past year.Footnote 3 Wages have also grown 2.8% so far this year, nearly twice the rate of inflation.Footnote 4 And the Census Bureau just reported that real median household income rose by 5.2% last year, the largest increase in nearly two decades.Footnote 5 Much of that increase came in low-income households, as the poverty rate also fell by the largest amount since 1999.Footnote 6

Three million workers rejoined the U.S. labor force in the past 12 months, the greatest year-over-year increase since December 2000.

U.S. LABOR FORCE (9/09 – 9/16), Source: U.S. Bureau of Labor Statistics

The Fed May Take a Hike

After predicting as many as four interest rate increases in 2016, the Federal Reserve is finally expected to raise rates when it meets in mid-December for the first time this year, if U.S. and global financial markets remain stable given the recent improvement in U.S. fundamentals. As of this writing, futures markets were predicting an 82% chance of a rate hike this month. The Fed has been reluctant to raise rates too quickly, not wanting to “take away the punch bowl” before the party really gets going. But it is forced to act by the persistent rise in employment and wages, as well as early signs of accelerating inflation. The year-over-year inflation rate (excluding food and energy targeted by the Fed) is still at 1.7% but could approach its targeted annual rate of 2% by the end of this year.

Looking ahead to 2017, we currently forecast the Fed will continue on its cautious path by raising rates just one or two times. This is based on our assumption the economy will grow at approximately 2% next year, which is slightly higher than 2016 but lower than last year’s 2.6% growth. Of course, if the new Congress passes a significant fiscal stimulus, in the form of either tax cuts or infrastructure spending, the Fed could feel free to move toward “normal” (i.e., higher) interest rates even faster.

Global Central Banks Approach Their Limits

This monetary retrenchment is not limited to the United States. We’re seeing a global movement by central banks to pull back on their aggressive monetary policies of recent years and turn to other kinds of stimuli. This summer, the Japanese government announced a $130 billion spending program to complement the Bank of Japan’s quantitative easing.Footnote 7 Although the European Central Bank is likely to extend its QE program next year, we expect it to cut back from its current level of buying 80 billion euros of bonds every month. The United Kingdom presents a special situation — the UK pound has already declined so much because of Brexit that it should eventually drive an increase in economic activity.

In China, the combination of monetary and fiscal policy has been so successful that it’s caused the housing market to overheat. The Chinese government is now moving to offset some of this speculative activity by increasing down payments on second homes and similar moves. We’re already seeing some preliminary data that suggests that housing is starting to slow down. The Chinese government has ample foreign reserves to pull out its checkbook whenever it needs to make adjustments.

Will We See a Correction Next Year?

Generally, the U.S. stock market performs well in the first year of an eight-year Presidential cycle. As we reported this summer, average returns in the first year of a new administration are 8.9%. However, after eight consecutive years of positive total returns (assuming the market doesn’t collapse in the closing weeks of 2016), we could be due for another correction — especially with the S&P 500 price/earnings ratio in the mid-20s, well above the long-term average of about 15.Footnote 8

It’s impossible to predict what would trigger a correction, but a likely scenario is for the Fed to signal another aggressive program of tightening as it did last January, which caused the market to drop around 10%. This, however, would be no reason for investors to panic. The Fed has consistently overstated the pace of rate hikes for the past five years. Every time the market reacts, the Fed pulls back — just as it did last year when it promised four rate hikes in 2016 but will end up doing just one, at most.

Sectors to Watch in 2017

Many sectors of American business are expected to benefit from Republican policies. At the head of the list could be energy companies, defense contractors, manufacturers, pharmaceutical biotech, infrastructure-related companies and the financial services industry.

However, there remains a great deal of uncertainty around the impact of the Trump administration’s economic and trade policies. As markets hate uncertainty, it could lead to a choppy ride in the coming year.

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