The end of the year is upon us. While markets move each and every day, we still like the calendar constraints to put a given year in context, so let’s proceed into some big picture thinking. I’m never wedded to my year-ahead views, but they serve as a roadmap and keep me aware of where things change (and where I’m wrong). With that, here are the key bullets on my mind.
- Fed hiking – Odds favor an ending rate near 1.87+ percent, with 30 percent for 2-2.25 percent. I give more odds to the latter, the logic being that the Fed will remain concerned over inflation and the tax bill does raise the risk of at least a bit to added growth.
- Speaking of wage gains – If some of the Fed’s alt views on inflation influence policy, then we have the risk of a more aggressive hiking cycle. I think the odds are low, but I refer to the Fed’s persistent view that soft inflation is due to transitory elements. A recent San Francisco Fed report, “What’s Down With Inflation?,” says procyclical inflation is back up to pre-recession levels, while acyclical ones are indeed temporary, like reduced Medicare and healthcare inflation, due to the influence of the AFA. The subtext could be that this means real wage gains are less than advertised, so even the 0.2 percent year-over-year real average hourly earnings could be exaggerated.
- Base effects – Could lift inflation early in the year, maybe aided by oil, commodities and the dollar. I don’t think it will last but it gives the Fed cover.
- Overall growth to remain modest – Along the 2.1 percent lines that have been the average since 2012, though the impact of the tax plan might help. I’m just not sure if that’s 2018 or 2019. Still, the expansion has been a long one, and there are some late cycle elements that make me more cautious on growth.
- Treasury debt and auctions – The deficit was going to rise sharply and that doesn’t include the consequences of the tax plan. Treasury wants increase in debt-financing to be concentrated on the front end, which along with hike errs for more pressure on the front end relative to the back end, i.e., a flatter curve.
- Longer issuance ultimately – While they’ve backed off on the added longer-term plans for now, I don’t believe that can last. First, ALL issuance will have to rise with the bounding deficit. Second, the logic of a flatter curve, with rates still low, makes a compelling case for more 30s and introduction of maybe 40s and 50s. This isn’t a 2018 issue, but the debate will go on and I think it will become serious later in the year.
- Mid-term elections – At the risk of getting into a bit of trouble, I think the risk is that GOP loses a lot, raising uncertainty. The intensity of Trump’s tweets, and silly barbs at unimportant issues or personal peeves, is something the country is getting tired of. A year into his administration, the questions of his temperament and maturity, to say nothing of focus on the critical issues, seems undermined by his narcissism. I’m not sure what the GOP’s agenda will be once they get the tax thing done, but then I’m not impressed with the Democratic leadership on the issues other than to say, “we’re not Trump’s party.” That might be enough.
- The GOP Tax “reform” – It’s not reform but deficit-financed tax cuts, the GDP impact of which remains to be seen and whose scoring in terms of GDP-boosting is dubious. The Joint Committee on Taxations says it will increase GDP by just 0.8 percent over 10 years in total, 0.08 percent per year. Further, while it’s good for corporations and the wealthy, it will be neutral for many and downright negative for those in high tax states, with high mortgage interest deductions.
- Risk assets – With central banks taking away the proverbial punch bowls and equity markets high credit spreads taut, and, yes, things like bitcoin reeking of a speculative bubble, I look for, ahem, subdued returns.
- Monetary policy – To the extent easy money, negative rates and central bank balance sheets have aided the bullish behavior in risk assets, the follow through is the slowing of that activity from central banks and reversals would have dragging consequences. One could make the same case for higher interest rates, of course, but that influence seems more related to curve flattening with rising short rates, at least in the U.S. versus dire consequences further out of the curve.
- Credit – U.S. corporations have incurred a massive amount of debt relative to GDP and used that for buybacks and other activities unrelated to expansion or productivity-enhancing investment. Various surveys and anecdotes suggest that with any gains from the tax plan, corporations will use that to: (1) pay down debt, (2) buy back stock, and (3) look to acquisitions and mergers. A Washington Post article on the topic relayed, “Actual investments in new factories and more research were low on the list of plans for how to spend extra money.”
- ETFs vs. Active – The growth in exchange traded funds creates a concern for me in the event of a bear market (or bull market I suppose). The issue is that ETFs are liquid but their assets are not so if there’s a panic then the selling pressure can exacerbate price deterioration. I’m thinking, of course, about the less liquid areas like high yield and emerging markets. A flipside to that is if active managers have added more risky things to their portfolios to enhance performance, they may be forced to sell in a bear market for such assets. But then, I’m a worry wart. The point is that if we do face a bear market, there could be more selling pressure than historically and my sense is neither the Street nor hedge funds have the liquidity to handle that. (The Fed’s balance sheet is a possibility though has a very high bar for expansion versus contraction.)
- Demographics – This is such a big topic that a mere bullet point doesn’t do it justice. Suffice it to say that the population is growing older, which has implications for more conservative spending and investment habits. Slow population growth is also a generic drag on GDP. Wages gains for aging populations are slow to negative as older workers are: (1) less productive, (2) less upwardly mobile, (3) less geographically mobile, (4) less demanding on wages, and (5) more interested in flexible hours and health benefits. Further, the benefits they expect have to be paid for, which means higher taxes, benefit reductions or a combination of both. The uncertainty surely will weigh on spending to encourage savings.
- Rates – I hate being in consensus, but with Fed transparency and Treasury intentions regarding auctions, we have reason to see pressure on the front end of the curve. I “allow" for seasonal patterns, such as bearish modes in H2, to put upward pressure on long rates that might be aided by a temporary uptick in inflation pressures and spillover enthusiasm from the tax plan and recent global data. I do think 10s can probe the post-election high near 2.64 percent and perhaps maybe take a stab at the 2.75-90 percent range. I would deem the latter a buying opportunity, especially against shifts into bonds vs. stocks, that would keep the flattening intact and bring 10s into a 2.20-2.50 percent in the second half of the year. The bull market in bonds may be over; I don’t believe we’ve entered a major bear market.
David Ader is Chief Macro Strategist for Informa Financial Intelligence.