The silver lining in the cloud that has been U.S. politics the past several years has been the strength of the economy. Economic growth has been brisk while inflation and unemployment have been low. The resulting sense of optimism has lifted consumer confidence and helped investors rationalize elevated stock prices. That silver lining appears to be losing its luster, as the economic fundamentals are shifting. Numerous factors influence this shift. Any one factor warrants in-depth analysis, but the breadth of the issues arising begs for a broad initial assessment.
Monetary Policy
The Federal Reserve (or Fed) pursues its statutory dual mandate of full employment and price stability by various means. The most watched means of implementing monetary policy is by setting the interest rate, known as the fed funds rate, at which banks trade federal funds with each other overnight. The Fed raised the fed funds rate four times in 2018. Interest rates had been at historical lows because the Fed’s focus in the wake of the financial crisis of 2008-9 was on preventing another Great Depression by doing all it could to encourage investment. As the economy strengthened in 2017 and 2018, the Fed began to shift its focus instead to keeping the renewed economic growth from triggering an acceleration of inflation.
Like all methods for guiding the colossus that is the U.S. economy, there is a lag in the impact of changes in the fed funds rate on the economy. In the case of fed funds rate increases (or decreases), this lag tends to take about a year. While economic growth in the first quarter of this year was strong (3.1%), forward-looking economic indicators suggest a slowing in the economy. The Institute for Supply Management purchasing managers’ index (PMI®), an indicator of the health of the manufacturing sector, has fallen in both April and May. Fed officials (e.g., St. Louis Fed President James Bullard) now are talking of possible fed funds rate cuts this year if growth fails to meet expectations. In fact, forecasters at two major Wall Street banks are predicting two rate cuts later this year. Among the reasons for this expectation is the uncertainty introduced by the imposition of import tariffs and threat of further duties.
Import Tariffs
Tariffs are a type of tax, and consumers pay all or part of the increased cost of imported goods incurred by U.S. manufacturers. In response to the Trump administration’s imposition of tariffs on imports from China, China has announced its plans to retaliate, starting with reduced purchases of U.S. farmers’ soybeans. Furthermore, China is threatening to blacklist U.S. firms in response to the U.S. ban on Chinese tech giant Huawei. While U.S. manufacturers and investors were digesting the prospect of a trade war with China, the administration announced plans to impose tariffs on products from Mexico. Automotive company stocks were among the first to fall on the news on May 31st of the initial tariffs (of 5%) on imports from Mexico. Mexico’s economy is intertwined with ours, more than twenty-five years after the signing of the North American Free Trade Agreement (NAFTA). The negative impact on the U.S. economy will take time to reveal itself in full, but the debate among economists is not whether the impact will be negative. The question discussed is the magnitude in the reduction in U.S. GDP, and how soon.
Inflation
Inflation is, to use social media slang, “trending” low, with levels below the Federal Reserve’s stated target of 2% per year. In addition to dampening GDP growth, the administration’s trade war with China and Mexico could reverse the trend in inflation. Silicon Valley companies have begun incorporating into their budgets the tariffs imposed on China. It is only a question of time before consumer prices reflect those rising production cost levels. Perhaps more important, the U.S. and China economies are intertwined and cannot be separated on a whim without causing significant disruption to the U.S. and global economy. The impact of tariffs imposed on food, cars and clothes from Mexico will be visible to U.S. consumers faster than those imposed on technology products from China. Avocado prices will rise sooner than they will for smartphones.
Impact of Tax Act of 2017
The 2017 tax revision, referenced by its authors as the Tax Cuts and Jobs Act (TCJA), is projected to cost $1.5 trillion over 10 years (per the Joint Committee on Taxation). Remarkable in its own right, an increase in national debt of this scale may not be the most controversial effect of the TCJA. The Congressional Research Service (CRS) has issued a report (The Economic Effects of the 2017 Tax Revision) with its preliminary observations of the TCJA’s impact on the economy. As the report’s authors Jane G. Gravelle and Donald J. Marples state in the introduction, “the growth effects tend to show a relatively small (if any) first-year effect on the economy.” Further, the study finds “the evidence does not suggest a surge in investment from abroad in 2018,” as promised the by law’s sponsors (p. 13). As many taxpayers have by now discovered, there was a small change in individual income tax rates: an estimated reduction in the effective individual tax rate of 4% (p. 8). So-called blue-state residences may have seen an increase, as the TCJA imposed a $10,000 cap on the deduction of state and local taxes (SALT).
The meat of the tax cuts, however, applied to rates paid by corporations. The authors estimate the effect of the reduction in the statutory corporate tax rate from 35% to 21%, summarizing that “[t]he effective average tax rate for corporations was 17.2% in calendar year 2017, and fell to 8.8% in calendar year 2018.” (p. 8) While this corporate tax cut was sold as an incentive to increase investment and increase employment, the authors note that the funds freed-up by the cuts in question have “been used for a record-breaking amount of stock buybacks, with $1 trillion announced by the end of 2018.” (p. 14).
In contrast, the effect of the TCJA has been little growth in wages for ordinary workers. Average weekly wages of what the Department of Labor calls “production and nonsupervisory workers,” after adjusting for inflation, was 1.2% (p. 11). While an estimated headline-grabbing $4.4 billion was paid in worker bonuses, “With US employment of 157 million, this amount is $28 per worker” (p. 14) Inequities aside, the TCJA’s impact on economic growth, such as it was, appears to be fading. In fact, the diminishing impact appears to have been on the wane before the administration’s opening salvo in the trade war(s).
Wealth Effect
Consumer spending powers more than two-thirds of the U.S. economy. Economists advocating the wealth effect theory argue that the wealthier consumers (and companies) feel, the greater their propensity to spend. One source of this wealth effect, as it is known, is the value of business or personal investments (for consumers fortunate enough to have savings to invest). To that end, stock price gains since in 2017 were significant (21.8% for the S&P 500 Total Return Index), but the same stock index was down 4.4% in 2018 and its 2019 gains (10.7% as of May 31st) are receding, giving back 6.4% in May. Another source of the wealth effect is home prices (for consumers fortunate enough to own their own home), and housing price gains are slowing, with the S&P CoreLogic Case-Shiller National Home Price Index up 3.7% for the year ending March, down from the annual gain the prior month (3.9%).
To the extent that this theory holds, the less wealthy consumers and companies feel as asset price growth tapers off or falls, the lower will be the propensity to spend or invest. The lower the propensity of consumers to spend and businesses to invest, extending this logic, the greater the drag on aggregate demand. Hence, the greater the potential dampening effect on economic growth.
Conclusion
The U.S. economy has served as a ballast for citizens concerned about the questionable state of core institutions of the republic. The chaotic executive and paralyzed legislative branches are the two most obvious examples. For those of us fortunate enough to own stocks and/or own our own home, the financial gains accompanying the growing economy have eased some of the stress of those straining societal pillars. Perhaps as a response to the sad state of national politics, the economy seems to have morphed into the American equivalent of Britain’s royal family. At times enigmatic to its most studied observers, and symbolic of strength even for the those distant from its decadence. When we have felt overwhelmed by the news of continual political conflict, we have been able to point to reassuring economic statistics and take some comfort in the expectation of national prosperity. The thing is, an economy that serves as the core of national identity is problematic.
What if the silver lining that is the economy is in fact losing its luster? What are we to do?
We cannot afford to sell all of our investments, store our cash under the mattress and risk missing out if these fears prove unwarranted. Political pressure on the Fed to reduce interest rates heading into an election year could prove effective in propping up the economy. To wit, this political pressure has been reinforced by the threat of trade war(s). The potential impact of softening economic fundamentals demands, however, that we ground our expectations in the lessons of history. If and when the fallout ensues, we need to be prepared for the knock-on effects of these shifts on financial markets. Maintaining an asset allocation commensurate with our risk appetite is essential. Diversifying within those asset classes, rather than betting on the next stock darling, is important as well. A focus on the long-term helps shield us from the distraction of short-term volatility and helps us to stay the course.
When an economy that is essential to national identity loses its luster, there is no avoiding a significant impact on financial markets and politics alike. The Bard of Avon speaks to this phenomenon best:
“…Never alone
Did the king sigh, but with a general groan.”
–William Shakespeare, Hamlet, Act III, Scene III