Booming Economy and Inflation Above Expectations
Our outlook for the stock market, real assets, and cash is positive. We see positive economic fundamentals supporting stock market growth but with rising inflation expectations. Real assets will benefit from higher inflation as asset values rise. Cash returns should also benefit as the Federal Reserve raises interest rates. However, the outlook for fixed income assets is negative on account of a rising rate environment.
We see the U.S. economy running at full speed with most of the Conference Board U.S. Composite of Economic Indicators showing positive trends. 19 out of 21 indicators are showing a positive trend. Trade tensions due to the Trump Administration's protectionist policies have yet to be reflected in the data we looked at but could pose a risk to future economic growth. The economy risks overheating as the Trump Administration and Congressional Republicans add $2.289 trillion (Congressional Budget Office estimate) to the national debt through the Tax Cuts and Jobs Act of 2017.
*Shaded red regions within charts represent past economic recessions according to the National Bureau of Economic Research (NBER).
The Conference Board Leading, Coincident, and Lagging economic indices are all trending higher. Leading indicators suggests the economy is likely to continue expanding over the next 6-12 months. Coincident indicators indicate the economy is currently growing while lagging indicators provide confirmation of the economic upswing.
We believe the U.S. economy is in the late upswing phase of the business cycle. In the late upswing of the business cycle, inflation is gradually picking up and monetary policy becomes restrictive. Investor confidence exhibits a boom mentality as short-term rates rise, bond yields rise, and stocks experience more severe spikes in volatility. However, the stock market rally continues to persist as positive economic fundamentals provide momentum support.
Monetary policy is currently restrictive with the Federal Reserve raising interest rates and reducing their balance sheet in an effort to prevent the economy from overheating. Meanwhile, fiscal policy threatens to do just that as the federal government enacts the Tax Cuts and Jobs Act of 2017 which is expected to increase the national debt by $2.289 trillion over 10 years according to the nonpartisan Congressional Budget Office (CBO). We believe a tight monetary and loose fiscal policy with high capital mobility will contribute to a flattening of the yield curve.
We think the U.S. dollar will remain strong as higher yields attract foreign investors. At some point though, the Federal government may be forced to cut spending or raise taxes as larger deficit spending becomes harder to finance. The central bank may have to monetize (print more money) the debt if the economy contracts. In the long run, we believe the U.S. dollar is likely to depreciate especially if the European Central Bank (ECB) and/or Bank of Japan (BOJ) switch to a restrictive monetary policy.
The U.S. inflation rate is higher than most of the G10 industrialized countries' inflation rates based on CPI. This suggests that the U.S. dollar could depreciate according to Purchasing Power Parity (PPP) theory. The table below indicates that most of the G10 currencies are undervalued relative to the U.S. dollar based on PPP.
Inflation is currently above consensus expectations. This may have a positive effect on cash which is biased toward rising interest rates. The effect on fixed income bonds is likely negative as yields rise due to an increasing inflation premium. Variable rate bonds and short duration fixed income bonds may perform better than longer duration fixed income bonds in this environment. Higher inflation could be a headwind for stocks as cost of capital and labor costs increase but less negative for companies/industries which are able to pass on inflated costs. Real estate and other real assets may see a positive effect from increasing asset values, increased cash flows, and higher expected returns.
The output gap turned positive in 2017 indicating inflationary pressure will be a key concern for the Federal Reserve. The output gap is a key measure of real activity for policy making because it provides information about future inflationary pressures as well as an output objective. We expect the central bank to continue hiking interest rates in response to inflationary pressures from the output gap.
The Taylor Rule Model below suggests the Federal Reserve should hike the federal funds target rate to 4.93% over the current rate hike cycle. The federal funds rate is currently 2.00% which suggests we are still in the early phase of the current rate hike cycle. The labor market is already at full employment and headed for labor shortages which should put pressure on wage inflation. Wage growth is increasing according to the Atlanta Fed Wage Growth Tracker as labor supply tightens and employers raise wages to retain workers.
Appendix 1: Conference Board U.S. Leading Economic Indicators in Charts
Appendix 2: Conference Board U.S. Coincident Economic Indicators in Charts
Appendix 3: Conference Board U.S. Lagging Economic Indicators in Charts
Notes: The Cyclical Indicator Approach
The composite economic indexes are the key elements in an analytic system designed to signal peaks and troughs in the business cycle. The leading (LEI), coincident (CEI), and lagging (LAG) economic indexes are essentially composite averages of several individual leading, coincident, or lagging indicators. They are constructed to summarize and reveal common turning point patterns in economic data in a clearer and more convincing manner than any individual component—primarily because they smooth out some of the volatility of individual components.
Historically, the cyclical turning points in The Conference Board LEI for the U.S. have occurred before those in aggregate economic activity, while the cyclical turning points in The Conference Board CEI for the U.S. have occurred at about the same time as those in aggregate economic activity. The cyclical turning points in The Conference Board LAG for the U.S. generally have occurred after those in aggregate economic activity.
Source: The Conference Board.
This material is prepared by NR Capital Management, LLC and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of July 2018 and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by NR Capital Management, LLC to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by NR Capital Management, LLC, its officers, employees or agents. This material may contain ‘forward-looking’ information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Economic data cited herein are from Bloomberg, unless otherwise noted.