Happy 2017, everyone! Who is ready for all of the change that is about to be upon us? A new President will be inaugurated tomorrow, January 20th, and Donald Trump has promised change. He has used his slogan of Make America Great Again to show that his focus will be on the US and the US economy. His election has already brought change to the financial markets, sending stocks rising 6%, as measured on the S&P 500 index, and sending interest rates to their highest levels in years. Clearly, the markets expect change. After Trump becomes President, the markets are expecting actions that will mean positive change for the economy,
Analyzing what change will mean to economic growth is clearly a challenge. I wrote in October that there is no momentum and no catalyst to push GDP much above 2.0%. The thought of change may have tried to do that, but change itself may not accomplish it. For so long, we have been stuck at 2.0% growth. Since the recovery began in June, 2009, real GDP growth has averaged 2.3%. Most recoveries in the US have averaged far more than that. This recovery is already 90 months old and growth has not yet reached its potential. In the past ten years, the economy has not managed even one year of 3.0%+ growth. So what has been holding us back? First, we have inordinately high debt levels, especially in the federal government sector, of nearly $20 trillion. Actual non-financial debt in the US totals about $70 trillion, or 370% of GDP. Debt at multiples above 100% begins to hurt the economy. Debt at multiples above 250% to 300% has been proven to dramatically slow economic growth and push inflation downward. The last seven years are proof. Debt is not going away, change or not, and will keep pressure on growth.
Secondly, productivity has been very poor over the past five years or so. Since 2011, productivity has fallen by -.4%. Compounding the issue has been a reduction in the labor force, with retirements removing skills from the workforce, discouraged workers, and skills mismatches resulting in people not able to find appropriate jobs. Corporate profits have been held back as costs rose on a relative basis as productivity fell. Third, the explosion in regulations over the past eight years has served to hinder businesses, especially new small business formation, and has drained valuable resources as compliance costs soared. Bank lending has not been the catalyst it used to be for improved growth in this recovery compared to prior ones; maybe we can point at regulation after regulation being forced onto banks and higher, more restrictive capital requirements. Maybe change will be coming.
What Will Change Look Like?
Change has already resulted in higher stock prices and higher interest rates. I mentioned that interest rates have risen dramatically since Election Day. The two year Treasury yield reached 1.26%, its highest level since August, 2009 and the ten year Treasury yield reached 2.58%, its highest level since September, 2014. The quick jump in rates in late 2016 is reminiscent of the increases in 2013, with rates rising in both cases up 100 basis points in just over 100 trading days. The markets must think that GDP growth will soar on January 21st. I have news for them; it takes a lot longer for fiscal policy to translate to growth than you think.
President Trump has promised several policies that should improve economic growth, and Make the Economy Great Again. He has promised the elimination of many regulations that are strangling businesses. If bank regulations are lifted, lending and thus growth can improve. Some regulations have had a negative impact on the markets, such as the Volcker Rule, which has reduced liquidity in the marketplace by restricting trading activities. I have a theory that some of the rate increases and drop in bond prices were due to reduced liquidity and lack of market making. I cannot quantify how much at this time, but I am sure it’s there. Other regulatory reform promised by Trump involves energy production, which could improve growth and serve to keep gas and oil prices lower, keeping inflation at bay.
Corporate and personal tax cuts were promised, with the corporate rate dropping from 35% to 15%. I don’t know if that large a cut would occur, but these actions will add to economic growth. I saw an estimate that 50% of the effect of tax cuts flows through to growth in the first eighteen months. To be truly effective, tax cuts should be paired with cuts in government spending so that there is not additional borrowing to fill the deficit. In the early 1980s, the Reagan tax cuts took two years to push GDP growth above 3.0% and that was with a Federal Reserve, run by Paul Volcker, who was aggressively lowering rates. Trump has a Fed, run by Janet Yellen, who continues to believe that they need to raise rates.
Rebuilding our infrastructure is another proposal, but I think government borrowing would increase- either from paying for projects or from tax credits to companies to do the work. If government borrowing continues to increase, it will add to the crowding out effect on private investment, and not adding much to growth. But I am in favor of much of this infrastructure improvement and am so tired of having to drive to dodge potholes.
Economists are mixed on their reviews of the Trump proposals and change on GDP growth. The latest Fed forecasts, released in December, 2016, have ranges for 2017 for GDP of 1.9% to 2.3% and 2018 at 1.8% to 2.2%. Wait! That is no better than the 2.3% since 2009. And the Fed felt compelled to raise rates and to say they will keep raising them? I think they must be looking at a few signs of inflation and thinking they must tighten now. If inflation sticks, they will be right, since it will exceed their 2.0% target. More than likely, high debt levels will keep it under control. The latest Bloomberg survey, released in January, 2017, has GDP in 2017 at 2.3% with rising rates. Wait! That is no better than the 2.3% since 2009. Some of the “higher” projections are from private economists, Dr. Don Ratajczak and Brian Wesbury with 2017 at 2.6%. Dr. Ratajczak has 2018 at 2.9%. The lowest I have seen is for real GDP below 2.0% for 2017, because high levels of debt keep growth and inflation at reduced levels. With many of these forecasts, I wonder: Why did rates rise so much?
Thanks for reading! DJ 01/18/17
Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with Penn Community Bank and its predecessor since November, 2004. She is the author of Just Another Good Soldier, and Honoring Stephen Jaworski, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure of devotion.