economic perspective

February 2017

  

While 2016 revealed mixed economic growth in the United States and abroad, data is beginning to suggest strengthening growth worldwide. However, much will depend on the implementation of and impact from various proposed policies and executive orders from President Trump's administration. With these issues in mind, Thomas Dillman, President of Mutual of America Capital Management LLC, provides a close look at the critical issues that may impact sustained global and domestic economic growth in 2017.

Global and U.S. Data Suggests Economic Growth

Most recent global economic data suggests that growth is continuing and actually picking up in Europe and Japan. Despite the United Kingdom's vote to exit the European Union, the U.K. economy has shown no immediate deterioration. China recently announced that the Gross Domestic Product (GDP) for 2016 grew at a slightly higher rate than in 2015. And, according to J.P. Morgan, all developed market Purchasing Managers' Indexes (PMIs) are above 50—signaling growth—and most have been improving over the past several months.

Similarly in the United States, results from all business and consumer confidence surveys over the past several months show significant advancements in economic growth. Likewise, U.S. focused business activity surveys, such as the Institute for Supply Management's PMIs for both manufacturing and services, as well as Federal Reserve regional reports, are signaling continued growth. The actual hard data, as opposed to survey results, generally support the surveys: the unemployment rate remains below 5%; nonfarm payrolls exceeded 250,000 in January, up from an average of around 150,000 per month over the preceding three months; jobless claims remain at historical lows; and productivity adjusted wages are increasing at 2.5%, as compared to average cycle peaks of about 3.0%. Consumer spending continues to advance at about a 2.5% rate, low by historical standards, but in line with the rate throughout most of the current business cycle.

These economic trends are showing up in corporate earnings reports. With about 80% of S&P 500® earnings and sales reported for the 4th quarter of 2016, earnings are running 2% ahead of expectations, at a rate of 5%, versus the same period a year ago. This is the strongest showing in the last eight quarters. Earnings growth is being driven by a solid 4% sales growth. Earnings and sales surprises are tracking long-term averages. All sectors except Utilities and Telecommunications are ahead of expectations. These improving results were generated during a relatively lackluster quarter for the U.S. economy as a whole during which GDP growth came in at 1.9%, well below earlier expectations. However, the markets are not responding to positive and negative surprises in customary fashion. Positive surprises are advancing less than average, while negative surprises are declining more than average.

Similar upturns in earnings are being reported in Great Britain, Japan and Europe—the first two because of imports lifted by weak currencies, the third because of generally improving economic strength from very depressed levels. Chinese companies have also shown fairly good earnings, largely because of significant fiscal stimulus throughout much of 2016.

Various Macro Issues Continue to Hamper Growth

Nevertheless, as usual, future prospects are weighed down by a host of macro concerns. After a year of significant government stimulus, China has begun to curtail its support of the economy. Reserve outflows continue, threatening a currency crisis that would have a worldwide negative impact. The desired shift away from such a dependence on trade to a more balanced economy between trade and a vibrant domestic economy is taking longer than expected and more difficult than assumed. The financial system remains overburdened with debt on the balance sheets of state banks. Of course, these issues are not new, but they remain unresolved and represent risks to the global economy.

Europe has its own problems. The key issue is the long-term viability of the European Union. Brexit, the U.K.'s vote to leave the EU, may prove to be the first in a series of withdrawals. Italy continues to struggle economically, with the banking system on the brink of bankruptcy. But a recent referendum to reform the legislative branch of the government to reduce its stranglehold on reform and progress was rejected, resulting in the resignation of its president, who was the driving force behind the proposed reforms. The European Central Bank (ECB) is reluctant to offer assistance. Populist forces are calling for withdrawal from the EU, which would allow Italy to escape the euro and devalue its currency to make the economy more competitive.

Similarly, the leading contender to win the first round of voting in the upcoming French election, Marie Le Pen, a far-right activist, is a staunch advocate of leaving the EU and ending its use of the euro. And, of course, there is Greece. While showing some economic improvement over the past couple of years, admittedly from very depressed levels, the country remains dependent on loans from the International Monetary Fund (IMF) and the ECB.

Impact of President Trump's Policies and Executive Orders Felt

In the U.S., President Trump created turmoil throughout the world with aggressive initial policies and many off-the-cuff statements that are inconsistent with long-term U.S. foreign policy and that focus on reversing many domestic policies and practices. Domestic targets include the Affordable Care Act (ACA), nicknamed Obamacare, and U.S. immigration policy. His executive order to institute an immediate ban on entry into the U.S. by anyone from a list of seven predominantly Muslim countries, and a ban on all refugees, resulted in numerous protest demonstrations around the world as well as lawsuits. A ruling by a federal district judge temporarily suspended the ban, a decision that was subsequently upheld by the U.S. Court of Appeals for the Ninth Circuit. The Trump administration subsequently dropped its appeal in favor of a new executive order.

In a spate of other executive orders within the first three weeks of his administration, the president ordered initiatives to address the following: begin financial deregulation; buttress the military; plan for a defeat of ISIS; roll back constraints on building energy infrastructure (i.e., pipelines); curtail lobbying; re-examine all aspects of U.S. trade policy; cut back on funds to international groups that perform or support abortion; institute a hiring freeze on government employees; and reorganize U.S. agencies charged with responsibilities for national security.

On the foreign policy front, President Trump's first steps caused extreme consternation throughout the world. His campaign pledge to build a wall on the border between Mexico and the U.S., and force Mexico to pay the cost, ended with the Mexican president cancelling a trip to meet Trump in Washington, D.C. Similarly, another campaign pledge, which encouraged Israel to continue building homes for its citizens on lands claimed by Palestine, as well as the relocation of the U.S. embassy from Tel Aviv to Jerusalem, represented reversals from long-standing policy toward Israel aimed at a negotiated settlement between Israel and Palestine.

Similarly, President Trump's post-election acceptance of a telephone call from the president of Taiwan, and statement that the "One China" policy—the open acknowledgement that Taiwan was a sovereign part of China, and the pre-condition for China's opening its economy to the world negotiated by Richard Nixon in 1972—was open to renegotiation, further chilled U.S.-China relations. This followed his campaign promise to label China a currency manipulator and slap high tariffs on Chinese imports to the U.S.

One of the most disturbing comments the president made on the campaign trail was his threat to have the U.S. leave NATO, the post-WWII alliance between the U.S., U.K. and most European countries to stand together against any hostile force, especially the Soviet Union, and subsequently Russia. The rationale for this threat was that almost no member of NATO has paid its allotted share to the alliance. Perhaps the threat of withdrawal is an example only of Mr. Trump's negotiating style, but the statement has, to say the least, ruffled feathers in Europe. In addition, a U.S. exit from NATO would likely set off a rapid reordering of world alliances and thus create conditions of extreme uncertainty.

The good news, at least in the foreign policy arena, is that the president walked back most of these positions toward current and foreign policy stances. In our last Economic Perspective, we suggested that political reality and wise counsel from experienced advisors would ameliorate Mr. Trump's hard edges. This seems to be happening, at least within the foreign policy arena.

Domestic policy may be different. First, it is important for the credibility of this administration to fulfill its pledges to those who elected the president. Second, much of the domestic policy agenda pertaining to economic policy is well within the Republican tradition, but incorporating a Trumpian twist toward actively improving the economic well-being of the middle class rather than waiting for the benefits of a strong economy to "trickle down" to the masses. The goal is laudable, and longer term, probably vital for our economic growth and social stability. That said, the task of getting tax reform and substantial fiscal spending legislation through Congress will be formidable. Predicting what eventually comes out of legislative action is highly speculative, while the actual impact on economic growth and corporate and consumer well-being is impossible to forecast.

Financial Markets and Global Economy Face Uncertainty

Clearly, the future of the world economy, as well as prospective geopolitical dynamics, have become much more uncertain. As we've repeated many times, markets do not like uncertainty.

Why then have financial markets remained so stable over the past few months? The market has gone through one of its longest periods in history without trading up or down by more than 1%. This stability seems to contradict all the old and new uncertainties facing the world economy. As discussed in our last Economic Perspective, the recent firmness in economic data around the world, and the market's anticipation of major tax reform and infrastructure spending from the Trump administration, seem to have suspended the market at record levels. If economic growth accelerates, either on its own merits or on indications that anticipated fiscal stimulus is growing more probable, the market will almost assuredly advance. To the extent that much of current market dynamics are being affected by the potential implementation of Trump's economic program, that program remains open to changes and limitations in the negotiating process. In addition, the time required to pass and implement whatever tax or infrastructure plan is forthcoming will likely prove longer than the enthusiasts anticipate. This is only to say that the market may be prone to disappointments along the way, especially since its valuations remain high by historical standards and appear to be based on highly probabilistic expectations.

However, if the economy does not continue to show further improvement, or begins to slow, and/or the Trump tax and infrastructure initiatives are delayed, diluted or outright rejected, the market would be vulnerable on the downside. This expansion is now the second longest on record. Inflation is rising, although a large part of that increase is from the bounce in the price of oil and its derivatives. But other components of inflation, such as housing and health care costs are rising. Unemployment is near record lows and some data show wages advancing more than the customary measure of average hourly earnings. Rising wages will put pressure on margins. In the meantime, the Federal Reserve is raising interest rates, slowly so far, but telegraphing a more accelerated pace in the future. Should short-term rates rise faster than long-term rates, investors will begin to anticipate the point at which short rates exceed long rates—which almost inevitably leads to recession. We are not forecasting a recession, but some of the recessionary precedents are beginning to line up.

It seems reasonable to conclude that we are closer to the end of the economic cycle than the beginning. But as we've suggested before, growth at 2% without excesses or distortions in the forces driving economic growth could persist for years. That said, risks have risen further, in both the global economic and the geopolitical realm. The wild card here is Mr. Trump's presidency. Thus far, his policies seem to lack a coherent strategy, and appear hurried in some cases, lacking adequate preparation as well as advanced notice to Congress and even to some of his close advisors. If this style persists, it will likely increase turmoil and uncertainty both in the U.S. and throughout the world.

The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.

Mutual of America Capital Management LLC is an indirect, wholly owned subsidiary of Mutual of America Life Insurance Company. Mutual of America Life Insurance Company is a registered Broker-Dealer.



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