The end of a year and the start of another tend to get the mind to focus on milestones, even if they are arbitrary, set by the calendar. Normally, forecasting falls back on either extrapolation of recent trends or an analysis of potential changes to those same trends, based on things seen in the environment which have not manifested themselves statistically.
For forecasting 2017, neither approach works. With a new President, one would expect a break with the past and a reshuffling of priorities. This makes extrapolation irrelevant. At the same time, the lack of background on Donald Trump as an elected official gives precious little in the way of material for environmental analysis.
For what Donald Trump has done is not so much win the presidency as a Republican; he staged a hostile takeover of the Republican Party, and then used its infrastructure to win the presidency. Many of Trump’s supporters identify with him and not with the Republican Party. Republicans try to paper over these differences, but with declining effect.
This means we have, for the first time, a leader who owes no one anything. This creates two issues: what will Trump do, and how long will the Republicans continue to publicly back him?
To the first question: Trump has shown a propensity to want to be on the winning side of any argument, with facts playing at times, and at most, a supporting role. The issue is how long he will stay with an unpopular stance until he cuts his losses. Most of the tax cuts envisioned by Republicans require cutbacks in Social Security and Medicare/Medicaid to not blow a hole in the budget. Will core Trump supporters permit their social benefits to be cut so that corporations and the wealthy can pay less in taxes? That is very doubtful. Bear in mind that Trump listens to his supporters before he listens to the Republican Party.
Thus, the best hope Republicans have for passing tax cuts is to convince Trump that, in the words of Dick Cheney, “Deficits don’t matter.” By doing this, the Republicans can have their tax cuts, infrastructure spending can be increased, and no benefits will be reduced. The annual estimated cost of this will be to increase the deficit by $300-500 billion a year, which will serve to accelerate the day to when deficits do matter, but hopefully for Trump and the Republicans, not on their watch.
An infrastructure program will increase economic activity, although as Janet Yellen pointed out, it was economically needed more eight years ago than today. With the economy already approaching full employment and the current restrictive immigration policy not relaxed, the only way to find the workers needed by employers will be to take them from other employers. This is the classic environment of wage-price inflation.
Trump’s threat on trade with other countries, especially Mexico and China, is at this point very difficult to read. At best, it is a negotiating tactic. At worst, it will plunge the world into a trade war not seen since the 1930s, with devastative results on emerging markets and our own growth vaporized. The goal of returning manufacturing jobs to the American Heartland is a mirage. Advances in automation will make returning production a source of, at most, a tenth of the employment of the capacity transferred out. The jobs will also require a level of educational competence largely unavailable among the existing unemployed. Meanwhile, China offers to resurrect the Trans-Pacific Partnership Agreement (TPP) in a way that excludes the US and increases Chinese influence in Asia. It is hard to get a running start as President when you have shot yourself in the foot in a manner such as this.
At stake here is more than just bragging rights. Net exports from the US have been the strongest economic sector this year. Not one worker in a hundred understands this. For most companies, foreign demand is diffused, while plant closings are specific. If Trump were to do anything to jeopardize this trend of export growth, he could be cutting his nose off to spite his face. He could also be reducing economic growth.
Implied by all of this is the willingness of Republicans to continue to play nice with Trump. There are still enough fiscal hawks in both parties to question any increase in deficits. The tax approach of Paul Ryan depends heavily on cutting social spending. At some point goals will diverge, and it will be up to Trump to commandeer his followers to get the Republicans to do as he wants, if he can.
The Japanese have two sayings about the future. The first is, “He who can see three days ahead will be rich for three thousand years.” The second quotation: “Only children and fools try to predict the future.” It is incumbent as investors to be able to discern trends; in essence, this means predicting the future. If one waits for all the information to become manifest, the investment opportunity is lost. Having said that, not knowing more about the President-elect and his true intentions makes predicting more difficult than usual. Perhaps after the first hundred days, a better trend will manifest itself. Until then, one can only wait, assume, and hope.
In spite of all the externalities, the economy continues to rock along. Economic growth in the fourth quarter is estimated to be the highest for any quarter this year.
With this trend has come a tighter labor market and the first stirrings of price increases which are a hallmark of inflation.
What 2017 will be like in terms of the economy is anyone’s guess, but unless labor productivity picks up, look at 3-3.5% growth, more if immigration is liberalized.
As mentioned above, manufacturers are becoming more aggressive about raising prices. If there is any sort of tariff on imported goods, the inflation rate will skyrocket, as import competition will be neutered by a tax or enforced price increase on foreign-made goods.
The side effect of such a tariff would be to make domestic firms less competitive internationally. Reciprocating tariffs on American goods will close off foreign markets. Many countries in South America such as Argentina and Brazil are excellent case studies in the mal-effects of a tariff protected domestic industry policy, such as that being proposed.
Interest rates are expected to be higher, but how much higher depends on the deficit and whether a way is found to expropriate foreign cash reserves back to the US. It also depends on the amount of foreign money in the US, and whether that money stays or goes in response to various edicts from Washington.
Analysis of current trends is becoming a parlor game. One analyst to the housing industry made the case that lower taxes will offset higher mortgage payments. Overlooked is the fact that mortgage rates are going up, lower taxes or not.
From things that have been said, it would seem that the Federal Reserve will become more aggressive about raising interest rates in 2017. This will be especially true if infrastructure spending is increased without some sort of funding.
The Stock Market
Stock market performance continues to gain, as investors continue to see what they want to see from the rally.
Valuations need sharply higher corporate profits to be supported and advance further. However, the history of corporate profit growth in excess of revenues usually depends on slack labor markets, when wages trail revenue increases. When labor markets tighten, profit growth grows at slower rate than revenues. This usually results in a valuation adjustment. How much adjustment depends on several factors, such as the amount of labor used relative to revenues, the availability of labor at a given price, the quality or trainability of labor, etc. Not all companies are affected equally. But then, in a given environment, companies never are.
Warren M. Barnett
December 30, 2016