I ask if economic growth is on the verge of rising for a very specific reason. The stock market in 2016 is up 10% as measured by the S&P 500 Index, led by materials, industrials, financial and telecommunications stocks; and with health care and consumer staple stocks being the two worst performing sectors. In addition, gold and bond prices are on the decline. Please note: when bond prices decline interest rates are rising. This market behavior is classically associated with rising economic activity and certainly not indicative of the latter stage of an economic cycle.
1-2% Real GDP Growth
This market behavior may cause confusion to many, especially after nine years of economic expansion. Although the U.S. economy has been expanding, it has done so anemically with 1-2% real GDP growth. This compares to 6-8% annual GDP growth immediately after the deep recession of 1981 when the unemployment rate hit almost 10%. Then in the 1980s and 1990s GDP growth was 2-5% annually.
After eight years of so-so economic growth, corporate and consumer balance sheets are in good shape and not overextended as is usually the case when the economic cycle is nearing a peak. The U.S. government however continues to run deficits, and its share of GDP has expanded from 19 to 21%. Obviously our government has not had the will to curtail expenses, and its balance sheet poses risk to our economy and taxpayers.
A Republican President and a Republican Congress
What should we expect with a Republican President and a Republican Congress? The Trump campaign and policy initiatives were straight forward: reduce regulations; cut corporate taxes; increase infrastructure spending; renegotiate trade agreements, rebuild the military; and border control. These initiatives are pro-economic growth and the markets responded swiftly.
Some observers (pre-election) opined that the federal deficit would expand regardless of the election outcome. However Mitch McConnell (Senate Majority leader) stated last week that any corporate tax reduction must be matched with budget cuts to fully offset the revenue decline. So let the bargaining begin!
Higher Economic Activity
The stock market is an excellent economic predictor for six months, but that is about all. The market is expecting solid low-teen earnings growth in 2017, along with rising inflation and interest rates. If our government enacts policies of lower taxes and regulation the “animal spirits” of our country may finally be ignited resulting with capital investment and business formation. The result: higher economic activity.
Primary Market Risks
I envision two primary market risks as 2017 unfolds: saber rattling as we attempt to slow the transfer of U.S. wealth to China, and to a lesser extent a strengthening dollar.
As we all know we are in a $400 billion trade deficit annually with China. Why does this matter? Let’s “follow the money”. We sell China plenty of products, especially high technology and complex industrial products. China sells us a wide variety of products from low to high tech, most of which have a high labor content. There is a well know economic theory called comparative advantage that supports free trade. Essentially, comparative advantage stipulates that trading partners all win when each country produces that which they can produce most efficiently. And if trade balances are equal both trading partners win through sharing higher productivity.
Wealth Transfer to China
Our trading situation with China is far different. The regulatory environment of the U.S. and China could not be more different in term of labor laws, environment and market access. Our trade deficit with China has been running between $300 and $400 billion annually for the past few years, and is literally a wealth transfer to China. These deficits provide China with $300 to $400 billion of U.S. dollar currency which can be used to buy U.S. Treasury bonds, businesses or real estate around the globe including back here in the U.S. If this trade imbalance goes unchecked, we will see a slow but continued wealth transfer to China.
President-Elect Trump brought this issue to the fore and it is at the cornerstone of Trumps economic policy. I expect both countries will be pushing back against each other providing uncertainty and potentially stock market corrections. The good news is that both countries are economically dependent upon one another, so both economies will benefit greatly if trading activity remains brisk but moving back into balance.
Is economic growth on the verge of rising? Most indicators suggest our economy is gaining momentum. If you have questions about economic growth, financial planning, or would like to learn more about investment management advice offered on a fee-only basis, contact me Richard Lawrence at Lawrence Wealth Management LLC, a small, private investment firm. Phone 215-540-0896; email firstname.lastname@example.org.