Download The bumper lane economy Monthly Commentary

Monthly Commentary
May 2017
The bumper lane economy
On rainy weekends, when our sons were much younger, I would often take them
to the local bowladrome. Upon entering we would head straight to for the
bumper lanes. The bumper lanes, as the name suggests, had pads at the gutters,
allowing an errant bowling ball to zig-zag its way down the lane with a guarantee
of hitting something at the end. Not very exciting but clearly an advantage to
those who were either too young or too uncoordinated to bowl in a straight line –
which pretty much covered the three of us.
This economic expansion, which is now in its 96th month, still seems to be
operating in the bumper lanes, tracing out a dull middle path between recession
and inflation. Moreover, fears of too much monetary tightening leading to the
former or too much fiscal stimulus prompting the latter still seem overdone.
Recent economic data might appear to have tilted the odds towards recession.
Real GDP rose just 0.7% annualized in the first quarter in its weakest
performance in three years. Meanwhile, the March jobs report showed payroll
employment rising by just 98,000 – the smallest gain since last May.
However, the GDP data were suppressed by a big falloff in inventory investment
and declining government spending. These are both very volatile components
that should bounce back in the second quarter. Moreover, consumer spending,
which grew by a very weak 0.3% in the first quarter, should also post better
numbers in the second.
The March employment report was distorted by bad weather which, we estimate,
cost the economy 39,000 jobs. The April jobs report should look much stronger,
with a 200,000+ gain in payrolls and a possible fall in the unemployment rate to
a fresh 10-year low of 4.4%.
In addition, PMI data in recent months have portrayed a global economy growing
at its fastest pace in six years.
Dr. David Kelly, CFA
Chief Global Strategist
J.P. Morgan Asset Management
Looking forward, many have penciled in stronger growth this year and next due
to the stimulative effect of President Trump’s promised tax cuts. However, the
MONTHLY COMMENTARY | MAY 2017
rough outline provided by his Treasury Secretary and Economic Advisor served to underscore the difficulty in
actually stimulating the economy in this manner.
Repealing the estate tax, the alternative minimum tax and the Medicare tax on investment and higher-end wage
and salary income would be expensive, as would be a big cut in the corporate tax rate, even if paid for in part by
taxes on the repatriation of corporate money held overseas. A big cut to personal income taxes for middle-income
tax payers would also be costly.
Some of this cost could be offset, as was suggested by the Treasury Secretary, by eliminating tax deductions for
state and local taxes and health insurance. There are solid economic arguments for doing this as neither state
government spending nor medical spending enhance productivity and, from an efficiency standpoint, should
probably not be subsidized.
However, while the cost of removing the state and local tax deduction would fall largely on “blue states”, there are
30 Republican House members from the high-tax states of California, New Jersey, New York, Illinois and Maryland
who would presumably have significant difficulty supporting this proposal.
Getting rid of the deduction for health insurance payments, while it would raise a great deal of revenue, would
also serve to undermine the employer-based health insurance that covers most Americans. Given the chronic
problems in the individual private health insurance market, this is also probably a tough sell with many
Republicans, never mind Democrats.
The problem is that without eliminating major deductions, the total cost of the tax proposal would likely be more
than fiscal conservatives could swallow. Given all of this, and the sobering experience of the first attempt to repeal
and replace the Affordable Care Act, prospects for significant tax-cut-driven fiscal stimulus seem fairly remote.
That being said, fears that Federal Reserve tightening would choke off the expansion are also likely overblown.
Provided economic data for the second quarter strengthens as we expect, we believe a June rate hike remains
more likely than not.
It must be emphasized, however, that Fed tightening this year will likely do very little to slow the economy. For
one thing, it is extremely modest by historical standards. Even four rate hikes this year, at the top of analyst
expectations, would represent just 40% of the pace of previous tightening cycles. In addition, partly because low
bond yields overseas make U.S. bonds appear attractive, long-term interest rates will likely much more slowly
than short rates.
Increases in short-term interest rates that are not matched in a significant way by increases in long-term interest
rates do not impose any drag on the economy at all. Higher short rates provide increased income to savers while
slow-rising long rates would only have a small negative impact on the borrowing behavior of corporations and
home-buyers. Of course, the Fed could see this and try to boost long rates by normalizing their balance sheet
faster. However, this remains a very dovish Fed and could become more so, depending on the President’s
nominations to the Board, so aggressive monetary tightening still seems unlikely.
Meanwhile, corporate earnings, having zigged rather badly down in 2015 have now zagged very strongly back. The
first-quarter earnings season has been particularly strong, with an unusually high number of firms beating both
earnings and revenue expectations. However, while the rebound has been impressive, the pace of earnings growth
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MONTHLY COMMENTARY | MAY 2017
should slow in the quarters ahead as energy company earnings reach a new equilibrium and higher wages and
interest rates apply some pressure to margins.
In this environment, and with equity and bond valuations running above average levels, investors will need to be
realistic on returns going forward. A simple, traditional strategy based on large-cap U.S. equities and high-quality
bonds will likely provide lower returns than in the past. This argues for more precision in asset allocation, sector
weightings and security selection, with a willingness to overweight areas that could benefit from higher interest
rates and embrace international investing,
Getting back to the bowling alley, I should say that despite our general lack of skill, our bumper lane contests
became more competitive over time. Rather than carefully rolling the ball down the middle, we adopted various
eccentric ricochet strategies to hit the 10 pins from the right angle.
In a bumper-lane economy and market, investors may also want to adopt more inventive strategies to achieve
better results than would normally be provided by a slow economy following two very strong, but now old, bull
markets.
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