Economic Check-In: Mixed Signals

Posted: 2/15/2018 by Fidelity Viewpoints

US tax cuts add stimulus, while central banks withdraw it.

Key Takeaways

  • Global economic growth is strong and tax cuts could lift earnings.
  • China's economic signals indicate a potential slowdown.
  • With the Fed tightening and richer valuations, it may not be wise to make big asset allocation bets now.

Global economies are thriving, with strong growth and low unemployment, and the new US tax law offers the potential of increased corporate spending. At the same time, the Fed and other central banks are likely to tighten their monetary policies.

In Viewpoints latest check-in, Lisa Emsbo-Mattingly, Fidelity's director of asset allocation research, talks about the combined effect of taxes, central banks, and foreign economies. While things look good now, with asset valuations rich and a tightening Fed, she says now is not the time for investors to stray too far from their long-term investment plan.

What is your current outlook for the global economy?

Emsbo-Mattingly: We have seen really strong growth signals in the US and worldwide. Global industrial indicators are performing well, gross domestic product (GDP) numbers are surprising to the upside, and unemployment is low. European economies in particular are thriving. Germany's growth numbers are excellent, for example, and its unemployment rate is very low. The Ifo Business Climate Survey, which measures business confidence in Germany, is at the highest level recorded since its inception in 1991.

Are you seeing any risks to this period of synchronized global growth?

Emsbo-Mattingly: Monetary policy has been extremely stimulative across the globe, and we're starting to see central banks change direction. The Federal Reserve is a case in point. Over the last 7 years or so, the US economy has been expanding, the unemployment rate has been falling and the Fed has kept interest rates low. But we saw 3 rate hikes in 2017, and we'll probably see a few more this year, which means we're entering an environment we haven't experienced in a long time.

Internationally, the indicators I use to track the economy in China have been decelerating. This has yet to show up in the official government data, but we're monitoring the situation carefully. It looks a little like 2014 and 2015, when most economies were strong and accelerating and Chinese activity started to drop off. There is still a lot of uncertainty about the path of China's economy and what it will mean for investors globally, but my team will be watching China closely in the coming months.

What effects should we expect from the recently passed US tax law?

Emsbo-Mattingly: The tax cut is going to go straight to the bottom line for almost all of corporate America. Falling tax rates create higher earnings and positive effects in the capital markets, something we have already started to see. I estimate the tax cut should raise the GDP by about 0.3%. So it is a stimulus.

That said, the effect probably will be mitigated by how late the stimulus is coming in the cycle. Economists look at something called a multiplier, which basically measures the amount of economic growth for every dollar of fiscal stimulus that goes into the economy. Early in the cycle, the multiplier is roughly 1.5, but late in the cycle, when the economy is closer to full potential and the Fed is not accommodative, I estimate the multiplier to be around 0.5. That's not bad, but not a dramatic change for the course of the economy.

The other thing to watch out for with regard to the tax bill is inflation. Whenever there's a fiscal stimulus, part of its effect comes in the form of real economic activity and part of it comes in the form of inflation. When the stimulus comes toward the end of a cycle, it tends to create more inflation on the margin than it would if it came earlier in the cycle. So my team thinks this fiscal package is more inflationary than it would have been if it had come during a downturn.

American companies announced plans to bring a lot of cash earned overseas into the United States. What impact will that influx of cash have on the economy and the markets?

Emsbo-Mattingly: It depends on how the companies use the money. For example, increased capital investment would strengthen the economy; share buybacks largely wouldn't, but would give a short-term boost to stocks.

At this point, projections for how companies will use repatriated profits are all over the map.

Could you talk more about why you expect higher inflation and what its consequences could be?

Emsbo-Mattingly: Inflation has a lot of moving parts, but one of the key drivers is the labor market. In general, if the labor market is tight and employees can demand higher wages, those costs eventually get passed on to customers in the form of higher prices. Right now, the labor market does seem to be tightening, and wages are going up in some places. For example, Walmart recently raised its minimum wage, and that's going to have big implications for the labor rate in the lower-income parts of the US economy. As these wage increases percolate through the economy, they put pressure on profit margins in corporate America.

We don't have extremely strong inflation expectations for 2018, but we do expect a global upward trend. The recent rise in energy prices is another factor that could result in accelerating inflation.

On the other hand, we're also seeing a couple of forces working against inflation in the US economy. One of the unintended consequences of ultra-low interest rates globally has been the ability for companies to produce goods at a lower cost. In some cases, this has increased supply of goods, holding down prices. We can see an example of this in multi-family housing. Low interest rates incentivized more construction of multi-family housing. This supply is putting downward pressure on rents and having a significant disinflationary effect on the Consumer Price Index.

Another counterforce to inflation is the Amazon effect. For the first time since World War II, we're seeing retail employment fall in the United States without a recession. The reason is that eCommerce is growing rapidly, and the labor footprint needed to run a warehouse is much smaller than to run a retail shop. Online retailers can keep prices low, which also holds down inflation. That said, overall we expect inflation to percolate upward somewhat in the months ahead.

How might investors respond to the current economic environment?

Emsbo-Mattingly: It's an interesting time to be an asset allocator, because when we think about asset allocation decisions, we tend to look at things that are mispriced, or extremely cheap with a positive catalyst, or extremely expensive with a negative catalyst. And when we look around the markets today, we would say that most assets are fully priced. At the same time we see central banks tightening, which may be a catalyst for more uncertainty going forward. And though it's true that earnings are going to accelerate because of the tax cut, we don't know how much of that has been priced into the market already.

When you see low valuations and the business cycle moving to favor a certain asset class, it may be time to move from your long-term asset allocation to a more aggressive tilt. But with high valuations, and the potential for the business cycle to worsen, it's not a great time to make big moves. We've been pounding that drum for quite some time now, and we feel even more strongly about it now than we have to this point. Growth is good for equities and other risk assets, so it may not be a good time to cut back on stocks and derisk your portfolio, but you also don't want to become much more aggressive with central banks tightening and China decelerating.

2017 may have been the least volatile year in stock market history. Is that reason for investor optimism?

Emsbo-Mattingly: To me it's a little spooky. Low volatility actually pushes people to take more risk. As a cycle nears its end, people tend to make bigger and bigger bets as volatility falls away. But the volatility always returns at some point, and for a lot of people that can be a painful wakeup call.


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