This last week we saw valuations increase on the hopes of fiscal stimulus (tax reform) and dovish monetary policy expectations for 2018. WHAT IS MISSING? Psst, the clue is above!
Typically, fiscal stimulus is reserved during bad economic conditions to assist in the reacceleration of the economy. Not this time. After 9 years of economic expansion, the federal government is about to deliver tax reform. It should greatly increase corporate earnings as well as disposable income for most Americans. While the plan will add to the deficit, the Federal Reserve Board (FRB) is likely welcoming the assistance in order to improve their balance sheet and arsenal for the next recession.
The FRB raised interest rates last week, as expected. They also forecasted, a fairly dovish, three hikes in 2018. They expect growth to increase as a result of tax reform and they also expect unemployment to continue its downward trajectory. Something hard to fathom as we sit at 4.1%. So why not more rate increases? Inflation…
INFLATION (OR THE LACK THERE OF)
With growth expected to increase and unemployment expected to fall further, surely inflation will start to increase. Not exactly, part of the equation that seems to be disjointed from the other two factors would be productivity. Since the start of this expansion, non-farm productivity has average Quarter-over-Quarter growth of 1.64%… This year has been a good year, so it has to be better than that, right? 1.80%… If productivity does not improve, then we likely will not see a sustainable increase in GDP. This would leave long term bonds susceptible to short term volatility and possibly an inversion of the yield curve. An inverted yield curve is a strong indication of the big “R” word.
So, roll up your sleeves America and take a lesson from Rosie the Riveter… Get to work!
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