Keynes, Kuznets & Trump

Author: David R. Kotok, Post Date: October 30, 2017
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At 8:22 a.m. on Saturday morning, @realDonaldTrump greeted the world with this observation: “Very little reporting about the GREAT GDP numbers announced yesterday (3.0 despite the big hurricane hits). Best consecutive Q’s in years!” – Hat tip: Politico.

Our president may wish to revisit the National Income and Product Accounts (NIPA) methodology. He may start with a history lesson about Simon Kuznets who is best known for his studies of national income and its components. Kuznets was a Russian-born American economist and statistician who won the 1971 Nobel Prize for Economics. One may only speculate if Kuznets would have made it into the US today. Readers may want to know more about the father of GDP accounting.  Google will do the rest for you.  Readers may wish to read the NY Times obituary (July 11, 1985) of this Nobel Laureate for an exquisite history lesson by Nicholas Kristof.

Note that this 3% number is a first estimate of the quarter, and such early estimates are notorious for the revisions that almost always follow. Also, the 3% number is an annualized figure from a quarterly statistic, as is always the case with GDP. So was Q3 really the best in years?

In the details we find that inventories grew. Imports strangely fell. And the hurricanes caused a pop in automobiles as flooded cars were replaced. A better indication gleaned from this data release is that domestic demand grew at about 2%, which is consistent with the slow-growth economy we have been experiencing. Meanwhile, inflation measures remain subdued and well under the targeted 2% number that the Fed has sought and found elusive for years (without providing a clear explanation as to why 2% has been so hard to attain). The core Personal Consumption Expenditure (PCE) deflator was 1.3%. That is a long way from the Fed’s 2% target.

Meanwhile, the Fed is hell-bent on raising rates a quarter point before yearend, and the market is anticipating that rate hike. The Fed will simultaneously commence shrinking its balance sheet. The first stage is underway with a $10 billion-a-month reduction that will eventually grow to a monthly $50 billion. At the initial $10 billion level, the market impact is benign. We shall see if pressures develop over the next year as the Fed persists on a dual track of balance sheet shrinkage and interest rate hikes. It is hard to see how such a path lowers market-driven interest rates – the odds favor higher rates. But slower economic growth, at about 2%, and a low inflation rate of well under 2% hamper this upward rate trajectory. This dual policy of balance sheet shrinkage and interest rate increases has never been tried before in American monetary history. Stay tuned.

Meanwhile, the European Central Bank (ECB) continues a “lower for longer” policy. That will extend the life of the zero interest rate policy (ZIRP) for a likely one to two, or even three, more years.  The ECB is tapering the amount of purchases starting next year but allowing extension of zero interest rate time.  The impact is seen in credit spreads and that is one of the downward pressures on US bond rates.  Note that the difference between an AA credit borrower of 5 years and a BB credit rated borrower of 5 years is only 7 basis points in Japan, a country that measures ZIRP by decades.  In Europe, a BB rated corporate borrower pays a lower interest rate on a euro loan than the US government does on its 5 year treasury note denominated in US dollars.  Hat tip: Fundstrat.

So, negative rates are going to persist. About $8 trillion in global debt trades with a negative interest rate. This amount is down from over $13 trillion right after the Brexit vote, but it is still very high. Aggregate global debt is about $49 trillion, and no economic landscape that we recognize as “normal” would have that debt trading at a negative interest rate. So the continued action of the ECB acts as a dampening force on any interest rate rises in the bond markets of the mature economies of the world, the US included.

An unknown is the forthcoming tax reform legislation. If the tax rates for corporations are lowered, the corporate interest expense becomes a greater burden, relatively speaking, because the deduction for interest expense is lessened. A marginal shift away from borrowing will exert a downward pressure on interest rates. While this is true for businesses, the tax bill looks to be benign for municipalities. It seems likely that the highest tax bracket for individual Americans will remain in the upper 30s or even stay near 40%. It also appears that the tax-free nature of borrowing by state and local governments will remain. Thus the tectonic shifts in bond markets are likely to be more dramatic in the taxable Treasury, agency, and corporate markets, and that will actually favor the municipal bond market.

We like tax-free bonds, as we have for years. They remain relatively cheap. That said, the yearend muni calendar buildup may deliver a mild shock, according to my partner John Mousseau. Our separately managed muni accounts are positioning to take advantage of that shock if it comes.

What about the stock market?

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