Five Reasons for Optimism About This Market
For most of 2017 and the early part of 2018, investors believed a benign narrative of accelerating output and productivity growth that was raising profits, slowing cost growth and extending the cycle. At the end of last week, the storyline shifted abruptly to rising inflation and cost pressures, and a Federal Reserve that is no longer friendly.
Here are five reasons why this lurch toward pessimism is misguided:
- The accelerating growth and productivity narrative is being dismissed too quickly. Markets were looking for growth of more than 3 percent in fourth-quarter gross domestic product along with a moderate inflation story based data leading up to January’s GDP release. When the data for GDP, productivity and costs disappointed badly, investors shifted to a rising-cost, higher-inflation, stagnant-growth scenario that lowered medium-term profit expectations and raised the discount factor. Yet fourth-quarter GDP numbers probably were understated, and we are likely to see the supposed lost ground turn up in first-quarter data or in revisions of the fourth quarter.
When net exports show up as a pronounced negative contribution, as in the last quarter of 2017, the statistical regularity is that the following quarter’s GDP is significantly higher. In addition, nonresidential investment has been making a strong contribution, suggesting business optimism that counters the fourth-quarter headline GDP disappointment. Business optimism in surveys remains very strong. So the output and productivity growth story may yet be there, but we may not know how strong the trend is for some months.
- The wage fear is overstated. January’s average hourly earnings, or AHE, were pushed up by a sharp drop in the length of the workweek. The acceleration that spooked investors in overall AHE did not show in the data for production and non-supervisory workers, which have been stable and below 2.5 percent year on year. These are the employees who punch time clocks and whose hourly wages are best measured. You would expect wage inflation to show up among production workers if it were a broad phenomenon. Overall, I would want to see more confirmation before an inflation epidemic is declared.
- Any inflation pickup is likely to be shallow, not steep. Even in the 1960s through the ’80s, the heyday of the conventional Phillips curve, labor-market tightness took a long time to show up in inflation. The technical reason is that there are long lags embedded in each step of the inflation process, so a gradual tightening of labor markets produces an even more gradual upward move in inflation. Sharp moves were driven by oil and commodity shocks of much bigger magnitude than we are encountering now. So the Fed does not have to panic.
- The great unknown is how closely the Fed is targeting 2 percent. Aiming for that goal means that you want an equal chance of 1.8 percent or 2.2 percent inflation every time. If the objective is to make up for past shortfalls, there will be strong preference for 2.2 percent over 1.8 percent. This comes up in almost every discussion of Fed policy. It looks as if the centrists and doves at the Fed would like to say they are targeting 2 percent, but tolerate a bit more in practice. This would be equities positive, negative for the dollar, positive for the short end of the yield curve, and probably negative at the long end.
- The economy may be more robust than we think. This is particularly true when it comes to fears the business cycle could end prematurely. In 1994, the bond market got crushed, equities were essentially flat, and the economy did just fine. Having spent years bemoaning the lack of output response to low rates, investors now worry that an extra 25 or 50 basis points of hikes will advance the end of the cycle. But those fears, and those about the accompanying cyclical shortfall in profits, may be premature. Activity might be more robust in the face of Fed tightening than investors fear.
Investors have jumped from pricing in an increasingly benign economic and profits outlook to positing an environment with far more headwinds. The worst may happen, but the data at hand do not show it. However, there is no near-term data release that is likely to show that the accelerated growth and improved supply side remains correct. Real-time economic volatility masks underlying trends, but it doesn’t mean the trends are not there. Should there be any sign the supply side is working, either for exogenous reasons or because of tax reform, the positive scenario will be back.
Professionals offering actionable insights on markets, the economy and monetary policy. Contributors may have a stake in the areas they write about.
To contact the editor responsible for this story:
Max Berley at email@example.com