Tuesday Morning Minute 022018
THE WEEK AHEAD
We assess the developing shift in fiscal policy and conclude that it is near-term bullish for growth and bearish for rates.
The recently published Budget of the United States, Fiscal Year 2019 introduces a large increase in government spending and cuts in taxes. The net effect of these changes introduces a very large swing in the government deficit this year and next. The deficit is expected to increase to 4.7% of gross domestic product from 3.4% in 2017, and this assumes the economy expands at a 3% clip, substantially faster than the 2% pace we’ve become accustomed to. To put a 4.7% deficit in perspective, the only other times this sized deficit was run was during periods of economic hardship or crisis. The graph below charts the size of the annual deficit over the past 90 years. Notice that the projected 2019 deficit was only exceeded in size by the Great Depression, World War II, the severe recession of the early 1980’s, and the 2008-2009 Financial Crisis. The turnabout in the direction of the deficit comes late in an expansion and not during a cyclical trough, and represents a likely push in demand against an economy that is already nearing full capacity. All else being equal, the shift in fiscal stance this late in the cycle is likely to cause market participants to begin to anticipate higher real growth, rising inflation pressures, higher short-term rates, and higher corporate earnings.
The budget proposes nearly $400 billion of additional spending in addition to the stimulative effects of the already enacted tax cut. We are somewhat surprised by the size and timing of the shift in policy because it sets out a path for a widening deficit that is much higher than the administration initially expected. The increased deficit has the potential to further stoke confidence and impart a near-term push to growth and profit expectations. Ultimately, we think this is best viewed as a pro-cyclical shift that pulls forward demand, potentially extending the cycle and further lifting expectations that drive risk assets. A potential risk of starting a fiscal push at this point is the unhinging of interest rate expectations. Should markets decide that the expected increase in demand will push against resource constraints and unleash rising consumer prices, or if rising growth expectations feed further increases in asset values, it could pressure the central bank to accelerate interest rate hikes. Given over a decade of easy monetary policy, it is hard to anticipate how the economy or financial markets might adjust to a sudden tightening shift from the Fed.
Either way, the newly released budget outlines a path toward an unusually timed, significant shift toward a fiscal expansion by the federal government. The change is significant and has the potential to shift near-term growth and interest rate expectations higher. Longer-term issues including the financing and sustainability of the deficit, along with implications for policy options in the event of a future downturn, are relevant but more likely to be dealt with by markets further on down the road.
ECONOMIC DATA THIS WEEK
|Monday, Feb 19:||U.S. Holiday: President’s Day|
|Tuesday, Feb 20:||No Economic Data|
|Wednesday, Feb 21:||Markit US Manufacturing PMI||Feb||55.5||55.5|
|Markit US Services PMI||Feb||—||53.3|
|Markit US Composite PMI||Feb||—||53.8|
|Existing Home Sales M/M||Jan||1.2%||-3.6%|
|FOMC Meeting Minutes||Jan|
|Thursday, Feb 22:||Weekly Jobless Claims||2/17||—||230k|
|Friday, Feb 23:||No Economic Data|
ASSET ALLOCATION PORTFOLIO POSTURE
Based on shorter-term expectations, the “tactical satellite” allocation within portfolios is:
OVERWEIGHT STOCKS vs BONDS.
Kevin Caron, CFA, Senior Portfolio Manager
Chad Morganlander, Senior Portfolio Manager
Matthew Battipaglia, Portfolio Manager
Suzanne Ashley, Analyst
WCA Fundamental Conditions Barometer Description: We regularly assess changes in fundamental conditions to help guide near-term asset allocation decisions. The analysis incorporates approximately 30 forward-looking indicators in categories ranging from Credit and Capital Markets to U.S. Economic Conditions and Foreign Conditions. From each category of data, we create three diffusion-style sub-indices that measure the trends in the underlying data. Sustained improvement that is spread across a wide variety of observations will produce index readings above 50 (potentially favoring stocks), while readings below 50 would indicate potential deterioration (potentially favoring bonds). The WCA Fundamental Conditions Index combines the three underlying categories into a single summary measure. This measure can be thought of as a “barometer” for changes in fundamental conditions.
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