Last Wednesday, American equity indices set records for the longest bull run in history. The longstanding rally began as the world came out of a global financial crisis and, as of late, has continued because business-friendly fiscal policy from the Trump administration has contributed to strong economic growth. However, the spectacular rally has left many investors wondering when and how the tides will turn.
Because growth and inflation are the central variables considered in the Federal Reserve’s monetary policy decisions, and because monetary policy impacts the rest of the economy and financial markets, it is useful to take stock of the drivers of US growth and inflation in the context of the broader business cycle. Between the two, it seems that expectations for inflation are more subject to unforeseen risks. Below we offer preliminary thoughts on each.
Growth
There are three main sources of spending in the US economy: consumer, business, and government.
Consumer
Consumer spending makes up roughly two-thirds of US GDP, so understanding consumer demand and sentiment is a relatively good proxy for understanding the economy. Though consumer spending (orange) seems to have cooled a bit recently, measures of consumer confidence are still strong, suggesting further room for spending to grow. Similarly, disposable personal income seems to be growing at a strong clip, which will also serve as a support to spending.
Business
The picture for business spending is similarly optimistic. Strong consumer demand has resulted in similarly robust business spending, as business fixed investment (blue, below) continues to accelerate. The ISM Purchasing Manager’s Index, a monthly survey of manufacturing managers and leading indicator of fixed investment (shown below in orange) continues to suggest strong business demand. Increased spending from businesses also results in a virtuous cycle of higher consumer demand, as businesses employ more workers, enabling further retail spending.
Government
The fiscal stimulus and tax policies of the current administration have been particularly instrumental in supporting economic activity. However, the fading of the boost from fiscal policy may be a drag going forward. Still, the policies seem to have led to a self-reinforcing dynamic between businesses and consumers.
Inflation
The above drivers of growth also serve as upward pressures on inflation. A tightening labor market pushes wages upwards, while cyclically high capacity utilization means that producers are less able to increase production to meet that demand. The confluence of these factors would suggest that cyclical pressures on inflation are running high. On the other hand, as of late, wages have been slow to rise materially. To this end, Fed economists are uncertain about the amount of slack left in the economy, and believe that the economy is not at risk of overheating. As such, monetary policy remains “accommodative”.
In a previous essay, we mentioned that it is unlikely that inflation will overshoot expectations because: (1) as the Fed continues to hike as planned, each hike will bite disproportionally more (2) the benefits of fiscal policy will continue to roll off, and (3) the secular forces of automation and globalization may continue to keep prices down. However, with respect to (1), notes from the Fed this week seem to suggest that they are erring on the side of caution. This reticence to raise rates too quickly may increase the possibility that the Fed will be behind the curve on inflation. Risks of (2) seem to be mitigated by strong retail and private economic activity. As for automation in (3), it is unclear to what extent automation has truly affected labor markets in the last decade. It seems more likely that unforeseen slack in the labor markets has been hidden in the labor force participation rate, which took an enormous hit in 2008. As a general rule of thumb, we also believe that people always overestimate the extent to which a phenomenon with historical analogues is materially different from past examples (i.e., the “this time is different” tendency). However, this is not a principled refutation, so we may explore automation in labor markets in a further essay.
Finally, the escalating global trade war seems directly at odds with the disinflationary pressure of globalization. Indeed, the main pole of uncertainty around the path of inflation stems from tariff tensions. Tariffs, which are taxes on imported goods, will result in higher costs to consumers, as producers pass the costs of materials through to consumers. The consensus in the private sector thus far seems to be that the tariffs have not materially impacted businesses yet, but may negatively affect consumer sentiment as prices rise faster than wages.
Future
It seems that for both growth and inflation, cyclical indicators suggest that we are still in the mid-to-late phase of the business cycle: strong growth still has some room to continue, and inflation is poised to pick up. The main “known unknown”, then, is how and when the global trade situation will flow through to inflation. As such, in the next essay, we will delve deeper into the central question of our present discussion: the potential impact of tariffs in the coming few years.
