It’s approaching that time of year again. No, I don’t mean Christmas or all the other holidays, but the time of year when the US economy underperforms expectations.
Over the past five years the 1st quarter has consistently disappointed. Have a look at the chart of the Citibank Economic Surprise Index (which measures economic performance versus expectations) over the past five years:
Every new year has ushered in an economic decline versus expectations. Some years were worse than others. 2012, 2014 and 2015 were especially painful, while last year and 2013 were more mellow. Yet all first quarters were down.
I am not sure of the reason for this behaviour. It might be a fluke, a statistical anomaly like when the SuperBowl winner ends up predicting future stock market performance.
But if I had to bet, I would guess there is something more to this pattern. Maybe it is China. I believe too many investors underestimate the effect their economic shifts play on Western markets. Or maybe there is some locally produced seasonal policy that chokes off growth in the first quarter. Who knows? But I will not simply ignore this pattern because I don’t understand what causes it.
As Paul Tudor Jones says, “I always believe that prices move first and fundamentals come second.”
I am especially concerned about a potential repeat of this pattern because of the recent infatuation the markets have heaped on the newly elected President. The amount of optimism showered on Trump will be a difficult act to live up to.
I have been skeptical of the later part of the Trumpflation rally. I don’t think it will be quite as easy as the markets assume. I have had trouble articulating my worries, but David Rosenberg did such a terrific job, I thought I would just borrow a piece of his recent report:
Now, let’s be charitable and assume that this infrastructure comes through — it would amount to $100 billion annually and add a less than a half-point per year to growth (Obama’s plan in 2009-2010 was far larger, also whipped up excitement at the time, and years later…forgotten). It helps, but is no panacea to the business cycle.
And it is likely that these gains will be negated by Trump’s anti-trade policies, and if my assumptions are correct, the tax cuts go into savings and debt pay downs just as the de facto tax relief from the past few years of gas price reduction did. Deregulation is nice, it will lead to some extra risk-taking at the margin, but again, will likely not bring the economy into some nirvana state. Of course, the implications of the massive runup in government debt in the absence of entitlement reforms will keep a cloud over spending growth in the future — there is no such thing as a free lunch. While the move to repatriate profits from abroad is beneficial too, the evidence from 2004 shows most of the proceeds go into dividend payouts, stock repurchases, and this time, looking at how stretched corporate balance sheets are, into debt reduction and balance sheet repair.
Little of this went into capex or job creation when George W. Bush tried it twelve years ago… just a historical note on that score.
Already, Mr. Trump has backtracked on several of his campaign pledges and we shall see the extent to which fiscal conservatives in the House allow for the runaway deficits that the Trump economic plan calls for. What is fascinating is that after months railing against Clinton for her Wall Street ties, the scuttlebutt is that Trump is going to select Steven Mnuchin as his Treasury Secretary — oh, only with 17 years under his belt at Goldman Sachs (and his Senior Advisor, Stephen Bannon, was also a partner at the investment bank prior).
Same old, same old.
Maybe it is a political revolution, but this is no Reagan era shift for positive change. No doubt avoiding a Democratic win that would have had Elizabeth Warren and Bernie Sanders writing the policy script is good enough. With Clinton in charge with a hardened GOP in the House and Senate, who needed another four years of gridlock? So all is not horrible, even though we are in a situation where we have a new President who has no idea how to govern and who seems to blow with the wind.
The honeymoon won’t last that much longer.
Even with Reagan, the S&P 500 rallied 1% the day after the U.S. election in 1980, the feel-good factor lasted a month and another 8% up for the market — then the current reality of soft growth for the ‘here and now’ knocked the market down more than 20% over the next year-and-change. Once the policy proposals turned to action, the market found a bottom and went into a new bull phase based on reality as opposed to hope.
Point is that it’s only easy to talk about the Reagan Rally with the benefit of hindsight. At the beginning, the honeymoon was short-lived. I think that is the major point — faith-based risk rallies have a shorter shelf life than reality-based bull runs do. There is a lot of speculation going on here — question is how justifiable it is.
I think Reagan had a far stronger mandate, at the time there was a 70% top marginal rate to slice (not sub-40% as there is now); the price-to earnings multiple was 9x (not 18x); the unemployment rate was near-8% (not 5%); and he had much greater room to ease fiscal policy seeing as the debt-to-GDP ratio was 30% then, versus 75% now. We also were coming off a 14-year bear market; the first of the boomers were turning 34, not 60; the Fed was embarking on a vast easing cycle. Finally, Reagan was an optimist, pure and simple, while Trump is adept on tapping negative emotions like anger and fear.
Now it also pays to take note that much of what we are seeing is based on shifting perceptions and nobody truly knows how this all plays out. I remain skeptical that the House will allow a hole to be blown through the budget, as the bond market is pricing in.
I couldn’t agree more with Rosie. Markets are way ahead of themselves. And that includes overly optimistic economic assumptions about next quarter’s growth.
Given I already thought the first quarter was bound to disappoint expectations, the recent exuberance from Trump’s win is just icing on the cake.
And the rising US dollar and soaring interest rates only make my confidence grow. To bet on a booming first quarter is to assume Trump will be able to halt the global balance sheet constrained stop-and-start moribund economic vicious circle without even taking office. Now maybe he is that good. After all, he has fantastic ability. Everyone agrees, he has fantastic ability. So there’s no problem with his ability, believe him.
However great Trump’s ability, I am worried it will take more than talking about the size of his ability to break the economy out of this slump.
This worry is only heightened when you look back at history and realize that according to Citibank, “eight of the last 11 recessions have coincided with the first year of a presidential term, and since 1920, recessions during a new president’s first year have been three times as common as in other periods.”
I am not predicting a recession in 2017. I am merely highlighting that the market is greatly underestimating that possibility.
Everyone is focused on Trump’s infrastructure plans and his ambitious tax cuts, but the reality is we should all be looking much more closely at China.
I suspect the US economy might not be as independent to the global economy as most investors assume. And that while economic weakness is the farthest thing on their mind, the surprise for the coming quarter will be an underperforming US economy, not the other way round.
Thanks for reading,