The cacophony of nonsense emanating from both the White House and the Congress often makes it difficult for investors to focus on the far more important economic, corporate and financial market fundamentals which drive the prices of both equities and bonds. Most important, even without any pro-growth initiatives out of Washington, it is clear from a mountain of current high frequency data as well as critical free market indicators, including interest rates, commodity prices and the Dollar, that the U.S. economy, as well as those in the Eurozone and China, are experiencing faster rates of growth, which are contributing to a further rise in corporate profits. Although some recent data have been mixed, it appears that wage growth, which began to pick up in 2015, is continuing to accelerate, with a resulting positive impact on domestic consumption. Employment among Millenials is accelerating, partially offsetting the retiring Baby Boomers. Inflation, which has been suppressed, due to global excess capacity, the steep decline in the price of oil as well as the benefits of a strong Dollar, is also creeping toward the Federal Reserve Board's long-term target of 2%.
Labor markets are gradually tightening, as business confidence has picked up in the hopes that the Trump Administration will reduce taxes, dismantle onerous regulations, reform healthcare and initiate a multi-year rebuilding of our infrastructure. None of this has yet occurred, and in our view, the enactment of the necessary legislation will require many months and the actual implementation, particularly regarding healthcare and infrastructure rebuilding, will take years. Notwithstanding these lags, the Federal Reserve's Open Market Committee is on the verge of a series of interest rate boosts, which at the outset will be interpreted as a vote of confidence in the economic expansion, but over time will gradually reduce the surplus financial market liquidity, which has driven stock prices higher over the last eight years in the face of lackluster corporate earnings.
At its current level of about 2,370, the S&P 500 stock index is selling at roughly 20 times trailing earnings for 2016, clearly a very full valuation. While it is too early to have firm conviction on 2017 profits, the current consensus suggests a number around $130, which brings the forward P/E down to 18. Even with corporate BBB yields of about 4%+, this valuation is also pretty full. On the other hand, a reduction in the Federal tax rate on corporate profits could augment this forecast significantly. Moreover, as long as the U.S. Dollar does not appreciate too much from its current level, and assuming no foolhardy protectionist measures are undertaken by this Administration, the economic expansion could be extended. However, with an unemployment rate already below 5%, albeit with an underemployment rate still at 9%, the labor market is clearly tightening. There are already shortages of skilled construction and oilfield workers as well as long haul truck drivers, among others. The monthly JOLTS survey shows more than 5.0 million unfilled job openings due to a skills mismatch or labor immobility. As wage growth picks up further, however, some of those currently unemployed may return to the work force. Any successful attempt to limit immigration will clearly inhibit GDP growth, even if productivity picks up from its abysmal pace of recent years. A Border Adjustment Tax (BAT) also has the potential to impede economic growth by disrupting the global supply chains upon which much of American manufacturing relies, and, in addition, consumer prices for many essential goods will increase. Moreover, if a BAT results in a stronger dollar, American exporters will be at a further disadvantage, even if they receive a tax break.
In short, the probability of gradually rising inflation and a less accommodative monetary policy will inhibit the advance of equity prices, even if the Fed stops short of precipitating the next economic recession. The current Administration did not "inherit a mess." Indeed, it inherited an economy that was already gathering momentum and beginning to run short of labor market slack. Over the near term, as the pace of economic growth and corporate profit gains picks up, investors will be in the "feel-good" stage of the rally, but irrespective of whatever pro-growth policies are eventually enacted and implemented, the business cycle will not be repealed, and investors will do well to keep an historical perspective in mind. Without a higher rate of labor force growth and a higher rate of productivity, real growth cannot accelerate. Any attempt to stimulate output will serve only to boost inflation, and bring forth a tighter Fed policy. We remain bullish for now, but as bond yields continue to increase to reflect rising inflation and a less accommodative monetary policy, stock market volatility will increase, and many equities will top out long before the economy crests. The simple truth is that the stronger the economy gets, the less liquid the financial system will be; the lower the returns from financial assets. The only unknown is the timing.