AT a time when the next US administration finally became a little more distinct and OPEC managed to agree on a supply cut, incoming economic data continued to point to brighter times ahead. With the US likely set on policies that would better fit a less fully employed economy, we may soon have to worry about too much growth and inflation rather than too little.
The world’s most important capitalist economy looks in good shape. Most of the people who want work have work, and wages are starting to pick-up no matter which indicator you look at. Investment has been weak recently, but that, like many of the other signals used by this year’s legion of doom-sayers, has been warped by the collapse in commodity prices and mining investment.
There is already a bounce in motion here, something that OPEC’s as-yet unforced supply cut will no doubt nurture. Improving business confidence suggests that US companies are not feeling too bleak about life in any case, and neither are their international peers. The current level of global growth does not look weak relative to history, even if the contribution from developed market economies has necessarily shrunk.
Enter the next US administration, where the latest appointments are already reiterating their commitment to tax cuts and infrastructure spending, whilst sidling away from some of the campaign’s more abrasive comments on trade. For its part, Congress could well approve the former by using dynamic scoring, a technique that allows lawmakers to reduce an expected hit to the future budget deficit if they assume that the legislative action (in this case tax cuts) will have meaningful benefit to future economic activity, and therefore tax revenue growth.
Tax cuts may have the positive benefit of boosting economic growth – by encouraging more people to work for example – leading to higher tax revenues. If the positive effects are large enough, these additional tax revenues can offset the revenue lost from initial tax cuts. In practice though, there is very patchy precedent for a positive relationship between tax cuts and long-term economic growth. We’ve already expressed our scepticism that these plans, if implemented to the full, would be revenue-neutral after the dust has settled.
This suggests that we may just be looking at a one-off boost to consumer spending, but more importantly a pronounced increase in the US government deficit and debt load. That this kind of stimulus arrives at a time when the US is nearing full employment and a better-balanced oil market is forcing prices up, certainly suggests that investors need to be very careful where they tread in the bond market.
We remain tactically underweight high quality government and corporate credit, but still see some carry value to high yield, particularly in the US where firmer oil prices will likely help. Deregulation, tax cuts and deficit spending in an economy with full employment, rising wages and household credit provision could be the cocktail to eventually usher in the private sector hubris of which we’ve warned.
From the Great Depression to the most recent US housing bubble, some of the worst recessions in history have been preceded by a bout of private sector excess. The end of the cycle is still not imminent in our view, but we will be watching for more of those cyclical warning lights to flash amber in the year ahead.
