State Of the Union: Jam Today, Cuts Tomorrow

23 January 2018

On 30 January, President Trump will deliver his first State of the Union speech.  To be sure, the state of the US economy is healthy  (I will leave it to others to assess the state of the Union). Indeed, GDP has  advanced at over a 3% clip during the past nine months.  Pundits will use the occasion to debate whether the improved trends should be attributed to the new US administration or rather reflect the rewards of successful world-wide policy decisions  following the global financial crisis.  President Trump (perhaps unwisely, as markets can come back to haunt one) likes to point to the stock market’s performance as a gauge of the sucess of his Presidency. For whatever it’s worth, I attribute the S&P 500’s 30% post-election rise to the following: 14% to the prevailing global economic and profit upswing (which accelerated beginning in the summer of 2016),  9% to the recently passed US business business tax cuts (of course, the higher recorded earnings reflect past corporate performance), and about 7% to improved post-election “animal spirits” (reflecting actual and promised deregulation, etc).

President Trump will use the SOTU address to build support for his supply-side agenda, aimed at lifting America’s long-term growth trend above the lacklustre pace prevailing in previous years.  And, while I do not expect the corporate tax reform to deliver the jobs, wages, capex, and GDP growth to the extent promised, it is a step in the right direction.   Boosting US infrastructure spending will be the next piece of the puzzle, and I expect it will feature heavily in the President’s speech.  In addition to making economic sense, the idea is likely to gather bipartisan support (although the devil is in the detail), which could be politically advantageous to the Administration prior to the mid-term elections.

To be sure, the fiscal expansion — tax cuts and infrastructure spending — will certainly provide a cyclical boost to the US economy in 2018: Jam today!   However, further fiscal stimulus may prove ill-timed: posing inflation risks as the US economy approaches full employment.  Even more worrisome, however, these policies — and the delay in addressing the budgetary impact of an aging population and runaway medical costs — will add to the significant fiscal challenges the nation will confront in the years ahead. But make no mistake, there will be tough, painful fiscal decisions to make  in the not distant future.  How America deals with its medium term fiscal issues will be important for financial markets: how will the Fed react, is a monetary policy mistake possible?  Perhaps more importantly, the choices made will help define American society for the generation ahead.  (Lots of interesting Charts to come; Market Implications at the end).

Infrastructure:  The Next Leg of the Supply-Side Agenda

There is broad agreement that American infrastructure is in need of updating, if not an overhaul.  Every four years,  the American Society of Civil Engineers issues a “report card” on the state of US infrastructure.  The latest made grim reading (the scale runs from A to F, A is best and omit E). Only rail transport gets good marks: industrial rail is world-class, but passenger is substandard. Overall, the standard is poor, and getting worse.  Anecdotal evidence supports this appraisal.  Bridges are built to last 50 years.  The average age is now 45 years old, and 40% are over 50 (and bridges got a C+)! The roads got a well deserved D: 20% are assessed in a poor condition. Congestion costs the US economy $160 bn annually (nearly 1% GDP), double the level 20 years ago.  53% of schools need improvement to reach “good” condition; and, 17% of dams are in hazardous condition.  You get the point!

American infrastructure also does not compare well versus international competitors.  While the World Economic Forum ranks the USA 3rd in overall competitiveness, it ranks 11th for infrastructure, and behind most other G7 nations.

The quality of infrastructure improves, of course,  as national income rises, but McKinsey Global Institute reveals that the quality of American infrastructure is below the standard expected given the nations’ level of income. By contrast, Switzerland is excellent.  And, while Chinese infrastructure is not as good as in the USA, it is better after accounting for its much lower  income level.

Under-investment is at the heart of the problem.  Figure 4 illustrates that spending has declined in real terms at both the Federal and state levels during the past 15years, while outlays have been declining as a percent of GDP for decades as well.

Paradoxically, public investment was slashed during the financial crisis when it could have helped stimulate economic activity.  This occurred also in Europe during their debt crisis.  Amongst the G7 nations, only Japan sustained infrastructure spending through the downturn.

McKinsey also highlights that while the level of US spending as a percent of GDP is comparable to Europe’s, the superior quality of  Europe’s infrastrucutre reveals more efficient spending.  American investment also lags well behind Japan,  China, and the Middle East.  No surprise that the quality is better in those areas. By this measure US spending lags the global average by 1% of GDP.

* How much additional spending will be required to upgrade America’s infrastructure to meet the future needs of its growing economy? Both the ASCE and McKinsey independently reach the same conclusion — 1% of GDP annually for the next 10 to 15 years.

What sectors should  be the focus for policymakers and investors? The energy/power sectors have enormous investment requirements to shift away from coal and other fossil fuels.  However, spending in this area, as well as in rail and telecoms will be mostly funded commercially, as they are largely in the private sector.  The public focus will be on ROADS, bridges, water/waste, dams, schools, and to a lesser degree ports and aviation (both largely in the private domain — see the ASCE projections above).

The following Chart illustrates the degree of under-investment in the critical Roads segment:

Creative funding solutions for such a large-scale program will need to be sought.  The following figure illustrates that the USA uses public-private partnerships much less than elsewhere.  The Democrats will oppose this solution, but it is likely to be unavoidable.  Likewise, productivity in the US construction sector lags well behind the overall economy, as well as other G7 nations.  This will need to improve in order to control costs, and deliver needed results.

Precarious Fiscal Implications:  Jam Today, Pain Tomorrow

The planned fiscal expansion takes place against an already precarious fiscal backdrop.  To be sure, strong GDP growth is likely to shrink the 2018 Federal deficit (from 3.6% to 2.8% of GDP).  However, even before accounting for the impact of either the tax cuts or any infrastructure plan — which together we conservatively estimate will boost the government’s red ink by 1% of GDP annually — the CBO projects the government shortfall to rise steadily towards 5.2% of GDP by 2027.  As a result, in the absence of policy changes, Federal debt will rise from 77% of GDP to 90% during the coming decade, and continue rising indefinitely into the future. Optimists opine that stronger growth will take care of this issue, and point to the Reagan era as evidence.  However, “so-called” supply-side Reagan tax cuts ballooned the deficit from 2% to 5% of GDP, and government debt rose from 30% to 50% of GDP.  We do not have the luxury to make the same mistakes again.

In addition, to the planned fiscal expansion, US fiscal policy will need to confront the impact of the aging population and runaway health care outlays. The following Chart highlights some of the tough choices that lie ahead.  Outlays on social security , health care, and interest payments will rise from 11% to nearly 16% of GDP during the next decade.  Spending on these items alone with will account for two-thirds of overall government spending by 2027 (compared to roughly 50% at present), and consume over 85% of projected government revenues.

We project that in order to stabilise the government debt ratio before it approaches 100% of GDP, the Federal deficit will need to be cut by roughly 3% of GDP . To be sure, this will be a painful adjustment, but imagine if the goal was to reduce debt to its pre-crisis level of 50% of GDP!  To put this in context, the Table above illustrates that this adjustment amounts to eliminating the entire defense budget.  Alternatively, ALL non-defense discretionary spending would need to disappear!

Inevitably, entitlement reform will need to play a central role in curbing the red ink, along with a combination of reduced non-defense discretionary spending, military outlays, and higher revenues. The precise combination of measures chosen to curtail the build up in government debt will reveal much about the nation’s priorities and values.

Strategic Conclusions

The expected announcement of plans to meaningfully boost infrstructure spending re-enforces many of our strategic views:

  • The US Federal Reserve will raise interest rates 4 times this year — more than markets expect.  10-year bond yields are already approaching our 2.75% target, and could rise towards 3% in 2018 — a level which would begin to worry equity markets as well.
  • We favour stocks over bonds, and expect further gains in H1 2018.  Market volatilty will rise after the Fed funds rate exceeds 2% during H2 2018 , or becomes positive in real terms.
  • Rising rates support overweight positions in financials.  Underweight yield plays: utilities, telecoms, and consumer staples. Additional infrastructure spending re-enforces our overweight in industrials and cyclicals.
  • So far, the central focus of the political debate on health care has been justifiably  on the extent of coverage.  Inevitably, attention will need also to focus on the arguably more difficult question of how to control the cost of care.  This could be bad news for pharma, but good news for diagnostics and other subsectors aimed improving health outcomes and controlling medical costs.
  • The US mid-term elections will be important.  Republican Congressional gains will embolden President Trump to attempt again to repeal Obamacare, even though an alternative has not been presented.  Likewise, the Administration would take aim at entitlement spending — Trump already floated this idea, but discovered it would be unpopular prior to polling day.  Democratic gains in Congress would force the Administration to seek more creative ways to deal with future budgetary challenges: means testing social security benefits , raising the SS eligibility age, curbing health care costs, etc.  The CBO has produced a 316 page report providing  options, although I may be one of the few people wo have read it!
  • The recent tax reform has already shifted $1 trillion of the nation’s resources to the corporate sector (the owners of capital).  Upcoming elections will help determine who will eventually bear the burden of the inevitable fiscal adjustment.  Let’s hope it is not the sick and elderly.