BCA, Independent Investment Research Since 1949

U.S. Growth Is Heating Up

U.S. residential and non-residential investment will rebound from the depressed levels seen last year.

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Residential investment was a drag on GDP growth for two quarters in 2016, which is unlikely to persist in 2017. The progress made on foreclosures since the financial crisis has driven housing inventory to its lowest level since the mid-1990s, meaning that housing supply no longer poses a headwind to construction. Further, demographics should also help boost the housing market during the next few years. According to the Joint Center for Housing Studies of Harvard University, over the next ten years, the aging of the millennial generation will boost the population in their 30s. The growth in this age cohort implies an increase of 2 million new households each year on average.

While rising mortgage rates will be a drag on housing at the margin, they will not pose a significant headwind to residential investment in 2017. At least so far, mortgage purchase applications have been resilient in the face of rising rates.

Non-residential investment was a small drag on growth in 2016, but this was largely related to depressed investment in the energy sector. Now that oil prices have recovered, non-residential investment should return to being a small positive contributor to growth. Our composite indicator of new orders also suggests that non-residential investment will trend higher this year.

The Odds Of March

Investors should fade the recent increase in expectations of a March rate hike by the Fed.

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In the current cycle, the Fed has not lifted rates without having first guided market expectations in the months leading up to the hike. As can be seen in the above chart, rate hike probabilities implied by fed funds futures were already well above 50% one month prior to each of the last two rate hikes. If there was a strong desire to lift rates in March, Yellen would have likely sent a more powerfully hawkish signal in her testimony last week. Instead, Yellen chose not to mention the March meeting specifically and said only that the Fed would continue to evaluate the case for further rate hikes at its upcoming “meetings”.

Besides the lack of a clear signal from Yellen, still-low inflation and elevated policy uncertainty will keep the Fed on hold until June.

Trump And The Fed

President Trump could appoint up to six members to the Fed’s Board of Governors, which will affect the direction of U.S. monetary policy for several years.

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The Fed’s Board of Governors consists of seven members appointed for a fourteen year term. This includes a Chair and a Vice Chair, who serve separate four year terms in this capacity. The seven individuals on the Board of Governors, along with the president of the New York Fed, are permanent voting members of the FOMC. The remaining four votes are rotated annually among the other Fed districts. The key point is that with seven out of twelve votes, the Board of Governors has a disproportionate weight in setting U.S. monetary policy.

With Governor Tarullo announcing his resignation on Friday, there are now three vacancies on the Board of Governors. Janet Yellen’s term as Fed Chair expires in February 2018 and Stanley Fischer’s term as the Vice Chair will expire in June 2018. It is very likely that they will not be reappointed. In addition, it is quite possible that Governor Brainard, a Democrat and Clinton supporter, will also step down sometime in the next few years. All this means that President Trump may end up appointing five or six Fed governors.

It is certainly easy to envision Trump stacking the Board of Governors with doves. An accommodative Fed would help his agenda on two fronts. First, he is a self-proclaimed “king of debt” and his fiscal policies would blow out the deficit. The budgetary shortfalls could be financed at lower than otherwise interest rates. Second, a dovish Fed would push the dollar lower, providing support to manufacturing and exports.

The problem with this theory is that Trump’s public pronouncements on monetary policy have generally been on the hawkish side. He criticized Janet Yellen on the campaign trail, accusing her of trying to goose the economy in order to help the Democrats at the polls. Granted, Trump’s views on the hard money/easy money debate may have changed now that he is president and poised to benefit politically from a more stimulative monetary policy. Nevertheless, it could still be difficult for him to make a complete U-turn on the subject, especially since Senate Republicans are likely to resist efforts to pack the Fed with doves.

Is The ECB’s Policy Stance Counterproductive?

If the ECB’s ultra-looseness is an attempt to quell a flare-up of ever-present political risk, the strategy is becoming counterproductive.

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In addition to irking President Trump, the ECB’s extreme policy is riling Germany’s Finance Minister Wolfgang Schäuble, who has blamed Mario Draghi for “50 per cent” of the success of the populist right-wing Alternativ Für Deutschland. And by frustrating voters worried about the low interest rates on their hard-earned savings, the ECB is also playing right into the hands of Marine Le Pen’s Front Nationale.

The ECB acknowledges that “the risks surrounding the euro area growth outlook relate predominantly to global factors” rather than domestic factors. If the ECB is right, the extent of anticipated monetary tightening outside the euro area is overdone. If the ECB is wrong, then the extent of anticipated monetary tightening inside the euro area is underdone. Either way, the investment conclusion is the same. Our European strategists recommend an underweight position in German Bunds relative to U.S. Treasuries. Near-term risks to the euro are to the upside, especially versus sterling.

Global Equities: From Gloom To Boom

The surge in developed market equities since the U.S. election has pushed stocks deep into overbought territory. A correction is likely over the next few weeks.

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Markets tend to swing from one extreme to another. This time last year, investors were fixated on secular stagnation. Now they are convinced that we are on the edge of a new global economic boom. Neither position is justified. Global growth has picked up, and this should provide a tailwind to risk assets over the next twelve months. However, as discussed in the prior two Insights, there are still plenty of headwinds around. This suggests that the recovery will be a halting affair, with plenty of setbacks along the way.

We expect global equities to fall by 5-10%, paving the way for higher returns over the remainder of the year. Once that recovery begins, European and Japanese stocks will outperform their U.S. counterparts in local-currency terms. We continue to expect EM equities to lag DM.