Earnings Growth and Economic Growth

I refrained from sending out the obligatory post-election analysis until I thought I had something to say. I think I do now, so here it is.

To get to the punch line first, we added to our equity positions just before the election, putting about half of the cash on hand to work. Our GTAS strategy benefited greatly from the post-election run-up.

President-elect Trump appears to have won largely on the votes of the forgotten segments of our country who believe that they have been underserved by establishment politicians and gridlock. Despite the recovery from the financial crisis and a 15% increase in real GDP since the 2009 trough, large segments of the population feel that they have been left behind economically. You don’t have to look very deeply into the statistics to confirm their beliefs. While job growth has entered its 73rd consecutive month, the real (adjusted for inflation) median income of US families has barely budged in twenty years. At $56,516 in 2015, it is lower than it was in 2007 ($57,423) and the same as it was in 1998. Yet real per capita GDP rose 21% since 1998. When the mid-point stays in one place and the average rises dramatically, that means the upper end of the income distribution has skyrocketed in the last 20 years.

Income inequality is inevitable in a market economy. In fact, it is a powerful incentive for the engines of innovation and growth. However a mountain of research here and abroad has shown, that too much inequality has an adverse economic impact because it stifles incentives and importantly, reduces the growth of aggregate demand to levels well below the growth of GDP. We’ve seen that in the last 10 years. Healthy dynamic economic growth depends not only on growth of production (supply) but also growth of demand. If you have one without the other, economic growth is fighting an uphill battle. Indeed for most of the post-crisis recovery, 70% of the growth in S&P earnings came from international trade, not domestic demand. Unfortunately, that has levelled off for reasons that are and will remain outside of our control.

With that as backdrop, let’s look at what we think we can sketch of Pres. Trump’s economic priorities. The key elements thus far appear to include:

  • Reducing the burden of government regulation
  • Reducing effective corporate income tax rates
  • Improving incentives for domestic energy extraction and utilization, including coal
  • Renegotiating trade treaties to protect domestic industry and workers
  • Restricting immigration and potentially deporting some workers and families
  • Launch a large-scale infrastructure rebuilding and modernization program

Let’s assume that we have a cooperative Congress so that we won’t worry about which of these is likely or not and instead assume that we can take them all at face value.

The first three of these focus on production/supply. They are all oriented toward reducing the cost of doing business. Reducing business costs has two likely effects: Short term profit growth – we are seeing the excitement in the stock market this week over this prospect – and more business. However, more supply only leads to more sustained profits if you have more demand as well. Otherwise, you get more competition and falling prices and a normalization of profits once again. (As we’ve seen domestically in the last 3 to 5 years). These measures by themselves will probably spur profits but the impact on economic growth may be disappointing. Of course you will get employment growth but likely far less than some pundits predict. Put differently, these measures intensify the income skew that has limited aggregate demand growth.

Renegotiation of trade is a two-edged sword. In contrast to conventional trade theory that holds that freer international trade enhances growth everywhere, President-elect Trump’s critique that free trade can hurt US workers is reasonable and is supported by research that I’ve done. Moreover, it is especially damaging to workers in capital-intensive industries where incomes tend otherwise to be higher. Renegotiating treaties to recognize this could be very helpful to our economy and to the demand-side. However, done badly, renegotiating trade deals will merely suppress international demand, hurting our overall aggregate demand and therefore profits and growth.

Given my framework above, immigration restrictions or reversals have an obvious impact: They may increase median incomes a little but they are more likely to hurt aggregate demand. It has become increasingly apparent in surveys of businesses that their greatest limiter for future growth and profitability is the availability of qualified hires. To the extent that policy restricts that pool any further, it cannot be good for profit growth or economic growth on either the aggregate demand or aggregate supply sides.

Finally, we come to infrastructure rebuilding. That, coupled with tax relief, represents a classic Keynesian stimulus package. Under the current economic conditions, this is likely to be growth enhancing on both the supply side – company business and profits expansion – and on the demand side – more employment at better wages. This would be unambiguously a short- to medium-term growth spur and the stock markets would be right to be excited by this prospect. Getting a large program like this through Congress may be tricky, especially because it is inevitably going to increase deficits, but if successful, it would argue for optimism where the US stock market is concerned in 2017 and 2018. The program is also likely to affect the bond yield curve and possibly inflation. That’s a big topic by itself and I will leave it for a subsequent note.

From an economic growth standpoint, as opposed to earnings growth, the weakness in the Trump agenda is the same as the weakness in the establishment growth strategies since 2009: It focuses largely on the production/supply side to the exclusion of the aggregate demand. (With the exception of the last item.) Therefore, like the programs to date, the longer term impact on growth may be disappointing unless there is more attention on the aggregate demand side of the recovery.

© RBC Wealth Management


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