President Trump Has Promised to “Make America Great Again” – but Can the Economy Make the Transition From Good to Great?
Louis P. Abel, CFA, CAIA
Chief Investment Officer, Chair of the Investment Committee
First Foundation Advisors
“We have a great economic plan. We will double our growth and have the strongest economy anywhere in the world.”
– Donald J. Trump’s election victory speech
President Trump’s campaign slogan was “Make America Great Again.” The red hats with the slogan emblazoned on them were a ubiquitous feature at Trump campaign rallies across America. In his election victory speech, he noted that he had “a great economic plan.” Interestingly, he used the word “great” no less than seven times in that speech. Becoming “great” seems to be a key theme in Trump’s political narrative. But can the economy become “great”?
There is a broad consensus among economists that the economy right now is “good.” However, can it transition from merely “good” to truly “great”? Investors seem to think so. The stock market, as measured by the S&P 500, rose 12% last year, with much of the gains coming after the November election. And so far this year, the market has rallied another 6%. Are these gains sustainable? Consumer confidence increased sharply in March. Business confidence is also improving. Some say Trump’s election victory has triggered Keynes’ notion of “animal spirits” and that in turn will lead to faster economic growth. But does the economic environment justify such optimism? Can Trump’s policy agenda shift the economy from good to great?
Jim Collins’ book Good to Great, which was released in the fall of 2001, became an instant best-seller and one of the most influential business books of the decade. It’s also among the top 20 best-selling business books of all time. (Interestingly, despite Trump’s claim that his book, The Art of the Deal, is the best-selling business book of all time, it actually isn’t even among the top 50.) In Good to Great, Collins showed how some companies make the transition from merely good to truly great. However, only a handful of companies ever make this leap. After combing through every company ever listed on the Fortune 500, some 1,435 companies in all, Collins settled on only 11 that he felt met the criteria for “great,” and he describes in detail the necessary conditions for a company to go from good to great. Similarly, along with describing President Trump’s goal of shifting the economy from good to great, we thought we would examine exactly how feasible that transition might be.
Unpacking the Equation: From Good to Great
In his election victory speech, President Trump said his goal was to double economic growth and to have the strongest economy in the world. Let’s unpack this statement.
Figure 1. Long-term drivers of economic growth
The right-hand chart in Figure 1 shows that the average GDP growth rate for the past six decades has been steadily declining, from the 4% range to the 3% range to a mere 1.3% over the most recent decade. That’s a significant slowdown.
The rate of GDP growth can be broken down into two components – the growth in the working-age population (which in turn is a function of the labor force participation rate) and the productivity rate, which is defined as the growth in real output per worker. Put very simply, there are essentially only two ways to grow – either with more workers or through more productivity.
The right-hand chart in Figure 1 shows the breakdown of growth between those two drivers – the growth in workers and in productivity. Of that 1.3% growth rate over the past decade, 0.4% of it came from the growth in workers. As you can see from the chart, that’s a substantially lower rate than in the past. Why? The simple answer is – you guessed it – demographics. It’s well-known that the U.S., like other developed countries, has an aging population. With the retirement of the baby boomers, more and more people are leaving the workforce. The labor force participation rate, which increased steadily in the 1980s and 1990s, peaked in 2000 and has declined ever since. Economists joke that a chart of the labor force participation rate looks like a “frowny face.”
The decline in the labor force participation rate has a negative impact on the overall growth in workers. The chart in the upper-left of Figure 1 illustrates this. The growth in the working-age population (ages 16-64) has been only 0.6% over the past decade, as compared with 1.0%-1.4% in previous decades. And it’s interesting to consider the breakdown of the growth in the working-age population. As you can see from the chart, half of it is coming from immigrants (in this case, the data includes solely legal immigrants). Translating the upper-left chart to the right-hand chart of Figure 1, if the overall GDP growth rate of 1.3% comprises 0.4% from the growth in workers – and roughly half of that is from immigrants – then our immigration policy clearly has important implications for economic growth going forward.
Set Aside Politics – We’re Focused on Economics
Now, here is the part of the discussion where we need to interject a very important note (which perhaps we should have mentioned at the outset): This is not a political commentary. Each of us, of course, has our own political views. And everyone is entitled to their political views. We strive to keep politics out of the discussion. We remain squarely focused here on economics – and the impact it has on the investment markets and hence your investment portfolio. Okay – with that important note out of the way – now back to the topic at hand: the components of growth and the importance of immigration.
Sticking with the chart in the upper-left of Figure 1, not only has the growth in the working-age population slowed substantially over the years, but it is also forecast to slow even further going forward, from 0.6% over the past decade to 0.3% in the coming decade. In addition, look at the composition of that figure. Whereas in the past the growth in the working-age population was split evenly between immigrants and native-born workers, going forward immigrants are expected to represent roughly 85% of the growth in workers. Again, we want to keep politics out of this discussion. We’re not saying there isn’t room for some immigration reform. Trump announced recently that he was discussing efforts to reform the nation’s immigration policy with Senator Tom Cotton of Arkansas and Senator David Perdue of Georgia. What we are saying, however, is that regardless of the merits of any proposed reform, immigration is a critical issue for economic growth. Immigrants are important just to maintain the current low level of economic growth, let alone achieve the goal of increasing that growth – and especially if the goal is to double it, as President Trump wants to do.
So Trump’s policy agenda of curtailing immigration seems to be at odds with his goal of trying to boost economic growth. The numbers alone tell you that without immigrants, it’s going to be hard to go from “good” to “great.”
The Productivity Paradox
“You can see the computer age everywhere but in the productivity statistics.”
– Nobel Prize-winning economist Robert Solow
What about the other driver of GDP growth – productivity? First, let’s define it again. Productivity is the output per hour by the average worker. Productivity is immensely important for not only economic growth, but also rising living standards. Productivity can be broken down into three parts: (1) what’s called “capital deepening” – i.e., giving more tools to workers to work with; (2) improving education – i.e., smarter workers; and (3) “multifactor productivity,” which is basically a catchall category that includes all the other things that affect productivity that we can’t break out easily.
Historically, productivity growth has been up and down at various points in time. It was strong in the 1950s and 1960s, but then slumped in the 1970s and 1980s, and then picked up again in the 1990s and 2000s. However, more recently, it has slumped again. It has been weak over the past few years, even in the face of the expansion. This raises a natural question: Why have we seen a slowdown recently? The financial crisis and recession clearly had an impact on productivity as employment fell. But why hasn’t productivity growth improved as employment has recovered? Clearly, there’s something more than just the business cycle impacting productivity. In the late 1980s and 1990s, we witnessed an increase in the penetration of computers. And then, in the 2000s, we entered the Internet age. Businesses spent substantially on technology. Some of this spending was clearly wasteful, but some of it no doubt helped workers become more productive. Productivity began to increase until 2000, when it suddenly fell off again. The slump was triggered in part by the bursting of the tech bubble. Then, in 2008, we had the financial crisis. We have seen some recovery in productivity since that time, but not much. Capital-to-labor ratios are not rising. We are simply not giving our workers enough tools.
As the “capital deepening” component of the equation (giving workers more tools to work with) suggests, there is an important connection between investment spending and productivity. Turning to Figure 1 again, the chart in the lower-left shows investment spending. While it has rebounded from its trough in 2008, it nevertheless has not recovered to its pre-financial crisis levels, and recently it has been trending down somewhat. To boost productivity growth, and hence overall economic growth, we’re going to need to boost investment spending.
What About Those Smartphones We All Have?
First we saw the introduction of computers, and then the Internet, and now mobile devices such as smartphones. Have they boosted productivity? In some ways, probably, yes. But the question is, when you’re on your smartphone, are you actually busy sending work-related emails, or are you on Facebook or Instagram? Are you using your smartphone for a work-related project or playing Candy Crush? There’s no question smartphones have changed our lives, making them much easier in many ways – but are they really adding to productivity? In the 1980s and 1990s, we saw investment spending on technology by businesses showing up in the productivity statistics. While we now have some amazing new technologies such as smartphones, so far we aren’t seeing them translate into greater output per worker. Maybe there is a measurement problem or a lag effect, but whatever the case, we aren’t seeing it in the statistics. Other emerging technologies, such as robotics, for example, hold out the promise of boosting productivity. The impact of self-driving cars, on the other hand, is a little more uncertain. Does sitting in the back of the car versus driving the car make much of a difference in terms of productivity? Autonomous cars are likely to change the shape of the auto industry. And, no doubt, there will be knock-on effects from such a shift. Our best guess is that these cars will likely boost productivity in the long run. But it’s hard to see much impact in the near term.
Clearly, innovation is critical for productivity. For investment spending to drive productivity, it matters what kind of investment we’re talking about. What about infrastructure spending? President Trump has proposed a $1 trillion infrastructure spending program. Will that drive productivity growth? Fixing potholes and repairing aging bridges is very important for society, but this type of investment spending is unlikely to boost output per worker. And infrastructure spending of this kind often has a negative impact on growth in the short term. For example, Boston’s Big Dig, the central artery and tunnel project through the downtown section of the city, was the biggest highway project in U.S. history. It took three decades to complete and was eight years behind schedule. Plus, it was plagued by substantial cost overruns. The final price tag was $15 billion, nearly double the budgeted cost. Including interest on the debt, the total cost was $24 billion. (And you thought your kitchen remodel was over budget and behind schedule!) Early on, the project caused traffic to snarl, especially around the Callahan Tunnel to Logan Airport, East Boston, and areas to the north. But more than 10 years after the Big Dig’s completion, this mega-infrastructure project seems to have boosted productivity. When the project started, the highway handled 75,000 cars per day. By the early 1990s, it was handling 200,000 cars per day with ample capacity. Today, it handles 536,000 vehicles per day. But while the project has eased gridlock and boosted throughput in downtown Boston, the surrounding areas still remain heavily congested. While overall it has likely been beneficial to the flow of goods and services and hence the overall economy, its full impact on productivity is unclear. In any case, there seems to be little doubt that an infrastructure spending program conducted by the Trump administration will have at least some beneficial impact on productivity, especially in the short run. However, its effect in the long run may be smaller than many people think. It all depends on what type of infrastructure spending we get.
The Virtuous Cycle of Trade
Economists have established an important link between trade and productivity. Remember that third component of output per worker, called multifactor productivity? There is a tight correlation between growing trade and increasing multifactor productivity. Trade has slowed since 2007. Some of that slowdown is explained by weak global demand. And many economists point to China’s economic slowdown and transition away from a manufacturing-led economy to a consumer-led economy. Also, the rising U.S. dollar has had an impact on export growth. With President Trump’s talk of protectionist trade policies, including the possible imposition of tariffs or a border-adjustment tax, trade could slow even further. That would clearly be bad for productivity growth. And trade doesn’t just affect multifactor productivity; it also affects investment spending. As trade picks up, businesses tend to invest more. There’s a sort of virtuous cycle of trade, investment spending, and productivity. Whatever you think of protectionism, it’s clearly a roadblock to productivity growth. Here again, like his immigration policy, Trump’s trade policy would seem to be at odds with his goal of boosting economic growth.
On the Other Hand…Lower Taxes Help!
President Trump’s tax reform policies are likely to benefit productivity growth. In particular, lower corporate taxes should boost productivity. Corporate tax cuts typically lead to greater investment spending by businesses, which (as we’ve seen) is one of the factors that improves productivity. Personal tax cuts, however, are likely to have less of an impact on productivity.
Let’s Do the Math
GDP growth in the fourth quarter of 2016 was 2.1% on a quarter-over-quarter basis. On a year-over-year basis, the economy is growing at 2%.
Figure 2. Economic growth and composition of GDP
As the chart on the left-hand side of Figure 2 indicates, this is exactly in line with the average growth rate since the current expansion began in the second quarter of 2009. However, it’s below the average growth rate of 2.8% since 1965. But it’s above average compared with the rate in the past decade – recall that the average growth since 2007 is only 1.3%. As we have recovered from the financial crisis and recession in 2008, with unemployment falling from nearly 10% to 4.7% today, we have been able to grow at an above-average rate of about 2%. Remember, Trump’s goal is to double that – so he’s looking to achieve growth of around 4%. While a boost in growth to perhaps 3% or 3.5% might be feasible in the short term, driven by infrastructure spending, tax cuts, and deregulation, we think that with long-run growth running at a mere 1.3%, it’s going to be hard to sustain 3% or more growth over time. And 4% seems like a real stretch. Many economists argue that with unemployment at 4.7%, the economy is already at, or at least very near, full capacity. Any fiscal stimulus applied to an economy already at or near full capacity might add to growth at the margin in the near term, but could ultimately result in inflation in the long term. And with Trump’s stated policies on immigration and trade working at odds with the already tepid growth in workers and productivity, it’s hard to see how the economy goes from “good” to “great” in the long run. Any boost to growth we might see would likely be temporary.
We are already seeing some signs recently that the economy may be softening, despite optimism among consumers. For example, retail sales in March suddenly declined, and February sales were revised downward. All the while, consumer confidence, as measured by the University of Michigan Consumer Sentiment Index, is at its highest level since 2000. Inflation has suddenly weakened too. The most recent CPI figure, including both the headline number and core inflation, showed a decline. We have also seen a slowdown in auto sales recently, from a record high at the end of 2016. This is worrisome, since auto sales have been one of the key drivers of this expansion. Loan growth is also slowing. It’s still growing, but it has decelerated markedly from its previously rapid pace. Many economists are now projecting a sharp slowdown in growth for the first quarter. For example, Macroeconomic Advisors, an economic forecasting firm, is projecting growth of just 0.6% in the first quarter. That’s down sharply from the 2.1% pace we saw in the fourth quarter of 2016 and a far cry from 4%. Of course, these recent signs of weakness may be temporary, as is typically the case with the first quarter, which is often weaker than the rest of the year for seasonal reasons. And there is often a lot of “noise” in economic data. But what if the economy is not actually as good as we think? It’s going to be hard enough to go from good to great, let alone from “not so good” to great.
Good, Not Great
For our part, despite the recent slowing trend in some of the economic data, we think the economy is, in fact, still good. And although it’s possible we could see a boost in economic growth in the short term as President Trump’s policy agenda begins to take hold, we remain skeptical that it can shift the economy from good to great over the long run. We’re optimistic about the outlook for the economy, but cautiously so. We think the economy is merely good, not great. And “good” is fine, as long as investor expectations don’t get too far ahead of economic reality.
With that background for context, let’s shift gears now and do a quick tour through the different asset classes and discuss how we’re positioning our clients’ portfolios for a “merely good, not great” economic environment.
After such a strong rally last year and this year too, U.S. stocks currently trade at a price-earnings ratio of 17.5x. This is 10% above the average P/E ratio of 15.9x over the past 25 years. We’re not yet at one standard deviation above the historical average, which would seem to be a sure warning sign, but we are approaching it. This suggests to us that at least some caution is warranted. If we can’t shift the economy from good to great, investors could be in for a surprise. We need continued corporate profit growth to justify these above-average valuations. If valuations were to revert back to the average over, say, the next five years, that would imply a 2% decline in the price of stocks per year. If earnings grow at, say, 5%, then investors would be left with only a 3% return. Adding in dividends of 2% would bring the total return to 5% – which is good but not great.
We think Trump’s policy agenda will shift GDP growth up to perhaps 2.5% or so this year and maybe even 3% temporarily, and thus the stock market likely still has upside potential from here. But the timing of Trump’s policy agenda, and the ultimate impact it might have on the economy, might cause investors to be disappointed in the meantime. And so while we remain optimistic, as we said, we are cautiously optimistic. Even though we think the market can eventually go higher over time, we expect volatility along the way.
Most countries around the world are experiencing an improving economy. The Purchasing Managers’ Index (PMI), an index of manufacturing activity and thus an important indicator of economic activity, has improved in recent months for the developed markets and currently stands at 53.9. Readings over 50 indicate expansion, while those below 50 indicate contraction. These PMI levels are the best we’ve seen in five years. Canada and Australia are showing strong PMIs of 55.5 and 57.5, respectively. Even the PMI for the eurozone, which has suffered from weak growth in recent years, has picked up sharply, with the most recent measure at 56.2. We appear to be witnessing a global synchronized expansion. Only a few countries remain below the threshold level of 50, indicating a contraction in their manufacturing sector; these include Greece, which continues to suffer from high debt levels and austerity measures; Brazil, which entered a recession when oil prices dropped sharply in 2015 but is now beginning to see some improvement; and Korea, which seems to be experiencing some temporary weakness due to its recent political problems. With the recovery in oil prices, even Russia has rebounded from a contraction in mid-2016 to expansion recently.
And while U.S. stocks trade at above-average valuation levels, international stocks trade at their historical average. While average valuation levels may not sound all that compelling, with an improving economic environment likely to translate into increasing earnings growth, this bodes well for international stocks. We currently have a position in developed market stocks already and are benefitting from the strong gains in international markets we’ve seen so far this year. We are looking for opportunities to add further to our position in international stocks, with any volatility that might arise.
We don’t currently have exposure to emerging market stocks, but we have our eye on them. While the U.S. market is at above-average valuations, and international developed market stocks are attractive by comparison at average valuation levels, emerging market stocks are even more attractive at below-average valuation levels. However, the environment for emerging markets is still quite uncertain, with the possibility of continued strength in the U.S. dollar; the slowdown in China and a possible currency devaluation, debt crisis, banking crisis, and property bubble; and the possibility of protectionist policies being implemented by the Trump administration, triggering a potential trade war. Nevertheless, even with these issues, emerging markets may be compelling given their below-average valuations. Uncertainty creates opportunity. We continue to size up the probability of these events coming to fruition and look for opportunities to perhaps re-enter the asset class with the emergence of volatility.
The Federal Reserve signaled its intention to raise interest rates three times this year. It has already raised rates once, which implies two more rate hikes are in store for the rest of the year that will probably occur at the June and September FOMC meetings. With the economy having already hit or exceeded the Fed’s long-run targets for growth, inflation, and unemployment, continued rate hikes seem almost inevitable at this point, especially given that the federal funds rate remains below the Fed’s long-run target. Investors are also looking for signs that the Fed will begin tapering its balance sheet, which holds $4.5 trillion in securities that it has purchased over time. We expect the Fed to announce the beginning of this tapering process in December, but we think the process will be very slow – at, say, $5 billion to $10 billion per month – to avoid rattling investors.
Relative to past periods when the Fed hiked rates, this time the Fed has been very cautious and slow at raising rates. A rising rate environment almost always acts as a headwind for bonds. We think the impact of rising rates will be less severe than in past periods of rising rates, given that the Fed is likely to continue to raise rates cautiously and modestly, especially with growth at below-average levels (even if it picks up somewhat as Trump implements his policy agenda). As a result, we have sought to position the fixed income component of our portfolios to earn the best yield we can, while simultaneously trying to protect against the potential negative impact of rising rates. Fortunately, not all bonds are created equal, and thus there are categories that we think still offer some relatively decent opportunities and a degree of protection against rising interest rates, including shorter duration bonds, high-yield bonds, floating rate bank loans, mortgage-backed securities, and asset-backed securities. We have made some significant changes to the composition of the fixed income component of our portfolios recently to reflect our view of the changing environment.
Real estate values have risen too as the economic recovery has unfolded. Publicly-traded REITs, in particular, have benefited from the sharp rise in the stock market over time. In this context, we have been very selective about the securities that we invest in, sticking with a small, select group of publicly-traded REITs that we think offer continued appreciation potential due to their compelling valuations and unique company-specific factors.
Will We Make the Leap?
Despite some very recent data to the contrary, the overall evidence suggests that the economy is still good. While we applaud President Trump’s goal of trying to transition the economy from good to great, we remain somewhat skeptical about this possibility. Trump’s policy agenda of infrastructure spending, tax reform, and deregulation may boost economic growth in the short term, but we think such a boost may be difficult to sustain in the long run. The trends in the growth of workers and productivity suggest that it will be difficult to transition from good to great. Trump’s policy agenda on immigration and trade is at odds with his goal of boosting growth. Investor expectations may very well be ahead of the curve. Any disappointment about the timing or the magnitude of the Trump policy agenda could cause volatility. Moreover, disappointment over the ability to shift from good to great could exacerbate that volatility. Ultimately, we remain cautiously optimistic, on guard for short-term volatility, but generally positive about the future overall. The economy may be merely good, not great, but good is good enough.
As always, we thank you for your continued confidence and trust in us as stewards of your capital. We appreciate your business. If you have any questions or comments, we invite you to reach out to your Wealth Advisor.
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