Krishna Memani, Chief Investment Officer and Portfolio Manager
You are forgiven if you thought I was reminded of the famous Alicia Keys song, “Girl on Fire,” following the U.S. Bureau of Labor Statistics’ latest Consumer Price Index (CPI) inflation report. As everyone knows by now, the CPI came in a tad higher than expected.
No, that is not the reason I am thinking things could get heated. I am not that bothered by the inflation report, as the source of that uptick – apparel – is not sustainable, just as the source of the downtick last year – cellular services – was not sustainable. For example, the fact that department store chain Kohl’s Corp., for the first time in recent memory, ordered the right amount of merchandise for the Christmas season and didn’t have to discount leftover inventory in the New Year is not cause for significant alarm in my book.
Instead, what I am getting worried about is the size of the fiscal stimulus that is being dumped on the U.S. economy at this point in the cycle. When we wrote our 2018 outlook last year, we clearly were expecting a fiscal expansion on the back of the proposed tax cuts. That was the reason why we speculated that, while we may not be there yet, the end of the cycle is getting closer.
What I did not expect was the fiscal expansion due to increased federal government spending of almost $300 billion over the next two years. Now we are talking real money, almost 2% of GDP in 2019. As a result, U.S. economic growth in 2019 could be as high as 3%.
One Scenario: Fed Hastens End of Cycle
It is a perverse irony that the one way growth does not get to that level is if the U.S. Federal Reserve (Fed) tightens aggressively in the face of accelerating growth. In other words, the U.S. Congress giveth and the Fed taketh away. Given the still-fragile structural nature of growth in the U.S., the aggressive nature of the monetary tightening implied in that scenario – the Fed further raising rates by more than 150 basis points – brings us closer to the end of the cycle. We can argue whether it will be in 2019 or 2020, but it isn’t that far off.
Another Scenario: Foreign Savings Finance U.S. Deficit
One other less obvious and less appreciated way for growth not to get to that high level is for the U.S. stimulus to leak overseas. That is, with savings rates in the U.S. already low because of household leveraging, the way the U.S. fiscal deficit gets financed is with a meaningful widening of the current account deficit, which of course implies that U.S. GDP growth improves, but the multipliers are not large enough for the domestic economy. For this to be sustainable, it would have to occur in a period of dollar stability and substantial buying of U.S. assets by other central banks.
In other words, we would essentially be bringing back the mid-2000s: Decent growth in the United States, ever-widening U.S. trade deficits, modest inflation, boom times for emerging markets (EM), and foreign reserves rising everywhere in the world. Remember the savings glut I keep talking about? It will be headed to the United States to finance the leveraging of the federal government in a meaningful way. That, of course, is stability in the near to medium term, and potentially absolutely catastrophic if sustained in the long run.
To be honest, I don’t know at the moment which is the more likely outcome. In my opinion, it will become clearer toward the end of 2018. Much will depend on what the Fed does as growth, as opposed to some measure of inflation, heats up. If the Fed is preemptive, the first scenario becomes more likely. If the Fed moves gradually, as it so far has articulated it will, the second scenario becomes more likely, in my view.
Dollar Movements Will Be a Key Indicator
I am quite sure that the dollar, rather than the rates markets, will tell us which way we are headed. If the dollar is volatile – appreciating or depreciating by significant degrees at various points over the next year – the markets are in charge and it is the first scenario playing out. On the other hand, if the dollar is relatively stable, especially in the face of widening deficits – which means that EM central banks are intervening to prevent their currencies from appreciating – the second scenario is playing out.
Asset Classes Will Fare Differently Under Each Scenario
The performance of various asset classes in either scenario is quite different as well.
In the first scenario, where the Fed is tightening aggressively and the dollar is all over the place, we will be getting close to the end of the cycle:
- Equities, especially DM equities, recover and do well for a bit and then roll over,
- It becomes a value over growth market,
- Credit continues to be in the cross hairs of the markets, and
- Rates keep their upward trend for a while until the cycle ends and then rally.
It may still turn out to be a relatively long cycle, but the end would be imminent.
In the second scenario, in which U.S. growth is decent but not spectacular and the dollar is relatively stable, the Fed moves gradually and eases off in 2019, and we bring back the noughties and all sorts of conundrums:
- The cycle gets extended,
- Developed market equities do well, but EM growth accelerates and EM equities deliver solid performance,
- Credit remains stable, and
- Interest rates don’t go up meaningfully.
Essentially, this would be a more acute version of the 2018 outlook we expected – the current volatility dies down, and we get back to the longest cycle and potentially the best returns we have ever experienced in the short to medium term.
For now, I am leaning towards the second scenario but watching the dollar to see if I need to adjust my views.
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These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.
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