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New Momentum for Aging U.S. Business Cycle

Higher fiscal spending will likely ramp economic growth and allow the Fed to normalize key interest rates at a faster clip over the next two years. What’s that mean for investors?

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The aging U.S. business expansion could get a new lease on life. With the change in leadership, the baseline assumptions now include President-elect Donald Trump delivering a fiscal spending boost in 2017—with monetary policy responding accordingly.

“Trump's economic agenda is likely to provide a needed fiscal boost to U.S. growth, lifting our forecasts and enabling a pickup in the pace of monetary policy normalization,” says Morgan Stanley Chief U.S. Economist Ellen Zentner. With 2016 GDP growth tracking at 1.6% for the year, Zentner and her team have lifted their forecast for 2017 to 2.0%.

We are assuming that trade protectionism goes little further than threats.

Does that bode well for the U.S. stock market? Not so fast, says Chief Equity Strategist Adam Parker. “We are wary of embedding huge macro bets into our expectations for market microstructure,” he says, adding: “Our gut instinct is to fade the optimism about reflation and go long legislative gridlock relative to the consensus banter.”

On Jan 20, 2017, President Trump will preside over a unified Republican Congress. Tax reform and infrastructure spending are the likeliest policies to get passed initially, says Zentner. On net, those policies will likely provide a healthy lift to the U.S. economy and should allow the Federal Reserve to pick up its pace of policy normalization.

Zentner, who expects the Fed to raise its key interest rate by a quarter percentage point to 0.5% when its policy-setting group next meets in mid-December, is projecting two more rate increases in 2017. “Facing an economy growing beyond its potential, policymakers may remain cautious at first, continuing to pursue a gradual path before normalizing policy more quickly in 2018.” At that point, she expects three more rate increases, bringing the key fed funds rate to a target range of 1.75% to 2%, a level not seen since 2008.

Austerity's End?

America’s prolonged fiscal austerity may soon end. “Years of pent-up demand will result in an increase in the budget deficit and overall debt that includes an increase of roughly $500 billion per year in fiscal spending,” Zentner says. Indeed, the deficit-to-GDP ratio, which bottomed at 2.5% in 2015, is expected to increase to 5.9% by 2018, while debt could grow to more than 80% of GDP by 2018, from a little over 70% in 2015.

Meanwhile, she sees a slightly better picture for business investment unfolding in 2017. Over the past two years, business investment has been anemic, weakened initially by collapsing energy-related investment, then more broadly by the dollar’s rapid appreciation against other major currencies, such as the euro, pound and yen. As the earlier declines in energy prices fade, energy sector investment is expected to rebound. After averaging annual growth of less than 1% in 2015 and 2016, Zentner forecasts business investment will grow by 2.8% in 2017.

However, the dollar is expected to appreciate further next year, making U.S. exports more expensive and further pressuring the manufacturing sector. As for trade policy, “We are assuming that trade protectionism goes little further than threats,” says Zentner. Yet, those threats could be enough to dampen business investment and tighten financial conditions, providing a prolonged underlying current of uncertainty in 2017.

Consumer Outlook

What about U.S. consumers, who have remained a bastion for the economy when all else seemed on shaky ground? “On the back of tax reform, personal disposable income increases, despite slower job growth, while a lower unemployment rate helps support further wage gains,” Zentner predicts. Although the windfall from lower fuel prices has faded, and motor vehicle sales growth has slowed, higher disposable income growth will help consumers maintain a steady pace of spending, even as the level of personal savings is expected to stay high.

The housing sector recovery should also provide key economic support over the next couple of years.  Demographic factors are expected to keep household formation trending above a million units a year in the coming years. Moreover, tight supply conditions and solid demand will help home prices grow at around 4% a year. “In the aggregate, roughly 10% negative equity remains in the housing market,” Zentner notes, “but by 2018, we will have whittled it away, thus, removing what's been an important headwind to middle-income households.”

To be sure, risks remain. “Fiscal stimulus lowers our 12-month probability of recession to 30%,” Zentner says, “but sizable late-cycle stimulus could create a boom-bust cycle that brings forward the end of the business expansion.” Moreover, with the debt-to-GDP ratio already around 70% and likely to rise much higher, should an economic shock occur, the government wouldn’t have a lot of fiscal space to respond. Adds Zentner: “One can easily say the same regarding monetary policy.”

In terms of U.S. market recommendations, Parker says: “We now prefer small caps over large caps, given the supportive outlook for currency, taxes and trade. At the sector level, we prefer Industrials to Consumer Discretionary, Biotechnology to Software, and Utilities to Staples. We are neutral Financials with a bias toward credit cards and banks over insurance and asset managers.”

For more Morgan Stanley Research on the 2017 U.S. economic, policy and market outlook, ask your Morgan Stanley representative or Financial Advisor for the full reports, “2017 US Economic Outlook: A Shot in the Arm” and “2017 Global Strategy Outlook: Sparkle and Fade” (Nov 27, 2016). Plus, more Ideas.