Reasons to be Bullish

We wish we had a dollar for every time we’ve heard that the bull market in equities is only due to loose money.  We have consistently disagreed, arguing that although the Federal Reserve is loose, the bull market is primarily a function of the rebound in profits after the disaster in 2008-09.

The government’s economy-wide measure of profits – the one’s it releases with the GDP reports – was $2.15 trillion at an annual rate in the fourth quarter of 2016, up 9.3% from the prior year and very close to a record high.  In turn, given the strong statistical link between the S&P measure of profits and the government’s measure, as well as the robust gains in S&P profits reported so far for the first quarter, we wouldn’t be surprised at all if the economy-wide measure of profits is hitting a record high in Q1.

The gains in profits are a testament to the enduring ability of entrepreneurs in the face of what has been a bipartisan movement toward more government involvement in the economy dating back to the latter couple of years of the Clinton Administration.  These include more government spending, new entitlements, and much heavier regulation.

Now it looks like government policy stands a solid chance of becoming a tailwind to growth rather than a headwind, with less regulation on the energy sector paired with respectable prospects for major reforms of Medicaid and Obamacare as well as supply-side tax cuts.

These changes will sustain the growth of corporate profits even in the face of an acceleration of wage gains as the unemployment rate declines.  Notice the lack of a negative equity reaction to Wednesday’s Fed statement that sent a clear signal a June rate hike was on the way.  Supply-side policies are the way policymakers can break through the Keynesian mindset that labor and capital have to battle it out for the upper hand and that a “tight” labor market must mean weakening profits.

Meanwhile, it looks like France, and, in turn, the EU can continue on a bullish path. Emmanuel Macron, France’s incoming president, has proposed curbs on France’s wealth tax, wants to decentralize corporate bargaining with unions, plans to cut the corporate tax rate to 25% from 33%, and wants to reduce government jobs (through attrition).

The European Union is in dire need of economic reform, to move toward free-market capitalism rather than (democratic) socialism.  But the best way to do this is for major countries in the EU, like France, to reform their economies themselves.

If some countries move toward freer markets, other countries will have to follow or capital will move toward more freedom, leaving the others behind.  Now it looks like one of those countries is on its way.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

Prepare for Q2 GDP Surge

Economic data is volatile.  Weather, seasonal adjustments, calendar flukes, and measurement errors all affect the data.  Nonetheless, those with a political axe to grind, or an economic forecast of recession or boom, will grab one piece of data and act as if they have discovered the Holy Grail.

This happened with Q1 real GDP, which grew just 0.7%.  Pessimists went into a tizzy, but they shouldn’t have.  We think the Plow Horse economy, with all its features, both good and bad, is still fully intact.

Despite the soft Q1 report, real GDP was up 1.9% from a year ago, very close to the trend.  The pace of inventory accumulation fell, pulling down the number.  This is unlikely to continue.  “Core” GDP, which excludes inventories, government spending, and trade with the rest of the world – none of which can be counted on for sustainable growth – grew at a 2.2% pace in Q1 and is up 2.8% from a year ago.

In fact, there were some key signs of a pick-up in growth ahead.  Business fixed investment soared in the first quarter, growing at a 9.4% annual rate, the fastest pace for any quarter since 2013.  And corporate profits are accelerating.  With roughly 60% of the S&P 500 having reported for Q1 so far, earnings are up about 15.6% from a year ago.

Meanwhile, home building grew at a 13.7% annual rate in Q1, the fastest pace for any quarter since 2015.  Although the recovery in home building is about seven years old, we expect gains in housing to continue for at least the next couple for years as builders battle pent-up demand from population growth, scrappage, and years of under-building.

Yes, consumer spending grew at only a 0.3% annual rate in Q1, but a few extenuating circumstances suggest a hearty rebound in Q2.  First, autos sales were unusually weak in Q1, in part a reflection of an unusually late March snowstorm in the East. (We get April auto sales data tomorrow, and we expect a pickup in pace.)  Second, unusually warm weather in January and February suppressed utility (heating) output.  Third, that same warm weather may have suppressed winter clothing sales.

As these patterns reverse, growth will bounce.  Although it’s still early, we are looking for real GDP to grow at a 3.5% annual rate in Q2.  That would put the first half of the year at a growth rate of 2.1%, right at the Plow Horse trend.

Even more important, the Trump Administration looks serious about supply-side tax cuts that will boost the economy’s long-term growth potential.  If and when these policies get enacted, that’s when GDP will finally accelerate.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist