Saturday, January 23, 2021

Foundation For Slower Economic Growth Being Laid, Stocks Still Work

In our Winter 2020 Investor Letter released earlier this month, our firm indicated our real GDP growth expectation for this year is in the mid single digit percentage range. We continue to hold that view given likely pent-up demand and our expectation the economy is exciting the recession. The uncertainty around the virus spread and vaccination progress is a headwind to our growth expectation though. Additionally, before the inauguration of President Biden on January 20, I highlighted the potential risk of a policy error to the economic recovery. Some of the executive orders (EO) signed by the President after he was sworn into office on January 20 now heighten this risk in my view. For investors it is important to separate their political/policy concerns with the view of the performance of the investment markets.

To that end the recently signed EO's will have a direct impact on some economic activity. For example, revoking the Keystone pipeline permit will result in some job losses. Keep in mind, some investors view this as a positive and green and alternative energy investments might benefit from this action. One EO signed by the President instructs the government to revise fuel economy standards in California essentially allowing the state to have stricter caps on emissions. The Biden administration is also proposing higher taxes for individuals and businesses. I highlight some of these EO actions and the administration’s tax policy goals as it increases the regulatory and tax burden on businesses and individuals which could create a headwind to economic growth.

The Legatum Institute maintains a  Prosperity Index for a large number of countries with one component categorized as the Burden of Government Regulation. According to the institute, this index component "captures how much effort and time are required to comply with regulations, including tax regulations." The index goes back to 2007 and below is a chart of the index overlaid with the rolling 10-year annualized U.S. real GDP growth rate. Correlation does not mean causation; however, the higher regulatory burden does seem to equate to slower economic growth as shown on the chart. Coming out of the 2008/2009 recession the GDP rolling average growth rate saw a brief pick up; however, as the regulatory burden increased, GDP growth slowed.

The report on jobs this past week might be a canary in the coal mine as it relates to how robust the economy grows. Claims were reported at 900,000, a decline of 26,000 versus the prior week; however, they remain up from the low 700,000 level reached in November 2020 as seen below. Then, looking at continuing claims in the second chart below, with the Pandemic category included, continuing unemployment claims are simply too high and this is a drag on economic growth. In short the improvement in claims seems to have stalled and actually trending higher.

Finally, Cornerstone Macro's Daily Consumer Confidence Index has fallen back to the June 2020 recession level. Consumers account for about 70% of GDP and weakening confidence will likely add to the economic growth headwind. One should not discount the positive impact that stimulus by the Federal Reserve and U.S. government can have on the economy and equity prices though, and more stimulus is likely on its way which should bolster confidence in the short term.

In summary, positive economic growth is expected in the year ahead especially if some of the larger state economies reopen, like California and New York, as vaccination levels increase. Overheated growth will likely not occur if the regulatory and tax burden increases which might keep downward pressure on inflation. But just as the economy experienced slower growth under President Obama, the stock market performance was favorable to investors. A similar environment may be in the offing in the few years ahead.

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