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Moderate economic growth, relatively low inflation expected for second quarter

By Staff | Apr 26, 2018

Richard Pyle

We have now experienced nearly 18 months of the “Trump Effect” on the economy, interest rates, corporate profits, asset markets and investor psyche. Both consumer and business confidence are at 15-year highs. World economies continue to experience a synchronized growth spurt. Corporate America is seeing improved cash flows as a result of a dramatic cut in its 2018 tax rate. And individuals are seeing improvement in after-tax incomes. But the uncertainty of “what’s next” puts a slight damper on all-out euphoria. Questions regarding what the next move on interest rates will be by the Federal Reserve Board and its new chairman remain somewhat unresolved. Threats of international tensions, as well as the recent “trade war” talk led by the United States, cause some to fear a self-inflicted wound to the generally good economic reports we are seeing.

We continue to expect moderate economic growth and relatively low inflation for the foreseeable future. Much has been made of the possible effects of monetary authorities cutting back on the extraordinary easy money of the past decade. At this point, the Fed has telegraphed at least three 0.25 percent short-term interest rate increases this year and another three next year. This suggests that we may be looking at a 3 percent short-term interest rate by the end of 2019. While the Fed can control short-term interest rates, the longer-term interest rates are determined by market forces. With the 10-year U.S. Treasury Note currently yielding near 3 percent, and no change in that rate expected near-term due to tame inflation and worldwide demand for U.S. government bonds, we could be looking at a flat or possibly “inverted” yield curve – long-term rates are lower than short-term rates. Seldom has the economy performed well in that circumstance. The threat of a flat or inverted yield curve could prompt the Fed to hold off on any further increases in short-term rates next year. While we are not predicting this will happen, we are ever mindful of the possibility.

Another uncertainty is the path of trade policy. After years of trade policy stability, the Trump administration has taken on a decidedly hawkish approach to our trade imbalance. Not only have tariffs been imposed on selected items, but long-standing trade agreements such as the North American Free Trade Agreement are in the midst of renegotiation. Free trade has been the bedrock of U.S. policy since the end of World War II and has produced much prosperity. Whether or not U.S. policy now prompts widespread retaliation is yet to be known, but it is clear that any disruption could cause both higher inflation and slower growth – “stagflation” anyone?

Finally, we are also watching the political situation both domestically and around the world. As investors, we not only track what is happening to the fundamentals of various asset classes, but also their valuation. Valuation depends greatly on the populace’s current mood, and that mood generally is dictated by the flow of current events. We are in an election year again in the United States. After the 2016 cycle brought one-party rule to the United States, the mood was decidedly upbeat. The possibility of another divided government after November may cause investors to mark-down asset valuations. Talk of amending the new tax bill, as well as a return to gridlock, is something we must monitor closely. Asset allocations may have to be adjusted going forward to reflect this possible change in investor mood. We maintain our overall positive outlook, but because of persistent uncertainties we will have to remain flexible to the opportunities ahead for wealth creation.

Richard Pyle is president of the Sanibel Captiva Trust Company. He is also an active investment analyst and portfolio manager for the company and member of the Asset Management Committee.