An economist recently shared a disturbing vision, projecting that the 2020s will look a lot like the 1970s. The stock market went nowhere during the 1970s, inflation was out of control, and a deep recession brought the unemployment rate to 9%.
Two terms became widely used during the decade. “Stagflation,” the combination of stagnant economic growth and high inflation, and the “misery index,” the sum of the unemployment rate and the inflation rate. The misery index peaked at 21.98 toward the end of Jimmy Carter’s presidency. The economy recovered in the 1980s, but only after severe monetary “shock therapy” from Federal Reserve Board Chair Paul Volcker.
I’m less fatalistic about the outlook for the 2020s, as I expect the disinflationary impact of technology, demographic trends and globalization to keep inflation from reaching prior peaks. However, the favorable near-term economic outlook may be creating a false sense of security about the long-term outlook. Although President Donald Trump’s economic policies will boost near-term growth, an overstimulated economy and lack of progress on structural issues may cause the next recession to be more severe.
Some aspects of the Republican tax overhaul strengthen the foundation for long-term economic growth. Reduction of the maximum corporate tax rate from 35% to 21% and elimination of the corporate alternative minimum tax (AMT) will move U.S. corporations from having one of the highest corporate tax burdens in the world to being in the middle of the pack. The tax law moves towards a territorial tax system, reducing incentives for corporate inversions and motivating companies to repatriate overseas profits back to the U.S. Although capital spending will receive a near-term boost because capital expenditures become fully deductible from profits in the year of the expense, it is likely that companies will pull forward spending that was already planned. Consequently, capital spending may spike in 2018 and 2019, but will probably fall back in 2020.
Personal tax code changes have far-reaching implications, despite being scheduled to expire in 2026. Consumer spending will also get a near-term boost, as the majority of taxpayers should benefit from reduced taxes. Longer-term, however, the impact on consumers will be more ambiguous as provisions expire and inflation adjustments become less generous.
Despite claims from Treasury Secretary Steve Mnuchin, incremental growth isn’t likely to fully offset the cost of tax cuts. As was the case when taxes were cut during the Reagan and George W. Bush presidencies, the impact of tax cuts will increase the federal budget deficit.
The deficit will also grow because of increased government spending. Congress increased defense and nondefense spending in the recent continuing resolution to fund the government, bypassing the sequestration process imposed by the Budget Control Act of 2011. Increases of $165 billion in military spending, $131 million of nondefense discretionary spending and $45 billion for disaster relief are projected by the Congressional Budget Office to increase the U.S. budget deficit from 3.3% to 5.5% of GDP in fiscal year 2019.
The federal budget deficit increasingly will need to be financed by investors other than the Federal Reserve. Rising interest rates and inflation are a likely consequence. All of this fiscal stimulus comes at a time when the economy is operating above full capacity. Consequently, faster growth in the coming quarters and a rising deficit may deepen the next recession.
The solvency of Medicare and Social Security is a problem that continues to be unaddressed by policymakers in Washington. Entitlement claims are the largest spending category in the federal budget, and represents about two-thirds of federal spending today. That proportion will grow dramatically. President Donald Trump has ruled out any meaningful changes to the politically sensitive Social Security and Medicare programs, though he is attempting to reduce funding of Medicaid, a far less popular program among his voter base. Federal debt is projected to approach 100% of GDP by 2030, with more than $1 trillion added to the deficit by 2027. Demographic issues involving entitlements may not reach the “tipping point” during Trump’s first term, but represent a challenge that is not going away.
Deficit spending isn’t the only potential problem on the horizon. The elevation of trade hawk Peter Navarro, author of the book “Death by China,” is a signal that Trump’s trade policy may turn more confrontational. The president has ordered tariffs and import restrictions on steel and aluminum following earlier trade actions targeting imported washing machines and solar panels. Protectionist trade actions may be counterproductive for the U.S. economy, adding to inflationary pressures that are starting to build. Consumers will tend to pay higher prices for goods. Although domestic steel and aluminum producers will get a bump in earnings from tariffs and import limits, auto manufacturers, oil and gas producers, and construction companies are among those that will have higher input costs. China is likely to retaliate to protectionist actions by the U.S., should steel and aluminum be the first step in a range of trade actions. China owns more than $1 trillion of U.S. debt and is a major export destination for American planes, cars and agricultural products. Chinese is also less dependent on exports to the U.S. than was the case in the early days of China’s emergence as an economic power. Exports are a much smaller percentage of China’s GDP today, and exports to the U.S. have declined from more than 40% in 2000 to less than 25% today.
The Trump administration may be underestimating the long-term impact of fiscal stimulus and protectionism. According to Secretary Mnuchin, “there are a lot of ways to have the economy grow. “You can have wage inflation and not necessarily have inflation concerns in general.”
Unfortunately, it is hard to envision a scenario in which wage growth doesn’t contribute to either rising consumer prices or corporate margin compression, unless companies respond to wage pressures by substituting capital for labor. Capital substitution, in the form of robots and automation, is the primary explanation why U.S. manufacturing output has grown in the past two decades amid a dramatic fall in manufacturing employment.
Although a return to the stagflation and misery index of the 1970s does not have to be an inevitable outcome of today’s economic policies, the day of reckoning is not far away. Investors and policymakers should avoid becoming complacent about today’s economic growth and bull market, and should use today’s boom to start addressing the challenges that could create tomorrow’s bust.
Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston.
Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds.
Daniel is a graduate of Brandeis University and earned his MBA in Finance from the University of California, Berkeley. He is a CFA Charterholder and a former president of the CFA Society of San Francisco. He also sits on the Board of Trustees for the Green Century Funds.