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Economic events don’t usually sneak up on Jim O’Sullivan. He has won a prestigious forecasting competition — predicting jobs reports, inflation rates, and growth trends — for six consecutive years. MarketWatch, which runs the contest, says the odds of pulling off that streak by sheer guessing would be about 10 billion to 1. Which is to say, when something surprises O’Sullivan, it’s a big deal.
Since November, it’s happened twice.
“Like most people, I was first surprised by the outcome of the election,” O’Sullivan, the chief US economist at High Frequency Economics, said in an interview, “and I was, second, surprised by the market reaction to that surprise.”
The reaction was a surge in stock prices that, after a brief leveling-off period, has resumed over the past month. It has burned long and bright enough to be called a proper stock rally, properly named for the man whose upset presidential victory lit its fuse.
The “Trump rally” has lifted stock indexes by about 10 percent in the three and a half months since Election Day. It has pushed the Dow Jones industrial average above 20,000 and added nearly $2 trillion in value to the S&P 500.
The rally started off powered by banking stocks, but it has spread across industries. It appears to be fueled by both improving economic indicators and a buoyant optimism about the prospects for sharp tax cuts and sweeping deregulation under unified Republican government in Washington. And it coincides with a spike in business confidence that can only be seen as a reaction to Trump’s victory.
Those data points are enough, taken together, to brighten O’Sullivan’s growth predictions for this year. But, he cautions, there are other data points worth considering — including some of the Trump promises, in the area of international trade, that investors continue to whistle past on their buying spree.
There remains a real chance that Trump won’t be able to deliver on his tax-cutting plans, or that those plans won’t deliver the added growth markets expect, or that the Federal Reserve will raise interest rates fast enough to counteract any big growth gains from the Trump stimulus. Trump’s threats to rip up trade deals and potentially levy tariffs on Mexico and China still pose a risk of a trade war.
Wall Street appears to be ignoring all of that, at investors’ peril.
“I suspect,” O’Sullivan said, “hopes have risen too much.”
Stock highs have become a favorite Trump bragging point
At the beginning of his epic press conference on Thursday, Trump cited the “incredible progress” his administration has made in his first four weeks as president, and he ticked through a list of evidence to support the claim. He mentioned nominees confirmed, federal contracts renegotiated, and, of course, his Rasmussen approval ratings, before settling into a quick riff on the economy.
“The stock market has hit record numbers, as you know,” he said. “And there has been a tremendous surge of optimism in the business world, which to me means something much different than what it used to. It used to mean, ‘Oh, that’s good.’ Now it means, ‘That’s good for jobs.’”
Market highs have become an oft-raised point of pride for Trump and his allies. Conservatives have complained reporters have underplayed those highs in the leak-filled frenzy of covering Trump’s early days — and they have celebrated when stocks respond to Trump’s policy pronouncements, including his pledge earlier this month to do something “phenomenal in terms of tax” in the next three weeks.
Stocks surge as Trump signals plan for lower taxes https://t.co/h2iCp9EymP via @WSJ
— Larry Kudlow (@larry_kudlow) February 9, 2017
Even many Democrats say Trump deserves credit for much, if not all, of those market gains.
“He does” deserve credit, said Austan Goolsbee, an economist at the University of Chicago’s Booth School of Business who served as chair of the White House Council of Economic Advisers under President Barack Obama. “Much of that is from him promising to give [companies] a tax cut and give them regulatory waivers. I don’t think it’s about growth. It’s about him increasing their profits.”
Trump’s promises have driven stocks upward, but that’s not the full story
Maybe the simplest way to think about the market gains, Goolsbee said, is as a one-time corporate windfall from the expected value of Trump’s tax cuts. If the S&P 500 has gained $2 trillion in value since Trump’s election, by that math, that translates to an expectation of tax cuts and regulatory benefits totaling $2 trillion over the course of several years.
You can make a good case for that reading by breaking down the early days of the Trump rally, right after the election. The massive market gains were concentrated largely in the banking sector.
From November 8 to the middle of last week, according to data from Howard Silverblatt, the Dow Jones Indices senior industry analyst for S&P, financial stocks in the S&P 500 rose by nearly 23 percent. Non-financial stocks in the index were up by just under 8 percent. That means Wall Street stocks have risen nearly three times as fast as stocks from other industries.
In the Dow, it’s particularly pronounced: One investment bank, Goldman Sachs, has risen nearly 40 percent — and contributed 20 percent of the gains for the entire stock index since the election. Goldman, not coincidentally, is the alma mater of several top Trump advisers, including Treasury Secretary Steven Mnuchin, National Economic Council Director Gary Cohn, and chief strategist Steve Bannon.
Analysts say investors clearly believe Trump is going to make life easier — or at least, stop making it harder — for Wall Street firms that Obama moved to regulate more aggressively under the Dodd-Frank bill, which was passed in the wake of the 2008 financial crisis. It is a clear case of an expected regulatory rollback paving the way for higher profits.
“Almost the 100 percent belief is that you’ve stopped, excuse the word, the bleeding for financials” from government regulators, Silverblatt said. Goldman Sachs, he added, “went from persona non grata to the White House.”
But while financial stocks kicked off the rally and juiced it through the fall, the gains of the past few weeks have been more evenly spread across industries. By Silverblatt’s numbers, financial stocks in the S&P 500 are up just under 6 percent since inauguration. Non-financial stocks are up about 3 percent.
More importantly, other measures of economic health — and, yes, many of them are much better gauges than stocks — are looking really good lately. The January jobs report beat economists’ expectations. As Neil Irwin notes at the New York Times, retail sales, new housing permits, and even inflation are all picking up.
This is partly an extension of the sneakily strong labor market that President Obama bequeathed his successor. It also appears to be partly due to a new confidence infusion under Trump. An influential survey of small-business sentiment just reached its highest level in more than a decade. A manufacturing activity survey from the Federal Reserve Bank of Philadelphia just hit its highest level in 33 years.
That’s not just one favored, deregulated industry showing up in those numbers. It’s an economy-wide expectation of accelerating growth.
There are reasons to think Trump might not deliver, but investors don’t want to hear them
Near the end of his Thursday presser, Trump was asked about the progress on what, from a stock trader perspective, is the single most important piece of his economic agenda — his tax reform plan. His answer should give traders pause:
Tax reform is going to happen fairly quickly. We’re doing Obamacare. We’re in final stages. We should be submitting the initial plan in March, early March, I would say. And we have to, as you know, statutorily and for reasons of budget, we have to go first — it’s not like, frankly, the tax would be easier in my opinion. But for statutory reasons and for budgetary reasons, we have to submit the health care sooner. So we’ll be submitting health care sometime in early March, mid-March. And after that, we’re going to come up with — we’re doing very well on tax reform.
Tax reform never happens “fairly quickly” in Washington; there’s a long-running joke among some reporters that the next big reform bill is always a year or two away, every year. That’s even true when your party controls Congress and the presidency, because the big fights in reform bills are often less about parties and more about splintered factions in the business community.
Already this year, Republicans in the House and Senate are divided over a key provision of the House GOP’s tax plan, which would change the way the United States taxes imports and exports on a corporate level, and which has cleaved the business lobby. It’s a messy fight with no easy resolution, and Trump has not weighed into it heavily yet.
It’s also a fight that, as Trump alluded to in the press conference, can’t really be resolved until Republicans figure out how to repeal and replace Obamacare. The GOP strategy to pass health care and tax bills without any Democratic help in the Senate rests on a careful sequencing, and Obamacare has to come first. As with taxes, Trump has not inserted himself deeply into the health care debate on Capitol Hill. If he doesn’t — and soon — in both cases, the odds start to climb that neither big health care nor tax reform bills make their way to his desk this year.
Markets don’t seem to have priced in those odds. They also don’t seem worried about another, parallel possibility: that even if tax cuts pass, the Fed will move to blunt their effect on growth. Interest rates remain low, and Fed officials have shown no tolerance lately for inflation running above their target rate of 2 percent. The economy remains at or close to full employment, meaning any additional growth is likely to spur faster wage inflation, which is likely to accelerate the pace of Fed rate hikes.
“There definitely is danger” in those areas, Silverblatt said. If tax reform appears to bog down, Goolsbee said, stocks could nosedive as well.
And then, of course, there is trade, the public policy issue Trump has arguably been most consistent on throughout his public career. Some Wall Street economists, including researchers at Bank of America Merrill Lynch, have begun to warn that traders are underestimating the odds that, yes, Trump is serious about tariffs, renegotiations, and other measures that could restrict trade (and possibly growth).
Much of Wall Street still believes otherwise. “Markets are generally assuming this is a lot of bluster, the tough talk on trade,” O’Sullivan, the ace forecaster, said. “That at the end of it, there will be negotiations, and a trade war will be averted.”
He disagrees: “I personally think that’s the biggest risk.”
Investors are treating Trump as if he’s a conventional president. He’s not.
Perhaps the most glaring risk that markets have discounted is Trump’s own unpredictability. He is, in some senses, a walking embodiment of tail risk, and not just in economic policy areas (most notably on Wall Street, where liberals are already beginning to warn a new round of deregulation could seed another financial crisis). He has shown, in his first month, an impulsivity and unconventionality unseen in the modern presidency.
In his press conference, Trump mused casually about several events that could send the economy spiraling (opening fire on a Russian ship), and/or destroy civilization as we know it (nuclear holocaust). He laid out a military strategy built, in part, on keeping everyone guessing (emphasis added):
I don’t talk about military, and I don’t talk about certain other things. You’re going to be surprised to hear that.
And by the way, my whole campaign I’d say that. So I don’t have to tell you. I don’t want to be one of these guys that says, “Here’s what we’re going to do.” I don’t have to do that. I don’t have to tell you what I’m going to do in North Korea. I don’t have to tell you what I’m going to do in North Korea. And I don’t have to tell you what I’m going to do in Iran. You know why? Because they shouldn’t know. And eventually, you guys are going to get tired of asking that question. So when you ask what am I going to do with that ship, the Russian ship, as an example, I’m not going to tell you.
Market participants aren’t tired of asking that question. They do not appear, in any meaningful way, to be asking it at all. That willful ignorance in itself is a risk.
It’s the job of professional forecasters to weigh all those risks and potential rewards, large and small, and predict likely outcomes. For the record, O’Sullivan now projects the economy will grow 2.7 percent this year. That would be better than any year under Obama, and it’s a half-point higher than O’Sullivan forecast before the election.
But it’s not the extraordinary growth Trump keeps promising — or even the levels that long-term rallies are made of.
