This time last year, financial markets were very optimistic that a new political regime would bring forth fiscal stimulus and regulatory reforms sparking a new wave of economic growth and inflation. On the fiscal front, major tax reform was the most anticipated effort from a market perspective, particularly corporate tax overhauls. As we know, tax reform was delayed until the fourth quarter, and regulatory reforms have been hampered by the sluggish pace of appointments and confirmations of new regulatory heads by the White House and Senate, respectively. This includes key positions within the financial regulatory agencies, but these positions are now being filled at a more rapid pace, leading to a more constructive outlook on that front.
Despite these hiccups, the economy has continued to grow at a solid pace, although wage and consumer price inflation has been stubbornly low, and depository institutions in aggregate have performed well in 2017. Despite the flatter curve, net interest margin and profitability metrics have increased over the last year for depositories as a whole. This is due in large part to increased loan income from the increase in front-end rates, and at the same time, core deposit pricing has significantly lagged the move in LIBOR/OIS. What lies ahead in 2018 from an economic perspective? Will the Republican-controlled executive and legislative branches finally produce material fiscal changes that the markets have been expecting? If so, what will be the impact on growth and inflation? The answers depend largely on the language of the ultimate tax reform bill (assuming a bill is actually passed); if we assume $1-1.5 trillion of cuts over 10 years, some economists are estimating a near-term impact of an additional 25 bps to GDP growth. This would appear to be a modest benefit, but at the same time, there are many assumptions involved in gaging said impact.
The tax reform reconciliation process has begun, and conference committees in the House and Senate must now work together to come up with a single bill that can pass both chambers of Congress. There are some notable differences between the House and Senate versions, but some insiders indicate that a combined bill could be on President Trump’s desk by December 15. The most contentious components of the legislation will likely involve changes to eligible tax deductions, including state and local taxes (SALT) and mortgage interest. If SALT deductions are eliminated and mortgage interest deductions are more limited, some areas of the country will clearly be more affected than others. More specifically, metro areas like New York, with higher local taxes and housing prices, would experience the greatest impact. Some housing analysts have suggested national home prices could decline by approximately 1%, and regions with larger concentrations of jumbo mortgages could experience larger drops. Of course, this is all speculation at this point, and it will depend heavily on the final language of the bill.
While regulatory reform was mostly a disappointment in 2017, it has the opportunity to be a force of momentum in 2018 for financial markets. For financial regulation specifically, the Treasury Department has now released three reports in the last six months with recommended regulatory changes for banks & credit unions, capital markets, and asset managers & insurers. The vast majority can be carried out by the relevant regulator (as opposed to legislative changes), which is why filling the key appointments at these regulatory bodies in a timely manner is critical. In August, the NCUA established a regulatory reform task force to oversee the implementation of the agency’s reform agenda in response to the Treasury Department’s recommendations in June. Reforming post-crisis capital and liquidity regulations for larger banks will be a slower and more challenging effort.
Nevertheless, any revisions to existing regulations will still require two important components. First, new leadership must be appointed and confirmed at all of the relevant agencies, particularly for regulations that require joint rulemaking. Second, any proposed changes must still go through the same process of creating a proposed rule change followed by a comment period. In other words, regulatory reform is not a quick process, and the delays in accomplishing the first requirement (new leadership) hasn’t helped. That said, signs of momentum on this front in early 2018 should be well received by financial markets.
The markets are effectively pricing a 100% chance of a December rate hike, but opinions are naturally more varied as to what the Fed does in 2018. The Fed is currently projecting three rate hikes for 2018, but New York Fed President Bill Dudley suggested last week that fiscal stimulus (tax reform) might force the Fed to hike at a faster pace in 2018 than previously anticipated. He also questioned the timing of such stimulus at a time “when the economy’s already close to full employment,” but that’s a whole other matter. In a recent J.P. Morgan survey, 42% of survey respondents think the Fed will end up hiking three times next year, and 48% expect two hikes or fewer. There was more divergence on respondents’ opinions for the terminal (long-run) funds rate at the end of the current tightening cycle. The median expectation is 2.5%, which is 30 bps below the Fed’s September projection of 2.8%. However, 30% of participants expect a 2.0% or lower terminal rate, and 30% expect 3.0% or higher. J.P. Morgan’s economic team is on the hawkish end of the spectrum, expecting four rate hikes in 2018. They attribute this position to their opinion that current economic fundamentals “look about as favorable as they have at any point in the expansion.” They specifically point to the reversal of global headwinds in the last year and expectations for domestic fiscal stimulus, both of which should contribute to above trend GDP growth. This will require cooperation from policymakers in Washington, particularly on the fiscal and regulatory front, and recent history suggests this is no small order.
Another potential headwind is the reduced presence of central banks in the financial markets and what impact that will have on consumer and corporate borrowing rates (i.e., wider spreads). The current Fed leadership has laid out a balance sheet reduction plan that is very gradual and transparent, but several key Fed leaders (Yellen, Dudley, Fisher) have left or will be leaving the central bank in 2018. Incoming Fed Chair Jerome Powell is seen as a status quo appointment, and the current market expectation is for the Fed to maintain the current reduction plan, particular without significant inflation pressures. There is also risk that the Fed could decide to move more quickly to a Treasuries-only portfolio, which would put upward pressure on mortgage rates. The ECB has been less transparent with its future balance sheet plans, which presents greater uncertainty with regards to this potential headwind.
The first and second estimates of Q3 GDP both exceeded expectations at 3.0% and 3.3%, respectively, and this was part of a greater trend of upside data surprises in recent months. A positive surprise index reading implies that data releases, as a whole, have exceeded expectations (upside surprise), and a negative reading is just the opposite. Since hitting a recent low point in June, the surprise index has risen sharply to a 47-month high. One of the primary catalysts for the Q2 data disappointments was the core inflation trend. While still tracking below the Fed’s target, recent core inflation data have firmed and have contributed to the recent upswing in the surprise index. Consumer spending has been solid as well in recent months, but with the personal savings rate now holding near a post-crisis low (3.2%), wage inflation will have to pick up, particularly with the unemployment rate being so low.
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