The tone in global risk markets improved in the final week of April. A “less negative” scenario in the first round of the French presidential elections relieved some investor concerns of tail risk from Europe that had mounted in the previous weeks; and at least the announcement of the White House’s principles of tax reform was perceived to be a positive development. The S&P 500 had fallen nearly 3% from early March to mid-April, but it rebounded nearly 1.5% in the final week.

Looking back to August, a global reflation trade emerged on the perception that global central banks were finally pivoting from the ultra-accommodative policies of the last eight years. Market inflation expectations rose, and global yield curves generally steepened, particularly in the United States and Europe. The U.S. election results further fueled this trend on expectations that more business-friendly policies would come from the White House and Congress, and risk markets surged higher. However, the realization that, even with a Republican-controlled Congress, it will be very challenging to pass many of the White House’s key legislative agenda items poured cold water on the post-election optimism in the markets. The initial failure of healthcare reform efforts was especially disappointing for investors, due to the exposure of ideology divides just within the Republican Party.

The White House announced a broad framework for tax reform on April 26 and, not surprisingly, it was even more aggressive than the blueprint previously proposed by House Republican leaders (“Better Way”). For example, it suggests reducing the corporate tax rate to 15% versus 20% in the Better Way plan, with no border adjustment tax. Most observers understand that Trump is simply starting with a more aggressive proposal as a simple negotiation tactic, but some are suggesting it may be another

sign of a lack of unity between the White House and GOP leaders. The White House proposal is not a detailed plan; it’s just basic principles of tax reform. The initial reaction was that it has no chance of passing, given the negative impact on the federal budget deficit, if for no other reason. Nevertheless, the tax reform legislative process will be closely watched by the financial markets and a likely source of heightened volatility in the equity markets as we move forward.

Data Trend

The domestic economic trend softened somewhat recently, particularly on the inflation front. The March CPI report revealed a 0.12% month-over-month decline in the core growth rate, well below expectations and the biggest monthly drop since 1982. Moreover, it was difficult to point to any one metric with the core components for the surprise decline, which makes it more difficult to simply dismiss it as a 1-month anomaly. Prices for core goods declined 0.3%, the biggest monthly decline since 2006, and owners’ equivalent rent (OER) was up just 0.17%. OER accounts for approximately 25% of the overall CPI calculation (an even greater percentage of core CPI), and it has been a significant source of the firming in the CPI inflation measure in the current recovery. However, this measure of housing inflation has slowed in recent months. If the trend continues, price inflation for core goods and other components will need to accelerate in the coming months for CPI to remain above the Fed’s target.

The first estimate of Q1 GDP was weaker than initial expectations, growing at a 0.7% annualized pace (1% expected).  First-quarter growth was negatively impacted by inventories and personal consumption, the latter of which was the weakest since 2009 (Exhibit 1). The 0.3% increase in consumption was definitely the most disappointing component of the report, but some analysts are suggesting it is more of a one-off phenomenon. Auto sales fell sharply, which is likely at least a small consequence of automakers driving up sales at year end with aggressive incentives. Warmer weather is also being blamed for the weaker consumption figure, due primarily to the impact on utilities spending. On a positive note, business investment and housing activity were both strong in Q1, and investment in equipment was particularly encouraging. If personal consumption normalizes in Q2, overall growth should be much better; but the future growth trend may be dependent on progress in Washington, particularly on the tax-reform front.

While the GDP report was disappointing for the most part, the inflation data from last Friday surprised the upside. The GDP price index was 2.3% in Q1 (2% expected), up from 2.1% in Q4 and the highest level in two years. Additionally, the Employment Cost Index (ECI) rose 0.8% in Q1, versus expectations of a 0.6% gain. It was the highest reading for the index since 2007. The ECI is the preferred measure of wage inflation for many economists, including several Fed leaders, because it captures total compensation (salary, bonus, benefits, etc.), and it suggests that labor market tightening is beginning to fuel greater wage inflation. If so, the Fed will be even more comfortable with its desire to continue gradual policy normalization. On that note, nothing is really expected from the May 3 FOMC meeting, but the June meeting will be more highly anticipated.

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