Economic Update
The biggest headline to start 2018 is the successful passage of the Tax Cuts and Jobs Act (TCJA) just before Christmas. The legislation was much anticipated throughout 2017, particularly by equity and corporate credit markets. As expected, the new law reduces the corporate tax rate, from 35% to 21%, and it allows a one-time repatriation on accumulated foreign corporate earnings, just to name two reforms. For individual provisions, tax rates for most income brackets were lowered, and the framework for allowable deductions was significantly altered. One notable surprise is the law’s official effective date. The general expectation was a Q2 2018 effective date, but the TCJA became law on January 1, potentially resulting in a positive economic impact sooner than originally expected. Analysts are still dissecting the details of the final legislation in an effort to hone forecasts, but initial estimates suggest an annualized GDP impact of 20-30 basis points (bps) over the next two years. These estimates are driven in part by expectations for increased consumer spending in response to $100-150 billion of reduced individual tax liabilities this year.
The positive momentum in risk markets should persist in the first half of 2018. Economic fundamentals have been solid, and the most obvious headwind at this point is the ongoing reduction in central bank accommodation. While the Federal Reserve and Bank of England are the only G4 central banks actually tightening policy currently, the European Central Bank is now reducing its QE program. Credit markets remain in bull-market mode, but most would agree that it is late in the cycle (i.e., closer to the end than the beginning). With reduced central bank presence in the global financial markets, will long-end bond yields and asset spreads be able to hold at current levels? Regarding the former, inflation readings remain tame, and absent a surge in consumer prices, a significant curve steepening remains a less likely event, particularly if the Fed progresses with its projected rate hikes. That said, supply squeezes in long-term global government bonds, particularly German debt, could be alleviated with less central bank demand (ECB QE tapering and reduced Fed reinvestments).
Increased inflation expectations would be a natural catalyst for curve steepening, and following the passage of the TCJA, breakeven yields in the TIPS market have increased (see Exhibit 1), largely attributable to higher overall growth expectations. Market participants continue to look for signs of wage inflation as well, particularly with the headline unemployment rate at a 17-year low. National measures of wage growth (average hourly wages, employment cost index, etc.) have been underwhelming for many months, but a recent Wall Street Journal article highlights improved wage growth in metro areas where unemployment is the lowest. For example, Minneapolis has the lowest unemployment rate among large metro areas at 2.3% as of October, and its year-over-year wage growth at the end of Q2 was more than 4% according to Labor Department data. These data reassures some economists of the relationship between tighter labor markets and higher wages. If labor markets tighten further in more metro areas, competition for qualified labor could increase and drive wages higher.
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