Key takeaways

  • Tax cuts and increased federal spending have boosted the U.S. economy, pulling growth forward into 2018.
  • Corporate profits and capital expenditures are soaring; hiring and consumer spending are strong.
  • Growth could put upward pressure on inflation, raise Fed rate hike expectations.
  • Expect U.S. growth to slow in 2019 as stimulus fades and Fed tightens.

 

The United States’ economy, now in the ninth year of a marathon expansion, may have gotten a fresh set of legs this year.

Thanks to the sweeping tax cuts enacted at the end of 2017 and the increase in federal spending approved in February, the nation’s economy now has renewed strength at a time when the long recovery from the global financial crisis seemed at risk of running out of gas.

Call them performance-enhancing policies — together they are expected to add up to about $285 billion in fiscal stimulus to the U.S. economy this year.

“The tax bill is likely to stimulate U.S. economic growth in 2018 and into 2019 through higher consumer and business spending,” says Capital Group economist Jared Franz. “In addition, the combination of higher corporate profits, incentives to spend on business equipment and favorable global backdrop will likely pull forward economic activity. I expect to see GDP growth of about 3% this year.”

Cash in company coffers

The Tax Cuts and Jobs Act of 2017 cut corporate and personal taxes, and companies have responded by ramping up spending on their businesses at the fastest pace in years.

Capital expenditures — or spending on factories, equipment and other capital goods — by S&P 500 companies totaled about $167 billion in the first quarter, the fastest pace in seven years.

Technology companies are among the big spenders and winners in the capital spending surge. Google topped the list for spending during the first quarter at $7.3 billion, up from $2.5 billion during the same period a year ago. Apple and Microsoft were also among the top 10 spenders. Those companies have also benefited from widespread spending on technology infrastructure this year.

2018 Midyear Outlook

What are the insights and actions to consider as you position investment portfolios for the rest of the year?

Capital Group economist Darrell Spence says the reduced taxes and increased spending are game changers for the economy. “The amount of money that’s hitting the economy, not only from tax cuts but also because of the spending bill, is having a significant impact that’s likely to carry on into 2019,” Spence says. “It’s hard to put so much into the economy and not have an impact.”

Overall, Franz and Spence say, the jobs market is solid, companies are spending more money, industrial production is healthy, wages are rising and retail sales are picking up. They all point to the U.S. economy continuing to grow through this year and probably beyond.

Corporate America’s earnings soar

The tax cut is helping to drive profits to new highs among companies in the S&P 500. Overall, first-quarter after-tax earnings for S&P companies were up 25.3% over the same period in 2017, according to Thomson Reuters. That would mark the seventh straight quarter of per-share profit growth and the strongest gains in more than seven years.

“The environment that we’re laying out here is very good for profits,” Spence says. “Based simply on the cycle of stronger economic activity and better pricing power, I don’t think it’s being too wildly optimistic to think the earnings could go up 20% this year. Which normally would be, obviously, very constructive for the equity market.”

Inflation on the rise

Spence says given the health of companies, increased pricing power and the strength of the economy, attention must be paid to inflation.

“If there’s something the markets might start to pay a lot more attention to in the second half of 2018, it’s whether or not it’s appropriate to have a relatively sanguine inflation outlook,” Spence says. Core inflation — the measure that strips out volatile energy and food prices — was at 2.2% in May. Including food and energy, inflation hit 2.8% in May.

One of the most reliable indicators of impending inflation is resource utilization. The higher the utilization rate, the less slack in the economy and the greater the potential inflationary pressure. The utilization rate blends measures of manufacturing activity and employment, so this kind of relationship seems intuitive.

“Resource utilization is strongly signaling higher inflation,” Spence says.

Rate hikes will be gradual — for now

Spence says that, taken together, a variety of data points indicate that inflation may be increasing and could influence the speed with which the Fed increases interest rates. “It seems logical that any uptick in growth and inflation could cause the Federal Reserve to accelerate the pace of rate hikes in the next couple of years,” Spence says. “The market may have to reconsider whether estimates for the trajectory of Fed policy should be ratcheted upwards.”

For now, the Fed is on pace to gradually raise rates through the end of 2020. Spence says Fed policy is not considered “tight” until the federal funds rate exceeds the low that the 10-year Treasury bond yield reached during the course of the tightening cycle.

There is some evidence that the pace of Fed tightening could play a role in determining how long it takes a recession to develop, Spence says. As the chart below shows, the slower the rate hike, the greater the average amount of time between recessions.

Inflation doesn’t have to be a drag on equities

Earlier in the year, the threat of higher inflation stoked fears of rapidly rising interest rates, contributing to the first market correction since 2016. But inflation has been relatively low for years, so some acceleration should be welcome. Recent inflation readings are not at the level that typically drag on equities.

In fact, since 1946, equity returns have averaged in the double digits in years with inflation between 2% and 3%. The S&P 500 has even had relatively strong gains in the majority of years with 3% to 4% inflation. Of course, inflation is only one consideration and future returns may vary, but investors should take comfort that, on its own, a moderate increase in inflation is not typically negative for equities.

Long expansion continues

Since World War II, expansions of the U.S. economy have lasted 60 months on average. Spence and Franz say that after 108 months, this is not your average expansion — and there may be more to come, especially with the stimulation from tax cuts and increased fiscal spending.

“The U.S. economy has been in an expansion for a while now, but I think it still has a ways to go,” Spence says. “There doesn’t appear to be anything systemic, or any big imbalances, that we think are of significant size and nature that would push the U.S. economy into a recession with the next 12 to 18 months.”