First they came for the Trump Trade, then they came for the hope. And, as a result, BofA has thrown in the towel on its economic rebound for this year. As BofA's Michelle Meyer writes, "Hopes for a big fiscal stimulus have faded, prompting us to revise our 2018 GDP growth forecast to 2.1%, down from 2.5%. While growth will be slower, it is important to remember that the economy does not "need" stimulus to expand." Unless it does of course, because as Citi showed recently, all central bank liquidity injections are fungible, and prop up not only stocks but also economies. In any case, here is BofA's explanation why it, like the rest of Wall Street not to mention the Fed, were all wrong.
# Revising 2018; Back in November when we released our Year Ahead piece, we argued that growth would be a trend-like 2% this year but would rise to 2.5% next year amid fiscal stimulus. We feel generally comfortable with our forecast for this year but now believe growth will end up being slower next year. We are therefore revising our forecast to 2.1% for 2018, implying that the economy will continue to grow modestly above trend ...
# The hope trade; There are three main reasons for our downward revision to growth next year:
- The prospects of tax reform have dimmed. While it is still possible that legislation is passed, it seems that it would be later and smaller than previously speculated.
- Policy uncertainty is high and threatens to remain elevated into next year given tensions in Washington and controversies in the Trump administration. This has contributed to a "wait and see" mode among businesses and consumers.
- The auto sector is shifting from a tailwind to a headwind next year. This means that auto output should go from adding a few tenths to annual GDP growth to slicing a tenth or two.
*) Keep in mind that our downward revision in growth next year simply returns our forecast to the post-recession average of 2.1%. The US does not need fiscal easing to enjoy slightly above-trend growth. There are plenty of reasons to feel confident that the expansion will persist into 2018 without stimulus. The labor market is still adding workers in excess of what is necessary to keep up with population growth. The housing recovery is slow but steady. Financial conditions are supportive with low rates, recent softening in the dollar and appreciating equity markets. Household balance sheets appear robust with strong gains in net worth and low leverage.
Factor 1: where is the fiscal stimulus?
After the US presidential election expectations were high that President Trump and the Republican-controlled Congress would enact fiscal stimulus involving tax reform and, possibly, infrastructure spending. We therefore penciled into our forecasts tax reform (akin to the Better Way proposal (Ryan plan)) and some small amount of infrastructure spending. We estimated that this would add roughly 0.5pp to annualized GDP growth.
The path ahead for tax reform is challenging. We are halfway through the year and there has been little tangible progress made on tax reform. As Joe Song writes in Fiscal foibles, Congress is tied up with healthcare reform, negotiations around the debt ceiling and the budget. The likelihood of progress this year appears to be declining, especially for comprehensive reform of the tax system. As such, we think that we either see no legislation passed or a much simpler and smaller plan.
Factor 2: Waiting and seeing. While business and consumer confidence climbed higher after the election, it was accompanied by greater policy uncertainty. This seems like a natural contradiction - how can you be more confident about the outlook when you are also more uncertain? The result is to delay investments or spending until there is clarity on potential changes. Recent surveys suggest this is the case. The Duke CFO Business Outlook Survey from June 9th revealed that almost 40% of CFOs indicated that uncertainty is higher than normal and of those, 60% said that this uncertainty has caused them to delay new projects and investments. In other words - 1 out of every 4 companies are delaying or canceling investments.
We have recently seen a rationalization of these measures with sentiment slipping lower, particularly among consumers (Chart 2). The most recent University of Michigan consumer sentiment report was particularly notable, highlighting how developments in Washington can influence confidence.
Factor 3: Auto sector pumping the breaks. Auto sales have been on a weak trend since the beginning of the year, leading John Murphy and team to revise down forecasts for sales and production. They now believe that auto sales and production peaked last year and will be on a downward trajectory over the next several years. As John notes, the concern rests in the "looming tsunami" of off-lease vehicle volumes that will flood supply in the used car market and provide competition for new vehicles. Moreover, the credit environment has become more challenging with auto delinquencies on the rise and the demand for auto loans declining while lenders tighten lending standards.
# Trouble in the auto sector threatens to weigh on economic growth and inflation. While auto output has been a shrinking share of the economy, it is still an important sector with strong linkages to other parts of the economy. As a simple rule of thumb, we estimate that a slowdown of one million in the annual pace of auto sales slices 0.2pp from annualized GDP growth (Table 1). Since 2010, auto output has added an average 0.2pp to annual GDP growth. We think we could see a modest drag from the sector this year and perhaps a more severe hit next year.
# The economy doesn't "need" stimulus;
While the economy would have received a jolt from fiscal stimulus, we do not believe that fiscal easing is a necessary condition for the recovery to persist. Rather, a large degree of fiscal stimulus at this stage of the business cycle would risk overheating the economy. The stock market is at a record high while the unemployment rate is hovering near record lows - stimulus could create undue pressure for both. This would put the Fed in a difficult position having to fight inflation at the risk of pushing the economy into recession.
# The role of the Fed;
The Fed has been savvy in its approach to handling the uncertainty around fiscal policy that followed the election. The majority of Fed officials did not alter forecasts to account for potential changes in fiscal policy. As such, the median expectation for GDP growth next year is 2.1% which has been the forecast (give or take a tenth) since the 2018 forecasts were first released in September 2015. The prospects of fiscal policy changed how Fed officials considered the balance of risks around the forecast, but it did not affect the modal forecast.
Our new forecast for 2018 is consistent with the Fed's expectation. As such, even with our change in the outlook, we are holding to our view of a hike in December and three hikes next year. That said, we think the risks are clearly skewed toward a slower cycle, particularly next year. This has less to do with weaker growth and more to do with weaker inflation.
As Alex Lin explains in his latest inflation write up, inflation has been weaker than expected and transitory shocks are only part of the disappointment, with risks skewed to the downside for inflation going forward. Moreover, there is a wide error band in forecasting Fed policy next year given the potential for a change in leadership. The bond market is pricing in less than 1 hike next year while the Fed dots imply 3 hikes. The truth will likely lie somewhere in between....