Recent upticks in consumer and business confidence will support economic growth in the short term, and policy initiatives, which are expected to take hold later in 2017 and into 2018, will boost the economy further. In the near term, potential post-election derivative impacts of a stronger U.S. dollar, higher interest rates and increased policy uncertainty could weigh on U.S. GDP growth.
President Trump and House Republicans have proposed tax reform plans to reduce the 35% federal tax rate to 15% – 20%, which includes a repeal of net interest deductibility and the implementation of a controversial, and potentially onerous, destination-based (border-adjusted) tax that places a heavy penalty on import-oriented sectors, such as retailing that could lead to considerable inflationary pressures in the intermediate term. Key beneficiaries of the tax reform proposals include domestic-centric companies that have a high tax burden with low debt levels and multinational companies with considerable amounts of undistributed foreign earnings. Tax code changes are not expected to become effective until 2018.
It is estimated that U.S. multinationals hold roughly $2.6 trillion in undistributed foreign earnings. President Trump has proposed a one-time tax rate of 10% on repatriated profits held offshore in the hope that U.S. multinationals would use a portion of those cash holdings to retool and expand domestic operations – perhaps leading to a manufacturing renaissance in the U.S. Combined with proposed tax reform, protectionism and deregulation, these measures could bode well for a resurgence in U.S. manufacturing and capital investment.
Other policy initiatives include the reduction of burdensome business regulations, lifting restrictions on the extraction of domestic fossil fuels, and repealing the Affordable Care Act and Dodd-Frank, as well as limiting new federal regulations. These regulations have undoubtedly contributed to the decline in the number of jobs created over the last two decades. Offsetting the Federal Reserve’s accommodative monetary policy wind-down are President Trump’s proposed increases in infrastructure and defense spending to further stimulate GDP.
We expect consumer spending to remain the linchpin of GDP growth due to upward momentum in wages, favorable credit conditions, and buoyant confidence. Discretionary income will get a boost from proposed individual income tax cuts. Although interest rates are low by historical levels, higher inflation could dampen spending on housing and autos in particular.
We expect growth in Europe to remain at subdued levels, with a challenged banking system and politics posing risks to a fragile backdrop. A weaker euro, a diminishing fiscal drag, and continued easy monetary policy should provide support for modest growth. Political risks and growing populism will continue in 2017. The U.K. will likely initiate the complex and economically-risky process of extracting itself from the EU, which make’s the UK’s economic outlook less certain.
The EU has seen an uptick in manufacturing and the strengthening U.S. dollar, relative to the euro, should provide a much-needed tailwind for Europe. The European Central Bank recently announced that it would maintain its highly accommodative stance, but reduce purchases under its asset purchase program.
Japan continues to struggle to stimulate growth while contending with a rapidly aging population, towering public debt load and a rigid labor market. Pro-growth reforms have made limited progress in creating conditions for sustained growth, and the Bank of Japan appears, in some ways, to have reached the limits of monetary easing. The reversal of the yen strength and modest improvement in external demand seem to have bought much-needed time for the economy.
The Chinese economy stabilized in 2016 and was slightly better than expected, but the powerful U.S. dollar rally that followed President Trump’s victory and the U.S. Federal Reserve’s December rate hike are bringing new challenges for China (the Renminbi depreciated -7% against the U.S. dollar in 2016). Potential future rate hikes in the U.S. could add more downward pressure on the Renminbi. With rising depreciation expectations, capital outflow pressure continues building in China. China is still a largely capital-controlled country with a managed currency, which is a concern, but we don’t expect capital outflows to get out of control. Positive factors include a largely stable economy, continued current account surplus and limited foreign debt exposure.