Fourth Quarter 2016 Letter
January 17, 2017 By: Harris L. Kempner, Jr., President
THE ECONOMY
As a reminder, in January of last year, a lot of people believed that there would be a United States recession in 2016. Falling markets were indicating it as well. I told you then I didn’t think so, primarily based on projected consumer strength. Remember that the consumer is 70+% of the U.S. economy. It turned out I was right that time; we’ll have about 2.0% growth in 2016 and end the year stronger than that. This year, 2017, my view is somewhat different. I believe there is a better than 50-50 likelihood that a recession will begin in the U.S. by the end of 2017.
Why? After all, the consumer is still dominant and will still be doing well, possibly, more so than last year. Wages are up and 2+ million more people are working than was true at the beginning of 2016. In fact, the unemployment rate is at a 10-year low. Furthermore, the dollar strength in recent months has provided a future boost to the U.S. consumer’s ability to make purchases because imported things are presently cheaper in dollar terms, under the present economic circumstances. In light of this, consumer confidence is up strongly now: which is another reason to think that consumer purchasing will be considerably stronger early this year, at least. And further, worldwide, there are some indications, at least in important places like Europe, Japan and even to some slight extent China, that the economies are stronger toward the end of 2016 than they were at the beginning. World growth usually helps our economy.
However, on the cautionary side, I need to point out that our present recovery is beginning to show stresses and strains. This is not surprising, since it is already eight years in existence. So far it is the third longest economic recovery in post WWII American economic history. Certain headwinds now exist. One of the reasons that the consumer is getting higher wages these days is because labor markets have become tighter as time has gone on. This will have the effect of limiting employment growth and increasing unit labor costs during 2017, something that will negatively affect corporate cash flow. This inflation from wages has already contributed to overall increased inflation rates, which in turn has already begun to cause a rise in bond yields that could continue. If so, higher rates will affect the housing and construction industry negatively. Corporate profit growth is likely to be very slow in 2017, at the best. Not down, necessarily, although there may be some exceptions to that, but the increasing costs from the labor force and increasing interest costs are going to put a headwind on overall profit growth. And finally, banks have learned to tighten their standards over time and it is harder to get borrowing, for small businesses particularly, than it was at the beginning of last year.
Nevertheless, I think that all this together would probably not outweigh the strength that would be coming in consumer activity. We would be projecting slow, but positive, U.S. growth were it not for a new factor. After the elections, there’s a New Deal, a House, Senate and President all of the same party. Fewer checks and balances now exist. Because of this the U.S. is facing some new economic uncertainties, from new policies likely to pass, that will be affecting either industries as a whole or all of us directly during 2017. They are the tipping point, if you will, of reasons why I lean toward a 50+ probability of a recession beginning late in 2017.
I will name just a few important policies, though one can point to still others. Note that these are only economic policies, which are proposed by substantial numbers of important people in the incoming administration and in Congress. They are new economic policies which are primarily Congressional, not Presidential, would make significant changes, and will cause negative economic hesitations and confusion.
To start – taxes. There is likely to be a tax reduction, certainly at the corporate level and maybe at the individual level, voted sometime in 2017 by the incoming administration and Congress. Good news – but the question is not whether there will be a voted tax reduction, but when it is going to be effective? I think most people are assuming that if there is a tax reduction in 2017, it will be effective retroactive to the beginning of 2017, but everything I have been able to understand throws that into question. Basically I, and others, believe that the budget-conscious, Republican Congress is unlikely to burden itself in 2017 with a retroactive tax reduction and with its increased deficits. It is likely to begin to be clear that it is more certain to be effective in 2018. So, logically, people and companies are going to delay some of their economic activity, particularly some of their aggressive economic activity from 2017 to 2018, just on the basis of the fact that they might then have a lower tax rate as a payoff.
The second new factor is “Repeal and Replace the ACA”. This is a policy change that will affect the economics of entire companies and their employees. Repeal is likely, replacement almost certainly will take years, but note that the companies and individuals affected make up the collective healthcare industry, which in total has been one of the largest contributor to increased jobs and increased salaries in the U. S. over the past four years. More so than almost any other industry. So – how many years till replacement? And, what will that mean specifically? How will it affect Medicare and Medicaid? Will insurance markets be disrupted? Many hiring and expansion decisions of the industry, hospitals, drug companies, insurance, etc. will be in suspense in 2017, waiting to find out the answer to those questions – and what the details will be. No question, in my mind, that there will be new and enormous caution in terms of economic moves taken by all these industries and their employees until some of this gets clear. So, here’s another substantial new economic uncertainty, one which affects one of the country’s most important growth engines.
The third, very new policy I wish to emphasize is “border taxes” or “border adjustability”, etc. Don’t confuse this with Mr. Trump’s recent targeted threats of corporate punishment. This is instead, the concept long built into Republican economic plans, especially the House Republican Economic Plans of Speaker Ryan and Ways & Means Chair Brady, of something presently called border taxes and/or border adjustability. I don’t know if you have heard those terms or any of the other euphemisms but you had better get used to them. What it is, at the base, is an attempt to raise a lot of money for the government by substantially increasing taxes on businesses and the consumer of anything imported, be it commodities, like oil, partially finished goods like steel, iron, parts, textiles, or finished goods. Commensurately, it would simultaneously rebate taxes on any such goods that any company exports. It is a concept that you can listen to economists natter on about forever, but there are a couple of things about it that are very clear no matter how it might shape up.
Number one, the injection of this tax regime into private industry decision-making would cause massive confusion. This will come in two stages: while the new policy is debated and afterwards if passed. Just visualize for yourselves, those of you who work with unfinished goods to make them into finished goods, those of you who buy and sell electronics and cars, those of you who make and sell most anything, just what happens with your supply chains and all that if such a new approach is applied? It will certainly cause a lot of economic confusion, and stutter-stepping in 2017, trying to figure how to deal with it, what is it going to look like, how much is it going to cost me or benefit me, do I need to change my supply chain right away, etc.? So, economic hesitation for companies, in my opinion, as this is proposed and debated, and far more of an economic difficulty if this begins to appear to be passed.
Further, if passed, the individual U.S. consumer would be faced with some sudden increases in prices, a factor which would undercut their vaunted buying strength.
And also, all such “border taxes” will clearly have one other specific effect. It will, initially, make all goods imported into this country more expensive and it will reduce the cost of that which we export. This is a U.S.- generated formula for protectionism and a formula for the kind of retaliation trade wars that massively deepened the depression in the ‘30’s. The Smoot-Hawley tariff had effects similar to this. For one possibility, GM sells more cars in China than it does in North America. The Chinese could easily make this more difficult in retaliation, with anti-trust laws, for example.
So, what I am suggesting is that this border tax policy, as it is being introduced into the thought processes of the country, will have a stunting effect on the decisions that business and consumers make in their daily lives and, if passed, would be a major dislocative force in world trade.
Before it became clear following November 8 that we would be facing the uncertainties of all these new potentialities, we felt it probable that the strong consumer would again outweigh all other negatives of an aging recovery and that the U. S. would have tepid, but positive, economic growth in 2017. Now there are these new economic uncertainties, among several others, that will present themselves during the year – concerns about when are the tax changes effective? What replaces the ACA? What is the possibility and shape of the so-called border tax? It is a qualitatively different situation than before.
MARKET
We expect those new economic uncertainties will sufficiently reduce the animal spirit of corporations and of consumers over the year to most probably tip a slow growth economy into a recession by end 2017. So, those who believe that this optimism that you see now, and the consumer strength that you see at year end 2016, are going to carry over into all of 2017 and positively dominate the year, are likely mistaken. I believe that we are facing a very tentative economic future as many of the new set of policies are proposed, and some adopted. Change can be destructive, as well as positive, particularly in the short term. Brace yourselves.