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Finding Opportunity in a World of Unprecedented Risks

John Dessauer’s market review and update as of Wednesday November 15, 2017

              In October 1981, the United States national debt rose above $1 trillion for the first time. The economy was in trouble and pessimists had a field day predicting gloom and doom. The national debt clock appeared regularly in popular media. It was scary. Fortunately, President Reagan and the Congress were able to enact tax reform and get the economy back on a growth track. Strong economic growth increased tax revenue. The federal deficit stabilized and declined. The debt clock faded from popular view.

            What strikes me as odd is that the U.S. national debt almost doubled during President Obama’s two terms, is now over $20 trillion and the pessimists are all but silent. What happened to the debt clock? I assume it is still ticking away. In recent years we have seen a European sovereign debt crisis with Greece demonstrating that dire economic conditions really do follow in the wake of too much government debt. The lessons from Europe say that Americans should not be complacent about our large and growing national debt. It is forecast to reach $30 trillion over the next ten years. Left unchecked it will, at some point, become a major economic issue.

            The reason the dramatic increase in our national debt has not stirred pessimists and the media to raise an alarm is that the cost of financing the debt remains very low. That is thanks to very low inflation and very low interest rates. The risk, of course, is that a significant rise in inflation and interest rates would change the financing burden. That is a lesson the U.S. learned in the 1970s and early 1980s. When inflation and interest rates rise, financing the national debt increases sharply. What seems to be a benign debt situation today can become a budget busting situation quickly, if inflation soars.

            Another part of the explanation for why a near doubling of the national debt has received so little attention is the Federal Reserve’s Quantitative Easing program. The Federal Reserve bought roughly $4 trillion worth of securities during President Obama’s two terms. Now the Federal Reserve is reversing that course, beginning to shrink its balance sheet. Fortunately, inflation remains low - below central bank expectations. That means interest rates will remain low and the cost for financing the growing national debt will remain affordable.

            The challenge now being addressed by the President and Congress is how to get the economy growing at a faster, sustainable pace. Tax reform is the method that worked in the past - for President Reagan, for example. However, with the national debt above $20 trillion, tax reform this time is a much more difficult task. If Congress gets the mix of tax changes right, then faster growth will increase tax revenue, even with lower tax rates. However, there likely will be a lag between enacting the new tax changes and seeing the increase in economic activity.

            If the President and Congress err in selecting the tax reform mix, then the economy might not respond with an increase in activity. Slow growth could persist, and tax revenues would decline, making the annual deficit worse. The never-ending battle between right and left over taxing the “rich” does not help. As Thomas Sowell points out, the “rich” is a statistical category. Individuals move in and out of that category all the time. The purpose of tax reform is to help individuals. Confusing individuals with a statistical category makes the task of achieving real tax reform and faster economic growth much more difficult.

            At this point we can be thankful that inflation remains stubbornly low, and hope that the President and Congress will enact a tax reform package that works. Economic growth above a 3.5% annual rate a year from now would be very good news.

            Ken Fisher, friend and founder of Fisher Investments, is fond of saying, what the markets do best is make fools out of experts. He is right again. This time the market’s target has been Nobel Laureate, economist Paul Krugman. A year ago in an article in the New York Times titled “The Economic Fallout” Paul Krugman wrote: “It really does now look like President Donald J. Trump, and markets are plunging. When might we expect them to recover? Frankly, I find it hard to care much, even though this is my specialty. The disaster for America and the world has so many aspects that the economic ramifications are way down my list of things to fear. Still, I guess people want an answer. If the question is when markets will recover, a first-pass answer is never. Under any circumstances, putting an irresponsible, ignorant man who takes his advice from all the wrong people in charge of the nation with the world’s most important economy would be very bad news. What makes it especially bad right now, however, is the fundamentally fragile state much of the world is still in, eight years after the great financial crisis.”

            Paul Krugman has not just been wrong; the stock market’s performance since last Election Day makes him look the fool. One year later the Dow Jones Industrial Average was up 28.5%. That is second best in presidential election stock market history. One year after the re-election of FDR in 1944 the Dow rose 29.8%. The post-Trump election market performance came very close to setting a new record, missing by less than 2%.

            We don’t know how Paul Krugman feels after missing a market call by so much. He hasn’t written a follow-up article for the New York Times.

            Of course, the stocks market’s stellar performance has more to do with growth in corporate profits than political elections.

            Where will stocks go from here? Morgan Stanley says the stock market needs a pause to refresh. I agree, although predicting the timing and extent of such a pause is impossible. The best strategy is to stay invested in quality companies.

 I will have the next market review and update for you one week from today on Wednesday November 22, 2017.

             All the best,                                                                                                               

John Dessauer

©November 2017