How long will our 'Goldilocks' economy under Trump last?
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After the Republican sweep last November, expectations were high that 2017 would be the year the U.S. economy would move out of neutral and step into high gear. America’s gross domestic product (GDP) growth of 3 percent or higher was more than just a possibility, as new fiscal stimulus would take the handoff from monetary policy accommodation, which was showing serious signs of exhaustion.

The Federal Reserve has done its part with two quarter-point rate hikes this year, but Republicans have fumbled the handoff, as both the House and Senate remain stuck on the increasingly divisive issue of healthcare reform. The result has been a continuation of 2 percent economic growth and inflation staying below the Fed’s 2 percent target.

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The Trump administration and Republicans will likely pivot away from ObamaCare “repeal and replace” and shift to tax reform and infrastructure spending. Despite President Trump predicting quick passage of tax reform, divisions between factions within the Republican Party pose an increasing risk of more gridlock in Washington.

 

The Senate’s failure to cut ObamaCare taxes on investment income as part of its latest “repeal and replace” proposal is a bad sign for tax reform happening this year. However, financial market performance continues to defy numerous skeptics, as investors are not giving up hope the Republicans will eventually deliver on pro-growth legislation.

The “new normal” economic environment — in which there is 2 percent growth and 1 percent to 2 percent inflation — in the aftermath of the financial crisis has been labeled disappointing by most experts, including Federal Reserve Chair Janet Yellen.

But on the bright side, both GDP growth and inflation measures in the U.S. have been remarkably steady, hovering around 2 percent on both measures with less and less volatility as the business cycle extends. This low volatility in the economy has arguably spilled over into the pricing of financial and physical assets — stocks, bonds, currency and commodity market volatility across the world is trading at the lowest level in years.

A virtuous cycle has developed recently with low volatility spurring both retail and institutional investor demand, boosting asset values, and further dampening volatility. Selling or shorting volatility has become an increasingly popular way for investors to generate income in today’s low interest rate environment.

Fast-growing risk parity and volatility-managed investment strategies also tend to place money more aggressively during periods of low volatility. This low volatility — a sign that Wall Street has little to fear at the moment — throughout the financial markets is another part of the post-crisis “new normal” we live in.

Even though bond investors face the challenge of low interest rates in the current environment, low and stable inflation offsets the pain and reduces the risk of a protracted rate rise. Corporate bond market performance remains on solid footing this year after posting very strong results in 2016. The “new normal” environment will sustain the extended credit cycle into extra innings and enable the Fed to be patient with future rate hikes.

Will too much investor complacency turn the virtuous cycle into a vicious one? Will growing geopolitical risks in Asia and the Middle East disrupt the market rally? Will the Trump administration implement steel tariffs and spur a trade war? All these risks are real, but so far the financial markets have successfully been able to climb the wall of worry and regularly set new highs.

The low volatility “Goldilocks” economy is alive and well in the U.S. and may not be so disappointing after all. John Williams, president of the Federal Reserve Bank of San Francisco, suggested it is the U.S. central bank’s job for now to keep the “porridge just right.” Investors should hope it is successful.

Mark Heppenstall, CFA, is chief investment officer at Penn Mutual Asset Management. He has spent more than 25 years managing assets for institutional investors.


The views expressed by contributors are their own and are not the views of The Hill.