March Business Conditions Monthly

Chart 1. Percentage of AIER Leaders expanding
Capital Market Performance
Consumer Finance Rates
Leaders (1950  –  2017)
Coinciders (1950  –  2017)
Laggers (1950  –  2017)
AIER Leaders point to economic expansion continuing in the months ahead

The U.S. economy continues to expand at a solid pace. The AIER Business-Cycle Conditions indexes all posted results well above the neutral 50 level in the latest month, February. Our Leaders registered 75 for the third consecutive month (Chart 1). 

Among the 12 individual leading indicators, eight are trending higher, while two are flat and two are falling. Ten months ago, in May 2016, our Leaders registered a very weak 38. That month saw just three heading higher, while six trended lower and three were flat. Over the past ten months several indicators have turned up to neutral and finally to positive trends, pushing our Leaders safely back into economic expansion territory. 

Real new orders for core capital goods is one of the indicators that has returned to a positive trend in recent months. Capital goods orders are a subset of total durable goods orders. The latest data on total durable goods orders showed a strong 1.8 percent increase. That gain was the result of very large jumps in new orders for civilian and defense aircraft. Excluding all transportation equipment, durable goods orders fell 0.2 percent and have been basically flat for more than three years.

Orders for the core capital goods component of durable goods also posted a slight decline for the month, dropping 0.4 percent in January. However, that decline followed three consecutive monthly gains as well as gains in six of the past eight months. That means there has been a clear turn in the trend of new orders for core capital goods, which are now 3.9 percent above their recent low in May 2016. 

Our Leaders indicator is adjusted for price changes. After adjusting nominal dollar orders for core capital goods for price changes, real new orders for core capital goods moved from a downward trend in December 2016 to a flat trend and is now up for the second month in a row.

Despite these favorable developments, another business investment-related leading indicator remains weak. Unit sales of heavy trucks is one of the two remaining Leaders that are still trending lower. This indicator has been headed lower for more than a year. While our evaluation is still suggesting a down trend, there are some early signs that it may be bottoming out. 

Overall, the recent performance of our Leaders is reassuring, pointing to continuing economic expansion in the months ahead, with a low risk of recession. Positive signs for the current expansion are reinforced by favorable results from our Coinciders and our Laggers. Our Coinciders registered 83 for the third month in a row as four indicators continued up, two trended flat, and none trended lower. Our Laggers posted a very solid 92 reading for the second consecutive month, with five indicators trending higher, just one remaining flat, and none moving lower.

Fed takes the slow road to raising rates
As economic activity picks up and consumer price increases and labor utilization rates approach the Federal Reserve’s goals, policy makers are likely to raise their target for the federal funds rate more aggressively. Having implemented just two 25 basis-point increases since December 2015, the Fed is currently on one of the slowest paths toward rate normalization on record. 

Given that a case can be made that policy tightening caused or contributed to some prior recessions, a slower pace of increase is a good thing. However, considering that ultra-low rates can create market distortions and a type of financial repression that benefits borrowers and penalizes savers, a more rapid return to a historically normal interest-rate environment might be preferred.

Beyond the pace of rate increases, a second critical element to monetary policy is the rate at which the Fed determines policy to be neutral. In recent decades, that rate was believed to be 4 percent, 5 percent or even 6 percent for the federal funds target. In the latest projections from the Fed, that rate is now believed to be about 3 percent. 

The preponderance of data suggests that two or three rate hikes this year are appropriate under the current mandate for Fed policy. The slow pace of increase means markets have more time to adjust to each rate hike. Combined with the likely lower neutral rate (stopping point) for the federal funds target, the risk to the economic expansion from overly aggressive policy tightening remains low.

How will interest rates react?
As the Fed raises its target for the federal funds rate, longer-term interest rates are likely to follow. When the Fed raised the target in December 2015, the 10-year Treasury yield held steady for a short time, then actually fell from about 2.40 percent to a low of 1.66 percent in February 2016. However, this was due to an economic slowdown that developed (and was reflected in our Leaders dropping from readings in the mid-60s around mid-year to 54 in December and 38 by March 2016).

When the Fed raised rates a second time in December 2016, the 10-year Treasury yield had already been drifting up from a low of about 1.36 percent around mid-year to a peak of 2.5 percent when the Fed tightened. The yield on the benchmark bond hit its highest level since 2014 on stronger economic activity and higher federal funds rates. Other things being equal, a third increase in the federal funds target is likely to put additional upward pressure on 10-year Treasury yields.

The same reaction may not be coming for corporate bonds, or at least not as severe a reaction. Higher federal funds rates should put upward pressure on yields across most fixed-income instruments. But with the economy picking up and fed policy moving very slowly (reducing the risk of a policy-error-induced new recession), the spread between corporate bond yields may narrow somewhat as the default risk declines slightly due to a strong economic environment. The decline in the spread would offset some of the likely rise in Treasury yields.

Stock prices often fall as interest rates rise
U.S. equity markets typically, though not always, react negatively to interest-rate increases. Prices tend to fall, pushing the earnings yield (earnings divided by price) on equities in the same direction as yields on fixed-income securities. Earnings may offset this over time. 

According to data from Standard & Poor’s, operating earnings per share for the S&P 500 hit a recent cycle low of $98.17 in the second quarter of 2016. That was down 14.3 percent from the prior peak of $114.51 in the third quarter of 2014. Most of that decline can be attributed, directly or indirectly, to the collapse in crude-oil prices. Earnings per share for fourth-quarter 2016 are estimated to be $106.86, up 6.4 percent from fourth-quarter 2015. 

We calculate long-term trends in earnings per share based on data since 1950. The trend calculation suggests that fourth-quarter 2016 earnings per share should be $119.52, 11.8 percent above the S&P estimate. That suggests that earnings per share are still below their long-term trend and have the potential to post above-average growth over the next few quarters.

Standard & Poor’s estimates that fourth-quarter 2017 operating earnings per share will be $130.66, a gain of 22.3 percent over their fourth-quarter 2016 estimate. That big a gain would push operating earnings per share about 2.7 percent above our long-term trend earnings calculation. For 2018, S&P estimates $146.98, a 12.5 percent rise over its fourth-quarter 2017 estimate. That is 8.6 percent above our long-term trend calculation and would begin to raise serious concern about the sustainability of such strong earnings-per-share growth.

Though the current earnings outlook through 2018 may be overly optimistic, there is reason to believe that the current earnings cycle has some room to run, and that should help offset some of the impact of rising interest rates.

Forecasting an approaching front for tax policy
During the presidential campaign, candidate Donald Trump ran on tax cuts for individuals and businesses. Now President Trump is set to propose a broad-based tax cut to Congress. The Trump administration views a tax cut for individuals and businesses as an economic stimulus. While the details of its tax plan have yet to be released, the Tax Foundation ( and the Tax Policy Center ( have evaluated the potential impact of a tax cut on the private sector as well as on the government deficit and debt. 

What will President Trump’s tax plan look like? The Tax Foundation estimates that individual tax brackets will be reduced from seven to three. For single filers, the highest tax bracket will likely be lowered to 33 percent from nearly 40 percent. The middle tax bracket is likely to be 25 percent, and the lowest bracket will be close to 12 percent. The capital-gains rate will be reduced across tax brackets as well. Important deductions will also be adjusted. The standard deduction will be doubled, and child-care expenses will be deductible from taxable income, according to the foundation. 

Lower income taxes would mean a higher return for labor. In other words, workers would take home more of their paycheck. In response, they might work more hours. In addition, lower taxes might incentivize new entrants to the labor force. With more money in their pockets, Americans could spend more. This is positive news for an economy driven by consumer spending.

In 2016 the U.S. had the third highest corporate tax rate in the world. President Trump plans to more than halve corporate taxes from 39 percent to 15 percent. Immediate depreciation is another important part of corporate tax reform. Under Trump’s plan corporations could immediately expense investments in plant and equipment. A corporate tax cut should spur business investment and raise worker productivity. 

Multinational U.S. companies have avoided paying relatively high corporate tax rates by keeping more than $2 trillion of their profits overseas. President Trump plans to offer a one-time tax of 10 percent on repatriated earnings. Based on previous tax breaks for repatriation, the money may go more often to stock buy-backs than to capital investment. 

The Tax Foundation estimates that President Trump’s tax cuts will have a significant effect on the private sector and government finances, increasing gross domestic product by an additional 7 to 8 percent over the next 10 years. The foundation says that tax cuts would help capital stock grow by 20 percent and would create 1.8 million jobs. On the downside, the Tax Policy Center points out that tax cuts would likely cause larger deficits and add to the national debt. A higher debt could lead to higher interest rates crowding out private investment. 

Chart 1. Percentage of AIER Leaders expanding
Capital Market Performance
Consumer Finance Rates
Leaders (1950  –  2017)
Coinciders (1950  –  2017)
Laggers (1950  –  2017)

Robert Hughes

Robert Hughes joined AIER in 2013 following more than 25 years in economic and financial markets research on Wall Street. Bob was formerly the head of Global Equity Strategy for Brown Brothers Harriman, where he developed equity investment strategy combining top-down macro analysis with bottom-up fundamentals. Prior to BBH, Bob was a Senior Equity Strategist for State Street Global Markets, Senior Economic Strategist with Prudential Equity Group and Senior Economist and Financial Markets Analyst for Citicorp Investment Services. Bob has a MA in economics from Fordham University and a BS in business from Lehigh University.

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