A Longer-Term Downtrend in Stocks?

The stock market turned down before the end of the strong corporate earnings season.  Moreover, the drop is in the face of solid US economic data and an FOMC Statement that suggested a continuing gradual approach to tightening by the Fed.  

While there is mixed opinion regarding its catalyst and whether the decline is only a short-term correction, a case can be made that stocks are shifting to a longer-term downtrend.  Ironically, stimulative fiscal policy is the stealth reason for this.   The tax cut, easing of regulations, etc. serve to boost economic growth.  This is problematic when the economy is operating near full capacity, as it would lead to bigger trade deficits (and a weaker dollar) and higher inflation.  In response, lower stocks and higher Treasury yields will work to depress private demand to make room for the effects of fiscal stimulus.  In other words, they will be the channel through which fiscal policy "crowds out" private spending.   From a market perspective, strong US economic data may have become a negative for stocks, while weaker data a positive.

The market downtrend should end when economic growth has slowed sufficiently to free up resources to meet the demands of fiscal policy -- that is, when the outlook for Real GDP Growth has slowed to under 2.0%.   Then, the outlook would be in line with the economy's long-run trend.    The end result of fiscal policy would be just a shift in the composition of GDP. 

Besides the boosts to business investment or consumer spending from the tax cut, the other significantly-sized fiscal policy that could weigh on the stock and Treasury markets in coming months is the proposed infrastructure spending -- regardless of whether it is funded through public or private monies.  While market commentators will probably focus on the benefits to construction-related companies, the macro significance is that resources will need to be freed up in the economy to accomplish the additional building.  Headlines regarding the progress of this proposal could become important negative market factors.

Fiscal stimulus would not be crowded out if the trend in productivity growth has ratcheted up to 1.5+% from sub-1.0% of the past few years.  Thus, the one important piece of information in last week's US economic data was not the strength seen in the Mfg ISM or Employment Report.  It was the 0.1% dip in Q417 Nonfarm Productivity.   The dip argued against the possibility of a stronger productivity trend that had been raised by the good-sized productivity gains in the prior two quarters.  The need for "crowding out" is still in the cards.