Morning Tack - “Supply Versus Demand”

Investment Strategy US RESEARCH | PUBLISHED BY

Jeffrey D. Saut, Chief Investment Strategist  (727) 567-2644

“Hey Jeff, you mentioned this morning that the equity market’s rise currently may be more about an absence of supply rather than a pickup in demand. Is it also fair to say December low was the opposite? Just want to make sure I am interpreting things correctly. Thanks.”

. . . A financial advisor


I received a number of emails yesterday about this statement in yesterday’s Morning Tack. Most of them read like this:

“Hey Jeff, you mentioned this morning that the equity market’s rise currently may be more about an absence of supply rather than a pickup in demand. Is it also fair to say December was the opposite? Just want to make sure I am interpreting things correctly. Thanks.”

I guess I need to further explain that comment. The selling climax low that ended on December 24, 2018 was one of the worst I have ever seen. It left the equity markets about as deeply oversold as they have ever been. I have explained the reasons for said selling (hedge fund liquidation, mutual fund redemptions, ETFs being sold, tax loss selling, etc.). The selling squall exhausted the sellers (read: no more “supply”). Consequently, even with little in “demand” (read: buyers) the slightest pick-up in potential “buyers” overwhelmed the reduced “sellers (read: supply of stocks). The subsequent rebound rally has been intense, with January being the best January performance in about 30 years. The rally has lifted the S&P 500 (SPX/2737.70) back above its 50-day moving average (DMA) of 2611.66 and is now challenging its 200-DMA of 2741.77. Clearly, the SPX has overshot my near-term trading target of 2600- 2650. However, as we have written earlier this week:

Despite the overbought condition, our work suggests the equity markets can trade higher into mid-February’s energy peak often referenced in these reports. Despite that outlook, we do not trust the overbought condition the equity markets have currently worked themselves into and continue to advise caution on a short-term trading basis. That said, there is now plenty of internal energy in the equity markets to continue the move.

In yesterday’s missive I expanded on that comment by noting:

The equity markets are consolidating to the upside, which is pretty consistent with what my indicators have been telegraphing even though I remain concerned with the overbought conditions of the equity markets. That upside consolidation should be followed by yet another breakout to the upside with a secondary trading target of 2800 – 2820, which should stall into the mid-February energy peak timing zone.

Ladies and gentlemen, if we are going to get a pullback it should come from that energy peak. However, to reiterate my comments since the second 90% upside day of January 3, 2019, we continue to think the December lows will not be retested. As the acute John Murphy, famed technical analyst and author, writes as a headline for a recent blog entry:


Obviously, I continue to embrace the secular bull market theme. As my pal Leon Tuey writes:

Many continue to hold the view that a bear market had commenced or that a "cyclical bear market" is in progress. Clearly, they have no understanding of the market’s logic and they confuse the various market indices with "the market." As mentioned, what investors saw was nothing more than a normal reaction to an overbought condition registered in the August/September period. The plunge in the averages was caused by the drop in the heavyweights; the various Advance-Decline Lines, however, just went through a garden variety correction, one of the mildest in this great bull market. Since the seers (and most investors) only pay attention to the market averages and not to “the market," the plunge in the market averages caused widespread fear.

Since Powell backtracked and the People's Bank of China stepped up liquidity injections, global money supply has round-tripped to March 18 levels. Forget earnings or macro. This is why markets have rallied. History shows that buying stocks at or near all-time highs, with stretched valuations, because the Fed is easy while the economy begins an ebbing cycle is a path to ruin (See 1999-2000, 2007-2008). U.S. stocks are extremely overbought on a trading basis and short-term basis. A spirited retreat can appear at any time. However, for the foreseeable future, most traders will continue to buy any and all dips because the Fed Put has been reinstated.

This should end with the mid-February energy peak, but I do not believe the December low will be retested. This morning futures are flat . . .


February 6, 2019


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2008 Myth and Reality

First Trust Monday Morning Outlook

February 4, 2019

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Dep. Chief Economist

Strider Elass – Senior Economist

We’ve written about it over and over, and while many advisors seem to understand, the media, politicians, and many analysts don’t…or won’t. So, we thought we’d try again to explain why so many people don’t understand the nearly ten-year long bull market in U.S. equity values.

Conventional Wisdom places the blame for the 2008 Financial Panic at the feet of Wall Street, and heaps praise on QE, TARP, and bank stress tests for saving the world. It has been repeated so often that even many conservative/libertarian analysts have succumbed to thinking the crises was papered-over by government money and that any day now the “sugar high” will come to an end.

This is why “corrections,” like the US stock markets experienced late last year generate so much fear. There is a cadre of traders, media-types, and just plain old hangers on who can’t wait to be the next Nouriel Roubini and make one great call in a row.

What makes it worse is that the truth is there for the taking, but the conventional wisdom simply ignores it. In Peter Wallison’s book “Hidden in Plain Sight,” he very clearly shows it was Fannie Mae and Freddie Mac who pushed the subprime loan space. Congress and HUD urged mandated that Fannie and Freddie buy more subprime paper, and by 2007 - along with the federal government - they owned 76% of it. Yes, Wall Street is culpable too, but government drove the marketplace. Wall Street simply wouldn’t have been issuing these bonds without Fannie and Freddie’s voracious appetites.

Even Ben Bernanke has argued that subprime loans themselves weren’t large enough to take down the system. He blames derivatives, undercapitalization, and interconnected banks. By his verdict, the government gets off scot-free.

But this completely ignores the role that FASB 157, otherwise known as mark-to-market accounting, played. Mark-to-market accounting forces banks to take a few bids from the marketplace and use those bids to value assets. Cash flow doesn’t matter, underlying asset values don’t matter. And what happened was a disaster. The market for loans froze, and even assets that were still paying on time sold at fire-sale prices.

If a bank owned a pool of 1000 mortgages and 300 of them defaulted (which given the collapse in underwriting standards by Fannie and Freddie wasn’t impossible to expect), then that pool still payed 70 cents on the dollar. But, because the market was frozen, bids fell into the teens for an asset paying 70 cents in cash. FASB 157 forced banks to take the “bid,” push it through their income statement, and subtract the losses from capital. This, in turn, created the bigger problems. There was no willingness to invest in banks when, at any time, they could be wiped out by mark-to-market losses. The fire became an inferno.

This was a capital problem, not a liquidity problem. But, the Federal Reserve started Quantitative Easing anyway in September 2008. Hank Paulson pushed the $700 billion TARP bill through that October. Nonetheless, the market kept falling. The S&P 500 fell an additional 40% after TARP – bank stocks fell 73%. QE and TARP weren’t the cure.

It was March 9, 2009, when Barney Frank’s Financial Services Committee announced a hearing with FASB on this really dumb accounting rule, that the market turned around. Yes, it’s true that the actual rule wasn’t reversed until April, but on March 9th the financial markets realized the change was coming.

What happened after that is recorded for history. The market is up 300%, banks healed, asset values rose, and a “normal recovery” began. New technology – fracking, apps, 3D printing, the cloud, smartphones – lifted productivity and profits, and stocks responded. It was not QE that lifted the stock market; TARP didn’t save the banks.

Unfortunately, because so many Republicans back the government-led version of history, many younger Americans have come to believe that free markets fail, and governments can engineer growth. No wonder there are so many fine young thinkers who seem to back socialism these days. After all, even Republicans support government intervention. President George W. Bush defended TARP by saying we had to “violate free market principles in order to save the free market.”

Nothing could be further from the truth. Either you believe in free markets, or you don’t. The Bush administration and its supporters bowed to the popular, but false, narrative. They have yet to find a way to explain their positions. As a result, socialist tendencies are rising in America.

Consensus forecasts come from Bloomberg. This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

No Sign of Recession

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Dep. Chief Economist

Strider Elass – Senior Economist

Talk about destroying a narrative. On Friday, the Labor Department reported 312,000 new jobs in December, with an additional 58,000 from upward revisions to prior months. Recession talk got crushed. The Pouting Pundits of Pessimism claim jobs are a lagging indicator, but the pace of payroll growth starts declining well before a recession starts. In the twelve months ending in June 1989 nonfarm payrolls increased a robust 225,000 per month. In the next twelve months payrolls rose a softer 153,000 per month and then a recession officially started in July 1990. A similar pattern happened before the next two recessions, as well. In the twelve months ending in February 2000, payrolls rose 250,000 per month before decelerating to 137,000 per month in the next twelve months. A recession started in March 2001.

“Click HERE to read more”

This information was developed by First Trust, an independent third party. The opinions of Brian S. Wesbury, Robert Stein and Strider Elass are independent from and not necessarily those of RJFS or Raymond James. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. All investments are subject to risk. There is no assurance that any investment strategy will be successful. There is no guarantee that these statements, opinions or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results .

Dow 28750, S&P 3100


Brian S. Wesbury Chief Economist

Robert Stein, CFA Dep. Chief Economist

Strider Elass Senior Economist

Early in 2018 we said the US economy has gone from being a Plow Horse to Kevlar.  Nothing that has been thrown at the economy since – neither trade conflicts nor tweets, not higher short-term interest rates nor the correction in stocks – is likely to pierce that armor.   

 A year ago the economic consensus was that real GDP would grow 2.5% in 2018.  And yes, that was after the tax cuts were passed.  By contrast, we were more optimistic, projecting that real GDP would be up 3.0% in 2018.  If we plug in our forecast for 2.0% real GDP growth in the fourth quarter, the economy will have grown 2.9% for the year.  If, instead, we use the Atlanta Fed’s estimate of 2.7% for Q4, we’d get 3.1% for the year.  Either way, we just about nailed it.

 Now, the same consensus that a year ago suggested the economy would only grow 2.5% in 2018 with the tax cuts is saying the economy is going to slow down to a pace of 2.3% in 2019, in part because of the supposed reduction in stimulus related to those very same tax cuts.  

 Once again, we’re not buying it.  The benefits to growth from having a lower tax rate on corporate profits and less regulation are going to take years to play out.  Companies and investors around the world have only begun to react to the US being a more attractive place to operate.  As a result, we’re forecasting another year of 3.0% economic growth.        

 Further, we expect the unemployment rate to keep gradually falling, as continued job growth offsets an expanding labor force to push the jobless rate down to 3.3%, the lowest since the early 1950s.  Last year the consensus predicted the jobless rate would decline to 3.8% in 2018; we predicted 3.7%.  Right now it’s already 3.7% and we think a drop to 3.6% is likely for December when that report comes out January 4.       

 On inflation, it looks like we’ll finish this year with the Consumer Price Index up about 2.0%, although it would have been higher were it not for what we think is a temporary downdraft in oil prices.  The consensus had projected 2.1% and we had been forecasting 2.5%.  Look for a rebound in oil prices and ample monetary liquidity to help push the CPI gain to 2.5% in 2019, which would be the largest gain since 2011.  

 The tricky part is what to expect from the Federal Reserve in 2019.  Based on our economic projections, and if the economy were the Fed’s only consideration, we could get as many as four rate hikes in 2019.  After all, nominal GDP growth – real GDP growth plus inflation – is up 5.5% in the past year and up at a 4.8% annual rate in the past two years.  Raising rates four times in 2019, which is more than any Fed decision-maker projected at the last meeting in December, would only take the top of the range for the federal funds rate to 3.5%, still well below the trend in nominal GDP growth. 

 But we think the Fed will have a two-part test for rate hikes in 2019.  First, as we just explained, the economy itself.  Second, the yield curve.  We think the Fed will be very reluctant to see the federal funds rate go above the yield on the 10-year Treasury Note and will strive to avoid either an active or passive inversion of the yield curve.  An active inversion would be the Fed directly raising the federal funds rate above the 10-year yield; a passive inversion would be raising the federal funds rate so close to the 10-year yield that normal market volatility could send the 10-year lower than the funds rate.  

 As a result, we think the Fed will want to leave a “buffer zone” between the 10-year and the funds rate of about 40 basis points.  So, for example, if the 10-year yield stays near its current level throughout all of 2019, we could end up with no rate hikes at all in spite of economic conditions.

 Our projection, though, is that the 10-year yield moves higher to reflect more strength and resilience than the consensus now expects.  If the 10-year yield finishes 2019 at 3.40%, as we expect, that would leave room for two rate hikes, maybe three.               

 For the stock market, we expect a soaring bull market, with the S&P 500 reaching the 3100 we projected for 2018 a year ago.  Yes, we know that sounds bold, but our Capitalized Profits Model is screaming BUY. 

 The model takes the government’s measure of profits from the GDP reports divided by interest rates to measure fair value for stocks.  Our traditional measure, using a current 10year Treasury yield of about 2.75% suggests the S&P 500 is still massively undervalued.  

 But if we use our forecast of 3.40% for the 10-year yield, the model says fair value for the S&P 500 is 3100.  And that leaves room for equities to go even higher if, as we think, profits move higher next year, as well.  The model needs a 10year yield of about 4.35% to conclude that the S&P 500 is already at fair value, with current profits.

 The bottom line is that we’re calling for the S&P 500 to finish at 3,100 or higher next year, which would represent a nearly 25% gain from Friday’s close.  The Dow Jones Industrial Average should end the year at 28,750.

 Yes, this is likely to be one of the most optimistic forecasts you see, if not the most optimistic one of all.  But, in the end, we do best by our readers when we tell them exactly what we think is going to happen, without altering our projections so we can run with the safety of the herd.  Grit your teeth if you have to; those who stay invested in the year ahead should earn substantial rewards.    

“Click HERE to

 Consensus forecasts come from Bloomberg.  This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors.  It is based upon sources and data believed to be accurate and reliable.  Opinions and forward looking statements expressed are subject to change without notice.  This information does not constitute a solicitation or an offer to buy or sell any security.                      

No Deal In Sight To Reopen The Government

With neither side showing any sign of compromise, the partial shutdown could extend until January, says Washington Policy Analyst Ed Mills.

December 31 , 2018

The government is shut down; the Treasury Secretary is holding a meeting of the “plunge protection team”; press reports provide conflicting accounts related to President Trump’s discussion to fire the Chairman of the Fed; the departure of the Secretary of Defense, General Jim Mattis, has been moved up to January 1; and the State Department’s special envoy to combat ISIS, Brett McGurk, is following Mattis out the door.

Government Shutdown

Parts of the U.S. Government – including the Department of Homeland Security, Treasury, Commerce, and Department of Interior – remain closed following a missed deadline to agree on funding the border wall with Mexico. No deal is in sight and Congress is adjourned through December 27. This shutdown could easily stretch into January as the new Congress convenes January 3. The normal pressure on the personal lives of members of Congress and the president did not produce a deal, and neither side shows any real sign of compromise. There are multiple paths forward but no consensus yet on the most likely resolution. We believe an increase in funding above the $1.3 billion for the construction of metal fencing could give the president enough of a victory to accept the deal.

Plunge Protection Team

Secretary Mnuchin is set to convene the president’s working group on financial markets, a committee that was created in the Reagan administration to monitor the stock market. The meeting comes after Mnuchin held calls with the CEOs of the top six U.S. banks over the weekend. Following these phone calls, he reported that all banks have adequate liquidity and the markets are functioning properly. These actions, while appropriate given the recent sell-off, seem to raise more questions than answers – especially as no one had seemed to raise any concerns related to these issues about which Mnuchin is seeking to reassure the market.

Fed Chair

The Secretary of the Treasury and the president’s Chief of Staff issued statements this weekend that the president will not fire/does not believe he has the authority to fire the Chair of the Federal Reserve, Jerome Powell. There is a debate about the ability of the president to "fire" the Chairman of the Federal Reserve, with question related to the ability to designate and/or appoint a new Chair. The Senate would need to confirm the president’s pick, and indications from the Senate is that there is no support for such an act. The longest-serving Republican on the Senate Banking Committee, Richard Shelby (R-AL), was critical of these reports over the weekend and supports the Fed’s independence. There are also reports that the president’s staff is discussing a potential Trump-Powell meeting. We do not believe the Senate would support any decision of the president to fire Powell, but the uncertainty created by these stories will add to the volatility surrounding each of the Fed’s decisions.

National Security Personnel Changes

Deputy Defense Secretary Patrick Shanahan will take over as acting secretary for departing Defense Secretary Jim Mattis on January 1, two months before his announced departure. Shanahan is a former Boeing executive and has been seen as a supporter of the Pentagon’s focus on procurement during the first two years of the Trump Presidency. It is unusual to have an acting secretary at the Defense Department, as the tradition is for the current secretary to stay on until his replacement is announced and confirmed by the Senate. Adding to the negative national security headlines, the State Department’s special envoy to defeat ISIS, Brett McGurk, also resigned. He is not a household name, but was well-respected in D.C. and his departure raises questions about other potential national security departures in the coming weeks.

February/March Likely Volatile Policy Months

The deadline on China trade is March 1, the Treasury is expected to begin emergency measures to manage the debt limit in March, and the Mueller investigation is expect to release its report in mid-to-late February. We will be monitoring these events to see how much they potentially weigh on the markets.

Legislative and regulatory agendas are subject to change at the discretion of leadership or as dictated by events.

Morning Tack - “Dow Theory Redux”

Jeffrey D. Saut, Chief Investment Strategist | (727) 567-2644 | December 14 2018 | 7:45 AM EST

Forgive me, but I am sick of answering questions about Dow Theory since there are FAR too many pundits that have not studied Dow Theory and, therefore, do not understand the concept put forth by Charles Dow, expanded on by Robert Rhea, William Hamilton, and our dear departed friend Richard Russell of Dow Theory Letters, which I have read since I began in this business in 1971 (I actually wrote an epitaph about him a few years ago). Yesterday’s questions were summed up in this composite letter from a Raymond James’ client:

“Can you explain why you are using the March 2018 lows of the D-J Industrials for a Dow Theory sell-signal instead of lows made since the new confirmed highs were made.”

So this is the last time I am doing this. First, the new all-time highs by the D-J Transports were made in September of this year along with new all-time highs from the D-J Industrials. Since then, both of those major indices have been on the skids. While it is true the Transports have broken below their closing low of the past 12 months, the Industrials have not. The trailing 12-month closing low for the Industrials was made on March 23, 2018 at 23533.20. By the method of interpreting Dow Theory that I was taught by my father, and after extensive readings of Charles Dow, Rhea, Hamilton, and Russell, THAT is the closing low that should be used as a confirmation by the Industrials of the breakdown by the Trannies, QED!

“Can you explain why you are using the March 2018 lows of the DJ Industrials for a Dow Theory sell-signal instead of the lows made since new confirmed highs were made?”

. . . A Raymond James client

“To view graph click HERE

. Source: FactSet. Data as of 12/14/18 6:57 a.m.

So yesterday’s Dow Theory questions were prompted by the slide in the Transports from their December 3, 2018 intraday high of 11044.67, into yesterday’s intraday low of 9604.23, for a 10-day pullback of some 13%. The culprits of yesterday’s decline seemed to be the airline stocks, which surrendered roughly 5% for the session on warnings about future revenue growth. Why revenue growth is in question is a mystery to us, since we fly roughly 200,000 air miles a year and are ALWAYS on full planes, but there you have it.

Then there was this from savvy seer Jason Goepfert (SentimenTrader):

"CFOs are pessimistic. A survey of 500 corporate CFOs shows that, during the recent quarter, they have become the least optimistic on the U.S. economy’s prospects in 7 years. Mom & pop are, too. The latest survey from the American Association of Individual Investors showed a big drop in optimism. The Bull Ratio dropped to 30%, the lowest since February 2016. Bank blahs. Several of the largest banks in the U.S. are down at least 7 days in a row and trading at 52-week lows. For the 2nd largest bank, BAC, it’s the first time since 2011. It’s happened 6 times in 25 years, leading to rebounds three weeks later 4 times."

The Industrials were again unable to hold their early gains, leaving yesterday’s declining issues at 64% of total Advancing to Declining issues. Downside volume also dominated with 60% of total Up/Down Volume coming on the downside. This morning, Theresa May’s bid to rescue the Brexit deal is rejected by the EU, the National Enquirer newspaper says it will share all of the information it has on the President (this is a big deal), and very weak economic reports out of China and Europe have left the preopening S&P 500 futures down some 22 points as we write at 5:20 Friday morning. If that holds into the opening bell, it means the S&P 500 (SPX/2650.54) is going to test the 2580-2600 level again. Good grief . . .

Please read domestic and foreign disclosure/risk information beginning on page 2 and Analyst Certification on page 2. INTERNATIONAL HEADQUARTERS: THE RAYMOND JAMES FINANCIAL CENTER | 880 CARILLON PARKWAY | ST. PETERSBURG FLORIDA 33716

“To view graphs and to read more click HERE

Morning Tack - Persistent Selling

Jeffrey D. Saut, Chief Investment Strategist | (727) 567-2644 | December 12 2018 | 8:02 AM EST

Yesterday, someone sent us this tweet from stock market guru Ralph Acampora that read, “Monday's intraday activity and its closes on the leading market indexes were impressive: it's called a ‘key reversal-day’ on a bar chart and a ‘hammer’ pattern on a candlestick chart. They suggest that an important near-term low was made.” Now, for nontechnical folks, a hammer formation in the candlestick charts is defined as follows:

“A hammer is a type of bullish reversal candlestick pattern, made up of just one candle, found in price charts of financial assets. The candle looks like a hammer, as it has a long lower wick and a short body at the top of the candlestick with little or no upper wick (see chart 1, page 2).”

Also suggestive that a bottom was made on Monday was what our deceased friend Ralph Block used to term a multi-swinging session. To wit, “Ralph was a huge fan of a crater opening, multi-swinging session that ends near the high of the day. Looks like it was just what he would have wanted!” We would add that the McClellan Oscillator is pretty oversold on a short-term basis (chart 2, page 2). Likewise, the Russell 2000 is some 10% below its 200-day moving average and, therefore, oversold (chart 3, page 3). And, don’t look now, but the energy complex is very oversold (also has a hammer chart formation – see chart 4, page 4) with the anecdotal evidence that a bottom is near with three large energy-centric hedge funds closing their doors.

"Monday's intraday activity and its closes on the leading market indexes were impressive: it's called a ‘key reversal-day’ on a bar chart and a ‘hammer’ pattern on a candlestick chart. They suggest that an important near-term low was made.”

. . . A tweet from stock market guru Ralph Acampora yesterday

“To view graphs and read more click HERE

.. Source: FactSet. Data as of 12/12/18 7:40 a.m.

As for the questions about a Dow Theory “sell signal” that are being trumpeted by some on the Street of Dreams, by our method of interpreting Dow Theory, there has been no “sell signal.” The problem is these folks are using the November closing low for the Industrials, which is the wrong reaction closing low to use. While it is true the D-J Transports notched a new reaction low last Friday, the D-J Industrials have not violated their March 2018 closing low (the right closing low to use). As such, what we have, according to Dow Theory by our method of interpretation, is a downside non-confirmation, which should be interpreted bullishly.

As for all of the questions about the “persistent selling” we are experiencing, it is due to the algos, tax loss selling, and hedge fund liquidation. Recall that many hedge funds only give their investors one time a year to pull their money from said funds. Those letters from the hedge funds tend to go out on November 15 with a “window” to pull your investment funds extending into December 31. Clearly, the hedge funds have had a really difficult year in 2018, and it is not being helped in the typically ebullient month of December. Remember, “If Santa fails to call, the bears will roam on Broad and Wall.” And then there was this from the sagacious Jason Goepfert of SentimenTrader fame, “It’s not just Financials, Energy stocks have been faltering, too, with more than 40% at a new low. And fewer than 5% of them are above their 10-, 50-, and 200-day moving averages. There have been 23 days since 1990 when selling was this widespread.” If that sounds like capitulation, it should! So, unless we are into another “selling stampede” (this would be session six in what typically is a 17–25 session stampede), there should be a near-term bottom at hand. Yesterday, NYSE breadth diverged negatively after the NYSE opening. Apparently traders and algos bought the incessantly recurring US-China trade deal hype, but large institutions did not. On a positive note, President Trump says he would intervene in the U.S. case against Huawei’s CFO if it would secure national security interests, or help close a trade deal, with China. As Sophocles said, “Not knowing anything is the sweetest life.” This morning, the preopening futures are sharply higher on the president's statement that he would intervene in the Huawei CFO incident if it will help with a Chinese trade deal.

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“Fading” Fiscal Stimulus; Really?

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Dep. Chief Economist

Strider Elass – Senior Economist

Fed Chair Jerome Powell and others have started a new narrative about economic “headwinds.” They think past rate hikes, slower foreign growth, and “fading fiscal stimulus” should slow the Fed’s rate hikes. But is fiscal stimulus really fading?

Powell and others think the growth benefits of both the 2018 tax cuts and increased federal spending are winding down. This is pure Keynesian analysis and we think it’s wrong. In our view it reflects a misunderstanding of both how tax cuts work and the actual path of federal spending.

The difference is between demand-side (Keynesian thinking) and supply-side thinking. Keynesians think demand drives growth. In other words tax cuts work by putting more money in people’s pockets, which increases consumption and, therefore, GDP. They say the first year of a tax cut boosts aftertax incomes and demand, but then, stimulus fades as this boost is removed and income falls back to the previous (slower) trend.

Keynesians also believe federal government spending stimulates growth because it, too, is part of demand. In fact, government purchases are a direct part of GDP accounting and so it appears like government spending is a stimulus.

By contrast, supply-siders think incentives for entrepreneurship and investment drive growth. It is the supply of new goods and services that leads to faster economic activity. Say’s Law says “supply creates its own demand.” In other words, the tax cut led to better incentives to invest, work, and invent. And, as long as tax rates remain low a “permanent” change in incentives has been initiated, which will boost growth rates permanently. There is no “fade.”

Before the tax cut, the corporate tax rate in the US was approximately a combined 40% (federal, state, and local). In 2017, Canada had a corporate tax rate of 26.5%. So, there was a 13.5% incentive to invest in Canada over the US. And, at the margin, more investment went to Canada (and other countries with lower corporate tax rates) than would have been the case if the US tax rate was not the highest in the developed world.

Now the combined U.S. corporate tax rate is approximately 27%, radically changing incentives. In other words, at the margin, as long as tax rates stay where they are, there is a

permanent incentive to invest more in the US. This does not mean growth will accelerate from where it is now (roughly 3% GDP), but it will not automatically revert back to 2%, where it was from 2010-2017.

The more curious and misguided argument is that fading government spending will slow and reduce GDP. We think this comes from a misunderstanding of the budget deal which was passed last year. Yes, that budget deal increased spending, but so far it hasn’t shown up as a boost to GDP growth.

In Fiscal Year 2018, nominal GDP rose 5.0% over FY2017, while total federal spending went up just 3.2%. Government purchases, which feed directly into GDP, rose just 4.0%. In other words, relative to the private sector, government demand grew more slowly.

On top of this, total federal revenue was up 1% in FY2018. While corporate tax receipts fell 22%, total individual receipts were up 6%. In other words, while it’s true that the federal government collected fewer tax receipts in FY2018 than it budgeted prior to the tax cut, it still collected more revenue than it did in FY2017.

The bottom line is that the entire demand-side basis for the fiscal stimulus argument has no data to support it. Government spending grew slower than GDP and actual tax receipts went up. As a result, any argument that there will be “fading” fiscal stimulus is based on a data that does not exist.

The reason growth has accelerated is because lower tax rates, and less regulation, increase entrepreneurial activity – a supply-side acceleration in growth, not Keynesian. Anyone waiting for slower economic activity as fiscal stimulus “fades” will be waiting in vain.

The one worry we have is the exact opposite of what Keynesians argue. A new divided government adds to pressure for bipartisan legislation. Bipartisanship often means more government spending. As supply-siders, we view increased government spending as a drag on growth, not a boost.

The more government spends as a share of GDP, the smaller the private sector. That’s how growth will really fade.

Consensus forecasts come from Bloomberg. This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

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