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The US stock market remains within reach of record levels.
Of course, current levels are connected with the amazing run up of stock prices since the election of Donald Trump as the president of the United States. President Trump talked about doing spectacular things for the American economy.
However, things have proven to be a little more complex for him than originally thought. And, other than a bump in “animal spirits,” there seems to be little else that is supporting the current position the stock market now finds itself in.
For the US stock markets to grow to even higher levels there are several factors that are needed to “goose up” corporate profits and these things, for the moment, seem to be missing in action.
For example, stronger economic growth and a faster rate of inflation could contribute to a higher profits and higher stock prices. Here is where the Trump vision impacted the rise in stock prices.
A second factor that could contribute to higher stock prices is an expansive monetary policy. The stock market has greatly benefited over the past eight years or so by a very, very loose Federal Reserve, which pumped an enormous amount of liquidity into the financial system. As a consequence of this performance, stock prices sizzled.
Connected with the massive injection of liquidity into the financial system, the US government feasted on the benefit of historically low interest rates, which allowed substantial increases in the Federal debt without the excessive burden of large interest payments. Increases in the debt burden were carried without the cumulative effect of rising interest payments allowing the stock markets to rise, unimpeded.
Furthermore, looking back over the past eight years or more, political risk factors seemed to be relatively modest. Brexit had not yet taken place, France was in the control of the Socialists, Italy had a young, reform-minded Prime Minister, the Middle East seemed to be relatively calm, Russian efforts in the Ukraine and in Syria were relatively modest and although there seemed to be sources of unease, things looked as if they would stay calm.
Where do we stand now?
The economy is growing, somewhere just over the 2.0 percent compound rate achieved since the beginning of the current economic recovery.
Some economists, like those at the Federal Reserve, believe that this rate of growth will not improve over the next several years. For example, the economic projections released by the Fed’s Federal Open Market Committee suggest that economic growth over the next three years will not exceed 2.1 percent per year, and the “longer run” projection indicates the belief that economic growth will not exceed 1.8 percent per year.
Whereas this looks pretty mediorce, unemployment is at and is expected to remain over the next three years are 4.5 percent, at roughly full employment level.
And, inflation, even over the longer-run, is not expected to exceed the Fed’s target rate of inflation, which is 2.0 percent.
Policy wise, what are the officials of the Federal Reserve supposed to do with respect to monetary policy given a forecast like this?
Can economic growth be pushed up to a faster rate of expansion?
There is a growing amount of sentiment that very little can be done, especially in the short run, to achieve improvement in the rate of economic growth. The reason for this sentiment is the belief that the economy is growing as slowly as it is because of supply side factors.
Fed Chair Janet Yellen spoke at an event at the University of Michigan and she emphasized the fact that economic growth was dependent upon the growth of the labor supply and the growth of labor productivity. At the present time, both of these factors remain low and do not appear to be increasing…at least in the near term.
Although these factors can increase in the future, improvements, as she mentioned in his discussion, are associated with longer-term influences needing structural changes. The hopes for achieving much higher growth rates, at this time, seem to be relatively slight.
But, this situation spills into the second factor mentioned above, the monetary policy of the Federal Reserve. Ms. Yellen, in her remarks, indicated that the job of the Federal Reserve right now was to make sure that the economic growth is sustained, not expanded. Given that the economy cannot grow much more rapidly due to supply constraints, the only real role that the Fed can play in the near future is to make sure that the economic expansion continues.
Thus, there is no further underwriting of higher stock prices in the Fed’s future.
As far as the budget of the federal government? Well, the Congressional Budget Office put out some “not so good” news last Friday in its March budget review.
The news is that the federal budget deficit has increased and is expected to increase further as interest rates rise into the future. The Federal Reserve has increased its policy rate once this year and two more increases are expected. More increases are in the works for next year.
The Congressional Budget Office is now estimating that government expenses will have to increase by around $160 billion per year over the next ten years to handle just a one percentage point increase over current forecasts. This does not include any increases that would occur on the reserve balances that commercial banks hold at Federal Reserve banks.
And, this does not include any payments on US Treasury securities that are now held by the Federal Reserve but will now have to be financed by the private sector as the Federal Reserve reduces the size of its balance sheet.
This “surprise” could have quite an impact on the performance of financial markets in the upcoming year or two.
Finally, the rise in political risks in today’s environment is having quite an impact on people’s thinking. The world is not calm, there is a restless undercurrent of concern that is expressed in most every view of world events today. And, there seems to be no good estimate of when these feelings might dissipate.
These are the realities now facing investors. And, hopes for expansive economic programs coming from the White House are fading as the complexity of the governmental process becomes more and more real.
Unfortunately, the only really stable actor on the scene right now seems to be the Federal Reserve, but what the Federal Reserve can do, and will do, is not going to be much help for the stock market. Right now, the best scenario I see coming out of what the Federal Reserve is trying to do is one in which the economy and economic growth is maintained for the foreseeable future.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.