Key charts updated

3rd Quarter GDP came in stronger than expected (3.0% vs 2.6%) and a bit stronger than the 2.2% growth rate of the current expansion, but the market remains unconvinced that the US economy is indeed accelerating. Tax reform may be on Congress' table, but I can detect few if any signs that the market is optimistic about it happening, or even if it happens, whether it will be a significant positive for the economic outlook. This may sound odd, to be sure, given that the stock market has been posting serial new, all-time highs since mid-2016. But consider that since its pre-recession (late 2007) peak, the S&P 500 is up at an annualized rate of just over 5%—which is lower than its long-term average of just over 6% per year. The market is doing well, of course, but arguably it's not yet in "off the charts" mode.

I've been posting updated versions of this spectacular chart for many years now. It shows clearly how unique the current business cycle expansion has been in the economic history of the US economy. From 1965 through 2007, the US economy grew at a trend rate of about 3.1% per year. It slipped below this trend during recessions, and exceeded the trend during boom times. But it invariably returned to trend given a few years. (Milton Friedman in 1964 wrote a paper about this, calling it the Plucking Model.) The current expansion has been by far the weakest on record. Relative to its previous trend, the US economy is more than $3 trillion smaller than it might have been had things played out this time as they have before.

What's the cause of this underperformance, especially considering that since late 2008 the Fed has massively expanded its balance sheet? My list of reasons lays the blame on two major factors: 1) an oppressive expansion of government, in the form of increased regulatory and tax burdens, and 2) a shell-shocked market that has yet to regain its former level of confidence in the wake of the worst recession since the Depression.

Thanks to TIPS (Treasury Inflation-Protected Securities), which were introduced in 1997, we have real-time knowledge of the market's expectation for risk-free, inflation-adjusted returns. (TIPS pay a real rate of interest in addition to whatever the inflation rate happens to be. The price of TIPS varies inversely with the market level of the real yield on TIPS.) As the chart above shows, the level of real yields on TIPS tends to track the economy's real growth rate, much as common sense would suggest. When economic growth was booming in the late 1990s, TIPS paid a real rate of interest of about 4%, since they had to compete with the market's expectation for 4-5% real economic growth. But with the trend rate of growth having now slowed to just over 2%, the real rate of interest on TIPS is only modestly positive: 0.2% for the next 5 years, as of today. If the market thought the US economy were on track to deliver 3%+ rates of growth in the years ahead, I'm confident that the real yield on 5-yr TIPS would be in the neighborhood of 1-2%, if not higher.

The chart above compares the real yield on 5-yr TIPS (red line) with the ex-post real yield on the Fed funds rate. This is akin to viewing two points on the real yield curve: overnight rates and 5-yr rates. In effect, the red line is the market's expectation for what the real Fed funds rate is going to average over the next 5 years. And of course, the real Fed funds rate is the rate that the Fed is actually targeting. As you can see, the market expects only a very modest amount of tightening from the Fed in the years to come; 2-3 rate nominal rate hikes over the next few years, and hardly any hike at all in real overnight rates. That makes sense only if you believe that both the market and the Fed agree that the economy has very limited upside growth potential. If the market thought the economy were set to grow at a 3%+ rate for the next several years, the market would immediately assume—and the Fed would probably agree—that there would be a series of rate hikes in the future, not just 2 or 3.

The chart above compares the real and nominal yields on 5-yr Treasuries (red and blue lines) with the difference between the two (green line), which is the market's expectation of what the CPI will average over the next 5 years. With 5-yr inflation expectations today at 1.85%, the market is only a tiny bit concerned that the Fed will be unable to hit its 2% inflation target. Looking ahead, the market sees pretty much the same amount of inflation that we have seen over the past few decades. Nothing surprising. The market is thus fairly confident that the Fed is not going to do much going forward, and whatever it does, the Fed is unlikely to be too tight or too easy. You may not agree with that assessment, but that's what the market tea leaves are saying.

The chart above suggests that one reason the market is up is because the market is not very worried about whatever is going on in the world right now. The Vix index is relatively low, and 10-yr Treasury yields are near the high end of their recent range. The combination of the two (red line) suggests a lack of fear and a lack of concern that the economy could decelerate meaningfully.

If the market is not very optimistic about the economy's ability to grow at a significantly faster pace, as the charts above strongly suggest, then it stands to reason that a failure by Trump and the Republicans to pass significant, growth-friendly tax reform would not likely result in a significant equity market selloff. But should they be successful, then the market's upside potential could be significant.

I hasten to add, however, that a stronger economy would perforce result in an unexpected rise in real and nominal interest rates (and more rate hikes from the Fed than are currently anticipated). Higher-than-expected rates would obviously depress bond prices, and, in similar fashion, could depress the market's PE ratio (which is the inverse of the earnings yield on equities, and thus similar to a bond price), thus limiting further gains in equity prices to a rate that is somewhat less than the increase in earnings. So even if Trump and the Republicans are successful, we are probably not on the cusp of a monster equity rally. In other words, the next Wall of Worry could be higher-than-expected interest rates, which would put downward pressure on equity prices because they would imply a higher discount rate and a lower present value of future after-tax corporate profits. That downward pressure on equity prices would probably be offset—though not entirely—by rising earnings.