Headwinds and tailwinds

Optimism is on the rise, and valuations arguably are a bit stretched, so headwinds should prevail for the near term: watch out for growth disappointments and setbacks. DOGE can't eliminate bloated bureaucracies overnight, and when they do manage to cut some fat, the ranks of the unemployed will grow. Large-scale deportations could be especially painful. It will take awhile to remove redundancies from the public sector and relocate those resources to the private sector. 

Over the long term, tailwinds should prevail as the economy becomes more efficient, government spending cools, and tax and regulatory burdens ease, generating growth in the range of 4-5%.

Chart #1

Headwind: Private sector jobs growth (Chart #1) has been decelerating for the past three years, from a high of 6% to now a mere 1% a year. Public sector jobs growth will likely be heading to zero as DOGE kicks in. As a result, the economy is quite unlikely to experience a near-term boom.

Chart #2

Headwind: The Civilian Labor Force (Chart #2) consists of all those of working age who are either working or looking for work. The recent drop in growth likely stems from a slowdown in illegal immigrant crossings and increasing self-deportations ahead of Trump's plan to do both. 

Chart #3

Headwind: The unemployment rate (Chart #3) currently is very low, and unlikely to fall further. Deportations and government spending cutbacks may lead to some worrisome signs of impending recession in the months to come, but an actual recession is unlikely given very healthy corporate profits, a further relaxation of monetary policy, and abundant financial market liquidity. 

Chart #4

Tailwing: A recent survey of small businesses (Chart #4) shows a huge jump in optimism. As the green asterisks show, this has happened only twice in the past 50 years, and both times were immediately following Trump's election victories. Business owners see a friend in Trump, and his promise of sweeping deregulation is music to any business man's ears. Increasing business optimism should lead to a gradual pickup in jobs and investment.

Chart #5

Chart #6

Tailwind: Chart #5 shows the intriguing correlation between the level of real yields on TIPS and the value of the dollar which began back in early 2020. Higher real yields make the dollar more attractive, and vice versa. Capital has flooded into the dollar in recent years, as the Fed has tightened monetary policy and corporate profits have surged. Real yields are the best measure of how tight monetary policy is (higher real yields being tighter). Real yields are also driven by the strength of the economy, since it takes a strong economy to drive the profits necessary to pay real returns on investments. At the same time, strong returns to equity create competition for capital, and that tends to increase yields on bonds.

Chart #6 shows a big-picture, long-term view of the dollar's strength vis a vis two currency baskets. This is the best measure of the dollar's overall strength, since it takes into account changes in relative inflation between the U.S. and other major economies. By any measure, the dollar today is quite strong from an historical perspective. Strong currencies tend to beget strong economies.

Chart #7

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Tailwind: The November CPI report was good. As Chart #7 shows, inflation is not materially different from the Fed's 2% target. Shelter costs have single-handedly kept headline inflation from falling below 2%.

Chart #8

Tailwind: Chart #8 shows the pronounced but irregular decline in the shelter component of the CPI. As this continues, the gap between headline inflation and inflation ex-shelter costs should narrow. At a minimum, this all but precludes any near-term tightening of monetary policy while leaving the door open for more easing. The market fully expects the Fed to cut rates by another quarter point next week, but only expects moderate easing over the course of next year.