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Will U.S. Tax Reform Lead to Growth or Inflation?

Will tax changes in the U.S. prolong the economic cycle or cause inflation to jump?

Emma Wall: Hello, and welcome to Morningstar. I'm Emma Wall, and I'm here today in London at the Morningstar Investment Conference to talk to JP Morgan's Karen Ward.

Hello, Karen.

Karen Ward: Good morning.

Wall: I've just listened your presentation. I thought we could focus on the U.S. There was a very interesting slide that showed the disassociation between growth in the U.S. and the amount of spending that is about to be done.

Ward: Yes. Exactly. So, the U.S. administration's announced not only an enormous government spending package, but obviously this is great big tax reform. That's going to push the budget deficit toward around 5.5% over the next two years. I think what's complicating the issue for market is whilst this sounds great, that's more growth, we have never seen a fiscal stimulus of this size at a time when the economy is already doing very well, when unemployment is already low. It raises so many interesting questions. 

How is this going to prolong the U.S. economic cycle? It might mean that actually it gives us another couple of years of very strong growth, if we see productivity come back, if we see that participation rate in the labor market continue to rise, then that will actually come through in additional growth, which is obviously great news for markets.

At the same time, there is a risk that it turns up in inflation, and of course, what that means then is whilst the U.S. administration are giving with one hand in fiscal stimulus, the Federal Reserve will be taking away with the other hand in higher interest rates. That's why the market's a bit schizophrenic about how to interpret this additional stimulus.

Wall: You said the key Friday is to be watching the job figures, because you've already seen it this year. We saw the jobs figures be better than expected, and the whole world went into meltdown for few days, didn't it?

Ward: Exactly. We saw wage growth pick up one month to 2.9%, just a 0.3 percentage point increase, pretty modest, still low by historical standards. At the same time, the U.S. 10-year rose 30 basis points, the equity market was down 10%.

This sensitivity to higher interest rates, what that means for stocks is absolutely acute. We're just going to be watching that payrolls number each Friday to see what extent wage growth is actually coming back, and as I say, whether this stimulus is showing up in growth--good--or showing up in inflation--not so good.

Wall: Why do you think it caused such volatility? You have mentioned the U.S. reaction, but it wasn't U.S.-centric. I am based in Hong Kong, the Asia markets fell considerably, European markets fell considerably. We know that this is an unnaturally low bond environment, and yet the idea of bond yields rising is still quite shocking.

Ward: You are right. There is this, I think, a gut feeling in many investors' minds that when the central banks were pumping money in, markets went up. So, therefore, if the central banks are taking money out, markets will go down. They can't get over that idea that that's the relationship. We've got to remember that the reason the central banks were operating so aggressively is the natural spirits in the economy were nonexistent. Companies, households were not willing to spend, and they were being forced to through low interest rates. For me, an environment where those animal spirits are coming back, where households and businesses want to spend, fine--we don't need low interest rates. The economies and therefore earnings and therefore the stock market should do perfectly well in that environment.

Wall: Karen, thank you very much.

Ward: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.