The so-called Donald Trump rally is unsurprising for a market that had been discounting a Hillary Clinton victory.

Investors apparently see more upside from a Trump presidency than a Clinton one. This perception is presumably premised on an anticipated pivot toward more laissez faire, market-oriented and stimulative policies out of Washington, versus a continuation of what some think would have been the status quo under Clinton.

But anticipation of any such pivot may be premature given Trump's relatively recent embrace of the Republican party. Many thoughtful conservatives have argued that he has shown no alignment whatsoever with Friedrich Hayek and Ronald Reagan principles.

The just-executed "deal" cut with United Technologies' Carrier unit is certainly not out of the supply-side-school-of-conservatism playbook.

Conservative think tank Heritage Foundation has estimated that under President Barack Obama, a net increase in the cost burden of regulatory compliance has increased by almost $108 billion per year or 0.6% of gross domestic product. Given persistent real growth of less than 2%, 0.6% allocated to regulatory compliance, with zero value creation on the expenditures, is significant.

But even if Trump aggressively scales back the Affordable Care Act and its pressure on small businesses, that account for a disproportionate share of historical jobs growth, to reduce full-time-equivalent employees to 50 or less; eliminates other regulatory burdens imposed on the private sector over the past 15 years for which cost/benefit is deemed un-compelling; and reduces the corporate tax burden to stimulate capital spending and incite the repatriation of some of an estimated $2.5 trillion in cash held offshore by U.S. companies for tax reasons, accelerating U.S. production growth will be a daunting task.

U.S. GDP Growth: Six-Year Trailing Compounded Annual Real Growth Since the End of World War II

 

Chart courtesy of the author and data from the Department of Commerce

U.S. economic sluggishness pre-dates the Obama administration. Real U.S. GDP growth has averaged less than 2% since 2000, a period that includes two recessions but two full recoveries as well, with neither of the recoveries producing a single year of 4% or more.

Indeed, this recovery is the weakest one since World War II. In fact, in the past 81 years, the post-financial crisis "recovery" is the 12th worst of any six-year-period.

Despite the weakness of production growth out of the last recession, the U.S. economy is experiencing the fourth-longest period between recessions since World War II. But the cumulative growth during this recovery since 2009 amounts to an anemic 13.4%, compared with 38% during the third-longest growth period of 1983 to 1990, 52% during the second-longest of 1961 to 1969 and 40% during the longest of 1991 to 2001.

Nearly 20 years of sub-2% growth -- more than a one-third drop in the long-term growth rate of 3.3%, with little variation within discreet 10-year periods -- suggests a new normal that capital market strategists and pundits haven't yet acknowledged, as evidenced by continued dogma that "15 times" remains a "normal" fair value market multiple.

What are the growth-inhibiting factors with which the incoming administration needs to grapple in order to accelerate growth off of the stubborn, 20-year trend of below 2%? Here are five.

1. Capital spending. This is a function of reinvestment economics as estimated by companies seeking to optimize returns. Capital spending levels have been at "maintenance capital" levels, high enough to ensure the integrity of existing facilities and machinery but not high enough to drive meaningful top-line growth.

Companies are hoarding cash or allocating to dividends, mergers and acquisitions, and share buybacks, none of which support growth. The contribution of "fixed investment" to GDP growth in the U.S. has actually been negative for the past four quarters.

No single factor is more important to jobs and real wage growth than private-sector capital spending.

2. Demographics. These trends aren't GDP growth's friends. The world's 10 largest economies account for about 65% of gross world product.

Most of these advanced economies have demonstrated decelerating population growth rates. The U.S. is in the relative early stages of a precipitous drop in the population of maximum spending age cohorts.

3. End of the computer/Internet/wireless industrial revolution. Staggering growth in global prosperity in the past 100 years-plus has been a function of industrial innovation. The industrial revolution began with steam engines and railroads between the late 18th and mid-19th centuries and re-accelerated with electricity, running water, internal combustion engines, communications, and cheap energy and its derivatives in the late 19th to early 20th centuries.

The last wave began in the 1960s with computers, followed by the Internet and wireless technology. This last discreet period of disruptive innovation has largely run its course in terms of accelerated growth, reflected in the steady decline in labor force productivity growth since the recession of 2001.

In the absence of more breakthroughs, necessarily greater in economic scale than previous innovation given the larger production base, it will be difficult to return to an organic growth rate commensurate with the pre-2000 long-term historical trend above 3%.

4. Sovereign debt and deficits. Claims of "deficit reduction" are patently misleading.

Yes, deficit spending has dropped each year since the post-recession peak of $1.4 trillion. But the drop from 2012 to 2013 of $1 trillion to $640 billion was almost entirely a function of the Budget Control Act of 2011 that called for across-the-board spending cuts known as "sequestration" if Congress and the White House failed to pass budget legislation.

It was meant to be a poison pill, if you will, ensuring compromise on the balance between changes to federal spending and taxation. Sequestration has been a sub-optimal policy approach to deficit reduction in the context of growth.

Moreover, the 2015 deficit was still almost $400 trillion, and this year is on pace to increase, while unfunded entitlement obligations and other spending are on a trajectory to produce a deficit of about negative 17% by 2039, compared with around 3.2% this year, pushing debt to more than 180% of GDP.

Research suggests that debt-to-GDP ratios above 90% reduce GDP growth.

5. Start-up activity. As previously mentioned, small businesses, and in particular new businesses, play a disproportionate role in jobs growth. Start-up activity in the U.S. has been in decline for about three decades, but the trend has been more steeply downward since the financial crisis.

This trend has been explained, in part, by demographic trends, as the decline parallels trends in the overall population. It seems odd to see company formation trends remain steadily negative when there is so much slack in the labor force, particularly among young people.

In conclusion, it seems likely that Trump will, as signaled, move on the easy fixes of reversing the high and rising regulatory compliance cost trend and adjusting corporate tax rates to be more competitive with other advanced economies. These changes should have at least some impact on capital spending and start-up activity and longer term on innovation-based productivity.

But only a more thoughtful reform of immigration policy beyond blanket amnesty for illegal immigrants will alter the contractionary demographic trends. And the ruinous deficit trajectory of U.S. spending and taxation policy will require painful and near-term recessionary changes constituting a political third rail that few legislators have had the courage to seriously discuss, other than House Speaker Paul Ryan (R-Wis.), who was parodied as pushing a wheelchair-bound grandma off a cliff in response to his proposals for Medicare reform.

In short, reversing the deceleration of U.S. and world gross product growth won't be easy and may not be possible. The "Trump rally" of a market already in nosebleed territory will likely prove optimistic.

The price-to-past-10-years-earnings multiple of the S&P 500 has only been this high or higher three times in history: before the 1929 crash, the technology bubble and the financial crisis collapses. Since the pre-financial crisis peak of the S&P 500, real S&P 500 annual earnings have grown by the compounded annual rate of 0.1%, while the S&P 500 has appreciated by 2.3% per year, not including dividends.

Unprecedented monetary policy is the only explanation. But the Federal Reserve is itching to normalize the federal funds rate, but as we have argued, think years, not quarters on full normalization, and at some point, slower secular economic and earnings growth must be fully accounted for in valuations.

Investors beware.

U.S. GDP Growth: Six-Year Trailing Compounded Annual Real Growth Since the End of World War II

 

Chart courtesy of the author, and data from Standard & Poor's for current S&P 500 earnings, Robert Shiller and his book Irrational Exuberance for historic S&P 500 earnings.

This article is commentary by an independent contributor.