If the US economy is going to grow faster, the US budget deficit has to rise: Strategist

Need policy action for markets to get to next level: Pro

The U.S. economy cannot grow faster without its budget deficit rising, either through increased spending or lower taxes, according to one investment strategist. But getting there won't be politically easy.

The "fiscal deficit has to widen. If it doesn't widen, growth will slow down in the second half," Krishna Memani, chief investment officer at OppenheimerFunds, told about 200 clients last Thursday at the firm's outlook event.

"Unfortunately, the people that the administration relies on to get those things passed are not enamored with fiscal spending," he said.

Annual projected federal budget deficit (2016-2020)

Source: OppenheimerFunds, Congressional Budget Office and Tax Policy Center as of 1/31/2017.

Last Tuesday, a report showed U.S. gross domestic product grew 1.6 percent in 2016, the slowest since 2011.

President Donald Trump has said the U.S. economy will grow at least 4 percent a year under his policies, and Treasury Secretary Steven Mnuchin expects 3 percent growth. The administration also claims it can achieve that growth without boosting the U.S. budget deficit, because Washington will supposedly cut spending enough to offset reduced tax revenue.

Budget Director Mick Mulvaney said in February that the administration aims to offset a $54 billion increase in defense spending with reduced domestic spending. Trump's budget is expected next week.

Treasury's Mnuchin: 'Dynamic scoring' very important

However, Oppenheimer's Memani said 3 percent growth is possible only if politicians choose to expand the fiscal deficit temporarily, by spending more or taking in less money. "If we don't do that, the likelihood we get sucked into a downward swirl is pretty high," he said.

For now, the U.S. market is showing some signs of losing confidence in an economic boost dependent on fiscal spending, Memani said.

He pointed out that:

  1. Large-cap stocks have recovered their edge over small caps, which were thought to benefit more from tax cuts. The is up 6.1 percent year to date, while the Russell 2000 is up just 2 percent.
  2. Fast-moving growth stocks such as technology companies have had better returns than the so-called value stocks such as banks – Apple contributed the most to gains in the Dow Jones industrial average between its run from 20,000 in late January to 21,000 last week, according to Howard Silverblatt of S&P Dow Jones Indices.
  3. U.S. stocks are losing their gains relative to international markets. The S&P 500 has jumped far more since the election than the iShares MSCI Emerging Markets ETF (EEM), but EEM is up 9.1 percent so far this year versus the S&P's 6.1 percent rise.

Memani likes emerging market and European stocks better than those in the U.S., where the major indexes are at record highs. His firm still favors stocks over bonds, however, as he expects interest rates to remain low.

"The Fed is gradual, and I expect them to be gradual," Memani said. "They are not the driver. The driver today is fiscal policy."

— CNBC's John Harwood and Ylan Mui contributed to this report.