December 4, 2017

Stocks fell on Friday amid some uncertainty over the Senate tax bill (that obviously got settled in the wee hours of Saturday morning) and a mid-morning revelation that Mike Flynn had pleaded guilty to lying about his contacts with the Russians and had agreed to cooperate with the Special Prosecutor’s office. Stocks regained a large portion of their losses by the time the market closed. This morning, with the tax bill now headed for reconciliation and almost assured passage, futures point to a sharply higher open.

The devil is always in the details. The last minute wrangling in the Senate produced abundant changes that still need to be sorted out. The final version that passed seemed to have more handwriting in the margins than printed text. While there are a significant number of differences between the House and Senate versions of the bill, Republicans will be able to iron out the differences before Christmas. As almost always happens with legislation, a lot of last minute pork provisions get stuffed in. In the case of tax reform, these items, which always increase the costs, have to be balanced out given that Republicans are required to keep the 10-year deficit below $1.5 trillion. In their haste to get the bill passed, Republican leaders made a few goofs along the way, most notably the unintended consequences that accompanied the decision to retain the corporate alternative minimum tax. With a couple of weeks to take a deep breath and look at the two bills more closely, hopefully a majority of the errors can be undone. It is quite possible that to make the corrections and keep the special “pork” deals in place, the ultimate corporate tax rate may be closer to 22% than 20%.

There is little doubt that Wall Street is going to celebrate this morning. Whether the top corporate rate goes to 22% or 20% from 35% probably doesn’t make a whole lot of difference. Many observers point out that the average publicly-owned corporation pays well under 30% in taxes today. That’s true, but it is not due to some accounting manipulations done by fancy highly paid accountants. Rather, it is due to the multi-national nature of most big company businesses. If the average big U.S. company does roughly half of its business in the U.S. and have outside, then a cut in the U.S. rate from 35% to 20-22% will save roughly 7 percentage points in taxes. That, of course, is a big deal and explains the explosive stock market over the last couple of weeks and again this morning.

But just as financial markets got a bit overenthusiastic in the weeks after Trump was elected President, there are reasons to be a bit skeptical of the impact of tax reform if the final product is some composite of what the House and Senate passed. For one, nobody should presume that corporations are going to be able to simply pocket all the savings and share them with their owners (i.e. shareholders) particularly in an environment where pricing power has been with the buyer and not the seller for years. Unless one expects a new world of significant undercapacity, the forces that have given the buyer the upper hand for years will still largely be in place. Whether companies themselves opt to use some of their tax savings to “buy” market share, or whether customers demand some of the savings get passed on makes no real difference.

Second, given that lower and middle class Americans are likely to receive directly a very small incremental amount of money as a result of this tax reform package, one has to wonder where the explosion in demand that proponents of the reform bills postulate is inevitable is going to come from. It is true that for the past several months, corporations have accelerated their pace of investment spending. Hopefully, that will show up in the form of enhanced productivity growth. While there has been a bit of improvement recently, productivity growth over the past several years remains well below historic averages. If that doesn’t improve meaningfully over the next couple of years, then the leverage of increased growth plus lower tax rates won’t be achieved.

Not only would the leverage not be achieved, but future deficits will rise quickly. The primary engines of deficit growth are (1) the ongoing expansion of entitlement spending and (2) the ongoing habit of Congress to create new goodies via legislation that doesn’t have offsetting revenues to pay for them. Republicans like to advertise themselves as fiscal conservatives, but by anyone’s definition, these bills now headed for reconciliation look to be the work of addicted spenders and not fiscal conservatives.

The bills also appear likely to expand the income inequality gap. This is a bill that heavily favors investors. It favors big corporations, and pass-through entities from S corporations to real estate developers. While equity investors are rightly celebrating now, nothing is free in the long run. The U.S. today has over $20 trillion in debt. On a net basis (net of the U.S. debt owned by Federal government entities, mostly the Federal Reserve), that total is closer to $16 trillion. This deal will add $1-2 trillion over 10 years on top of annual deficits near $500 billion. The Fed plans to sell off at least $1 trillion of its holdings over the next year or two. Thus, in about three years, assuming $1.5 trillion in accumulated deficits before tax reform, another $500 billion related to tax reform and just $1 trillion in debt liquidated by the Fed, the net debt will rise to $19 trillion. Current annual debt service is about $300 billion. If the interest cost in 3 years averages 3%, that would rise to $570 billion, an increase of $270 billion. If I add in the increase in entitlement spending already built in over that time, the increase in the debt service would be $350-400 billion, creating an annualized deficit that averages $850-900 billion!

Some would say “So what?” We ran higher deficits than that during and immediately after the financial crisis. That’s true, but it isn’t a sustainable number. Moreover, unless someone plans to moderate the growth in entitlement spending, it won’t be long before that figure becomes over $1 trillion per year. Supply siders will argue that we could grow our way out of the problem. That’s possible. But with birth rates slowing and the possibility of tighter immigration laws and enforcement, population growth is likely to fall to 0.65-0.70%. To get meaningful improvement in GDP growth would require a persistent explosion in productivity. Maybe in a world of totally automated vehicles or some other invention that revolutionizes how we conduct our daily activity that’s possible, but it is highly unlikely over the next 5 years or so. Thus, the answer would seem to be that at some time in the not-too-distant future, we are going to have to pay the piper. Exploding deficits will force Congress’s hand. The crisis that will force action could be a rapid escalation in the cost of debt service. All the numbers I spewed out above assumed just a 3% composite interest rate. For every additional percentage point, the debt service cost would rise by $190 billion per year.

To close this circle, we are likely to see an explosion in corporate profits for the next 1-2 years. Equity investors are celebrating. As soon as the final bill passes, the unknown quickly becomes the known, and markets always quickly discount the known. Everyone will recast earnings forecasts for the next two years. Obviously, companies that do the bulk or all of their business in the U.S. will benefit the most, a fact that hasn’t been lost on investors over the past week or two. Once markets quickly adjust, however, the key question becomes a judgment of future reality versus current expectations. When tax reform becomes the law, the reality of lower taxes will be priced in. The future movement of stocks will depend on other facts. Clearly, there will be differing opinions on the impact of tax reform on GDP growth. There are those who believe growth will quickly rise to 3-4%. Others think growth will be nearer to 2.5%. A few suggest even lower. It will be the outcome of that debate, plus the impact on interest rates, that will determine how stocks fare once the effect of tax reform is quickly discounted.

Today, Tyra Banks is 44. Jay Z is 48. Jeff Bridges turns 68.

James M. Meyer, CFA 610-260-2220

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