November 3, 2017

Stocks were mixed yesterday on a day where the focus was on the introduction by the House Ways and Means Committee of its big tax reform plan. Also yesterday, President Trump announced the appointment of Jerome Powell to be the new Chairman of the Federal Reserve in February when Janet Yellen’s term expires.

Today started with the release of the October employment report. As expected, October was a strong month for new job formation after anemic growth in September related to the multiple hurricanes of late summer. One can easily argue that the 252,000 jobs created last month were a bit inflated, as some of the gain reflects workers out of work because of storms, returning to their jobs. Unemployment fell to 4.1% and the average hours worked per week remained constant. Importantly, average hourly wages actually fell. The year over year gain is now 2.4%. Obviously, inflation isn’t a fear, at least for now.

Let me now circle back to the Powell appointment and the tax reform proposals. As for the Powell appointment, it was expected. Jerome Powell is not an economist but has been a member of the Federal Reserve Board for a number of years. He is not viewed as an idealist and is expected to continue the policies of the current board under Ms. Yellen’s leadership. In other words, rate increases will be coming at a measured pace. Another increase is expected in December with Ms. Yellen still in the Chairman’s role. Next year 2-4 increases are indicated, and Mr. Powell should stay in that range. He also is an advocate of slowly reducing the size of the Fed balance sheet and can be expected to stay on the current schedule Ms. Yellen laid out in the fall, assuming the economy stays in a 2-3% growth range. Importantly, the position of Vice-Chairman will be vacant with the resignation of Stanley Fischer. Conventional wisdom suggests that an academic economist would fill that role best. Here, President Trump has some leeway. He can go in the direction of Stanford Professor John Taylor who advocates increasing interest rates at a faster pace than now planned, or he could go to more conservative economists of which many would fit the bill. One hallmark of the Trump administration is the measured pace it goes in terms of making appointments. Mr. Trump leaves for an 11-day trip to Asia today and the position of Vice-Chairman of the Fed certainly isn’t at the top of his agenda. But given there are several Federal Reserve Board vacancies, one could expect a nominee before year end.

Now to tax reform. As one could predict, Republicans that wrote the package think it is great and that it will jump start growth for an extended period of time. Democrats, instinctively, opposed the bill even before the details were released. They were joined by a variety of predictable coalitions that will lose some tax loopholes that help to pay for the other benefits of the bill.

One thing I try to do, maybe sometimes to an extreme, is simplify. So here goes. The recently passed budget gives Republican leadership the ability to expand the deficit over 10 years by as much as $1.5 trillion and still pass legislation using reconciliation, which means only a majority vote is needed in the Senate rather than the normal 60-vote plurality. The proposed cut in corporate taxes will result in $1.46 trillion in lost revenue. You can do the math. That means everything else has to balance out. That means, aside from corporations that obviously benefit from the proposal, the rest of the bill creates an equal number of winners and losers.

So, who wins and who loses? High income individuals win. They win because the alternative minimum tax would be eliminated. They win because the estate tax will be eliminated beginning in 2024. They win because of an introduction of a pass-through rate for small businesses. Who else wins? Families with less than three children will benefit from the doubling of the standard deduction. Larger families lose because eliminating the personal exemption will offset the benefits of a doubled standard deduction. The doubling of the standard deduction will benefit those who don’t have many deductions. Renters in states with no income tax who have few medical expenses, for instance, would benefit. Who loses? From what I just said, losers will be those with big families, those in high tax states that itemize, and those with large medical expenses.

To keep it simple once again, the losers are likely to scream louder than the winners. Home builders don’t like the reduction of the cap on mortgage interest deductibility. The media, Democrats and middle class don’t like the abolishment of the estate tax (which only impacts those with estates over $11 million). Notably, the deduction for carried interest remains. That will be a big help for private equity, hedge fund and real estate investors. Might even help the Trump family.

Republicans stood unified yesterday as they introduced the plan. But the yelling and screaming is just beginning. There are several Republicans in the House from high tax states who will feel a lot of pressure.

My conclusion is that this plan as proposed has much less than a 50:50 chance of passage. That doesn’t mean it won’t serve as a good starting point for debate over the next several months. It simply means that the timetable to get something passed quickly is unlikely. It probably doesn’t help that the bill was introduced the day before the President left the country. Bill proponents, of course, see this as a springboard for greater growth. To the extent it increases the deficit, it will provide modest growth right away. But there is a long history of tax cuts and increases and they don’t correlate well with economic growth. Growth is a function of demographics and productivity. To the extent that corporations pay less in taxes and invest more, the argument might make sense. But corporations invest based on forecasts for rising demand, not because lower taxes simply give them more money. If the majority of Americans, on balance, don’t come out ahead from these proposals, it is hard to see a big acceleration. As for productivity, it is beginning to rise, perhaps related to less regulation. Indeed, one can argue that less regulation will be a bigger driver of growth than tax reform.

Judging by the market’s muted reaction to the introduction of the plan yesterday, I would assume my opinion is not all that divergent from consensus. In the end, there are cogent arguments for lower corporate taxes and the repatriation of overseas earnings. Some moderate cut in corporate taxes, coupled with a modest tax on repatriated earnings, eventually could pass and could fit within budget constraints. As for the individual pieces, it is hard to see how the proposed changes result in significant tax simplification or net savings to the middle class. The one item that can be a big help to millions is the doubling of the standard deduction. But that is costly and needs an offset. Looking at the bill’s math, doubling the standard deduction and repealing the alternative minimum tax would be an almost perfect offset to the elimination of personal exemptions. Couple them with the corporate tax cut and allowance for repatriation might make a nice package that could, ultimately, be successful.

In the meantime, a good economy pushes stocks higher. This morning the market will benefit from a strong earnings report from Apple# last night.

Today Colin Kaepernick turns 30. Roseanne Barr is 65. Anna Wintour is 68.

James M. Meyer, CFA 610-260-2220

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# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.

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