Stocks fell once again on Friday despite a strong start. In fact, losses accelerated into the close capping the worst week for the market since February.
Over the weekend, the House disclosed, in a 4-page framework, proposals to raise taxes needed to fund its planned $3.5 trillion in spending. As promised, no one earning $400,000 or less would see a tax increase, but the details had significant differences from President Biden’s earlier proposals. The corporate rate would go to 26.5%, not 28%. Importantly for investors, the maximum capital gains tax rate would rise to 28.8% from 23.8%. Biden had suggested that the capital gains rate could match the ordinary income rate with a $1 million exemption. That request clearly is dead on arrival. The increase in the estate tax exemption, due to expire in 2025, would expire on December 31 of this year. If that were to become law, and there is a long way to go before there is a bill for Biden to sign, you will see a lot of wealthy Americans scrambling to use to lifetime exemption before the end of this year. There are a bunch of other changes. These are just the highlights. The House math says individuals will pay an extra $1 trillion. Corporations would pay an added $900 billion. Drug pricing policy changes would add $700 billion. Tougher IRS enforcement would add $120 billion. The balance of over $700 billion will be closed by factoring in growth.
Note this is an outline, and it is only the House version. It presumes that $3.5 trillion in spending passes in its entirety. There is little doubt there will be significant pushback. Moderates have already said any corporate rate above 25% is a non-starter. There are many who believe that an added $3.5 trillion in budgeted spending is way too high. Senator Joe Manchin said this morning that the targeted September 27th date for passage isn’t a sensible expectation.
Equity futures are actually up this morning. The investor class will not like these changes to the tax structure, but it isn’t nearly as bad as Biden’s requests. Moreover, consensus will quickly coalesce around the idea that spending lower than $3.5 trillion will reduce expected tax increases.
Thus, stay tuned. If you have significant wealth, stay in touch with your tax advisor. It’s too early to make significant changes, but not too early to start developing strategies. Note that the expected start date for any changes has yet to be announced. Further details will be forthcoming this week. Again, this is an initial House proposal. The Senate is likely to have its own ideas and could pass a bill with significant differences that will have to be ironed out in conference. There remains a possibility that Democrats can’t come to a unified agreement, one necessary to get any bill passed.
As for the stock market, the biggest item in the 4-page draft is the proposed increase in corporate tax to 26.5%. As noted, that is almost certain to fall to 25% or less. There are some additional requests that impact corporations that pay no tax, small businesses that pass through income to owners, and minimum tax increases on foreign income. So far, analysts haven’t factored in any changes, but that will change if any bill is signed. Tax rates for 2022 and beyond will rise and earnings forecasts will be adjusted downward. While analysts haven’t made any adjustments yet, markets have.
Taxes aren’t the only item on investors’ minds. Next week, the FOMC meeting is likely to suggest that a final tapering plan should be announced at its next meeting in early November. The pace of tapering will be the topic of lively discussion. Right now, consensus seems to be centered on the notion that tapering could be completed by the end of next summer allowing time for an increase in the Federal Funds rate before the end of 2022. That doesn’t mean there will be any rate increase. Rather it means the table will be set to allow one, if deemed necessary. With that said, one shouldn’t assume that the tapering schedule is to be carved in stone. The Fed under Jerome Powell has proven to be very market sensitive. Should tapering happen too fast allowing bond yields to rise too quickly, the Fed could slow the tapering pace, pause, or even reverse course. With so much debt outstanding, at all levels of the economy, the Fed simply cannot tolerate high rates. What constitutes “high”? In 2009-2020, anything over a 2.5% yield on 10-year Treasuries got Federal Reserve attention. The Fed would also be concerned about the pace of rate increases. Ten basis points per month for a year would bring the 10-year rate to about 2.5%. That could be tolerated. A 20-basis point per month increase could only be tolerated for a short period of time.
The Fed does not have as much control over long rates as it does for Treasury bills, but it can step up its pace of bond purchases at the long end of the curve and have significant impact. The current $120 billion per month pace of bond purchases has certainly contributed to lifting all asset prices. In the bond market, higher prices mean lower rates.
It should also be noted that, in the past, tapering programs often actually led to lower rates in the short-term. Markets anticipate Fed action. Markets also view tapering as a form of monetary tightening. That means slower growth, reduced levels of demand, and lower rates. The ultimate arbiter of rates will be the pace of future inflation. The Fed and many economists persist in their belief that the current rapid pace of inflation will reverse once temporary supply constraints are overcome and broken supply chains get fixed. Markets can withstand 3-4% wage increases via higher productivity and keep long term inflation close to the Fed’s 2% target. Others see pressures from higher demand keeping inflation higher for longer. Americans have record savings and before long will have record employment. There are over 10 million job openings today, more than one job for every American seeking work. Assuming Covid-19 winds down, more people will seek employment, which will increase economic activity and end user demand.
Markets will determine who is right. That determination will drive asset prices over the next year. We know growth will occur. We assume an eventual end to the pandemic. The push to require more vaccinations will pull forward the economic end to the pandemic.
Good markets require balance between supply and demand. If the growth in demand exceeds the growth in supply, inflation occurs. Right now, that is pushing inflation higher because supply is constrained, allegedly by supply chain disruptions. Those believing inflation will return to low rates believe supply will be restored in coming months restoring balance. Those believing systemic inflation is rising accept that supply chains can be repaired but also see demand rising at a fast enough pace to overwhelm supply even when supply chains run smoothly. The key to markets is always a combination of earnings and interest rates. Earnings growth appears robust going forward, withstanding a short-term hiccup related to the Delta variant surge. The course of interest rates will define the stock market. Record low rates over the past decade have led to a surge in asset values. While we don’t expect a further significant decline in rates, simply staying near where they are will be good for equity prices. The course of interest rates and inflation will be the key driver for markets over the next year.
Today, Tyler Perry is 52.
James M. Meyer, CFA 610-260-2220