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posted on 08 November 2017

Selling Tax Cuts, Whither The Fed, And The Future For Stocks

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Macro Tides Monthly Investment Outlook 06 November 2017, Part 2

Read also Part 1.

Selling Tax Cuts

As discussed in prior commentaries, various studies have indicated that the economic benefits from the Fed’s QE programs were modest at best, but the impact on asset prices has been significant.

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Household net worth as a percent of Disposable Income has hit a new all-time high, boosted by rising home prices and record high stock prices.


The record in household net worth is deceiving since it is not evenly spread throughout the economy. The top 0.1% now owns 22% of total household wealth compared to 24% owned by the bottom 90% of households. In the late 1920’s, the top 0.1% owned more than the bottom 90% but the current level is extreme according to any reasonable metric.


In coming years I expect a backlash against the focus within corporate America of maximizing shareholder value as populism within the U.S. grows and becomes a political force that leads to changes in corporate governess. This movement could receive a big boost if tax cuts fail to increase GDP growth as advertised. GDP grew 3.1% in the second quarter and the initial estimate for the third quarter clocked in at 3.0% (more on that later).

First a quick comment on the ‘Tax Cut and Jobs Act’ which was released 02mNovember. In coming weeks, the airwaves, print journalism, and social media will be swamped by a torrent of misinformation, half truths, and cherry picking of data points that will be used to distort the possible outcomes by both political parties, special interest groups, and their minions. This morning Tom Perez, who is the Democratic National Chairman, made the following comment on CNBC:

“George Bush tried trickle-down economics when he cut taxes in 2001 and that led to the financial crisis."

I suspect this will not be the only time Tom Perez will use this line as I can’t think of anyone who wants another financial crisis. The fact that the 2001 tax cuts had nothing to do with the financial crisis isn’t the point, which is there are people who will accept his comment at face value.

As the Republicans promote the ‘Tax Cut and Jobs Act’ in coming weeks, it would be surprising if the promise of 4% GDP or better isn’t touted ad nauseam. As I discussed in the February 2017 Macro Tides, it’s possible the economy could produce a single quarter or two of 4% GDP growth in 2018. However, the odds of sustained 4% growth during the next 5 years are virtually nil.

The two primary drivers of GDP growth over time are labor market growth and the level of productivity. Employment is projected to increase by 11.5 million over the 2016-2026 decade, increasing from 156.1 million to 167.6 million, according to the U.S. Bureau of Labor Statistics.

This would represent a growth rate of 0.6 percent annually. This would be faster than the 0.5 percent rate of growth during the 2006 - 16 decade, which was affected by the recession in 2007 - 2009, but half as fast as the 1.2% rate from 1996-2006.


For most of the past half-century, adults in the U.S. Baby Boom generation have been the main driver of the nation’s expanding workforce. But as the Baby Boom generation retires, the increase in the potential labor force will slow markedly. According to the Pew Research Center (PRC), projections show a reduction of workers from 128.3 million in 2015 to 120.1 million in 2035 of those born in the U.S. to parents also born in the U.S, a decline of -8.2 million workers.

The growth rate of the U.S. labor force has historically been augmented by immigration and the children of immigrants. According to the PRC, the loss of -8.2 million U.S. born workers will be offset by an increase of 13.5 million in the number of working-age U.S.-born adults of immigrant parents. This group is projected to increase from 11.1 million in 2015 to 24.6 million in 2035.


Over the next two decades the number of working-age immigrants is projected by the PRC to rise from 33.9 million in 2015 to 38.5 million by 2035, an increase of 4.6 million workers. However, the number of current immigrants of working age is projected to decline as some will turn 65, while others are projected to leave the country or die. Maintaining a steady flow of immigration is needed to offset this decline.

Immigrants will play the primary role in the future growth of the working-age population even though they will remain a minority of it. The U.S. Bureau of Labor Statistics estimate of the labor force in 2026 incorporates assumptions of labor force participation, while the Pew Research Center is focused on working age population, which is one reason why the estimates vary.

President Trump is conceptually against immigration which could affect economic growth in coming decades as the Pew Research Center indicates. The trend in the domestic birth rate suggests this could be an even larger problem between 2025 and 2045. In the years after World War II, 2.5 babies were born for every 1,000 women in the U.S. After the baby boom ended in 1964, the birth rate plunged and was down to 16 per 1000 women by the late 1970’s.

After a bounce up to 16.7 in 1990, the downtrend resumed. At the end of 2014, the birth rate was down to 12.5 per 1000 women and was unchanged from that rate in 2015. In 2016, the birth rate fell to 7 per 1000 women, so the trend lower has continued.


The slower growth in the labor force will not only be a drag on economic growth during the next decade but will exacerbate the coming spending crisis in Social Security. The U.S. needs more workers to extend beyond 2033 when Social Security will run out of money as projected by the Social Security Trust Fund.

The five year average of productivity growth jumped from 1.2% in 1997 to 3.5% in 2004. It has since trended lower and in 2016 was holding near 0.7%.


As I have often discussed, monetary policy has encouraged stock buybacks over business investment at the expense of business investment. Interest rates near 0% made it attractive for companies to borrow money to buy back their stock in order to boost earnings and their stock price. Increasing business investment, or paying workers more, wouldn’t have had the same impact. In a corporate world obsessed with increasing shareholder value, choosing to buy back stock versus increasing investments was a no-brainer for the Board of Directors of public companies.

The regulatory tsunami from the Obama administration certainly had a dampening effect on risk taking, and the increased compliance costs for corporations large and small may have curbed wage increases. President Trump has already rolled back some regulation and an investment friendly tax policy will encourage businesses to ramp up investment. This will lead to an increase in productivity which could average annual growth of 2% in coming years. If productivity increases to 2.0% and the labor market grows 0.7% as projected, the sustained pace of GDP over the next five years could rise to 2.75% or so.

Increasing GDP from the 2.2% of the past six years to 2.75% is significant and would generate more tax revenue, jobs, and would increase the standard of living for the majority of American workers. That said the odds of sustained GDP growth of 4% or even 3% are low based on the projected growth in the labor market and productivity during the next five years.

In mid October President Trump said that reducing corporate tax rates from 35% to 20%, would give the average American family a $4,000 raise. Kevin Hassett, head of the Council of Economic Advisers, argues that reducing the top corporate tax rate from 35 percent to 20 percent would boost middle-class incomes substantially:

“I would expect to see an immediate jump in wage growth."

The average household brought home $83,143 in income last year. Hassett predicts that would increase by $4,000 to $9,000 a year from reducing business tax rates alone (families that earn less will see a smaller increase).

Since 2010, profit margins have been far higher than their average since 1948.


But since maximizing shareholder value has dominated decision making by corporate boards, the additional cash flow was not used to pay workers more. Average hourly earnings grew 2.2% and have improved to 2.4% over the past year. In the prior 10 recoveries since World War II average hourly earnings increased at a 3.3% rate, which is 50% more than the 2.2% gain during most of this recovery. Despite record profit margins, companies didn’t even pay their employees at the average rate of every other post World War II expansion. I’m skeptical that corporations will change their behavior as much as Hassett assumes if corporate tax rates are lowered.

This reminds me of how the Affordable Care Act was sold. Before the ACA was passed on Christmas Eve in 2010 and for several years after its passage, President Obama and many democrats repeatedly stated that the ACA would lower annual health care premiums by $2,500, as well allow people to keep their plan and doctor. These claims were maintained even after the administration knew they were false. The potential for an increase of $4,000 or more in annual earnings for the average family will be trumpeted by Republicans as they try to muster enough support to pass the ‘Tax Cut and Jobs Act’.

The Democrats will harp on their usual bullet point that the tax cut favors the wealthy at the expense of the middle class. They will hammer at the doubling of the estate tax from $5.49 million to $11 million and the elimination of the estate tax in six years as proof. For most American workers the idea of an estate worth $5.49 million sounds like a dream well beyond their reach and certainly worthy of an estate tax. According to the Tax Policy Center, due to a death in 2017 a total of 5,460 estates will be subject to the estate tax. In 2017 approximately 140 million tax returns will be filed so the number of estate tax filings will represent .004% of the total, which will not be mentioned by a single Democrat.


Personal income taxes are already fairly progressive. In 2015, those with adjusted gross income of less than $50,000 represented 61.4% of all filings but paid only 5.4% of total personal taxes. Those with adjusted gross income of more than $200,000 paid 73.7% of total personal taxes but represented just 4.5% of the tax returns filed. Mathematically it is virtually impossible to cut taxes and not include those who are paying the bulk of personal taxes. I doubt Chuck Schumer, Nancy Pelosi, and Elizabeth Warren will reference any of these numbers.

Of one thing I am certain. In coming weeks, the airwaves, print journalism, and social media will be swamped by a torrent of misinformation, half truths, and cherry picking of data points that will be used to distort the possible outcomes by both political parties, special interest groups, and their minions.

Federal Reserve

Although John Taylor was not nominated by President Trump to replace Janet Yellen as the next Chair of the Federal Reserve, his indirect influence will contribute in shaping monetary policy. The Taylor Rule is an interest rate forecasting model invented by John Taylor in 1992 and outlined in his 1993 study "Discretion Vs. Policy Rules in Practice". The Taylor Rule states that the Federal Reserve should raise rates when inflation is above target or when GDP growth is too high and above potential. The Fed should lower rates when inflation is below the target level or when GDP growth is too slow and below potential. When inflation is on target and GDP is growing at its potential, rates are said to be neutral. This model aims to stabilize the economy in the short term and to stabilize inflation over the long term.


A number of current Federal Reserve presidents and FOMC members have a measure of respect for the Taylor Rule, which is why they have been surprised that wage growth has not grown faster with the Unemployment rate (U3) falling below 5.0% and so low. Not long ago Janet Yellen called this anomaly a ‘mystery’.

The federal funds rate would have been almost 2.0% lower than the actual federal funds rate prior to the recession in 2001, so the shallow 2001 recession may have been avoided.

The Taylor Rule also would have called for the Fed to begin raising the federal funds rate in the first half of 2003, more than a year earlier than the first increase in June 2004. The federal funds rate would have been much higher in 2004 and 2005 and might have tempered the level of housing speculation. In the wake of the financial crisis, it was suggested that the Fed may have been partly to blame for the housing bubble and subsequent crisis by keeping the federal funds rate too low for too long in the years following the dot-com bubble.

The Fed didn’t increase the federal funds rate until December 2015, whereas the Taylor Rule would have called for the first increase to occur in 2010, with gradual increases in 2011, 2012, 2013 and 2014. Under the Taylor Rule the federal funds rate would now be 3.74%, more than 2.58% higher than its current level of 1.16%. Given the wide spread between the current federal funds rate and the Taylor Rule, it should come as no surprise that financial conditions are more accommodative now than since 2007, even after 4 rate increases since December 2015.


As noted, the Taylor Rule states that the Federal Reserve should raise rates when GDP growth is too high and above potential. What is the potential growth of an economy in its eighth year of expansion? At the September 2017 FOMC meeting the Fed’s median projection for real GDP was 2.4 percent in 2017, 2.1% in 2018, and 2.0% in 2019.

If the economy shows signs that GDP will be above 2.1% in 2018 an increasing number of FOMC members and district presidents will think the economy is growing above its potential which according to the Taylor Rule would be expected to put upward pressure on inflation.

If the ‘Tax Cut and Jobs Act’ is passed before the end of 2017, and even if some of its provisions have been watered down, estimates for GDP growth in 2018 will be raised by economists. If the Fed also raises its growth projection for 2018 and 2019, the odds will increase that the Fed will increase the federal funds rate three times in 2018 as they have projected, since growth would likely exceed its non-inflationary potential. This is noteworthy since the ‘market’ is only pricing in a single increase in 2018 at the June 2018.

The annual increase in the Fed’s preferred inflation measure - the Personal Consumption Expenditures Index - (PCE) has been trending lower since peaking in 1981 more than 36 years ago. It has ratcheted lower after each recession and has spent most of the time since the mid 1990’s below the Fed’s target of 2%. Low PCE inflation is not a new development or problem. Far weaker GDP and wage growth, when compared to prior post World War II recoveries, is far more important than inflation growing below the Fed’s 2.0% target. For years the sub 2.0% inflation rate provided the Fed cover to maintain an extreme accommodative policy for longer than justified as noted by the Taylor Rule. As discussed at length last month, the negative unintended consequences from the Fed’s accommodative policy are becoming a risk to financial stability that the Fed may be acknowledging. In the first half of 2017, the Fed increased the federal funds rate twice even though the average of monthly job growth and inflation were not rising.


The gap between the average hourly earnings of non supervisory workers and home prices is almost as wide as it was in 2006 during the housing bubble. Since the end of 2012, corporate debt has grown by more than 35% according to the Federal Reserve, more than 3 times as fast as the economy. The amount of corporate leverage has increased from 1.7 in 2010 to 2.44 at the end of the second quarter in 2017. The leverage ratio is the highest on record and above the prior highs in 2008 and 2002. In 2012, 53% of corporate debt was leveraged less than 2 to 1. In 2017 only 23% of debt had a gross leverage ratio of less than 2 to 1. The percent of corporations with a leverage ratio above 4.0 has doubled from 12% in 2012 to 24% in 2017.

Corporate covenant-lite loans offer less protection to institutional investors than traditionally structured credits. At the end of July, covenant-lite loans comprised 72.7% of the $943 billion U.S. leveraged loan market, according to LCD. The volume of leveraged loans in 2017 is up 52% in the U.S. and on pace to surpass the 2007 record of $534 billion, according to S&P Global Market. According to the minutes of the September 2016 FOMC meeting, some members of the Federal Open Market Committee worried that some corporations were using ultralow rates to do more than their usual borrowing:

“A few participants expressed concern that the protracted period of very low interest rates might be encouraging excessive borrowing and increased leverage in the nonfinancial corporate sector."

Whether one uses Tobin’s Q-Ratio, Shillers CAPE Ratio, Crestmont Research’s P/E Ratio, or the Buffett Indicator, the message is the same. The stock market is at the second most expensive level since 1900, exceeded only by the tech mania bubble in 2000.


Since the election, Commercial and Industrial lending has slowed to an annual increase of less than 2.5% from over 8%. My assumption is that much of this slowdown can be attributed to companies waiting to see the details of tax reform before committing to and borrowing for new investments. If tax reform is passed, it will be instructive if and how much lending improves. The falloff in lending has contributed to a decline in M2 money supply which is one reason why GDP growth seems tethered to an increase around 2.2%.


Over time there has been a strong correlation between the growth in M2 money supply and the Personal Consumption Expenditure (PCE) index which is the Fed’s favored measure of inflation. The recent decline in bank lending is putting downward pressure on M2 money supply which has exerted downward pressure on PCE inflation. If bank lending does increase after a tax reform bill is passed and M2 money supply rise, PCE inflation will begin to rise over time.


There are other factors that could push inflation higher in coming months. Although energy is not directly included in core measures of inflation, there is some measure of bleed through into overall inflation from higher oil prices. Inflation expectations are impacted when consumers pay more for gas and the Fed does pay attention to inflation expectations. WTI oil is trading above $57.00 a barrel, the highest level in 2.5 years. The 12% decline in the Dollar from its peak in early January is causing import prices to rise (red line). This is a trend reversal since import prices have subtracted from inflation since 2012, and should rise even more in coming months.


Once the U.S. Unemployment rate fell below 6.0% in September 2014 economists and the Federal Reserve expected wage growth to accelerate from the paltry level of 2.2% it had been growing since 2010. Expectations for better wage growth increased when the U3 rate fell to 4.9% in January 2016. Needless to say, the forecasts for faster wage growth in 2015, 2016, and 2017 did not materialized as the majority of economists and the Fed expected.

As I discussed in the September 2017 Macro Tides, the spread between the U6 unemployment rate minus the U3 unemployment rate has been a better predictor of wage growth than either the U3 rate or the Non-Accelerating Inflation Rate of Unemployment, or the natural unemployment rate (NAIRU).


The average monthly spread between the U3 and U6 unemployment rates was 3.85% from January 1994 and August 2008 based on data from the Bureau of Labor Statistics. The average annual gain in monthly wages from January 1994 through August 2008 was 3.32%, using data from the Federal Reserve Bank of St. Louis. I found that when the U6 minus the U3 spread was less than 3.85%, average monthly wages grew faster than 3.32%. This indicated that when the U6-U3 spread was below 3.85%, the labor market was tight enough to cause wages to rise faster than their longer term average. Conversely, when the U6-U3 spread was above 3.85%, wage growth was less than the long term average of 3.32%.

In the October employment report, the U6 rate fell to 7.9% and the U3 rate dipped to 4.1%, so the U6-U3 spread in October was 3.8%. This is the lowest in nine years, and if maintained in coming months, is at the level that has led to higher wage growth since 1994. Wage growth is finally likely to accelerate in coming months.

The potential for an upside surprise in inflation in coming months is higher now than in many years, especially if tax reform is passed and M2 money supply increases due to an increase in bank lending. The Fed would have another reason to proceed with more rate increases than the market expects if inflation begins to trend up toward 2.0%.

Stock Market

Since the bear market low in March 2008, the S&P 500 has incurred two major corrections. The first was in 2011 in response to the August downgrade of U.S. Treasury debt from AAA to AA by S&P, the European sovereign debt crisis, and a modest deterioration in financial conditions (see earlier chart). Financial conditions began to weaken in the first half of 2015 and were exacerbated by China’s devaluation of its currency in August 2015 and the plunge in oil prices and energy bonds.

Since the first quarter of 2016, financial conditions have continued to improve which is one reason why the U.S. stock market continues to make record highs. Central bank’s balance sheet will expand by $360 billion in the fourth quarter before dropping to $240 billion in the first quarter and $210 billion in the second quarter. Financial conditions could weaken in the first half of 2018 as the rate of change of central bank stimulus slows significantly.

Prior to the 2011 correction and the declines in the summer of 2015 and early 2016, the markets technical health deteriorated noticeably which provided an advance warning. For instance, the percent of stocks above their 200 day average declined below 50% in June 2011 and in June 2015, and then remained below 50% before the early 2016 correction. The percent of stocks above their 200 day average was 59% as of November 3. Although this is above 50%, it is not a strong showing given the new highs in the major market averages. This suggests that the recent new highs in the S&P 500 and DJIA are being driven by in a small number of big blue chip mega cap stocks. Since October 13, the percent of stocks above their 200 day average has fallen from 68% to 59% while the S&P 500 rose by 1.3% and the DJIA 1.4% through November 3.

Click for large image.


The weakness in the market’s internal strength suggests that the market is becoming more vulnerable to a 3% to 5% correction if a reason to sell materializes. The expectation that capital gains taxes will be lowered in 2018 will entice investors to hold on to the winners and sell their losers before the end of 2017. This indicates that retail and energy stocks could experience some additional selling pressure before year end, while the big winners hold up.

Sentiment is like a pendulum which swings from one extreme to the other over a period of years, as the nearby diagram illustrates. Since sentiment is most often the leading edge of a trend change, it is important to monitor whether sentiment is neutral or reaching an extreme. In the summer of 2007, investors were quite bullish and in March 2009 it was very difficult to find anyone who was positive.


In recent weeks a number of sentiment indicators have reflected a high level of optimism in response to the record highs in the stock market. If tax reform is passed, sentiment could quickly jump from Enthusiasm to Euphoria. The current level of bullish sentiment represents an early warning that investors should heed so they don’t get caught up in all the excitement.

If the technical indicators I use to monitor the market’s internal strength begin to exhibit the weakness that developed in the summer of 2011 and 2015, I will recommend a much more conservative and defensive posture.

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