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posted on 03 January 2018

The Impact Of The Tax Cuts And Jobs Bill

Written by

Macro Tides Monthly Report 02 January 2018

On February 12, 2002 Secretary of Defense Donald Rumsfeld held a press briefing regarding the future of Iraq and he made a statement that was noteworthy.

“Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns - the ones we don't know we don't know. And if one looks throughout the history of our country and other free countries, it is the latter category that tends to be the difficult one."

donald.rumsfeld


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This quote certainly applies to the Tax Cut and Jobs Bill. We know that tax rates for corporations and individuals are being lowered and by how much. We know that the tax cuts in aggregate will increase economic activity in 2018 and less so in the following years. We also know that comments made by politicians reflect their political persuasion and not reality.

According to Bloomberg, President Trump claimed that he sees

“no reason why we don’t go to 4%, 5%, even 6% growth in GDP". [President Trump claimed that] “the combination of high consumer confidence, job creation, and tax cuts would create this considerable growth."

On December 6, Trump told reporters that he expects to see a 6% annual growth rate. The 30-year average rate of GDP growth is 2.5% and the Congressional Budget Office forecasts GDP growth will average 1.9% over the next ten years. Unfortunately there are good reasons why average GDP growth is not likely to accelerate to 4%, let alone 6%.

welsh.monthly.2018.jan.fig.01

As discussed previously, the two primary drivers of GDP growth over time are labor market growth and the level of productivity. According to the U.S. Bureau of Labor Statistics, employment is projected to increase by 11.5 million over the 2016-2026 decade, increasing from 156.1 million to 167.6 million. This would represent a growth rate of 0.6 percent annually. That 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.

Increased immigration could augment the slow growth in the domestic workforce. 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.

President Trump does not favor immigration so an increase in immigration is not likely while he is president so it’s possible that immigration may be less than the 4.6 million projected by the PRC. This suggests the growth rate of the U.S. labor force may be less than the 0.6% projected by the U.S. Bureau of Labor Statistics.

welsh.monthly.2018.jan.fig.02

Since 1970 annual labor productivity growth in the U.S. was only 1.4%. The five year average of productivity growth jumped from 1.2% in 1997 to 3.5% in 2004, but at the end of 2016 was holding near 0.7%. 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 business investment and wage increases.

welsh.monthly.2018.jan.fig.03

President Trump has rolled back some regulation which has already encouraged businesses to ramp up investment as measured by the increase in spending for business equipment. This improvement has taken hold before passage of the tax cuts, which indicates the level of regulation does indeed matter. According to the U.S. Bureau of Labor Statistics, nonfarm business sector total labor productivity increased 3.0% during the third quarter of 2017. From the third quarter of 2016 to the third quarter of 2017, productivity increased 1.5%, reflecting a 3.0% increase in output and a 1.5% increase in hours worked.

welsh.monthly.2018.jan.fig.04

An investment friendly tax policy should accelerate this trend in 2018, since businesses will be able to write off 100% of an investment. Although this aspect of tax reform is good for the next five years, many companies may choose to act in 2018 after years of weak business investment. While the tax advantage will entice interest, the visibility of good economic growth in 2018 should provide companies the confidence that demand will remain firm and may rise in 2018 to justify the decision to increase investment. This will lead to an increase in productivity which could average annual growth of 2% in coming years and would represent a 43% increase above the average since 1970. If productivity increases to 2.0% and the labor market grows 0.6% as projected, the sustained pace of GDP over the next five years could rise to 2.60% or so. Increasing GDP from the 1.9% pace projected by the Congressional Budget Office to 2.60% 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 6%, 5% or even 4% are quite low based on the projected growth in the labor market and productivity during the next five years.

President Trump has said the Tax Cut and Jobs bill represents the biggest tax cut in history. It may be in absolute dollar terms, but as a percent of GDP, which is the proper method of comparing the potential impact of tax cuts on the economy, it ranks as the 8th largest in history.

welsh.monthly.2018.jan.fig.05

While President Trump has clearly overstated the economic benefit of the Tax Cut and Jobs bill, the Democrats have - no surprise - made statements that make Chicken ‘The Sky Is Falling’ Little look like an optimist. House Minority Leader Nancy Pelosi felt compelled to mix politics and the proximity of Christmas in her assessment. Pelosi declared the legislation “the end of the world" and if that wasn’t clear enough she added a reference to Armaggeddon:

“In this holy time, the moral obscenity and unrepentant greed of the GOP tax scam stands out even more clearly. This is Armageddon."

Senate minority leader Chuck Schumer took a different tack.

“With this stunning deception, with this reckless ramrodding of a bill, Republicans are reaching heretofore unreached heights of hypocrisy, and the Senate is descending to a new low of chicanery."

Senator Schumer curiously overlooked the parallel between the Republicans ramrodding their tax reform bill and Senate Democrats ramrodding the Affordable Care Act through on Christmas Eve in 2009. The Affordable Care Act did not lower annual premiums by $2,500, allow millions of Americans to keep their health insurance, or keep their doctors as repeatedly promised. The bar for hypocrisy is high and previously set by the Democrats. Schumer further proclaimed,

“If they haven't learned it yet, they're going to learn it next November. Republicans will rue the day they passed this bill and the American people will never let them forget it."

Schumer is speaking from experience and the 2010 midterm election. Although the sitting U.S. President's party usually loses seats in a midterm election, the Democrats lost 60 seats in the House which was the most since 1938 and 6 seats in the Senate. In this light Schumer’s warning can also be viewed as a wish for the 2018 midterm election.

The economic impact of the Tax Cut and Jobs bill will not generate the boom promised by President Trump nor the wipeout the Democrats have publically warned of and maybe secretly hope for. The lower tax rate in the U.S. will make U.S. corporations more competitive globally which was noted in a report released in mid December by Germany’s Center for European Economic Research entitled “Germany Loses Out in U.S. Tax Reform".

Irrespective of one’s political leanings this report should resonate with anyone who is skeptical of politicians in the U.S. since the assessment is from an objective competitor. The fact it is from Germany adds heft since Germany is the European Union’s economic locomotive and the E.U.’s most productive country, as opposed to France, Italy, or Spain. The statutory tax rate in Germany is 31% and that’s not the only consideration. Labor laws are onerous, the population is aging faster in Germany than in the U.S., and energy costs are high. Natural gas prices in the U.S. are trading near $2.75 per thousand cubic feet compared to $5.00 in Germany. For a German global conglomerate evaluating where to build their next plant, the U.S looks compelling with a lower tax rate, better demographics, cheaper energy costs, and the largest economy in the world. The comparison to the U.S. for multi-national companies in France, Italy, Spain and other less productive E.U. countries is even more pronounced. To be sure no one should expect a tidal wave of foreign companies building new plants or migrating to the U.S. in 2018. But over time the tide of companies leaving the U.S., and foreign companies coming into the U.S., will be coming in rather than going out.

As Donald Rumsfeld noted,

“We also know there are known unknowns; that is to say we know there are some things we do not know."

We know that the Tax Cut and Jobs bill will increase economic activity, we just don’t know how much. A key concept in estimating the impact on growth is the ‘user cost of capital’, which measures the expected cost of making new investments in equipment. As the user cost of capital goes down, companies choose to increase investment which increases overall economic activity. The reduction in the tax rate to 21% from 35% lowers the user cost of capital. Allowing 100% of the investment to be written off in the year the investment is made compared to depreciating the investment over a period of years also lowers the user cost of capital. Extensive academic research suggests the combination of a lower tax rate and immediate expensing could increase GDP by 3% to 4% over a 10 year period. The annual increase in GDP would amount to 0.3% to 0.4% during the next 10 years.

This may not sound like much but the Congressional Budget Office (CBO) estimates that each .1% increase in GDP during the next decade will generate $270 billion in additional revenue for the Treasury. If GDP growth increases 0.3% annual during the next 10 years, the projected increase in revenue of $810 billion would lower the increase in debt from $1.5 trillion to $690 billion. After the 2003 reduction in the capital gains tax rate, the CBO estimated that capital gains taxes would total $215 billion from 2004 through 2007. In fact, capital gains tax revenue was $377 billion or 75% more than the CBO estimated. Historically, the CBO has underestimated the economic impact and tax revenue after a tax cut since it is difficult to anticipate how businesses and people will respond if they have a little more in the till or their pocket. This is why the impact from this legislation qualifies as a known unknown.

welsh.monthly.2018.jan.fig.06

A poll by CNN taken between December 14 and December 17 found that only 33% of those polled were in favor of the Tax Cuts and Jobs bill. A whopping 95% of Democrats and 64% of Independents believed it favored the wealthy over the middle class. Some of the following headlines may have influenced the perception of the bill:

  • Yahoo News: “Meet some victims of the Trump tax bill."
  • Washington Post: “10 Reasons Democrats think the tax bill will be a political loser for Trump’s GOP."
  • New York Times: “In Tax Overhaul, Trump Tries to Defy Economic Odds."
  • Business Insider: “Americans have already made up their minds about the tax bill - and it looks brutal for the GOP."

The liberal Tax Policy Center has estimated that 90% of the middle class will benefit and the average tax cut will be $1,600 in 2018. When voters go into the voting booth many issues affect their decision but the one that often matters most is their pocket book.

welsh.monthly.2018.jan.fig.07

After the IRS publishes the new tax code in February, workers will notice that their net pay is higher and that will not make them unhappy. The investment boost from lower corporate taxes and full expensing of investments is likely to lift GDP growth in the second and third quarter of 2018. As voters enter the voting booth in November 2018, they are more likely to remember the extra money they have been receiving in each paycheck and will have forgotten what Nancy Pelosi and Chuck Schumer said. The landslide Democrats are expecting in November may not meet their expectations.

Federal Reserve

The impact from the Tax Cuts and Jobs bill will be front-end loaded meaning the biggest lift is likely to emerge in 2018 and 2019. By 2026 tax rates for those earning less than $100,000 will actually rise modestly while tax rates for those above that threshold will still be lower.

welsh.monthly.2018.jan.fig.08

GDP growth in the second quarter was 3.1%. After slashing inventories in the first quarter, inventories added 1.46% to GDP in the second quarter. Third quarter GDP was 3.2% and boosted by spending on the rebuilding of homes and the buying of new and used cars in the wake of the hurricanes which destroyed thousands of homes and 500,000 motor vehicles.

Gross Domestic Income (GDI) is the lesser-known cousin of Gross Domestic Product (GDP). While GDP measures what gets purchased, GDI measures who gets paid. GDI is a very useful measure for determining how Americans earn their incomes and maintain their standards of living and is less volatile than GDP, which gets whipsawed by large quarterly changes in inventories or trade. In the second quarter GDI rose 2.3% and 2.0% in Q3. The average of GDP and GDI suggests the inherent growth for Q2 and Q3 was 2.7% and 2.6%, which is probably more accurate but less Tweet worthy.

welsh.monthly.2018.jan.fig.09

Economic expectations for 2018 have increased due to the fiscal stimulus provided by the tax cuts. There are a number of reasons why growth in the first quarter may disappoint investors and could lead to a correction in the stock market. Whether it’s the weather or the seasonal adjustment process used by the Bureau of Economic Analysis (BEA), first quarter GDP growth has consistently been weaker than in the other quarters. The average GDP growth in the first quarter from 2011 through 2017 has been 1.16% compared to 2.60% in Q2, 2.46% in Q3, and 2.10% in Q4, which does not include 2017. The Atlanta’s GDPNow forecast for the fourth quarter is 2.8% while the New York Fed has Q4 growth pegged at 3.9%. If either of those forecasts is correct, the average for Q4 will rise from 2.10%.

In 2014 first quarter GDP fell -0.9% primarily due to extreme cold weather as the Polar Vortex pushed frigid air south into the U.S. From December through February of 2014, the average temperature in the U.S. was 7.5 degrees lower than normal. During the last half of December 2017, temperatures fell well below normal in the northern half of the U.S. Atmospheric and Environmental Research (AER) has forecast below-normal temperatures for the northern and eastern United States, and above-normal precipitation across the northern part of the country. The combination of cold and wet could result in an above-normal snow season for parts of the northern U.S., including the large population centers of the Northeast. If this forecast is accurate, bad weather could weigh on economic activity in the first quarter. On New Year’s Day, 90% of the U.S. was below freezing, and 35% was below 0 degrees.

In November the savings rate dropped to 2.9%, the lowest in a decade, while credit card debt likely surpassed its prior high from April 2008 at the end of 2017. With consumer confidence near all-time highs and a tax cut right around the corner, consumers probably spent a bit more than planned this past Christmas. Most consumers may be surprised when their January paycheck doesn’t reflect lower tax rates since the IRS won’t have them ready until February. The combination of low savings, higher credit card debt, and the delay in receiving the increase in net pay can be expected to lower consumer spending in the first quarter.

Click for large image.

welsh.monthly.2018.jan.fig.10

After improving during the last nine months of 2017, business investment will pick up in 2018 as companies respond to the opportunity to write off 100% of any investment in 2018. In anticipation of the improved environment for investment, company boards likely discussed in 2017 where they will target the increase in their investments but will need to approve them formally at a board meeting. Some investments will require additional planning before they can be started. This suggests the initial boost to investment will occur more in the second and third quarter than in the first quarter.

welsh.monthly.2018.jan.fig.11

Bank lending has been quite weak since the election falling from an annual growth rate of 8% to 1%. Normally this would be viewed as a negative for the economy, but I have thought it was a reflection of companies waiting for the details of any tax reform program to emerge, than providing any insight to future economic growth. In coming months, bank lending will provide a valuable barometer of changes in business investment and should begin to rise in the first half of 2018.

welsh.monthly.2018.jan.fig.12

Since bottoming in the spring of 2017, the Citi Economic Surprise Index has soared reaching a multi - year high in December. If I’m right and the economy slows in the first quarter, economic reports will come in lower than forecast and the Citi Economic Surprise Index will decline. The stock market ignored the sharp decline in the Citi Economic Surprise Index during the second quarter of 2017 since the allure of tax cuts kept selling pressure at bay as institutional investors expected the market to rally once tax reform was realized.

The rally in recent months has certainly ‘priced in’ a portion of the coming increase in corporate earnings and investors will be tempted to take some profits in the stocks that scored big in 2017. The big cap growth stocks could be vulnerable to profit taking in early 2018, and since they have a greater weight in the S&P 500 and DJIA, a correction in January in the major averages is likely. A deeper correction of more than 3% may develop during the first quarter if investors respond to less than robust growth as measured by the Citi Economic Surprise Index.

welsh.monthly.2018.jan.fig.13

At the December FOMC meeting, the Federal Reserve increased its 2018 estimates for economic growth, lowered the estimate for the unemployment rate, but left its forecast for PCE inflation and Core PCE inflation unchanged. The FOMC projected GDP growth of 2.1% in 2018 at its September meeting and increased it to 2.5% in December. That’s a big increase for the Fed and certainly reflects the expectation that fiscal stimulus will lift the economy in 2018.

welsh.monthly.2018.jan.fig.14

The Fed now expects the unemployment rate will fall to 3.9% in 2018 from the 4.1% rate it forecast in September. Despite stronger growth and a tighter labor market, the Fed did not increase its inflation estimates which underscores that the Fed remains mystified as to why inflation hasn’t already reached its 2.0% target. Inflation is likely to surprise the Fed in 2018.

As I have discussed previously, the spread between the U6 and U3 unemployment rates has narrowed to the level that has resulted in a pick-up in wage growth. This spread will narrow further in 2018 and cause wage growth to rise from the recent level of 2.5% as 2018 unfolds. Wage growth will also be lifted by the 18 states that will increase the minimum wage in 2018 which will help 4.5 million workers, according to the Economic Policy Institute. Increases in the minimum wage often results in a trickle up effect as workers earning just over the minimum wage also receive an increase based on their experience and value, so the impact will affect more than 4.5 million workers.

The decline in the corporate tax rate will increase profit margins and offer companies options. With corporate debt as a percent of GDP at an all-time high, some companies will choose to use the extra cash flow to pay down debt. Many public companies will use the extra cash flow to fund existing stock buyback programs or announce an increase in buybacks. Many companies will choose to increase investments to take advantage of the 100% write off provision. Some companies will choose to absorb a greater proportion of the health insurance cost for employees, which won’t show up as an increase in net pay, but will lower out-of-pocket health insurance costs for employees and represent an unseen pay increase. And finally, some number of companies large and small will increase wages more than they have in recent years. Wage growth is going to pick up in 2018.

Capacity Utilization measures the amount of slack within industrial America and is presented as a percentage. During the past 50 years, the level of Capacity Utilization has trended lower as shown by the red down trend line in the nearby chart. (Chart compliments Doug Short and Advisor Perspectives) The current level of utilization is shown by the blue line. When the blue line is below the red linear regression line, it indicates that there is excess production capacity and less inflation pressure. When the blue line is above the red line, capacity is tightening which increases inflation pressures.

welsh.monthly.2018.jan.fig.15

The correlation between excess or tight utilization is apparent in the Producer Price Index (PPI). When headline line PPI inflation (red line on PPI chart) is above the Core PPI (blue line) the upward pressure from headline PPI inflation feeds into the Core PPI over time. Conversely, when the headline line PPI inflation (red line on PPI chart) is below the Core PPI (blue line), the Core rate of PPI inflation subsequently falls. In November headline PPI inflation was 4.2% well above the Core rate of 2.2%. As long as the headline PPI holds above the Core rate, inflation pressure will mount and eventually cause the Core rate to climb.

welsh.monthly.2018.jan.fig.16

The Producer Price Index is a leading indicator of Consumer Price Inflation (CPI) since producer price inflation feeds into consumer prices over time. The relationship between headline CPI inflation and Core CPI inflation is the same as the PPI. When headline line CPI inflation (red line on CPI chart) is above the Core CPI (blue line) the upward pressure from headline CPI inflation feeds into the Core CPI over time. Conversely, when the headline line CPI inflation (red line on CPI chart) is below the Core CPI (blue line), the Core rate of CPI inflation subsequently falls. In November the headline CPI was 2.20% compared to 1.71% for Core inflation.

Most analysts do not pay attention to the relationship between the headline PPI and CPI figures and their impact on the core rates. When the November CPI was announced, strategists noted that the Core CPI fell and concluded that inflation pressures had receded in November. Although the Core rate did fall from 1.77% to 1.71%, the headline rate jumped from 2.04% to 2.20%, which means that future inflationary pressure actually increased in November rather than falling. I expect headline inflation for the PPI and the CPI to hold above their core rates and gradually lead to higher core inflation in 2018.

At the end of 2016, the Federal Reserve projected three rate increases for 2017. Even though inflation did not climb toward the Fed’s 2.0% target, the Fed did raise the federal funds rate three times in 2017. At the December 2017 FOMC meeting the Fed projected three more rate increases in 2018. Currently, the bond market is pricing in one increase in March and a 50% chance of a second increase in September for all of 2018. If inflation creeps higher as I expect, the Fed will hike three times in 2018.

One of the keys to the bond market could be the potential of the second increase coming in June rather than in September. If the bond market begins to speculate about a June increase, Treasury bond yields will rise more than most investors expect. At a minimum, I expect the yield on the 10-year Treasury bond to rise to 3.0%, which was the high in December 2013. If this occurs the yield on the 30-year Treasury bond will at least test its 2017 high of 3.20%. If inflation does more than just creep higher, bond investors could be forced to price in not just a third increase in the federal funds rate in September, but also a fourth increase in December. If this scenario develops, yields on the 10-year and 30-year have the potential to breakout above their 2013 and 2017 highs.

The cumulative gain for the S&P 500 during 2014, 2015, and 2016 was 21.1%. Earnings were responsible for 48% of the increase but an expansion in the Price / Earnings (P/E) accounted for 52% of the gain. In 2017, earnings accounted for 56% of the S&P 500’s gain of 19.5% and P/E expansion was responsible for 44%. Valuation based on P/E’s and many other valuation metrics is historically high.

welsh.monthly.2018.jan.fig.17

One justification for the market’s high valuation has been low interest rates which spawned the acronym TINA for There Is No Alternative to stocks. The yield on the 2-year Treasury note has climbed from 1.19% to 1.90% since the end of 2016 and now yields more than the S&P 500. For the first time since the financial crisis, short term note yields are truly competitive. If Treasury bond yields reach the targets I’ve discussed, it could spur a small reallocation out of stocks and into bonds. The odds of a 10% correction in the stock market will increase as interest rates rise during 2018.

welsh.monthly.2018.jan.fig.18

Total central bank bond purchases will be cut in half from $360 billion in the fourth quarter of 2017 to $180 billion in the third quarter in 2018. The Federal Reserve will shrink its balance sheet by $420 billion in 2018 or about 9%. Central bank purchases will decline from $2 trillion in 2017 to $1 trillion in 2018. I’m not willing to assume that this change will not have any impact on financial markets in 2018 even though central banks purchases will still be a net positive. But the tailwind from coordinated central bank quantitative easing will be $1 trillion less and the decline in central bank purchases must be replaced by demand from global investors. Bond yields will have to climb to entice investors to increase their allocation to bonds to make up for the shortfall from less central bank buying. This could be particularly challenging in the U.S. since the supply of Treasury bonds will soar from $518.7 billion in 2017 to $869 billion in 2018, an increase of 67%.

welsh.monthly.2018.jan.fig.19

European Central Bank

At its December 14 meeting the ECB made no change to their policy rate which remains at minus -0.40% and restated its commitment to keep rates at current levels until "well past" the end of net asset purchases. The ECB lowered its monthly purchases from $60 billion to $30 billion beginning in January and expects to maintain that pace through September. Notably the ECB raised its forecast for GDP growth in 2018 to 2.3% from 1.8% at its September meeting.

Although the ECB nudged its core inflation forecast up to 1.4%, it attributed the increase to rising oil prices rather than due to stronger economic growth. Just as is the case in the U.S. headline inflation was running comfortably above the core inflation rate in November 1.5% to 1.2%. If headline inflation continues to hold above the core rate, it will gradually pull the core rate up as higher costs are passed along, especially if headline inflation climbs above 2.0%.

welsh.monthly.2018.jan.fig.20

When headline inflation rose above 2.5% in 2011, it prompted the ECB to hike rates twice. Although the ECB will not raise rates if headline inflation gets up to 2.5%, it would put pressure on the ECB to end its QE purchases in September, rather than extending purchases. Inflation expectations, as measure by the 5 year forward inflation swap has been creeping higher since mid 2017. In December it reached 1.724%, up from 1.50% in June. A rise above the January high of 1.80% would represent a breakout and put pressure on the ECB to end its QE program in September. If headline inflation rises above 2.0% or inflation expectations exceed 1.80% in the first half of 2018, it would be significant since the ECB will want to communicate its plans for its QE program well in advance of September 30. The European bond market is likely to anticipate any potential change in the ECB’s QE policy, so watching these factors will be helpful. The European bond market will be watching U.S. Treasury yields. If the 10-year Treasury yield rises above the March 2017 high of 2.62%, it will exert pressure on the 10-year German Bund yield. Technically, a close above 0.50% on the 10-year Bund will represent a breakout and likely signal that a rise to 0.80% to 0.90% would follow.

In the November issue of Macro Tides I discussed the Taylor Rule which 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.

welsh.monthly.2018.jan.fig.21

As I noted in November, under the Taylor Rule the federal funds rate would now be 3.74%, more than 2.33% higher than its current level of 1.41%. If the Taylor Rule was applied to the ECB’s policy rate, it would be near 3.0% rather than at -0.40%. Since the Euro didn’t exist before 1999, the chart uses the Deutsche Mark (DM) as it reference. The spread between the ECB’s policy rate and the level as prescribed by the Taylor Rule underscores just how accommodative the ECB’s policy is. It is also why the ECB will be dragged into at least starting the normalization process in 2018, which may result in higher European bond yields.

As discussed in the December issue of Macro Tides, the first indication that the ECB is taking a baby step toward normalization could come if the ECB cuts the link between inflation and policy. At the ECB’s October meeting the ECB retained the link between asset purchases and inflation, stating purchases will continue until inflation moves closer toward its 2.0% target. That may change according to ECB board member Benoit Coeure who is the head of operations at the ECB. In a November 21 interview he said:

“I expect this link to change when the governing council is sufficiently confident that net asset purchases are less needed for inflation to return towards 2 percent in a sustainable way. We were not ready to make that change in October, but I expect it will come at some point between now and September 2018."

Whenever this change is made it has the potential to wake up the European bond market to the inevitability of the ECB winding down its QE program and the repression of European bond yields.

Benefits from Repatriated Profits

In 2004 the “Homeland Investment Act" was passed which allowed multinational firms to bring overseas profits back home and pay a tax rate of 5.25%, rather than the normal 35% corporate tax rate. The Homeland Investment Act specifically said repatriated money could not be used to raise dividends or to repurchase shares, since it was intended to spur economic activity. It was ‘sold’ as a way to spur investment in new plants, research and development, and new jobs.

In a June 2009 paper, the nonpartisan National Bureau of Economic Research (NBER) reported that 843 corporations took advantage of the Homeland Investment Act and repatriated $362 billion. In the prior five years, the average annual amount of repatriated earnings was $60 billion, so the Act resulted in an additional $300 billion coming home in 2005. The Bush administration and Congress estimated the tax holiday would create more than 500,000 new jobs, while J.P. Morgan Securities expected businesses would increase capital spending by 2% to 3%. NBER concluded in its 2009 analysis that

“the decreased costs of assessing earnings retained abroad under the Homeland Investment Act did not increase domestic employment, investment, or research and development."

For each $1.00 of earnings repatriated, domestic investment increased less than $0.01. It is likely that something similar will occur as U.S. companies bring foreign profits back to the U.S. in 2018 and beyond and use the cash to pay down debt, buyback stocks, and maybe increase investments and wages. The Homeland Investment Act was only good for 2005, which forced companies to act in 2005, rather than spreading repatriation over many years as the current law allows. Of the $2.6 trillion in overseas profits almost 25% is held by just 9 companies, so $632 billion of the total is concentrated. The concentration and openended nature of the current law suggests the amount of cash coming home in 2018 as a percent of overseas balances may not be as large as it was in 2005.

welsh.monthly.2018.jan.fig.22

There may be some unintended consequences in the global funding market for Dollars and the bond market in the U.S. from repatriation. Goldman Sachs and Bank of America Merrill Lynch estimate that 20% to 40% of the cash held overseas is in non Dollar assets. In order to bring non Dollar assets home, companies would first liquidate the investment, sell the currency they are denominated, and then purchase the Dollar with the proceeds. Potentially several hundred billions of other currencies could be sold and an equal amount of Dollars purchased, which could result in declines in some currencies and a rally in the Dollar. In 2005, the Dollar rose by 13% as money was repatriated, although other influences were certainly a factor.

welsh.monthly.2018.jan.fig.23

The Dollar has fallen more than 10% since the first few days of 2017 so it is massively oversold and sentiment toward the Dollar is uniformly negative. The Dollar is likely to make a trading low in the first quarter and begin to rally before mid 2018.

A 2016 Deutsche Bank study based on 12 companies with large overseas cash balances suggested that almost 25% of the total was held in cash equivalents or money market funds. As companies return cash to the U.S., a reliable source of Dollar funding for global money market funds and banks could shrink and result in higher dollar funding costs for currency trading as measured by the crosscurrency basis.

welsh.monthly.2018.jan.fig.24

In addition, even as profits are held overseas, the money can be used for investing and often is in high quality U.S. corporate bonds and Treasury bonds. Since liquidity will be a key consideration for any company liquidating assets held overseas, the liquidity of the U.S. corporate bond market and especially the Treasury market would make it an easy decision to sell those assets as opposed to those that are less liquid. To the extent this occurs, the selling of bonds by corporation repatriating overseas assets would put upward pressure on corporate and Treasury bond yields. Rather than being a source of demand, corporations could add to the supply of Treasury bonds just as the Treasury will boost supply by more than $350 billion in 2018 and the Federal Reserve is curbing its purchases by $420 billion. The potential mismatch between supply and demand sounds like it could become a perfect storm for the Treasury bond market, which is why I have recommended shorting Treasury bonds by using the 1 to 1 inverse ETF TBF. At a minimum, I expect the 30-year Treasury yield to rise to 3.15% to 3.20%, and possibly as high as 3.60% to 3.75% in 2018.

Gold and Gold Stocks

In the December Macro Tides and this month’s letter I have discussed many reasons why inflation is likely to rise in 2018 and potentially more than the Federal Reserve and most investors expect. If wage growth begins to pick up and core inflation as measured by the PPI, CPI, and PCE move toward the Fed’s 2.0% inflation target, investors are likely to become interested in owning Gold and Gold stocks. In the December 11 Weekly Technical Review I noted that Gold and Gold stocks were already oversold and recommended a 25% position if Gold fell below $1230.00 and the gold stock ETF (GDX) traded below $21.30. On December 12, GDX traded down to $21.27.

In the December 18 Weekly Technical Review entitled “Two Opportunities for Early 2018", I discussed a number of technical reasons why I thought it was time to add to Gold and Gold stocks. One positive was the positioning in the Gold futures market.

“Positioning in the futures market is probably the best measure of sentiment since it shows how money is positioned. When positioning becomes extreme, with Large Speculators holding a large long or short position, the odds are high that the trend is about to change. Large Speculators are trend followers so by definition as a group they hold their largest long position as an uptrend is nearing a high and the largest short position after a large decline that is close to a bottom. The unwinding of large long positions held by Large Speculators contributes to a decline as they sell, and pushes prices higher as they buy to cover a large short position. The positioning in the futures suggests Gold is likely rally to at least $1305 and could make a run at the September high of $1357 in the first quarter of 2018."

Based on the improved positioning in the futures market, I increased the position in GDX to 50% on December 18 at $22.17. On December 19, GDX opened at $22.16 and traded down to $22.035, so subscribers had the opportunity to enter GDX below $22.17. Based on the bullish outlook, I also established at 25% position in the Junior Gold stock ETF GDXJ at $32.035. On January 2, GDX closed at $23.82, GDXJ at $35.14, with Gold closing at $1316.97. If Gold does rally to near $1357, GDX may trade above $25.25 and GDXJ above $37.00.

A note about positioning: Many advisors allocate 5% or so to Gold and maintain that allocation through thick and thin as a form of ‘insurance’. This makes little sense to me. Given the volatility in Gold and Gold stocks, there are times to have less than a normal allocation and times to hold a larger than normal allocation. As discussed, the upside potential for Gold and the Gold stocks may be significant which argues for holding a larger than normal allocation. If Gold does rally to $1350 and GDX pushes above $25.25, the above average portion of the allocation can be pared to the normal allocation. Approaching Gold and Gold stocks in this manner allows Gold and Gold stocks to be accretive to portfolio performance rather than a mindless allocation that helps sometimes and is a drag at other times.

In my Tactical Sector Rotation program, a normal position is 25%. A 25% position in GDX thus meant a position of 6.25% which was increased to 12.50% on December 18. The position in GDXJ is therefore 6.25%.

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