Tax Bill Update

Previous articles have shown estimates of the GOP tax plan done by the Joint Tax Committee which have it leading to high deficits and not much economic growth. To counter some of its negativity, I have the chart below which shows that the CBO underestimated the GDP growth in 2003 after the Bush tax cuts were enacted. As you can see, actual nominal GDP growth was 1.2% higher than the estimate. The economic boost in the years following the tax cut might be better than the government estimates. Even though growth may have decelerated in 2018 because of cyclicality, it will probably end up being better than 2017 if the tax cuts are passed. This also means the estimates for the deficits in the next 10 years might be overzealous. I’m trying to look at all the analysis to figure out the most likely result of the tax plan. It’s a challenge because of how politically charged this topic can become.

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President Trump is going to give a speech on Wednesday. Hopefully, he mentions how the Democrats and Republicans will agree on a government spending bill by the deadline on December 22nd. The debate remains centered on defense spending with the GOP wanting more and the Dems resisting. With the GOP tax plan, the Senate and the House have appointed conferees to form a compromise between both plans. It seems likely the corporate tax rate will be cut to 20%. The goal is to get the compromise plan done by this week. When the plan comes out, the market will have a swift reaction, with the winners which are likely the banks and the retailers moving up and the losers which are tech firms with low tax rates and little cash overseas moving down. Next both chambers will vote on the plan, needing a simple majority to pass it. The two questions remaining are what will be in the compromise bill and whether both chambers will vote in favor of it. That vote should occur next week, making it the last noteworthy event of the year which can cause volatility in the markets.

Best Year Ever

If you are focused on records, then you’re going to be excited to see what happens in the next two weeks of trading as the S&P 500 might have the first year with positive total returns every month of the year. This will be the 14th straight month of positive returns which is a record as well. Obviously, you can’t come up with a historical analysis for what this usually means because it hasn’t happened before. The S&P 500 is up 0.47% for the month so far which means the possibility is high it will set that record. This isn’t actionable information because you wouldn’t want to sell your stocks just because of this streak. In fact, low volatility usually begets lower volatility. The point is to contextualize the rally. How you need to frame this depends on who you surround yourself with and where you get your information. If you follow many bears, then recognize this doesn’t mean a crash is coming. If you are around bulls, recognize that discipline says to take profits when bullish streaks are elongated and when the market goes up too far too fast.

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Fed To Hike Rates Wednesday

Wednesday is the Fed’s December meeting in which it is expected to hike rates by 25 basis points. The CME FedWatch tool shows there is an 85% chance of 1 hike and a 15% chance of 2 hikes. That’s the highest chance of 2 hikes I’ve seen. It would be shock if the Fed hiked twice. It makes no sense to me because it could easily have hiked in November if it wanted to hike rates that badly. The first step is to hike rates every meeting before the Fed gets to start hiking rates more than once per meeting. The market is more focused on what Powell will do next year, than what the statement in this meeting says. For the first time in years, this FOMC statement won’t matter as much as the decision does.

JP Morgan’s estimate for the developed market’s monetary policy in the next 2 years is shown in the chart below. Some critics have been complaining about how interest rates and inflation have been low for years. However, that was the Goldilocks scenario. That was when stocks were supposed to outperform. We are headed into the beginning of the end of the cycle if the JP Morgan forecast is accurate. As you can see, the policy rate for developed markets is expected to get to just south of 2% in early 2020. Last cycle, rates went up by 3% before a recession. It’s tough to say if that will repeat because rates were lower for longer this cycle. The unwind in QE could make for tighter financial conditions with less rate hikes. It’s also possible that the downtrend in inflation and bond yields could end, meaning rates could go much higher. That scenario would probably lead to stagflation as rate hikes would cause a recession, but inflation wouldn’t be tamed. The rate hikes in 2018 will be the first consistent hikes this cycle. As I have said, I expect the ECB to start raising rates in 2019 or 2020. It’s possible America goes into a recession before the other developed economies because it is further along on the hiking cycle. America dragging the global economy down would end the hike cycles of other countries like Europe prematurely.

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Conclusion

Not only will the Fed’s unwind and the ECB’s taper accelerate in 2018, but JP Morgan expects the rate hikes to come fast and furious. This could bring added volatility to the stock market, eventually ending the 14 month positive streak the S&P 500 is on. On the bright side, the GOP tax cut likely brings GDP growth more upside than expected by the CBO. I will be covering the next two weeks of discussions where the final tax plan will be hashed out. Each detail matters to investors.