How the tax bill made the next recession much more painful

today blog photoIf the stock market rally was a party, someone would be wondering if the punch bowl should be taken away. The tax bill, instead, has refilled the bowl to the brim. Party fun goes on, and the coming hangover has just gotten worse.

Shortly after the bill passed, Walmart, AT&T, Comcast and many other companies announced $1,000 bonuses to hundreds of thousands of employees. And this is peanuts compared to the large and permanent reduction in the corporate tax rate corporations get. The breaks extend to a mountain of profits accumulated abroad and a variety of loopholes that may lower taxes even further when they bring them back.

Corporate America was already flush with cash. The extra pile courtesy of the tax bill will spur some marginal increase in business investment and wages (as the $1,000 bonuses show), but the historical relationship between taxes and economic activity suggests that this effect is bound to be small.

Far more importantly, the extra money will accelerate stock buybacks. Data by the US Federal Reserve shows that corporate repurchases of stock have been a major source of demand for equities and arguably the most important factor in pushing stocks higher in recent years. Because it operated under the radar of individual investors, general belief in the soundness of the bull market never caught on. But now the tax cut is in place, and people are increasingly aware that offshore money will mostly go to dividends and repurchases. This is bringing a lot of investors in, pushing stocks even higher.

The tax cut, therefore, not only will have some marginal effect on economic activity, but also a hugely positive impact on the demand and supply of stocks. This makes it without a doubt a positive for the stock market. So what is not to like?

In our view, the tax cut comes exactly at the wrong time.

Back in the aftermath of the financial crisis the world desperately needed a fiscal shot in the arm – lower taxes, higher spending, or both. But politicians in the US and Europe, claiming concern by high levels of debt, declared that austerity was the only acceptable way to fight the crisis and denied the world of this medicine.

This was an enormous policy error. Without any fiscal help, central bankers were forced to engineer a global recovery through aggressive monetary loosening, at the cost of severe distortions such as zero (or negative) interest rates, massive asset inflation, and a huge accumulation of private debt.

But monetary authorities accomplished their goal. The world is firmly in growth territory, the US is at full employment, and inflation has stayed low. Not only we came out in pretty good shape, but conditions are now ideal for dealing with those distortions created by “unconventional” policies.

The tax bill, however, injects a sharp fiscal stimulus that not only is unnecessary at this time but also creates the opposite problem. If the economy speeds up too much or inflation starts rising, central bankers could be forced to raise rates too quickly to keep things under control. This is dangerous in a world with high indebtedness. And once again, fiscal and monetary policies will be at odds.

Even if inflation stays low and the economy does not overheat, the tax cut is bound to increase levels of public debt by at least $1TN over the next decade, according to the Congressional Budget Office, the Joint Committee on Taxation, and the Tax Policy Center. This will leave even less room for deploying fiscal tools (i.e. higher spending and/or even lower taxes) to fight the next recession when it comes.

This is a serious issue. While things look good right now, the business cycle is not dead. The current expansion has been running for 104 months straight, and we are well positioned to break the 120-month all-time record. When the streak ends, the size of outstanding public and private debt are very likely to be much larger than in 2008.

And it is a good bet that, unless the world’s political landscape changes radically, politicians will again be horrified by levels of debt and refuse to stimulate the economy through fiscal means, just as they refused during the last crisis. Monetary authorities will have no choice but loosening policy way too much, and the cycle will start all over again from a more extreme point of indebtedness.

Thus the tax bill has quite certainly, and unnecessarily, made future downturns far more painful than they needed to be. But when people party they don’t think about hangovers, especially when everybody was served another round. Higher stock prices in the short term are likely. What may happen later will not be as fun.


Raul cropped for facebookRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or

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Why bonds collapsed and what you can do about it

pathThe result of last week’s election made some Americans happy and others miserable. Given how high emotions are running, it is remarkable that voter participation was so low: Almost 47% of voters did not show up to choose the next president. Many people, it seems, were indifferent. Not so the bond market.

Take the US 10-year note, for example: in the week from 11/4 through 11/11 it climbed 44 basis points, from 1.78% to 2.22%. This is the largest move, both in absolute and relative terms, since the New York Fed started publishing data in 1962. Because prices and interest rates moved in opposite direction, bonds crashed.


The size of this change is hard to overstate. It dragged bonds around the world: the German 10-year bond rate surged 45 basis points from -0.13% to 0.32%, for example. The UK’s 10-year bond rose by an astonishing 78 basis points, from 0.64% to 1.42%.

These moves wiped out trillions of dollars of savings allocated to fixed income. Wealth destruction is probably more brutal in Europe and Japan, where individual savers and institutional investors rely far more heavily than Americans on fixed-income products.

Why did bonds suffered this much?

President-in-waiting Trump has said during the campaign that, under certain circumstances, he would be willing to renegotiate the US debt, which would be a repudiation of the “full faith and credit of the United States.” This is exceedingly unlikely to happen, both because he would be unleashing a catastrophe and because the legal hurdles are too steep. But he said it, and it affects perception.
Many economists expect that the combination of large tax cuts and public infrastructure spending promised by Donald Trump would increase the size of the US debt by trillions of dollars, even after accounting for the potential growth generated by the stimulus. We don’t know yet whether this is in fact the plan of the new administration. If it is, and economists are right, it will also weaken the credit quality of US Treasuries.

Inflation expectations have gone up, partly because of the possible stimulus mentioned above. Ten-year expected inflation (calculated from TIPs) climbed 20 basis points, from 1.68% on 11/4 to 1.88% on 11/11. In part, this is a consequence of the possible stimulus discussed above.

Whatever the reasons, the market appears convinced that rates are heading higher, and Investors who are still exposed to long-duration Treasuries need to look at ways of transitioning out of them.
Unfortunately, the precipitous and historical magnitude of the recent move raises the question of whether to cut losses now or to wait for some kind of “relief rally” providing a better exit point.
The problem is that rates are universally expected to climb. Therefore, the majority of investors are likely to be waiting for the same exit point, which gets in the way of it happening at all.

Another problem is that when the Fed started raising or lowering rates in the past, it almost never stopped at one or two hikes. The higher-rate path that started last December is likely to be a multi-hike trail. This will push bond rates higher still.

Investors are exposed to bonds in two ways. One is by holding individual bonds, which is not the worse option because the scheduled payments take place independent of market conditions. Another is through mutual bond funds, which unlike individual bonds are at the mercy of rising rates and have no guaranteed schedule of payments. Unfortunately, individual investors are far more likely to hold bond funds than individual bonds.

The larger issue is that fixed income, up to now an integral part of investment portfolios, may no longer be the best asset class to diversify equity exposure.

The well-known “60/40” strategy that calls for a mix of 60% in stocks and 40% in bonds worked very well for the last 35 years of declining interest rates. But, if rates have bottomed out and start to climb in earnest, bond funds could be a significant drag on portfolio performance. This is especially so in the early stages of rate increases, when higher interest payments are not enough to offset losses of principal. To make matters worse, interest rate trends are measured in decades, not years. Once they start, it’s anybody’s guess when they will end.

Investors needing diversification may have to change their approach. One is through cash, which simply muffles equity returns. Another, which we advocate, is by abandoning the idea that a static diversification such as the “60/40” is appropriate for all market conditions. A better way, in our view, is to become considerably more active in asset allocation. We have developed specific processes to implement such active strategies.

In the last few years, investors were told many times that interest rates were heading higher only to see they go lower. It’s still early to say whether we have finally reached the turning point. But the new era that the United States is entering could finally get us there. If so, investors will need to change the way they diversify their portfolios going forward.

What now?
We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return. We implement this process for our clients and we tailor it for their specific circumstances. We can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. Please send us a request for a copy of our most recent whitepaper describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more.

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