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.

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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 raul@pathfinancial.net.

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How to Handle the Flash Crash of 2018

path flash crashAfter a meteoric rise, the stock market lost more than 6% in only two days. Why did this happen, and where do we go from here?

At the close of Monday, February 5 2018, the S&P 500 gave up more than all the year’s gains. Put in perspective this is not a large move: the index is roughly back to where it was just a couple of months before. Also, there are no clear fundamental reasons behind the decline: both the economy and corporate earnings are strong, unemployment is low, and the global economy is in good shape.

Some reasons behind the sharp fall are most likely technical, such as the high levels of margin debt, elevated P/E ratios, side-effects brought about by the purchase of insurance by some market participants, and so on. These kind of factors rarely portend a large, structural move to the downside.

There are, however, some fundamental weaknesses in the system. The most important is the enormous increase in private sector debt that both households and non-financial corporations have accumulated in the last few years. When and if interest rates rise too much or beyond a certain threshold, a much more serious credit-driven problem can materialize and evolve into a full-fledged crisis that could profoundly affect markets. The quick rise in interest rates last week may therefore have something to do with the stock market move, but we think that rates are not yet close to trigger widespread credit problems.

As we described in a recent newsletter, the recent tax cut is another reason for concern. This is because coming at a time of full employment it can cause the economy to overheat and inflation to climb, driving the Federal Reserve to tighten monetary policy. This could trigger the kind of credit crisis we fear.

Additionally, the tax cut is likely to create a large increase of public debt, which would limit options to fight the next inevitable recession and thus turn a normal deceleration of the economy into a more serious downturn.

We believe, however, that we are not yet at the edge of recession or a negative credit event. The swift market fall seems due, instead, to the kind of technical factors that we mentioned earlier. If so, it could be useful to explore what happened in similar situations in the past when stocks had technically-driven two- or three-day declines of more than 6-7%.

We looked at the history of the S&P 500 since its inception and we identified nine such instances, from the “Kennedy Slide” of 1962 to the China-driven volatility of August 2015. We did not include the Crash of 2008 because it was not a mere technical decline but the result of serious fundamental concerns about the viability of the banking system. While technical factors could have exacerbated the 2008-2009 market rout, they were clearly not the cause.
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In all these instances we observed that after a few days, weeks or months the market recovered virtually all the lost ground. While the market fell more than 6% twice during the bear market of 2000-2003, it also found full relief soon after, even if it eventually resumed its downward march.

In conclusion, it seems that it rarely pays to sell immediately after a sharp two- or three-day move. Waiting for markets to stabilize instead appears to be a better strategy, because prices eventually tend to rebound even if they keep falling later on. This appears to be the case especially after climbing for a while, as can be seen in the charts of 1987, 1989, 1997, 1998, 2000, 2011 and 2015.

Even though we are concerned about the longer-term market outlook due to the stretched credit conditions, we think that investors who want to reduce their exposure to risk assets will not have to wait long before the market reaches a better point if they want to sell.

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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 raul@pathfinancial.net.

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