Weekend Reading: Recession Risk Hidden In Tax Bill

Authored by Lance Roberts via RealInvestmentAdvice.com,

Since the election, equity bulls have been pinning their hopes on “tax cuts” as the needed injection to support currently elevated stock prices. Stocks have advanced sharply since the election on these expectations, and while earnings have recovered, primarily due to the rise in oil prices, whatever economic growth was to come from tax reform has likely already been priced in. 

For some background on our views, both Michael Lebowitz and I have been discussing the tax bills as they are currently proposed since May of this year.

Buy The Rumor – Sell The News

We are currently in the second longest economic expansion since WWII. While Republican lawmakers are betting on jump-starting economic growth, the problem becomes the length of the current liquidity-driven expansion. All economic cycles end, and we are already closer to the end of the current expansion than not.

However, Patrick Watson over at Mauldin Economics recently made a brilliant observation. To wit:

“The gap between the gray line (potential GDP) and the red line (actual GDP) represents unused capacity. You can see we had a lot of it at the recession’s 2009 depth. The gap slowly shrank since then. Now it’s closed.

 

Great news, right? Yes, it is—but don’t celebrate just yet.

Actual GDP can’t stay above potential GDP for long before bad things start happening. This chart proves it:”

“We see here how GDP moved above and below its potential since the 1970s. Notice that each time the green line went above zero, a recession (the gray bars) began soon after.

‘Soon’ can vary, of course. GDP ran above potential for extended periods in the late 1990s and 2006–2007, but in both cases, intense downturns followed. Plus, the Fed wasn’t tightening as it is now—which suggests the current expansion is at least approaching its endpoint.”

While the Trump administration, and congressional Republicans, suggest their tax changes will stimulate years of economic growth and more than pay for themselves, the reality is likely quite the opposite.

What investors are missing is that while tax reform could well provide for a modest bump to GDP growth, that growth bump is being offset by the Federal Reserve tightening monetary policy by lifting interest rates. Don’t forget, the reason the Fed lifts interest rates is to SLOW economic growth to quell inflationary pressures.

Furthermore, as the brilliant minds at the Committee for a Responsible Federal Budget penned recently, the tax reform legislation will likely bring back trillion-dollar deficits by 2019. To wit:

“If they aren’t careful, we estimate legislation under consideration could bring back trillion-dollar deficits by next year. Even under current law, deficits are likely to reach almost $600 billion this year and $700 billion next year. By our estimate, a combination of tax cuts, sequester relief, and other changes would increase deficits to $1.05 trillion by 2019 and $1.1 trillion by 2020.”

Of course, a trillion-dollar deficit would require further debt growth in order to fund the revenue gap. As the debt levels continue to expand, estimated to hit $30 trillion over the next 8-years, the impact to economic growth will continue to be negative. 

With the Federal Reserve already in the process of reducing their balance sheet, with the rest of the world set to follow, the primary support of the markets is quickly fading. This elevates the risk of a policy mistake by the Fed, and as Doug Kass noted Wednesday, the risk of a Congressional mistake has also risen: 

“History shows that if the Senate version is adopted and the corporate tax rate reduction is delayed for another year, the odds of a recession are greatly increased. (A position that Art Laffer has publicly taken.)

 

The biggest mistake made by the Reagan Administration was to delay the corporate cuts by a year as the Senate version does. Companies waited a year to expand capital investments back then – causing a recession in 1981-82.”

Just something to think about as you catch up on your weekend reading list.

Trump, Economy & Fed

Markets

Research / Interesting Reads

“As contrarians, the only thing to fear is the lack of fear itself.” – Bernie Schaeffer

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