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Investment Strategy

The Baton Passes from Monetary Policy to Fiscal Policy

With passage of the Tax Cuts and Jobs Act in December, the “stimulus baton” has emphatically been passed from monetary policy to fiscal policy. The resulting $200 billion of tax cuts will stimulate the economy even as monetary policy tightens.

Last year, we wrote about the necessity of the “stimulus baton” being passed from monetary to fiscal policy. With passage of the Tax Cuts and Jobs Act in December, the baton has emphatically been passed. The resulting $200 billion of tax cuts—combined with an anticipated $200 billion increase in budget spending—will stimulate the economy even as monetary policy tightens. The result will be an increase in employee wage growth, U.S. corporate productivity and earnings, and short-term interest rates. The net impact will be a substantial boost to economic growth.

As Figure One shows, the last calendar year of gross domestic product growth of more than 3 percent was 2005. And 4 percent was last seen in 2000. You must be almost 35 years old to have experienced a strong economy during your working life. The Tax Cuts and Jobs Act has the potential to boost our economy to a level of growth not seen in more than a decade. The consensus estimate for GDP growth in 2018 is 2.5 percent, but we believe that growth will exceed 3 percent—and could accelerate to nearly 4 percent.

Figure One: Real Gross Domestic Product Growth (1997-2016)

Corporate Earnings

Most Americans will feel the effects of the Tax Cuts and Jobs Act in the first months of 2018, as their take-home pay ticks up slightly due to lower withholding and reduced tax tables. This increase in cash flow will put approximately $100 billion more in Americans’ pockets in 2018, and it will drive consumer confidence and spending. That will boost corporate earnings.

More importantly for corporations, the corporate tax rate falls from 35 percent to 21 percent. That’s a 40 percent drop in the cost of taxes. As Figure Two shows, the U.S. had the highest corporate tax rate among the world’s 10 largest economies. Under the new rules, the U.S. is second behind the United Kingdom—and ahead of China at 25 percent. The magnitude of this drop will fuel corporate profits and make U.S. corporations much more competitive against their foreign peers. Firms are now better off building new facilities in the U.S., instead of overseas. This will result in more jobs for American workers.

Figure Two: Corporate Tax Rates in the World’s Top 10 Economies (2018)

Corporate Reinvestment

The Tax Cuts and Jobs Act could spark a corporate reinvestment boom, which should, over time, increase potential productivity, profits, and employee wages. One key provision allows corporations to immediately expense 100 percent of the cost of capital equipment. This strongly incentivizes firms to invest in new technology and capital goods, which are sorely needed. As Figure Three shows, U.S. corporations have cut their reinvestment (measured as a percentage of nominal GDP) in half over the past 30 years. In fact, the average age of U.S. plants and equipment is 12.7 years. This is the oldest average age since records began after World War II. This average age, while old, has grown each year since 2000.

Figure Three: U.S. Net Domestic Investment as a Percentage of Nominal GDP (1983-2017)

Given this lack of reinvestment, it is no wonder that productivity and wage growth have been so meager. Many publicly traded companies have used their cash flow (or borrowing power) to fund stock buybacks rather than investing in their businesses, which has hindered their ability to grow robustly in the future. They have prioritized current profits and stock prices over the long-term health of their enterprises. The new tax bill reverses these incentives, favoring corporate reinvestment in plants, technology, and employees.

Lower corporate tax rates should substantially increase earnings. Figure Four below shows that the corporate tax cut should increase after-tax earnings by 21.5 percent! These tax savings will be allocated to employees, reinvested in technology and plants and equipment, or returned to shareholders via higher dividends or increased stock buybacks. In some cases, companies are sharing this windfall with their employees. More than 100 companies, including Wells Fargo and AT&T, have announced plans to pay employee bonuses or increase wages. This, of course, will further boost consumer spending.

Figure Four: Impact of Corporate Tax Cut on Earnings

Repatriation of U.S. earnings held abroad will also boost the amount of cash available to increase U.S. plant and equipment investments, reduce debt, and return shareholder capital through stock buybacks or higher dividends. For example, Apple recently announced that it will open and staff a new campus as part of a $30 billion plan for investment in the U.S. as it repatriates a portion of its foreign earnings. That said, we expect most companies will opt to reduce debt because the Tax Cuts and Jobs Act increases the after-tax cost of debt. For example, a loan with a 5 percent rate cost the firm just 3.25 percent after tax in 2017. This year, the after-tax rate increases to 3.95 percent.

February Surprise

The reduction in taxes for individuals totals $100 billion this year. When surveyed, only 20 percent of respondents believe that their tax burden will decrease, yet 95 percent will reap the benefit of lower taxes. This is a setup for a very pleasant surprise in mid-February when the new tax withholding tables will hit their payroll statements. The unlucky 5 percent who will pay higher taxes are concentrated in states like New York, New Jersey, and California with higher-priced homes, high incomes, and high local property taxes. This is due to a cap on the deductibility of state and local taxes and mortgage interest.

Higher-priced homes in these areas become even less attractive when considering the decrease in the maximum mortgage amount—from $1,000,000 to $750,000—from which interest may be deducted. This would cost a new buyer of our hypothetical $2 million home about $5,000 more after tax.

Looking for Buyers

The longer-term implications of the Tax Cuts and Jobs Act include more reinvestment and, perhaps, fewer stock buybacks. Over the last eight years, corporations buying back their own shares have constituted the largest class of stock buyers. So if buybacks wane, the stock market will need support from a new and different class of investors.

What about retail investors? Will they step up to replace corporate buyers? In recent years, they have not been buying stocks. As Figure Five shows, over the past three years, retail investors have actually been net sellers of U.S. stock mutual funds and exchange-traded funds (ETFs) and net buyers of U.S. bond funds.

Figure Five: U.S. Stock and Bond Fund Money Flows (2009-2017)

Another potential implication of the new tax regime is a higher foreign exchange value for the U.S. dollar. If U.S. corporations bring their foreign profits home, they will be selling their foreign currencies to buy U.S. dollars, which will push the dollar higher. Higher interest rates, which we predict, will add to the dollar’s support. A persistently strong dollar would prove to be a headwind for international developed and emerging market stocks.

Higher Interest Rates

While history does not provide us with a sufficient sample size, it does provide some food for the imagination in determining potential post-tax-cut market moves. About a month after the 2003 tax cut was signed, interest rates began a meaningful climb to higher levels. The yield on the 10-year U.S. Treasury increased by 1.5 percent within three months.

While we are not predicting a repeat of this event, this historical example illustrates how tax reform can and has impacted the markets quickly and consequently. While global bond buying continues, on net, from the large central banks (although the Fed has begun to shrink its balance sheet), the growth rate for 2018 will be the lowest in years at just 2.5 percent. The Fed stopped adding to its purchased bond fund portfolio in 2014, but the European Central Bank (ECB), the Bank of Japan (BOJ), and the People’s Bank of China (PBOC) continued buying. The ECB is expected to cease its buying this fall. Thereafter, the runoff from the Fed is expected to outweigh BOJ and PBOC buying.

Figure: Six: Select Central Bank Balance Sheets (2005-2017)

For 2019 and beyond, we expect that central banks will have ceased their quantitative easing (bond-buying) programs and will have started quantitative tightening. At present, we argue that our 10-year U.S. Treasury rate—and, by implication, the 30-year mortgage rate—is not being set by the market; it is a manipulated or mostly government-controlled rate. We expect that, by the end of 2019, the market will once again setting rates for Treasurys and mortgages. As a result, rates could move one-half to one-and-a-half percent higher. These higher rates should be viewed as normal rates for the level of economic growth and inflation we are experiencing.

The impact of the Tax Cuts and Jobs Act will be far reaching and historic. It will boost growth above the current 2.5 percent consensus for GDP growth, boost U.S. corporate earnings by 10 percent (or more) year over year, encourage much-needed domestic corporate investment, and enrich workers. A small fraction of Americans will pay more, but they will also benefit from the surge of economic growth and corporate earnings we expect. While several risks exist—notably, an acceleration of inflation and interest rate hikes—we attach a low probability to them at this time. We will be monitoring the markets and economy for signs of overheating.